Analysis of cost and revenues

Unit 3
Money cost: money costs are the cost which firm
has to incur in purchasing or hiring productive
services. These expenses include:
• All types of rental expenses incurred on land,
machines and buildings
• All types of expenses made on purchasing
machinery, equipments and raw materials
• Wages and salaries paid to labor
• Interest on borrowing
• Other monetary expanses
Real cost : The overall actual expense involved in
creating a good or service for sale to consumers.
The real cost of production for a business typically
includes the value of all tangible resources such as
raw materials and labor that are used in the
production process.
Explicit cost: explicit costs are the monetary costs paid
by the firm to the owners of various factors services.
These costs are the monetary payments which a firm
makes to those outsiders who supply labor services,
materials, fuel, transport services, power and so forth.
In other words, explicit costs are only the money
expenses actually incurred by firm on the purchases of
factor services.
Implicit cost: there are certain services which
are owned and provided by the entrepreneur
himself, for which no money payment is made.
The cost incurred on such self-owned or self-
employed resources are implicit cost. For
example, the entrepreneur may contribute his
own land, his own capital, and may provide
managerial and entrepreneurial services.
 Opportunity cost:

Opportunity cost:
• Opportunity cost is the opportunity lost.
• The benefit forgone from using a resource for one purpose
as opposed to its best alternative use.
• Suppose a farmer can produce 300 kg rice in one propane
land using certain inputs. If the farmer produces maize at
that land can produce 200 kg maize only using same inputs
as before. Here assume that cost of rice and maize is same.
At this situation the farmer sacrifices to produce maize. The
sacrifice of 200 kg of maize is the opportunity cost of 300
kg of rice
 Short run costs and cost curves
• All types of costs incurred on short run
production function are known as short run
costs. In short run, costs can be classified as
fixed and variable costs.
• Total cost= total variable cost + Total fixed cost
• TC=TVC+ TFC
Total Fixed Cost (TFC):
All type of money costs incurred on fixed factors of
production employed in the production process is called
TFC. It includes:
• Salaries to permanent staff
• All types of rental expenses
• All types of expenses on construction
• All types of expenses on machinery and equipment
1. It does not change with the change in output
and always greater than zero.
2. They are unavoidable because whatever be the change
in output it remains constant,
3. Also called overhead cost.
Total Variable Cost (TVC):
All types of cost incurred by the firm on the use of the variable
factors are known as TVC. It includes:
• Expenses on raw materials
• Running expenses of fixed capital such as fuel, ordinary repairs
and maintenance cost.
• Cost of direct labor
• Expenses on transport services.
1. It varies directly with the change in level of output.
2. When output is zero or production is closed, they will be zero.
3. They are avoidable.
4. It increases at a decreasing rate initially and increase at an
increasing rate later as output increases
In the short run, total cost is the sum of TVC and
TFC
TC=TVC+TFC
Q TFC TVC TC=T AFC= AVC= AC= MC=
VC+T TFC/ TVC/ TC/Q ∆TC/
FC Q Q ∆Q
0 200 0 200 - - - -
1 200 20 220 200 20 220 20
2 200 36 236 100 18 118 16
3 200 48 248 66.7 16 82.7 12
4 200 64 264 50 16 66 16
5 200 100 300 40 20 60 36
6 200 160 360 33.4 26.6 60 60
7 200 248 448 28.4 35.4 64 88
8 200 360 560 25 45 70 112
9 200 520 720 22.2 57.8 80 160
Graphically
 Cont……………
• TFC is the total fixed cost curve. It is parallel to
output axis because TFC remains constant
whatever be the level of output. Fixed cost
remains constant at zero or any level of
output. The producer must spend certain
amount of money before beginning output to
make buildings, develop land, purchase
machines, pay for supporting staffs and so on.
• TFC is independent of level of output.
 Cont……………
• TVC is total variable cost which begins from origin
and slopes upwards to the right as inverse S- shaped.
This indicates that TVC equals to zero at zero level of
output and increases at a decreasing rate as the total
output increases and subsequently it increases at an
increasing rate with increase in the output.
• TC is the total cost curve which is formed by the
vertical summation of the TFC curve and TVC curve.
TC curve starts from TFC curve because at zero level
of output, the TC=TFC.
 Short run average costs
• Average fixed cost (AFC):
It is the outcome of TFC divided by total
output(Total produced quantity).
AFC=TFC/Q
When output increases, it falls continuously at a
diminishing rate (it falls at a high rate initially and
at a low rate later). It is because the fixed
amount of cost is divided into a number of the
units of output.
 Cont…………..
Average variable cost (AVC):
It is the outcome of the total variable cost divided
by the total produced quantity (total output)
AVC=TVC/Q
The trend of AVC depends on the trend of the
TVC. When the TVC increases at a decreasing
rate, the AVC decreases and when the TVC
increases at increasing rate, the AVC increases.
 Cont…………….
Average cost (AC):
It is the outcome of the TC divided by the total
output.
AC=TC/Q=(TFC+TVC)/Q=TFC/Q+TVC/Q=AFC+AVC
Marginal cost (MC):
Marginal cost is addition made to total cost by
producing one more units of output(extra cost
required to produce an extra output ).
MC=∆TC/∆Q=Change in total cost/change in output
Relationship between AC
AND MC
•When AC slopes downwards,
MC lies below AC.
•When AC slopes upwards,
MC lies above AC.
•When the AC is minimum,
the MC is equal to AC.
•MC curve intersects AC at its
minimum point from below.
•Both MC and AC curves have
the same shape, U- shaped.
Why is AC U-shaped?
•AC cost curve falls initially,
reaches the minimum point and
rises later as output increases.
• It is due to the operation of
the law of variable proportions
in the short run production
function.
•When the law of variable
proportions operates in the
production, the average
product increases and becomes
maximum and average cost falls
and reaches at minimum point.
•When the law of diminishing
operates in production, the
average product decreases and
the average cost rises.
Modern theory of cost
(1) Short-Run Cost Curves:
•As in the traditional theory, the
short-run cost curves in the
modem theory of costs are the
AFC, SAVC, SAC and SMC curves.
• As usual, they are derived from
the total costs which are divided
into total fixed costs and total
variable costs.
•But in the modem theory, the
SAVC and SMC curves have a
saucer-type shape or bowl-
shape rather than a U-shape. As
the AFC curve is a rectangular
hyperbola, the SAC curve has a
U-shape even in the modem
version
The short-run average total cost curve
(SATC or SAC) is obtained by adding
vertically the average fixed cost curve
(AFC) and the SAVC curve at each level of
output. The SAC curve, as shown in
Figure , continues to fall up to the OQ level
of output at which the reserve capacity of
the plant is fully exhausted.
Beyond that output level, the SAC curve
rises as output increases. The smooth and
continuous fall in the SAC curve upto the
OQ level of output is due to the fact that
the AFC curve is a rectangular hyperbola
and the SAVC curve first falls and then
becomes horizontal within the range of
reserve capacity. Beyond the OQ output
level, it starts rising steeply. But the
minimum point M of the SAC curve where
the SMC curve intersects it, is to the right
of point E of the SAVC curve. This is
because the SAVC curve starts rising
steeply from point E while the AFC curve is
falling at a very low rate.
 Concepts of TR, AR &MR
TOTAL REVENUE:
it is defined as the total sales receipts that a firm receives from the sale
of its products.
TR=PXQ
Where, P= Per unit price
Q= Total sales quantity
Average Revenue:
it is the outcome of the total revenue divided by the total output
AR=TR/Q
Marginal Revenue:
additional made to the total revenue by selling one more unit of the
output.
MR=∆TR/∆Q
 TR,AR &MR PERFECT COMPETITION
Definition :
It is a market structure in which large number of sellers sells homogenous(identical
quality) product to large number of buyers.
Assumptions:
• Large number of buyers and sellers
• Product homogeneity with perfect substitutes
• Free entry and exit of firm
• Perfect knowledge
• Perfect mobility of factors of production
• Absence of transport cost
• No government regulation
• Firm is simply a price taker(industry is price maker on the basis of market demand
and supply) and output adjuster
• Profit maximization
Q P TR AR MR
1 20 20 20 -
2 20 40 20 20
3 20 60 20 20
4 20 80 20 20
5 20 100 20 20
6 20 120 20 20
7 20 140 20 20
 CONT……………
• When the seller increases his sales as
proportionately at constant price, total
revenue also increases at the same
proportion.
• Average and marginal revenues remain
constant at each increasing level of output.
• AR=MR at each level of output(a firm is simply
a price taker in perfect competition.).
Relationship between
AR,MR & TR
•TR curve is a straight line
starts from origin.
• TR increases at a constant
rate as output increases.
•AR=MR=P (Price is given)
•AR and MR are constant for
all level of sales.
 TR,AR &MR Monopoly

Features of monopoly:
• Single seller and large number of buyers
• No close substitutes
• Barriers to entry of new firms
• Imperfect knowledge about market
• Price maker
• Profit maximization
RELATIONSHIP BETWEEN
TR,AR &MR
•TR increases at a decreasing
rate so long as MR is positive
•TR reaches at its maximum
when MR becomes zero
•TR declines when MR is
negative
•AR and MR have positive
relationship. A decrease in MR
causes to decline in AR.
•The decrease in MR is greater
than the decrease in AR.
•MR might be negative
however AR remains always
positive.