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Chapter 7

Theory of Costs and Revenue

Introduction
Main objective of a firm : Profit Maximisation
Profit = Revenue Cost of Production
Cost of production is the expenditure incurred
by a firm when producing a given level of
output
Revenue is the total income earned by a firm
when it sells a given level of output

Types of Costs
Economic Costs
Private vs Social
Time Element & Costs

Economic Costs
Explicit Costs

Implicit Costs

Incurred when
a firm hires or
purchases a
factor of
production

Imputed costs
of a firm when
it uses its own
factors of
production

Termed as
Money Costs

Calculated
based on
opportunity
cost

Normal Profits
Minimum
profits
required to
keep the
entrepreneur
in production
in the long
run

Economic Costs
Explicit cost
Fast Fans Ltd
borrows money
from the bank @
8% p.a. to buy a
machine

V
S

Implicit cost
Fast Fans Ltd
uses its own
money (reserves
and surplus) to
buy a machine
Opportunity cost
of using the
firms own
money is
the Implicit Cost

Private vs Social Costs


Private Costs : incurred by a firm when it
produces a commodity
Eg: cost of raw material

Social Costs : borne by society as a whole


when a firm produces a commodity
Eg: loss of marine life from pollutants from
production process

Time Element and Costs


Very Short Run
All factors are
fixed
Costs remain
constant
Fixed costs

Time Element and Costs


Very Short Run
All factors are
fixed
Costs remain
constant
Fixed costs

Short Run
One factor is
variable; others
fixed
Cost changes to
the extent of
variable factor
Variable cost &
Fixed cost

Time Element and Costs


Very Short Run
All factors are
fixed
Costs remain
constant
Fixed costs

Short Run
One factor is
variable; others
fixed
Cost changes to
the extent of
variable factor
Variable cost &
Fixed cost

Long Run
All factors are
variable
Costs changeable
Variable costs

Costs in the Short Run


Total Fixed Cost (TFC)
Costs that do not change with the change in
output

Total Variable Cost (TVC)


Costs that change with the change in output

Total Cost
TC = TFC + TVC

Total Fixed Cost (Rs)

Total Fixed Costs

TFC

Output

Output TFC
(Q) (Rs)
0
1
2
3
4
5
6

100
100
100
100
100
100
100

Total Variable Cost


(Rs)

Output TFC
(Q) (Rs)
0
1
2
3
4
5
6
7

100
100
100
100
100
100
100
100

TVC
(Rs)

Total Variable Cost

0
20
30
35
45
60
80
126

TVC
TFC

Output

Total Cost
Output
(Q)

TFC
(Rs)

TVC
(Rs)

TC = TFC + TVC
(Rs)

0
1
2
3
4
5
6
7

100
100
100
100
100
100
100
100

0
20
30
35
45
60
80
126

100
120
130
135
145
160
180
226

TC

Total Cost (Rs)

Total Cost

TVC
TFC

Output

Total Cost (Rs)

Total Cost

TC

TVC
TFC

TFC

Output

Distinction between fixed costs and


variable costs
Fixed costs

Variable costs

Do not vary with the quantity


of output produced

Vary with the quantity of


output produced

Distinction between fixed costs and


variable costs
Fixed costs

Variable costs

Do not vary with the quantity


of output produced

Vary with the quantity of


output produced

Can never be zero in the


short run. Have to be incurred
even if production falls to
zero

Can fall to zero in the short


run, as they are directly
related to the level of output
produced

Distinction between fixed costs and


variable costs
Fixed costs

Variable costs

Do not vary with the quantity


of output produced

Vary with the quantity of


output produced

Can never be zero in the


short run. Have to be incurred
even if production falls to
zero

Can fall to zero in the short


run, as they are directly
related to the level of output
produced

In the short run a firm can


continue production even if
fixed costs are not met

In the short run a firm will


stop production if variable
costs are not met

Distinction between fixed costs and


variable costs
Fixed costs

Variable costs

Do not vary with the quantity


of output produced

Vary with the quantity of


output produced

Can never be zero in the


short run. Have to be incurred
even if production falls to
zero

Can fall to zero in the short


run, as they are directly
related to the level of output
produced

In the short run a firm can


continue production even if
fixed costs are not met

In the short run a firm will


stop production if variable
costs are not met

Related to the fixed factors of


production

Related to the variable


factors of production

Eg: rent

Eg: wage

Points to Remember
TC is obtained by adding TVC and TFC
Shape of the TC is dependent upon the
shape of the TVC
Vertical distance between the TFC and TC
gives the TVC

Costs in the Short Run


Average cost per unit cost of production
average fixed cost (AFC)
AFC = TFC
Q
average variable cost (AVC)
AVC = TVC
Q
average total cost (ATC)
ATC = TC
Q
ATC = AFC + AVC

Average Fixed Cost (AFC)

Average Fixed Cost

As output
increases, AFC
falls continuously
AFC tends towards
the x-axis, but
does not touch it
AFC
O

Quantity of output

AFC is never equal


to zero, as TFC is
never zero

Average Variable Cost


U-shaped curve
Average Variable Cost

AVC

Reflects the law of


variable proportions
Downward sloping
part of curve
Increasing Returns to
a factor

Quantity of output

Upward sloping part


of curve
Decreasing returns to
a factor

Average Total Cost


Cost incurred per unit of output
ATC = AVC +AFC

Schedule of AFC, AVC, ATC


Output AFC
AVC
ATC
0
1
100
20 120
2
50 15 65
3
33.3
11.7
45
4
25 11.25* 36.25
5
20 12 32
6
16.6
13.3
29.9*
7
14.3
18 32.3

* - min.pt.

Average Total Cost


AFC: Average Fixed Cost

AVC

Costs

AVC: Average Variable Cost

AFC
0
Output (Q)

Average Total Cost


Uptil output oa:
AFC falls

ATC

AVC falls

AVC

Costs

ATC falls

AFC
0

a
Output (Q)

Average Total Cost


Between output ab:
AFC fall > AVC rise

ATC

ATC falls

Costs

AVC

AFC
0

a
Output (Q)

Average Total Cost


Beyond output ob:
AFC fall < AVC rise

ATC

ATC rises

Costs

AVC

AFC
0

a
Output (Q)

Average Total Cost


As AFC tends to zero,
ATC tends to AVC

ATC

Costs

AVC

AFC
0

a
Output (Q)

Costs in the Short Run


Marginal cost
additional cost incurred in producing an
additional unit of the output
MC = TC
Q
Suppose the cost of producing 3 fans is Rs 135
and the cost of producing 2 fans is Rs 130
Marginal Cost of the 3rd fan is Rs 5

Marginal Cost
Output
of fans
0
1
2
3
4
5

TC
(in Rs)
100
120
130
135
145
160

TVC
(in Rs)
20
30
35
45
60

MC
(in Rs)
20
10
5
10
15

Marginal Cost

Schedule of TC, TVC and MC

MC is U-shaped
Reflects the change in TVC
Area under MC gives TVC

MC

Quantity of output

Relationship between TC and MC


TC

Prior to point A, MC
is falling. TC
increases at a
diminishing rate.
O

Quantity of output

MC

Quantity of output

(Law of Diminishing
Costs)

Relationship between TC and MC


TC

At point A, MC is at
its minimum. TC is at
point of inflexion
O

Quantity of output

MC

Quantity of output

Relationship between TC and MC


TC

Quantity of output

MC

Quantity of output

Beyond point A, MC
is increasing. TC is
increasing at an
increasing rate. (Law
of Increasing Costs)

Relationship between TC and MC


TC

Quantity of output

Prior to point A, MC is
falling. TC is increasing at
a diminishing rate. (Law of
Diminishing Costs)
At point A, MC is at its
minimum. TC is at point of
inflexion

MC

Quantity of output

Beyond point A, MC is
increasing. TC is increasing
at an increasing rate. (Law
of Increasing Costs)

Relationship between AVC and MC

Costs (Rs)

MC

Output

AVC

Prior to point A, MC <


AVC;
AVC

Relationship between AVC and MC

Costs (Rs)

MC

AVC

Prior to point A, MC <


AVC;
AVC
Between points A and B,
MC < AVC; AVC

Output

Relationship between AVC and MC

Costs (Rs)

MC

AVC

Prior to point A, MC <


AVC;
AVC
Between points A and B,
MC < AVC; AVC

Output

At point B , MC = AVC;
AVC is at its minimum

Relationship between AVC and MC

Costs (Rs)

MC

AVC

Prior to point A, MC <


AVC;
AVC
Between points A and B,
MC < AVC; AVC

Output

At point B , MC = AVC;
AVC is at its minimum
After point B , MC > AVC;
AVC starts to rise

Relationship between ATC and MC

Costs (Rs)

MC

Output

ATC

Prior to point A, MC <


ATC;
ATC

Relationship between ATC and MC

Costs (Rs)

MC

ATC

Prior to point A, MC <


ATC;
ATC
Between points A and C,
MC < ATC; ATC

Output

Relationship between ATC and MC

Costs (Rs)

MC

ATC

Prior to point A, MC <


ATC;
ATC
Between points A and C,
MC < ATC; ATC

Output

At point C , MC = ATC;
ATC is at its minimum

Relationship between ATC and MC

Costs (Rs)

MC

ATC

Prior to point A, MC <


ATC;
ATC
Between points A and C,
MC < ATC; ATC

Output

At point C , MC = ATC;
ATC is at its minimum
After point C , MC > ATC;
ATC starts to rise

Relationship between ATC, AVC and


MC
MC

ATC

Costs (Rs)

AVC

C
B
A

Output

MC cuts ATC and AVC at their respective minimum points

Costs in the Long Run


Long Run Total Cost (LTC)
Long Run Average Cost (LAC)
Long Run Marginal Cost (LMC)
No distinction between fixed and variable
costs

Long Run Average Cost


LAC = Long Run Total Cost
Output

Saucer shaped
Based on returns to
scale

Costs (Rs)

LAC

Output

Long Run Average Cost


LAC = Long Run Total Cost
Output

Saucer shaped

Costs (Rs)

Based on returns to
Scale

LAC

IRS

Output

Downward sloping part


due to increasing
returns to sale
(Decreasing Average
Cost)

Long Run Average Cost


LAC = Long Run Total Cost
Output

Saucer shaped

Costs (Rs)

Based on returns to Scale

LAC

IRS

S
DR

CRS

Output

Downward sloping part due


to increasing returns to
sale (Decreasing Average
Cost)
Upward sloping part due to
diminishing returns to scale
(Increasing Average Cost)

Long Run Average Cost


LAC = Long Run Total Cost
Output

Saucer shaped

Costs (Rs)

Based on returns to Scale

LAC

IRS

S
DR

CRS

Output

Downward sloping part due


to increasing returns to
sale (Decreasing Average
Cost)
Upward sloping part due to
diminishing returns to scale
(Increasing Average Cost)

Long Run Marginal Cost

Costs (Rs)

LMC =
LMC

LAC

Output

Long Run Cost


Factor Inputs

Also U - shaped
Cuts LAC at its
minimum point

Theory of Revenue
Total Revenue
Total money
earned by a firm
when it sells a
given amount of
output
TR = p x q,
where:
p is the per unit
price
q is the quantity
of output sold

Total Revenue Schedule


Output of fans
0

Total Revenue (Rs)


0

1
2

10
18

3
4

24
28

5
6

28
24

Total Revenue

Uptil point A, TR is
increasing

Total revenue

A
TR

At point A, TR is
maximum
Beyond point A, TR
starts declining

O
Quantity of fans sold

Average Revenue
Total Revenue
AR =
Output sold

Average Revenue
Total Revenue
AR =
Output sold
pxq
=p
=
q
AR = per unit price of the
commodity

Average Revenue
Average Revenue
Output Total

Average

Revenue (Rs)
0

10

10

18

24

28

28

5.6

24

Revenue (Rs)

Average Revenue
Average Revenue
Average

Revenue (Rs)
0

10

10

18

24

28

28

5.6

24

Revenue (Rs)
Average revenue

Output Total

AR
Quantity of fans sold

AR Curve downward
sloping

Average Revenue
Average Revenue
Average

Revenue (Rs)
0

10

10

18

24

28

28

5.6

24

Revenue (Rs)
Average revenue

Output Total

AR
Quantity of fans sold

As more units of output sold, price must fall


AR

as Q

AR curve is the demand curve faced by the

Marginal Revenue
MR =

MR =

Change in Total Revenue


Change in units of output sold
TR
Q

Marginal Revenue
MR =

MR =

Change in Total Revenue


Change in units of output sold
TR
Q

Marginal Revenue Schedule


Output
Revenue

Total Revenue

Marginal

10

10

18

24

28

28

MR =

MR =

Change in Total Revenue


Change in units of output sold
TR
Q

Marginal Revenue Schedule


Output
Revenue

Total Revenue

Marginal revenue

Marginal Revenue

Quantity of fans sold

Marginal

10

10

18

24

28

28

MR

MR =

MR =

Change in Total Revenue


Change in units of output sold
TR
Q

Marginal Revenue Schedule


Output
Revenue

Total Revenue

Marginal revenue

Marginal Revenue

Quantity of fans sold

Marginal

MR Curve

10

10

18

24

28

28

Downward
sloping
Could be
negative

MR

Relationship between TR & MR


Total revenue

A
TR

Output sold

Marginal revenue

Prior to point A, MR is
positive but falling, TR
increases at a
diminishing rate
At point A, MR = 0 and
TR is maximum
Beyond point A, MR is
falling and negative; TR
starts falling

MR Output sold

Relationship between AR and MR


When MR = AR, AR is
at its maximum
Revenue (Rs)

When MR is
decreasing and is less
than AR, AR is falling
AR

MR Output sold

MR can be 0; AR can
never be 0

Relationship of TR, MR & AR under


perfect competition

TR / AR / MR

TR

Units of output sold

TR rises at a constant
rate

Relationship of TR, MR & AR under


perfect competition

TR / AR / MR

TR

AR = MR

TR rises at a constant
rate
AR is constant
MR is constant

Units of output sold

AR = MR

Relationship of TR, MR & AR under


Perfect Competition

TR / AR / MR

TR

AR = MR

TR rises at a constant
rate
AR is constant
MR is constant

Units of output sold

AR = MR

TR, AR and MR under perfect competition


Units sold

Market Price per unit (Rs)

TR(Rs)

AR(Rs)

MR(Rs)

Relationship of TR, AR & MR under


Imperfect Competition
Total revenue

A
TR

Output sold

Firm retains some flexibility to


determine price
As price falls quantity sold
increases => AR curve is
downward sloping

MR / AR

MR also reduces

AR

Output sold

MR

TR increases at an diminishing
rate and then falls

Producers Equilibrium
That level of output produced and sold,
whereby a firm maximises profits
Profits = Revenue Cost
2 methods of determining produces
equilibrium
Gross Profit Approach
Marginal Revenue Marginal Cost Approach

Gross Profit Approach


Profit = Revenue Cost
TC = TFC + TVC
TFC is constant
Gross profit = Revenue
TVC
Area under MC curve = TVC
Area under MR curve = TR

Gross Profit Approach


MC

Costs / revenue (Rs)

P = MR

P = MR: Initial
Price Line
MC: Marginal
Cost Curve

O
Quantity of output

Gross Profit Approach

Costs / revenue (Rs)

MC

P = MR

At Output OQ:
P= MC
TR = OAEQ
TVC= OBEQ

Profit = AEB

Q
Quantity of output

Gross Profit Approach

Costs / revenue (Rs)

MC

P = MR

At Output
OQ*:
P > MC
TR = OAFQ*

TVC= OBGQ*
G

Q*
Quantity of output

Profit = AFGB

Gross Profit Approach

Costs / revenue (Rs)

MC

P = MR

At Output
OQ*:
Profit is LESS
than at OQ by
FEG

Q*
Quantity of output

Firm could still


earn this profit

Gross Profit Approach


MC

Costs / revenue (Rs)

P = MR
D

At Output OQ:
P < MC
TR = OADQ
TVC= OBCQ

Profit = AEB
minus ECD

Q
Quantity of output

Gross Profit Approach


MC
C

Costs / revenue (Rs)

Firm loses profits


by this area
E

P = MR
D

Ql
Quantity of output

At Output OQ:
Profit is LESS
than at OQ by
ECD

Gross Profit Approach

Costs / revenue (Rs)

MC

P = MR

Profits are
maximised at
OQ, where
P = MC

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach
MC

Costs / revenue (Rs)

P = MR

P = MR: Initial
Price Line
MC: Marginal
Cost Curve

O
Quantity of output

Marginal Cost Marginal Revenue


Approach

Costs / revenue (Rs)

MC

P = MR

At point E, P =
MC
Output
produced OQ

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach

Costs / revenue (Rs)

MC

P = MR

At output OQ:
P > MC
MR: AQ
MC: BQ

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach
MC

Costs / revenue (Rs)

Marginal Profit
A

P = MR

At output OQ:
P > MC
MR: AQ
MC: BQ

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach
MC

Costs / revenue (Rs)

Marginal Profit
A

P = MR

Increase
output
as long as
P>MC

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach
MC

Costs / revenue (Rs)

P = MR

At output OQ:
P < MC
MR: DQ
MC: CQ

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach
MC
C

Costs / revenue (Rs)

Marginal Loss
E

P = MR

At output OQ:
P < MC
MR: DQ
MC: CQ

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach
MC
C

Costs / revenue (Rs)

Marginal Loss
E

P = MR

Reduce output
as long as
P<MC

Q
Quantity of output

Marginal Cost Marginal Revenue


Approach

Costs / revenue (Rs)

MC

P = MR

Profits are
maximised at
OQ, where
P = MC

Q
Quantity of output

Break Even Analysis


Defined as the level of output where TR =
TC
Costs include: Fixed, Variable, Normal
Profits
At break even, firm earns normal profit

Break Even Analysis


Break-even chart
Output
TVC
Profit/Loss

TFC

20

TC

20

AR = P

TR

Profit/Loss

-20

Loss

Break Even Analysis


Break-even chart
Output
TVC
Profit/Loss

0
10

TFC

TC

AR = P

TR

Profit/Loss

20

20

-20

Loss

12

20

32

20

-12

Loss

Break Even Analysis


Break-even chart
Output
TVC
Profit/Loss

TFC

TC

AR = P

TR

Profit/Loss

20

20

-20

Loss

10

12

20

32

20

-12

Loss

20
Even

20

20

40

40

Break-

Break Even Analysis


Break-even chart
Output
TVC
Profit/Loss

TFC

TC

AR = P

TR

Profit/Loss

20

20

-20

Loss

10

12

20

32

20

-12

Loss

20
Even

20

20

40

40

30

24

20

44

60

16

BreakProfit

Break Even Analysis


Break-even chart
Output
TVC
Profit/Loss

TFC

TC

AR = P

TR

Profit/Loss

20

20

-20

Loss

10

12

20

32

20

-12

Loss

20
Even

20

20

40

40

30

24

20

44

60

16

Profit

40

26

20

46

80

34

Profit

Break-

Break Even Analysis


Break-even chart
Output
TVC
Profit/Loss

TFC

TC

AR = P

TR

Profit/Loss

20

20

-20

Loss

10

12

20

32

20

-12

Loss

20
Even

20

20

40

40

30

24

20

44

60

16

Profit

40

26

20

46

80

34

Profit

Break-

Costs and revenue (Rs)

Break Even Analysis


At breakeven:
TR = TC

TR

TC

=> TR
q

B
Supernormal profit
Break-even or Normal profit

Loss

Output

TC
= q

=> AR = ATC