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 Reading :

1. Principles of Economics by Deviga Vengedasalam & Karunagaran Madhavan,
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. L.P.Panda, 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

 Examples :
 Direct Material : Cotton in Cotton Textiles
 Indirect Material : oil, cotton waste etc.
Direct Labour Cost : Cost of labour directly engaged in production
 Indirect Labour Cost : Salesman Commission.
Direct Expenses : Wages and Salaries
Indirect Expenses : Hospital Expense of employees
Dr. L.P.Panda, GCEK
 Types of costs
Explicit (or paid out ) and Implicit (or, imputed)Costs:
A firm’s cost of production include explicit costs and implicit
costs.
•Explicit costs is the value of resources purchased for
production . (Wages and salaries to workers, payments for
fuel, 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
production.

Dr. L.P.Panda, GCEK

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

Dr. L.P.Panda, GCEK

 Economic Profit versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Dr. L.P.Panda, 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 machine with his resources.
Alternative – I 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. L.P.Panda, 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. L.P.Panda, 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. L.P.Panda, 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 changes
independent of output. with output.
 Examples: Factory, machinery  Example: Raw materials, labours,
and etc. etc.

Dr. L.P.Panda, 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. L.P.Panda, 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 another unit of output:
MC = TC
Q

Dr. L.P.Panda, 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. L.P.Panda, 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 = TC ATC = 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. L.P.Panda, 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. L.P.Panda, 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. L.P.Panda, 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. L.P.Panda, 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. L.P.Panda, 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. L.P.Panda, GCEK
1. Average Fixed Cost: AFC = FC/q
Since Total Fixed Cost is a constant dividing it
by an increasing output gives a steadily
falling AFC & 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
AVC falls initially and then rises.
3. Average Cost or Average Total Cost (AC or
ATC)
AC = TC/Q
AVC & AC are ‘U’ shaped on the short run.
Dr. L.P.Panda, GCEK
 COST CALCULATION
FIXED COST = 55

Dr. L.P.Panda, 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 of labour
r = Price of capital
Dr. L.P.Panda, GCEK
 ISOCOST (cont.)

Isocost Line
6
Capital

5
4
3
Isocost
2
1
0
1 2 3 4 5 Labour

Iso-cost line shows the various combinations of labour and

capital with given total cost for a firm in the production of shoes.

Dr. L.P.Panda, 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
Capital

2 5 Labour

Dr. L.P.Panda, 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 (RM100)
3
Isocost (RM120)
2
1
0
1 2 3 4 5 6 7 Labour
Dr. L.P.Panda, 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 (RM100)
3
Isocost (RM120)
2
1
0
1 2 3 4 5 6 7 Labour
Dr. L.P.Panda, 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 (RM100)
Capital

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

Dr. L.P.Panda, GCEK

 COST CURVES IN THE LONG RUN

 Long run is a period where there are only variable

factors and no fixed cost involved.
 Long run total cost (LRTC) starts from origin
because of the absence of total fixed cost.
LONG RUN AVERAGE COST CURVE (LRAC)

 Shows the minimum cost of producing any given

output when all of the inputs are variable.
 Long run is a period where firms plan how to
minimize average cost.

Dr. L.P.Panda, 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. L.P.Panda, 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

Increasing Constant Decreasing

Return to Return to Return to
Scale Scale Scale

Quantity
Dr. L.P.Panda, GCEK
 ECONOMIES OF SCALE
Economies of scale are benefits and advantages
of a firm as it expands its production.
• Reduce the average cost.
INTERNAL EXTERNAL
Internal economies happen inside an organization Advantages of the industry as a 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. L.P.Panda, 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 firm as The disadvantages faced by the industry
the firm expands as a whole

Labour Diseconomies Scarcity of Raw Material

Wage Differential
Management Problem

Concentration Problem
Technical Difficulties

Dr. L.P.Panda, 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.

Average Revenue (AR) = Total Revenue (TR)

Quantity (Q)
AR = PxQ = PRICE
Q

Dr. L.P.Panda, 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. L.P.Panda, GCEK