CHAPTER 8
COST AND REVENUE
STRUCTURE
LEARNING OBJECTIVES
By the end of the chapter, you should be able to:
-define costs
-explain the types of costs
-distinguish long run and short run
-illustrate average cost using diagrams
-explain the terms marginal costs, marginal revenue
-distinguish between abnormal, normal and subnormal profit
-identify the profit maximising rule
-explain the concept of economic efficiency
What are Costs of production
-The term costs are the sacrifices incurred by the business as they produce
goods and services which can be financial or non-financial.
-The theory of costs is concerned with all expenses that a firm incurs during
the production process and how these expenses are related.
-total costs are subdivided into two namely fixed costs and variable costs
-Total Costs =Fixed costs +Variable Costs
Types of Costs
i) Fixed Costs (FC)
A cost of production that does not change over a given range of quantity.
Fixed cost are indirectly related to quantity of a business.
Fixed costs are totally independent of output, that is, they do not vary
with output.
Fixed costs have to be paid out even if the factory stops production;
hence they are the firm’s overheads.
Fixed costs include rent paid for the use of premises and interest paid on
loans.
(i) Variable Costs (VC)
Variable costs are incurred by the firm on the variable factor inputs such
as raw materials and labour.
They are direct costs of production.
Thus variable costs vary in direct proportion to output.
They are zero when output is zero and rise directly with output e.g. wages
paid to shop floor workers and the cost of buying raw materials.
-Total costs, Fixed costs and variable costs can be shown below
(ii) Marginal Costs (MC)
The marginal cost is the addition to total cost resulting from the production of
an additional unit of output.
-In other words, marginal cost is the additional cost of producing one more unit
of output.
- It refers to the change in total cost that result s from a change in output by one
unit. –
-MC =TCn-TCn-1
Illustration of Total Cost, Fixed Costs, Variable Costs and Marginal
Costs calculation
Quantity Fixed Variable Total Marginal
costs cost Cost cost
0 50 - 50 -
1 50 80 130 80
2 50 110 160 30
3 50 130 180 20
4 50 210 260 80
5 50 300 350 90
Average costs
-average costs are gotten from dividing the total cost, average cost or
fixed costs by the output or the quantity produced
(i) Average Fixed Cost (AFC)
An average fixed cost is total fixed cost divided by output. AFC = TFC
Q
AFC is the amount of money that each unit of Q produced should
contribute towards the payment of fixed costs.
The average fixed cost declines or falls continuously with increases in
output.
This is due to total fixed cost which is held constant when output is
increasing.
(i) Average Variable Cost (AVC)
Average variable cost is total variable cost divided by output. AVC =
TVC
Q
At first, increases in output result in decreases in average variable cost,
beyond a point, they result in higher average variable cost.
Thus average variable costs declines initially, reaches a minimum, and
then increases again, giving them a graphical U-shape.
(ii) Average Total Cost (ATC)
The average total cost is total cost divided by output.
The average total cost equals the sum of average fixed cost and average
variable cost.
This we can state as: - ATC = AFC + AVC
Illustration of average fixed cost, average variable costs and average total cost
calculation
Quantity Fixed Average Variable Average Total Average
costs Fixed cost Variable Cost Total
Costs Costs Costs
0 50 infinity - - 50 Infinity
1 50 50 80 80 130 130
2 50 25 110 55 160 80
3 50 16,67 130 43,33 180 60
4 50 12,5 210 52,5 260 65
5 50 10 300 60 350 70
Profit
-is defined as a reward for bearing uncertain risks
Functions of Profit
-it provides a reward for bearing the uncertainty associated with running a
business
-it stimulates innovation as it provides an incentive for entrepreneurs to take
these risks
-it creates a source of funds for investment and expansion
Types of Profit
(i) Supernormal profit
-can also be referred to as abnormal profit
-it is earned where the price exceeds average cost
(ii) Normal profit
-it is the minimum which the entrepreneur have to receive to provide their
services and for their firms to stay in the industry in the long run
Profit maximisation Rule
-if a firm chooses to maximise its profits, it must choose that level of output
(i) where marginal cost is equal to marginal revenue
(ii) where marginal cost curve is rising
price
quantity
Distinguish between the Short Run and the Long Run time period
-the short run is a time period where at least one factor of production is fixed
and this is usually capital
-the law of variable proportions /law of diminishing returns apply in the short
run
-the long run is a time period where all factors of production are variable that is
labour and capital but not long enough for technology to variable
-the law of returns to scale apply in the long run
Short Run Average Costs (SRAC) and Long Run Average Costs
(LRAC)
-Average costs can be divided into short run and long run average costs.
- Both SRAC and LRAC are U-shaped.
-However the SRAC are narrow than the LRAC which are open U-shaped.
-The SRAC is U-shaped due to the influence of the law of diminishing
marginal returns
. While the LRAC is open U-shaped due to economic and diseconomies of
scale.
A comparison between SRAC and LRAC
Economic Efficiency
-is when all goods and factors of production in an economy are distributed or
allocated to their most valuable uses and waste is eliminated or minimised
-it is concerned with the optimal production and distribution of scarce resources
Types of economic efficiency
(i) Productive efficiency
-It when the maximum number of goods and services are produced with a
given amount of inputs
-it occurs at the lowest point on the firm ‘s average costs curve
-on the production possibility curve, any point along the curve is
productively efficient
(ii) Allocative efficiency
-occurs when goods and services are distributed according to consumer
preferences
-an economy can be productively efficient but produce goods people don’t
need thus it will be allocatively inefficient
-allocative efficiency occurs when the price of the good is equal to the
marginal cost of production
(iii) X efficiency
-it occurs when the firm produces at the lowest average cost curve
(iv) Dynamic efficiency
-it involves the introduction of new technology and working practices to
reduce costs over time
EXAM TYPE QUESTIONS
[Link] following are monthly costs of running a poultry project in a school
Interest on loan $10 000
Rent $5 000
Wages $40 000
Feeds $65 000
What is the project ‘s fixed cost per month?
A.$15 000 B.$45 000 C. $50 000 D. $105 000 [N2005, Q12 ]
[Link] run is a time period where
A. all factor inputs are fixed [Link] least one factor input is fixed
C. when output is fixed [Link] supply cannot adjust to change in demand
3.A firm ‘s average fixed cost (AFC)
A. falls continuously as output increases B. falls continuously as output falls
C. remains unchanged at all levels of output
D. initially falls to rise at higher output levels
[Link] table shows a firm ‘s fixed and variable costs at four levels of output
Quantity (units ) Fixed costs ($) Variable costs ($)
2 50 110
3 50 130
4 50 210
5 50 300
At which level of output is average cost at its lowest?
A. 2 B. 3 C.4 D. 5 [N2019,Q26]
Essay Type
[Link] reference to the theory of the firm , explain the terms
(i) marginal cost, [4]
(ii) average total cost [4] [N2014 ,Q8a]
EXAM TYPE QUESTIONS
Multiple choice questions