• No results found

Commerce, University of Delhi

N/A
N/A
Protected

Academic year: 2023

Share "Commerce, University of Delhi "

Copied!
29
0
0

Loading.... (view fulltext now)

Full text

(1)

Institute of Lifelong Learning, University of Delhi

1 Subject: Microeconomics

Lesson: Theory of Cost and Revenue Lesson Developer : Shelly Verma

College/Department: Shri Gobind Singh College of

Commerce, University of Delhi

(2)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

2

Table of Contents

Chapter : Theory of Cost and Revenue

 1: Learning Outcomes

 2: Introduction

 3: The Cost Function

 3.1: Factors determining costs

 3.2: Different Concepts of costs

 3.3: Short-run and Long-run Cost Functions

 4: Short-run Total Cost Curves

 4.1: Total Fixed Cost

 4.2: Total Variable Cost

 4.3: Total Cost

 5: Short-run Averageand Marginal Cost Curves

 5.1: Average Fixed Cost (AFC)

 5.2: Average Variable Cost (AVC)

 5.3: Average Cost (AC)

 5.4: Marginal Cost (MC)

 5.5: Relationship between AC, AVC and MC

 6: Long-run Cost curves

 6.1: Long-runTotal Cost

 6.2: Long-runMarginal Cost

 6.3: Long-runAverage Cost

 6.4: Economies and Diseconomies of Scale

 7: Relationship between Production Function and Cost Curves

 7.1: Production function and cost curves

 8: Significance of Cost Analysis in Decision Making

 8.1: Decision Making and Costs.

 9: Concept of Revenue

 9.1: Total Revenue

 9.2: Average Revenue

 9.3: Marginal Revenue

 10: Relationship between TR, AR and MR

 10.1: Derivation of AR and MR from TR

 10.2:AR and MR under Perfect Competition

 10.3: AR and MR under Imperfect Competition

 11: Relationship between AR, MR and Elasticity

 Summary

 Exercises

 Glossary

 References

 Quiz

1. Learning Outcomes

(3)

Institute of Lifelong Learning, University of Delhi

3

After you have read this chapter, you should be able to

 Understand the determinants of costs incurred by firms in the production of goods.

 Define the various concepts of costs for firms.

 Understand the relationship between different elements of costs in the short- run and long-run.

 Appreciate the significance of economies and diseconomies of scale in determination of shapeof cost curves.

 Apply the knowledge of cost analysis to decision making.

 Define total, average and marginal revenues.

 Derive AR and MR curves from TR curve.

 Understand the relation between TR, AR and MR

 Apply the knowledge of price elasticity to AR and MR

2. Introduction

3: The Cost Function Value addition1:

Topic 3.1: Factors determining Costs

The purpose of this section is to make you familiar with the relationship between factors that determine costs.

Cost analysis helps in properly appraising the behaviour of cost in relation to the scale of operations, size of output and several other factors in the production process.

Cost is considered to be a multivariate function as it is determined by many factors simultaneously.

Click on each factor that determines costs to know more.

Plant size: There is an inverse relationship between plant size and cost. So bigger the plant, higher will be the costs.

Price of inputs: There is a direct relationship between price of inputs and cost. So if the price of inputs is more, costs will be higher.

Management and administrative efficiency: There is an inverse relationship between management and administrative efficiency and cost. More the management and administrative efficiency, lower will be the costs.

State of technology: There is an inverse relationship between state of technology and cost. Better the technology, lesser will be the costs.

Level of Output: There is a direct relationship between level of output and cost. So if the outputis larger costs will be more.

3: The Cost Function (Continued) Value addition 2:

Topic 3.2: Different Concepts of Costs

The purpose of this section is to make you familiar with the different concepts of costs.

(4)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

4

There are different concepts of costs that are used in different contexts by firms.

Click on each Concept of Costs to know more.

Explicit or Direct or Accounting Costs: include the actual expenditure incurred by a firm to purchase or hire the inputs it needs in the production process. Accounting costs are the cash payments made by an entrepreneur to the suppliers of various factors of production.

These inputs do not belong to the firm itself like wages, rent, interest, payment for power, fuel, insurance, advertising, etc.

Implicit or Imputed Costs: includes the cost of inputs owned by the firm and used by the firm in its own production process. It includes payment for owned premises, self-invested capital and depreciation of capital equipment.

Opportunity Cost or alternative cost: includes the cost of alternative opportunity sacrificed or given up. It arises because resources are scarce and they have alternative uses.

Economic Costs: includes accounting cost plus normal return on capital invested by an entrepreneur himself.

The Cost Function 3: The Cost Function(Continued)

Value addition3:

Topic 3.3: Short-run and Long-run Cost Functions

The purpose of this section is to make you familiar with the role of time periods in determination of costs.

In cost theory time periods, either the short-run or long-run play a significant role.

The short-run costs are the costs over a small period of time; say a few months, during which some factors of production are fixed like plant, machinery while others are variable. Production in the short-run can be increased only to the extent possible by using fixed factors to the full capacity and by increasing the use of variable factors.

In the short-run the cost function is given as:

C = f (X, T, Pf, K)

where, C = Total Cost, X = Output, T= Technology, Pf = Prices of factors of production, K = Fixed factor(s) of production.

The long-run costs are the costs over a period of time long enough during which all factors of production can become variable. Production in the long-run can be increased by using more of all factors.

Long-run cost function: C = f (X, T, Pf)

Diagrammatically, the cost function is shown as a two-dimensional diagram by assuming C= f(X), ceteris paribus. So cost is a function only of output, other things remaining constant.

You must remember that when other factors, like technology (T) and prices of factors of production (Pf) change then the cost curve will tend to shift.

(5)

Institute of Lifelong Learning, University of Delhi

5

4: Short-run Total Cost Curves Value addition1:

Topic 4.1: Total Fixed Costs

The purpose of this section is to make you familiar with the elements of short-run total fixed cost curve.

In the short-run at least one input is considered to be fixed and its price constitutes the fixed cost.

Fixed costs have the following features:

 They do not vary with output.

 They are also called overhead costs or unavoidable costs.

 They include costs like salaries, wages, insurance, depreciation of machinery and buildings, opportunity cost of entrepreneurs.

 They can never be zero even when production is stopped.

 They cannot be changed in the short run.

 They are represented by a straight line parallel to the x-axis or a horizontal line.

Figure 1:Total Fixed Cost Curve

4: Short run Total Cost Curves(Continued) Value addition 2:

Topic 4.2: Total Variable Costs

The purpose of this section is to make you familiar with the elements of short-run total variable cost curve.

Total Variable Costs

In the short-run variable costs are those costs which vary with the quantity of output produced.

Variable costs have the following features:

 They are also known as prime costs.

 Variable costs include cost of direct labour, cost of raw material, power, fuel, andrunning expenses.

 They are zero when production stops.

 They can be changed in the short run.

 They are represented by an inverse-S shaped curve due to law of variable proportions.

Figure 2: Total Variable Cost Curve

(6)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

6

You need to remember:

 TVC is zero when output is zero and rises when output rises. Initially as more of the variable factor is combined with the fixed factor, total productivity increases at an increasing rate or TVC increases at a decreasing rate.

 At Pt. Rin the figure, the law of diminishing returns begins to operate.

 Beyond this point as more of the variable factor is combined with the fixed factor, total productivity increases at a decreasing rate, reaches a maximum and then falls, implying TVC increases at an increasing rate.

4: Short run Total Cost Curves(Continued) Value addition 3:

Topic 4.3: Total Variable Costs

The purpose of this section is to make you familiar with the elements of short-run total cost curve.

Total Costrefers to the aggregate of all fixed and variable costs of producing any given level of output.

TC = TFC + TVC

You need to remember:

 TC is above TVC by the amount of TFC.

 TC and TVC curves have the same slope.

 TC is inverse-S shaped starting from the level of fixed cost.

 The only difference between TVC and TC is that, TVC starts from the origin and TC starts from the level of fixed cost.

Figure 3:Total Cost Curve

(7)

Institute of Lifelong Learning, University of Delhi

7

5: Short run Average and Marginal Cost Curves Value addition1:

Topic 5.1: Average Fixed Cost

The purpose of this section is to make you familiar with the concept of average fixedcost.

Average Fixed Cost is defined as the total fixed cost divided by output.

AFC = TFC/X Diagrammatically,

 AFC at any point on the TFC is the slope of the straight line from the origin to that level of output.

 Corresponding to a horizontal TFC curve, AFC is a rectangular hyperbola showing decreasing fixed cost per unit as output increases.

Figure 4:Average Fixed Cost Curve

(8)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

8

5: Short run Average and Marginal Cost Curves(Continued) Value addition 2:

Topic 5.2: Average Variable Cost

The purpose of this section is to make you familiar with the concept of average variable cost.

Average Variable Cost is defined as the total variable cost divided by output.

AVC = TVC/ X Diagrammatically,

 AVC is the slope of the straight line from the origin on the TVC curve at each level of output.

 As output expands, the value of the slope declines continuously, till a point which corresponds to the minimum of AVC curve and rises thereafter.

 Corresponding to the inverse S-shape of the TVC curve, AVC is U-shaped.

You must remember that AVC curve is U-shaped because of the law of variable proportions.

According to the law of variable proportions,

 Initially when a variable factor is combined with a fixed factor, TVC increases at a decreasing rate and AVC falls.

 Eventually, an optimal combination of fixed and variable factors occurs.

 Beyond which TVC increases at an increasing rate and AVC rises.

Figure 5: Average Variable Cost Curve

(9)

Institute of Lifelong Learning, University of Delhi

9

5: Short run Average and Marginal Cost Curves(Continued) Value addition 3:

Topic 5.3: Average Cost

The purpose of this section is to make you familiar with the concept of average cost.

Average Cost is defined as the total cost divided by output.

AC = TC/X

Also, AC = AFC + AVC Diagrammatically,

 AC is the slope of the straight line from the origin on the TC curve at each level of output.

 As output expands, the value of the slope declines continuously, till a point which corresponds to the minimum of AC curve and rises thereafter.

 Corresponding to the inverse S-shape of the TC curve, AC is U-shaped.

 AC curve is also U-shaped because of the law of variable proportions.

Figure 6:Average Cost Curve

(10)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

10

5: Short run Average and Marginal Cost Curves(Continued) Value addition 4:

Topic 5.4: Marginal Cost

The purpose of this section is to make you familiar with the concept of marginal cost.

Marginal Cost

Marginal Cost is the addition made to TC or TVC as output is increased by one more unit.

MC = ΔTC/ΔX orMC = ΔTVC/ΔX

whereΔTC is change in total cost and ΔX is change in total quantity Diagrammatically,

 MC is the slope of the TC or TVC curve at each level of output.

 As output expands, the value of the slope declines continuously till a point and then rises thereafter.

 Corresponding to the inverse S-shape of the TC or TVC curve, MC is U- shaped.

 MC curve is also U-shaped because of the law of variable proportions.

(11)

Institute of Lifelong Learning, University of Delhi

11

Figure 7: Marginal Cost Curve

5: Short run Average and Marginal Cost Curves(Continued) Value addition 5:

Topic 5.5: Relationship between AVC, AC and MC

The purpose of this section is to make you familiar with the relationship between AVC, AC and MC.

Relationship between AVC, AC and MC Figure 8: Relation between AVC, AC and MC

(12)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

12

Diagrammatically,

 When AC is falling, MC is below AC

 When AC is rising, MC is above AC

 When AC is neither falling nor rising, MC is equal to AC

 There is a range over which Ac is falling but MC is rising

 MC curve cuts AC curve at ACs minimum point.

 Relationship between MC and AVC is the same as the relationship between MC and AC curves.

You must remember that, MC cuts AVC and AC curves at their respective minimum points.

6: Long-run Cost Curves Value addition1:

Topic 6.1: Long-run Total Cost

The purpose of this section is to make you familiar with the elements of long-run cost curves.

You know that in the long-run all inputs are variable as there are only limited constraints to expansion. There are no fixed factors so no fixed costs. LTC is also known as a planning curve because if the firm plans to produce output XN at minimum cost then LAC curve helps the firm in deciding the most appropriate plant size that should be chosen. So the firms long-run decisions are called planning decisions.

You must remember that any other plant size built to produce output XN will lead to increased production cost and less profit.

6: Long-run Cost Curves(Continued)

(13)

Institute of Lifelong Learning, University of Delhi

13

Value addition1:

Topic 6.1: Long-run Average Cost

The purpose of this section is to make you familiar with the concept of long-run average cost curve.

Long-Run Average Cost (LAC) shows the average cost of production when all factors are variable. It shows the minimum cost per unit of producing each level of output when the capacity of the firm is varied.

Figure 9:Long-run Average Cost Curve

Diagrammatically,

LAC is derived from SAC curves. LAC curve is a curve tangent to all SAC curves representing most appropriate plant size that the firm could build in the long-run.

The output, at which long-run cost is at its minimum, is known as Minimum Efficient Scale.

It is interesting to know that the LAC curve is called an envelope curve because no part of SAC curve can ever be below the LAC curve or LAC curve envelopes all the SAC curves. But what is the reason for this?

The reason why LAC curve is an enveloping curve is that there is no reserve capacity as each plant size can produce optimally only a single level of output.

The LAC curve is also said to be a cost frontier because it separates the inefficient levels of cost from the efficient levels of cost.

 Any point above LAC curve is attainable but inefficient as it shows a higher cost of producing the corresponding level of output.

 Any point below LAC curve is efficient but unattainable with given state of technology.

6: Long-run Cost curves(Continued)

(14)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

14

Value addition1:

Topic 6.2: Long-run Marginal Cost

The purpose of this section is to make you familiar with the concept of long-run marginal cost curve.

Long-Run Marginal Cost (LMC) shows the minimum amount by which cost is increased each time, when output is increased. LMC is derived from the short-run marginal cost curves.

Derivation of LMC

Given SAC and SMC curves and the corresponding LAC curve, the long-run marginal cost can be derived by taking the following steps:

1. Draw perpendiculars from points A, B and C where LAC and SACare tangent.

2. The perpendiculars intersect SMC1, SMC2 and SMC3 at D, B and E.

3. Join D, B and E to obtain LMC.

Figure 10:Long-run Marginal Cost Curve

LMC curve shows the minimum amount by which the cost is increased when output is expanded.

You must remember that, LMC cuts LAC curves at itsminimum point.

6: Long-run Cost curves(Continued) Value addition3:

Topic 6.3: Economies and Diseconomies of Scale

The purpose of this section is to make you familiar with economies and diseconomies of scale that affect the shape of long-run cost curves.

You must know that the LAC curve is U-shaped. The reason behind the U-shape of the LAC curve is the laws of returns to scale.

(15)

Institute of Lifelong Learning, University of Delhi

15

According to this law, as plant size increases, the AC of production decreases due to economies of scale.

Economies of scale are advantages, which accrue to firms on account of benefits of large scale production. However economies of scale exist, only till the optimum plant size is attained. Beyond which the LAC turns upwards.

The turning up of the LAC curve is due to decreasing returns to scale which are in turn due to diseconomies of scale.

Diseconomies of scale are disadvantages which a firm faces on account of over expansion of scale of operation beyond its optimal size.

Figure 11:Economies and Diseconomies of Scale

You must remember that

 LAC can be a horizontal straight line when returns to scale are constant over a wide range of output.

 LAC curve with a flat bottom implies that small firms coexist side by side with large firms in the same industry. In such a case, there is no single optimum scale of plant.

 The flat stretch of LAC is formed by the minimum points of the corresponding SAC curves.

Figure 12: LAC showing Constant Returns to Scale

(16)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

16

7: Relationship between Production Function and Cost Curves Value addition1:

Topic7.1:Production function and cost curves

The purpose of this section is to make you familiar with the relationship between production function and cost curves.

You know that a production function of a firm together with the prices of inputs that the firm must pay for them determines the firm’s cost curves.Diagrammatically this is shown as:

Figure 13:Relationship between Production Function and Cost Curves

(17)

Institute of Lifelong Learning, University of Delhi

17

You can observe that:

 AVC is the monetized mirror image of the APL curve.

 MC is the monetized mirror image of the MPL curve.

 When APL curve rises, AVC falls.

 When APL is maximum, AVC is minimum.

 When APL curve falls, AVC curve rises.

 When MPL curve rises, MC curve falls.

 When MPL curve is maximum, MC is minimum. When MPL curve falls, MC curve rises.

(18)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

18

 In stage II of production, the stage of diminishing returns, when MPL is eventually declining and MC is rising.

8: Significance of Cost Analysis in Decision Making Value addition1:

Topic8.1:Decision Making and Costs

The purpose of this section is to make you familiar with the importance of cost analysis to managers.

A firm should attempt to minimize its long-run profits by selecting any short-run production technology known as scale of plant that minimizes cost. For making anappropriate choice of output in the short-run decisions should be based on future demand of the product, developments in technology and changes in the prices of inputs.

A proper understanding of cost analysis helps managers take correct decisions about:

 orders to place for any inputs

 expansion or contraction of production

 introduction of a new product line or not

 prices to quote for their products

 payment of bonuses or incentives

 disbursement of dividends

 choice of new technology

 strategies for sales promotion 9. Concept of Revenue

Value addition 1:

Topic 9.1: Total Revenue

The purpose of this section is to make you familiar with the concept of revenue and its various components.

For a producer it is important to know two things in a market: total quantity and the price at which the final product produced by the firm can be sold in a market. You know that the quantity of final product depends on productivity of factors and the state of technology. The price at which the product can be sold depends on the cost of production. The main aim of the producer is then to recover the cost and earn a return on the sale of the product or make profit. The total amount of money that a producer receives from the sale of the product is known as revenue.

Total Revenue is the aggregate of the proceeds or income received by the producer from the sale of a final product.

TR is estimated by multiplying the price of a unit of the product with the total quantity sold in the market.

TR = P x Q

Where P = Price and Q = Quantity

Suppose a producer sells 100 units of tables each priced at Rs. 500 in a market. The total revenue or sale proceeds of the producer would be:

P x Q = TR 500 X 100 = Rs. 50,000.

(19)

Institute of Lifelong Learning, University of Delhi

19

Diagrammatically, TR is a bell shaped curve for a market structure where both price and quantity can change. This happens in the case of imperfect competition markets.

 For any product, TR increases at a decreasing rate initially as more consumers demand it. This happens because to sell more quantity the producer needs to lower the prices due to the law of demand.

 So after a point the product sales reach a peak or a maximum. After this point the TR starts decreasing at an increasing rate.

 Eventually TR falls to zero at a particular quantity and the producer does not earn any more revenue from this product.

Figure 14: TR curve under Imperfect Competition Markets

TR can also be an upward sloping straight line from the origin, when the price is given and revenue depends only on the quantity sold. This happens in the case of perfect competition markets where the firms are price takers and can sell any amount of the product at the given price.

For a given price as more quantity is sold, total revenue increases. There is a direct relation between quantity sold and total revenue.

Figure 15: TR curve under Perfect Competition Markets

(20)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

20

Value addition 2:

Topic 9.2: Average Revenue

The purpose of this section is to make you familiar with the concept of revenue and its various components.

Now if you want to find out the revenue for each unit of the product sold what would you do. You will simply need to find the average revenue.

Average Revenue is the revenue that a producer earns, per unit of final product sold.

AR is estimated by dividing TR by total number of units sold.

AR = TR/Q = (P x Q)/Q = P

It is interesting to observe that Average revenue is the same as price of the final product. You know that a buyer purchases different quantities at different prices, or has a demand curve to represent what is bought from a producer. Now can you say the demand curve and average revenue curve represent the same thing though from two different perspectives? Actually, this is true as what is sold by the producer is equal to what is bought by the consumer at the price of the final product given in the market.

Value addition 3: Focus of the Section Topic 9.3: Marginal Revenue

The purpose of this section is to make you familiar with the concept of revenue and its various components.

Another concept of revenue that is important is the Marginal Revenue.

MR is defined as the addition to total revenue by selling one additional unit of the final product.

(21)

Institute of Lifelong Learning, University of Delhi

21

MR = TR n – TR n-1 MC = ΔTR/ΔQ

whereΔTR is change in total revenue ΔQ is change in total quantity sold

10: Relationship between TR, AR and MR Value addition 1:

Topic 10.1: Derivation of AR and MR from TR

The purpose of this section is to make you familiar with the relationship between TR, AR and MR.

Consider a bell shaped TR curve.

Diagrammatically, AR can be derived from the TR by plotting the slope of the lines from the origin to each point on the TR curve.

Figure 16: TR and AR curves

Diagrammatically, MR is the slope of the TR curve at each level of quantity sold.

Figure 17: TR and MR curves

(22)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

22

10: Relationship between TR, AR and MR (Continued) Value addition 2:

Topic 10.2: AR and MR under Perfect Competition

The purpose of this section is to make you familiar with the shapes of AR and MR curves under perfect competition market structure.

All firms in a perfect competition market are price-takers. So they follow the price set by the industry. This means that the price is given.

It is interesting to note that if the TR is plotted as an upward sloping straight line from the origin then the shape of the AR and MR curves are horizontal straight lines parallel to the x axis. Moreover both of them coincide.

If price is given, then AR = (P x Q)/Q = P

MR = ΔTR/ΔQ = Δ(P x Q)/ΔQ = P (ΔTQ)/(ΔQ) = P

(23)

Institute of Lifelong Learning, University of Delhi

23

So, AR = MR = P

Figure 18: TR, AR and MR under Perfect Competition

10: Relationship between TR, AR and MR (Continued) Value addition 3:

Topic 10.3: AR and MR under Imperfect Competition

The purpose of this section is to make you familiar with the shapes of AR and MR curves under imperfect competition market structures.

In case of imperfect competition markets like monopoly or oligopoly, the firms can determine both prices and quantities to be sold.

If you derive the AR and MR curve from the bell shaped TR curve you can show the relation between all the three curves for an imperfect market structure.

You can observe the following from the figure:

 When TR is increasing at a decreasing rate, MR is declining but is positive.

 When TR reaches a maximum, MR becomes zero.

 When TR is decreasing at an increasing rate, MR is declining and is negative.

(24)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

24

 When TR is a bell shaped curve then AR curve tends to decline or is downward sloping. This adheres to the law of demand, that as prices fall consumers demand more products.

 When TR reaches zero AR also becomes zero. AR is never negative as there are no negative prices in a market.

 The AR curve lies above the MR curve always.

 MR falls with the fall in AR, but the rate of decrease in MR is much higher than that in AR.

 The slope of the MR curve is twice the slope of the AR curve. So while the y intercept of both curves is the same, MR curve is twice as steep as AR curve.

Figure 19: TR, AR and MR under Imperfect Competition

11: Relationship between AR, MR and Elasticity Value addition 1:

Topic 11.1: AR, MR and Elasticity

The purpose of this section is to make you familiar with the relationship between AR, MR and Elasticity.

(25)

Institute of Lifelong Learning, University of Delhi

25

You know that price elasticity measures the responsiveness of demand to a change in price of a product. There is a significant relationship between AR, MR and elasticity (e).

MR = AR (1 – 1/e) MR = AR (e-1/e) AR = MR (e/1-e)

ConsiderFigure 20: Relationship between AR, MR and Elasticity

On AR curve when e > 1 then MR is declining but remains positive.

On AR curve when e = 1 then MR is zero.

On AR curve when e < 1 then MR is declining and becomes negative.

On AR curve when e = ∞ then MR is equal to P or AR.

Summary

 The expenses incurred on factors of production are known as costs of production.

 Cost is considered to be a multivariate function.

 Various concepts of costs include Explicit or Direct or Accounting Costs, Implicit or Imputed Costs, Opportunity Cost or alternative cost, and Economic Costs.

 The short-run costs are the costs over a small period of time; say a few months, during which some factors of production are fixed like plant, machinery while others are variable.

 The long-run costs are the costs over a period of time long enough during which all factors of production can become variable.

(26)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

26

 Fixed costs are costs which do not vary with output and are also called overhead costs or unavoidable costs.

 Variable costs are costs which vary with the quantity of output produced and are also known as prime costs.

 Total Costrefers to the aggregate of all fixed and variable costs of producing any given level of output.

 TFC is represented by a straight line parallel to the x-axis or a horizontal line.

 TVC is represented by an inverse-S shaped curve due to law of variable proportions.

 TC is inverse-S shaped starting from the level of fixed cost.

 Average Variable Cost is defined as the total variable cost divided by output.

 Average Fixed Cost is defined as the total fixed cost divided by output.

 Average Cost is defined as the total cost divided by output.

 Marginal Cost is the addition made to TC or TVC as output is increased by one more unit.

 AVC, AC and MC curves are U-shaped because of the law of variable proportions.

 MC cuts AVC and AC curves at their respective minimum points.

 Long-Run Average Cost (LAC) shows the minimum cost per unit of producing each level of output when the capacity of the firm is varied.

 Long-Run Marginal Cost (LMC) shows the minimum amount by which cost is increased each time, when output is increased.

 The LAC curve is also said to be a cost frontier because it separates the inefficient levels of cost from the efficient levels of cost.

 Economies of scale are advantages, which accrue to firms on account of benefits of large scale production.

 Diseconomies of scale are disadvantages which a firm faces on account of over expansion of scale of operation beyond its optimal size.

 A proper understanding of cost analysis helps managers take correct decisions.

 Total Revenue is the aggregate of the proceeds or income received by the producer from the sale of a final product.

 TR is a bell shaped curve for a market structure where both price and quantity can change.

 TR can also be an upward sloping straight line from the origin, when the price is given and revenue depends only on the quantity sold.

 Average Revenue is the revenue that a producer earns, per unit of final product sold.

 Marginal Revenue is the addition to total revenue by selling one additional unit of the final product.

 While the y intercept of both AR and MR curves is the same, MR curve is twice as steep as AR curve.

 Price elasticity measures the responsiveness of demand to a change in price of a product. There is a significant relationship between AR, MR and elasticity.

Exercises

Short Questions

1. Differentiate between fixed costs and variable costs.

2. Explain the reasons for shift in cost curves.

3. Show the impact of determinants of costs on total costs.

(27)

Institute of Lifelong Learning, University of Delhi

27

4. Elaborate the various concepts of costs.

5. Describe economies and diseconomies of scale.

6. Explain the concept of total revenue for a firm under perfect competition market.

7. Explain the concept of total revenue for a firm under imperfect competition market.

Long Questions

1. Diagrammatically, show the relation between AVC, AC and MC.

2. Discuss how the shapes of cost curves are determined by the law of variable proportions.

3. Derive the long-run cost curves from short-run cost curves.

4. Diagrammatically, show the relation between production function and cost curves.

5. Show the difference in relationship between AR and MR curves for a price taker and a price maker firm.

6. Show diagrammatically the relation between AR, MR and elasticity of demand.

Complete the following table:

Output TFC TVC TC AFC AVC AC MC

0 100 70

1 100

2 110

3 115

4 125

5 145

6 180

Solution:

TC = TFC + TVC AFC = TFC/X AVC = TVC/X

AC = TC/X or AC = AFC + AVC MC = TCn – TCn-1

Output TFC TVC TC AFC AVC AC MC

0 100 70 170 - - - -

1 100 100 200 100 100 200 30

2 100 110 210 50 55 105 10

3 100 115 215 33.33 38.33 71.66 5

4 100 125 225 25 31.25 56.25 10

5 100 145 245 20 29 49 20

6 100 180 280 16.66 30 46.66 35

Complete the following table:

Quantity sold TR AR MR

- 1000 100 -

9 - 110 10

- 960 120 -

7 - 130 50

(28)

Theory of Cost and Revenue

Institute of Lifelong Learning, University of Delhi

28

- 840 140 70

5 - 150 90

- 640 160 -

Solution:

Quantity sold TR = AR x Q AR = TR/Q MR = TRn – TRn-1

10 1000 100 -

9 990 110 10

8 960 120 30

7 910 130 50

6 840 140 70

5 750 150 90

4 640 160 110

Glossary

A.Short-run costs

Term 1:The short-run costs are the costs over a small period of time; say a few months, during which some factors of production are fixed like plant, machinery while others are variable.

B.Long-run costs

Term 2:The long-run costs are the costs over a period of time long enough during which all factors of production can become variable.

C.Fixed Costs

Term 3: Fixed costs do not vary with output and are also called overhead costs or unavoidable costs.

D.Variable costs

Term 4: Variable costs are costs which vary with the quantity of output produced and are also known as prime costs.

E.Total Cost

Term 5:Total Costrefers to the aggregate of all fixed and variable costs of producing any given level of output.

F.Average Fixed Cost

Term 6:Average Fixed Cost is defined as the total fixed cost divided by output.

G.Average Variable Cost

Term 7:Average Variable Cost is defined as the total variable cost divided by output.

H.Average Cost

Term 8:Average Cost is defined as the total cost divided by output.

I.Marginal Cost

Term 9:Marginal Cost is the addition made to TC or TVC as output is increased by one more unit.

J.Total Revenue

Term 10:Total Revenue is the aggregate of the proceeds or income received by the producer from the sale of a final product.

K.Average Revenue

Term 10:Average Revenue is the revenue that a producer earns, per unit of final product sold.

L.Marginal Revenue

(29)

Institute of Lifelong Learning, University of Delhi

29

Term 11:Marginal Revenue is the addition to total revenue by selling one additional unit of the final product.

References 1. Work Cited

 Koutsoyiannis, A. Modern Micro Economics, (Macmillian), English Language Book Society, 2nd Edition, 1979, Chart 15.1, pp. 127

2. Suggested Readings:

 Business Economics, Theory & Applications. Dr. D. D. Chaturvedi&Dr. S. L. Gupta, International Book House Pvt. Ltd., 2nd Edition, 2011

References

Related documents

This report provides some important advances in our understanding of how the concept of planetary boundaries can be operationalised in Europe by (1) demonstrating how European

The Congo has ratified CITES and other international conventions relevant to shark conservation and management, notably the Convention on the Conservation of Migratory

Although a refined source apportionment study is needed to quantify the contribution of each source to the pollution level, road transport stands out as a key source of PM 2.5

INDEPENDENT MONITORING BOARD | RECOMMENDED ACTION.. Rationale: Repeatedly, in field surveys, from front-line polio workers, and in meeting after meeting, it has become clear that

Angola Benin Burkina Faso Burundi Central African Republic Chad Comoros Democratic Republic of the Congo Djibouti Eritrea Ethiopia Gambia Guinea Guinea-Bissau Haiti Lesotho

In addition to this we have applied the ECM based granger causality test to estimate the long run and short run causality the results indicates the presence of

The petitioner also seeks for a direction to the opposite parties to provide for the complete workable portal free from errors and glitches so as to enable

The matter has been reviewed by Pension Division and keeping in line with RBI instructions, it has been decided that all field offices may send the monthly BRS to banks in such a