Cost and Revenue Concepts:

Total Costs, Fixed cost, Variable cost, Total revenue, Average

revenue and Marginal revenue, Cost-Output Relationships in
the Short Run, and Cost-Output Relationships in the Long Run,
Analysis of cost minimization

Text Book for

1. Principles of Economics Reading : Vengedasalam &
by Deviga Madhava
Karunagaran n,
Oxford Publication
# Some of the e-resources of the book have taken from the book for explaining to the students in
the class purposes only

Dr. [Link],
GCEK
 What is Cost?
 The amount of expenditure (actual or
notional) incurred on or attributable to a
specified thing or activity (ICMA)

In producing a good or service, a firm

has to employ an aggregate of various factors
of production such as land, labour, capital and
entrepreneurship.

These factors are to be compensated by the

firm for their contribution in producing the
commodity,

 This compensation (factor price) is the cost.

 On the basis of Nature or
Element of Cost
 Material Cost : Direct Material & Indirect
Material

 Labour Cost : Direct Labour & Indirect

Labour

 Expenses : Direct Expenses & Indirect

Expenses
 Direct : Cotton in Cotton
MaterialMaterial Textiles
 Indirect : oil, cotton waste etc.
 Examples :
 Direct Labour Cost : Cost of labour directly engaged in
production
 Indirect Labour Cost : Salesman Commission.
 Direct Expenses : Wages and Salaries
 Indirect
Dr. [Link], Expenses : Hospital Expense of employees
GCEK
 Types of
costs
Explicit (or paid out ) and Implicit (or, imputed)Costs:
A firm’s cost of production includeexplicit costs
and implicit
costs.
•production
Explicit costs is and
.(Wages the salaries
value oftoresources
workers,
purchased
payments
fuel, forfor
transportation, electricity and power)
• Implicit costs is the value of input services that are
used in production which are not purchased in the
market . It is the value of self-owned, self
employed resources utilized in
productio
n.

Dr. [Link],
GCEK
 Types of costs
Economic Cost versus Accounting Cost :
• Accounting : Actual expenses plus
cost depreciation
• Economic charges for capital equipment.
cost : resources
Cost to a firm of utilizing
economic
in
production,
including
opportunity cost.
• Economic Cost = Implicit cost + Explicit Cost

Accounting Cost < Economic Cost

Dr. [Link],
GCEK
 Economic Profit versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accountin
g profit
Implic
Revenue it Revenue
costs
Total
opportuni
ty costs
Explici Explici
t t
costs costs

Dr. [Link],
GCEK
 Types of
costs
 opportunity cost : Cost associated with opportunities
that are forgone when a firm’s resources are not
put to their best alternative use.
 Ex: A businessman can go for a printing machine or
paper
cutting Alternative
machine –with
I his resources.
Alternative – I I
(Printing Machine) (Paper cutting Machine)
1,00,000 80,000
 A rational businessman will certainly buy printing
machine which
gives him a higher return.
 Opportunity cost is Rs 80,000
 Economic Profit = Rs 20,000
 As long as economic profit is above zero, it is rational to
invest resources in printing machine
Dr. [Link],
GCEK
 Types of
costs
sunk cost : Expenditure that has been made
and cannot be recovered. Because a sunk
cost cannot be recovered, it should not
influence the firm’s decisions.
•Ex: A specialized equipment for a plant is
purchased but not being utilized. As it has no
alternative use, its opportunity cost is zero. Thus it
should not be included as part of the firm’s
economic costs.
•Social Cost : is the total cost of production of a
product, and includes direct and indirect costs
incurred by society.
• Ex . Water pollution, air pollution, solid waste
Dr. [Link],
GCEK
 COST OF PRODUCTION
SHORT RUN

A production period in which at least

on
of the input is fixed*.
LONG RUN

A production period in which all the

inputs are variable**.

* A fixed input is an input which the quantity does

not change
according to the amount of output. E.g. machinery
** A variable input is an input which the quantity varies according to
the amount of output. E.g. labour
Dr. [Link],
GCEK
 Total Costs, Fixed cost,
Variable cost
TOTAL COST (TC)
 The sum of cost of all inputs used to produce goods and services.
 Total cost (TC ) also defined as total fixed cost (TFC) plus
total variable cost (TVC).

TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)

 The cost of inputs that are  The cost of inputs that
independent of output. changes
 Examples: Factory, with output.
machinery and etc.  Example: Raw materials,
labours, etc.

Dr. [Link],
GCEK
 AVERAGE TOTAL COST
(ATC)
 The total cost per unit of output.
 The formula for average total cost (ATC) is the total
cost (TC) divided by the output (Q).

ATC = TC
Q

TC = TVC + TFC

Dr. [Link],
GCEK
 SHORT-RUN PRODUCTION
AVERAGE FIXED COST (AFC)
Total fixed cost (TFC) divided by total output:
AFC = TFC
Q

AVERAGE VARIABLE COST

(AVC)
Total variable cost (TVC) divided
by total output:
AVC = TVC
Q

MARGINAL COST (MC)

The change in total cost that
results from a change in output;
the
extra cost incurred to produce
Dr. [Link],
GCEK
 SHORT-RUN COST CURVES
TOTAL COST (TC)
The sum of cost of all inputs used to produce
goods and services.
COST Also defined as TFC plus TVC
TC

TVC TC = TVC + TFC

TOTAL VARIABLE COST (TVC)

The cost of inputs that changes with
output.

TFC

TOTAL FIXED COST (TFC)

The cost of inputs that is independent of
output.

QUANTITY

Dr. [Link],
GCEK
 SHORT-RUN COST CURVES (cont.)
MARGINAL COST (MC)
COST Change in total cost that results from a change in
output
MC = TC
MC ATC Q

AVERAGE TOTAL COST (ATC)

Total cost per output

AVC ATC = TCATC = AFC + AVC

Q

AVERAGE VARIABLE COST (AVC)

Total variable cost (TVC) divided by total
output
AVC = TVC
Q

AVERAGE FIXED COST (AFC)

Total fixed cost (TFC) divided by total
output AFC = TFC
Q
AFC
QUANTITY

Dr. [Link],
GCEK
 Total costs Average costs

(1) (2) (3) (4) (5) (6) (7) (8)

Quantity Total Total Total Average Average Average Marginal
(Q) fixed variable cost fixed cost variable total cost cost (MC)
cost cost (TC) (AFC) cost (AVC) (ATC)
(TFC) (TVC) TC=TFC AFC = AVC = ATC = MC =
+TVC TFC/Q TVC/Q TC/Q TC/Q

(2)+(3) (2)/(1) (3)/ (1) (4)/(1) or (4) /(1)

(5)+(6)

0 20 0 20 - - - -

1 20 15 35 20 15 35 15

2 20 25 45 10 12.50 22.50 10

3 20 30 50 6.67 10 16.67 5

4 20 35 55 5 8.75 13.75 5

5 20 45 65 4 9 13 10

Dr. [Link],
GCEK
 RELATIONSHIP BETWEEN MC AND ATC
Cost
MC

ATC

Quantity

ATC falling, MC curve lies below ATC curve.

ATC is at minimum point, ATC curve and MC curve are
equal.
ATC starts to increase, MC curve lies above ATC curve.
Dr. [Link],
GCEK
 ANALYSIS OF COSTS
Firms make production and sales decisions on the basis
of a good’s cost and price. A profit-minded firm will keep
an eagle eye on its costs to maintain profitability.

Total Cost: Fixed and Variable

1 2 3 4
Qty Fixed Cost (FC) Variable Cost Total Cost (TC)
(VC)
0 55 0 55
1 55 30 85
2 55 55 110
3 55 75 130
4 55 105 160
5 55 155 210
6 55 225 280

Dr. [Link],
GCEK
 Output Total Cost Marginal cost Behavior of
(Q) (TC) (MC) MC

0 55 -

1 85 30

2 110 25 

3 130 20 

4 160 30 

5 210 50 

Dr. [Link],
GCEK
 How to calculate MC
(1)To calculate the MC of ith unit we subtract the
total cost of the i-1th unit from the total cost of ith
unit.

MC of 4th unit = 160-130 = 30

MC of 5th unit = 210-160 = 50

We could also get MC by subtracting VC of ith-1

from VC of ith term.
Why?
Average Cost or Unit Cost
One of the most important cost concept is average cost,
which, when compared with price or average revenue
will allow a business to determine whether or not it is
making a profit.
Dr. [Link],
GCEK
1. Average Fixed Cost: AFC = FC/q
Since Total Fixed Cost is a constant dividing it
by an increasing output givesa
falling AFC & steadily looks like a
hyperbola
approaching the horizontal axis as the
constant FC gets spread over more and more
units. (Asymptotic to X-axis.)
2. Average Variable Cost: AVC =
VC/q
3. AVC falls initially
Average Cost orand Average
then [Link] (AC or
Cost ATC)
AC = TC/Q
AVC & AC are ‘U’ shaped on the short run.
Dr. [Link],
GCEK
 COST CALCULATION
FIXED COST = 55

Dr. [Link],
GCEK
 ISOCOST
 An isocost line shows various combinations of
two inputs, capital and labour, which can be
purchased with a given amount of money for a
given total cost.
 An isocost equation shows the relationship
between the inputs (capital and labour) used in
the production and the given total cost by a firm.
 The isocost equation can be written as:
TC = wL + rk
Where: TC = Total
Cost
L = Labour
K = Capital
(fixed) w = Price
Dr. [Link],
GCEK of labour r =
 ISOCOST (cont.)

Isocost Line
6
5
Capital

4
3
Isocos
2 t
1
0
1 2 3 4 Labour
5
Iso-cost line shows the various combinations of labour and
capital with given total cost for a firm in the production of
shoes.
Dr. [Link],
GCEK
 Example to understand the
concept of Iso-cost
 Producer wants to spend Rs 100 a day
producing shoes . Labour Rs 20 /- per day and
rented machine Rs 20/- . Point C = 3*20 +
2*20 5 b

C
3
Capit
al
e

2 5 Labou
r

Dr. [Link],
GCEK
 ISOCOST MAP
An isocost map is a number of isocost lines
that
show different levels of total cost in one
diagram. Isocost Map
7
6
5
Capital

4
Isocost
3 (RM100)
Isocost
2 (RM120)
1
0
1 2 3 4 5 6 7 Labour
Dr. [Link],
GCEK
 ISOCOST MAP
An iso-cost map is a number of iso-cost
lines that
show different levels of total cost in one
diagram. Isocost Map
7
6
5
Capital

4
Isocost
3 (RM100)
Isocost
2 (RM120)
1
0
1 2 3 4 5 6 7 Labour
Dr. [Link],
GCEK
 COST MINIMIZING TECHNIQUES
The cost minimizing technique is selecting combinations
of inputs
that minimize the total cost at the given level of output.
At point y, the slope of isoquant curve is equal to that of isocost line
and this is the most efficient technique for production.
7
6
5 Isocost
Capital

4 x (RM100)
Isocost
3 (RM120)
Isoquan
2 y t
1 z
0 Labour
Points x and z are not efficient because the cost of production is exceeding
RM120.

Dr. [Link],
GCEK
 COST CURVES IN THE LONG RUN

 Long run is a periodwherethereare only

variable factors and no fixed cost involved.
 Long run total cost (LRTC) starts from
because of the absence of total fixed
origin
cost.
LONG RUN AVERAGE COST CURVE (LRAC)
 Shows the minimum cost of
producing
output when any
all of the inputs
given are
variable. how
 Long run is a period where firms to
plan minimize average cost.
Dr. [Link],
GCEK
 LONG-RUN PRODUCTION COST

LRAC curve are derived by a series of short run average cost curves

COST
SRAC1
SRAC5

SRAC2
SRAC4 LRAC
SRAC3

Tangential point of the SAC

are joined and made up the
LRAC.
QUANTITY

Dr. [Link],
GCEK
 LONG-RUN PRODUCTION COST (cont.)

 Long run average cost curve (LRAC) is “U–

Shaped”
due to the Law of Returns to Scale.
 Law of Returns to Scale states that as the firm
expand its size or scale of production, its long run
average cost (LRAC) will decrease and increase at
later stage.
Cost
LRAC

Increasin Constan Decreasin

g Return t Return g Return
to Scale to Scale to Scale

Quantity
Dr. [Link],
GCEK
 ECONOMIES OF SCALE
Economies of scale are benefits and
advantages
of a firm as it expands its production.
INTERNAL • Reduce the average cost. EXTERNAL
Internal economies happen inside an Advantages of the industry as a
organization whole
Labour Economies
Economies of Government Action
Managerial Economies

Marketing Economies Economies of Concentration

Technical Economies
Economies of Information
Financial Economies

Risk Bearing Economies Economies of Marketing

Transport and Storage

Economies

Dr. [Link],
GCEK
 ECONOMIES OF SCALE (cont.)

Diseconomies of scale are problems and

disadvantages faced by a firm when it
expands production.
• Increase the average cost.
INTERNAL EXTERNAL
Raise the cost of production of a The disadvantages faced by the
firm as the firm expands industry
as a whole

Labour Diseconomies Scarcity of Raw Material

Wage Differential
Management Problem

Concentration Problem
Technical Difficulties

Dr. [Link],
GCEK
 CONCEPT OF REVENUE

TOTAL REVENUE (TR)

The total amount received from the sale of a firm’s goods and
services
Total Revenue (TR)=Price (P) x Quantity (Q)

AVERAGE REVENUE (AR)

Average revenue is the total revenue per unit output
sold.
 Average revenue (AR) is also equal to the price (P) of the
good. Quantity (Q)

AverageAR =
Revenue P x Q=
(AR) PRICE
= Total Q
Revenue (TR)

Dr. [Link],
GCEK
 CONCEPT OF REVENUE
(cont.)
MARGINAL REVENUE (MR)
The change in total revenue resulting from one unit increase in
quantity sold.
Marginal Revenue (MR)= Change in Total Revenue
Change in Quantity

MR =  TR/  Q

(1) (2) (3) (4) (5)

Quantity Price Total Revenue Average Marginal Revenue
(1) x (2) Revenue (3) / (1)
(3) / (1)

10 50 500 50 50
20 45 900 45 40
30 40 1200 40 30
40 35 1400 35 20
50 30 1500 30 10
60 25 1500 25 0
70 20 1400 20 -10

Dr. [Link],
GCEK