CHAPTER-3

REVENUE AND COST ANALYSIS

1. Explain the Revenue Concepts.

Ans : Revenue, in simple words, is the amount that a firm receives from the sale of the output. According to
Prof. Dooley, ” The Revenue of a firm is its sales receipts or income.‘ In a firm, revenue is of three types:
1. Total Revenue

2. Average Revenue

3. Marginal Revenue

Let’s look at each one of them in detail:

1. Total Revenue
This is simple. The Total Revenue of a firm is the amount received from the sale of the output.
Therefore, the total revenue depends on the price per unit of output and the number of units sold.
Hence, we have
TR = Q x P
Where,
 TR – Total Revenue
 Q – Quantity of sale (units sold)
 P – Price per unit of output

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 2. Average Revenue

Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold.
Therefore, you can get the average revenue when you divide the total revenue with the total units sold.
Hence, we have,
AR=TR/Q
Where,

 AR – Average Revenue
 TR – Total Revenue
 Q – Total units sold

3. Marginal Revenue

Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit. In
other words, it is the additional revenue that a firm receives when an additional unit is sold. Hence, we
have
MR = TRn – TRn-1
Or
MR=ΔTRΔQ
Where,
 MR – Marginal Revenue
 ΔTR – Change in the Total revenue
 ΔQ – Change in the units sold
 TRn – Total Revenue of n units
 TRn-1 – Total Revenue of n-1 units

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2. Explain the AR and MR under Perfect Competition and Monoply Market situation.
Ans : A firm under perfect competition is price-taker. This simply means it can alter its volume of output
and sales level without significantly affecting the market price of its product. This explains why a firm
operating in a perfectly competitive market has no power to influence that market through its own
individual actions. It must passively accept whatever price happens to prevail in the market. At the
prevailing market (ruling) price it can sell as much as it likes. This means that the demand for its product is
completely elastic at a particular (market determined) price.

The Revenue Concepts:

To study the nature of a firm’s demand curve as also the revenues that firms receive from the sales of their
products, economists define 3 concepts, viz., TR, AR and MR. TR is the total amount received by the firm from
the sale of a product. If q units are sold at price of p rupees, TR = pq. AR is the amount of revenue per unit sold.

Since this is equal to the price at which the product is sold (AR = TR/q = pq/q = p) it is called the seller’s
demand curve or the demand curve for the product of the an individual seller. MR is the change in a seller’s TR
resulting from a change in its sales level by one unit. In economics, the word ‘margin’ always refers to anything
extra. This means at the existing level of sales, MR shows what revenue the firm could gain by selling one unit
more and what revenue it would lose by selling one unit less.

AR and MR under Perfect Competition /Industry Demand and Firm Demand:

Fig. 7 shows both the demand curve for the product of a single firm under perfect competition.

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To illustrate these three revenue concepts, let us consider a firm which is selling an agricultural product in a
perfectly competitive market (such as wheat) at a price of Rs. 3 per tonne. Since price remains fixed, TR
rises by Rs. 3 for every tonne sold. Since every unit brings in Rs. 3, the AR per unit sold is surely Rs. 3.
Moreover; since each additional unit sold brings in Rs. 3, the MR of an extra unit sold is also Rs. 3. Table 1
shows revenue figures for certain range of output (between 10 and 13 units). Fig. 8 illustrates the
corresponding total revenue (TR) curve.

The most important point to note here is that, as long as the volume of the firm’s output does not significantly
affect the price at which that output sells, MR = AR (which is always equal to p which is Rs. 3). We see that AR
and MR are the same horizontal line (drawn at the level of market price) and parallel to the x-axis.

In short- “if the market price is unaffected by variations in the firm’s output, then the firm’s demand curve, its
AR curve and MR curve will coincide in the same horizontal line”.

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This means that for a firm in perfect competition, p = MR. For such firm TR increases in direct proportion to
output.

AR and MR curve under Imperfect Market situation or Monopoly market

When a firm is working under conditions of monopoly or imperfect competition, its demand curve or AR
curve is less than perfectly elastic, the exact degree of elasticity being different in different market
situations depending upon the number of sellers and the nature of product.

In other words, the demand/AR curve has a negative slope and the MR curve lies below it. This is
because the monopolist seller ordinarily has to accept a lower price for his product, as he increases his
sales.

Under imperfect competition conditions, total revenue increases at a diminishing rate. It becomes
maximum and then begins to decline.

In table 7, 2 units can be sold at a unit price of Rs. 5, bringing in total revenue of Rs. 10. When 3 units
are sold, the price per unit is lowered to Rs. 4 to make it possible for larger quantity to be sold. The total
revenue in this case is Rs. 12.

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The marginal unit is not bringing in Rs. 4 which is its price, but only Rs. 2. This is because the additional
one unit is sold at Re. one less and the first 2 units which could have been sold for Rs. 5 are also sold at
Rs. 4. i.e., Re. one less.

Fig. 10 A shows that as additional units are sold when price comes down not only for the marginal units
but also for other previous units. As a result, marginal units do not bring revenue equal to its price. In fig.
10 B. TR increases at a diminishing rate, becomes maximum at point N and then begins to decline. This
has been represented by the curve TR. AR at any point on the TR curve is given by the slope of straight
line joining the point to the origin. For instance, AR at any point N on TR curve is given by the slope of
line

3. Explain the Different cost classification as per the Economic Concept.

Ans : Cost can be classified into different types :
Concept of Costs in terms of Treatment
1. Accounting costs : Accounting costs are those for which the entrepreneur pays direct cash for procuring
resources for production. These include costs of the price paid for raw materials and machines, wages paid to
workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs
are treated as expenses. Chartered accountants record them in financial statements.

2. Economic costs : There are certain costs that accounting costs disregard. These include money which the
entrepreneur forgoes but would have earned had he invested his time, efforts and investments in other ventures.
For example, the entrepreneur would have earned an income had he sold his services to others instead of
working on his own business.

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Concept of Costs in terms of the Nature of Expenses

1. Outlay costs : The actual expenses incurred by the entrepreneur in employing inputs are called outlay costs.
These include costs on payment of wages, rent, electricity or fuel charges, raw materials, etc. We have to treat
them are general expenses for the business.

2. Opportunity costs : Opportunity costs are incomes from the next best alternative that is foregone when the
entrepreneur makes certain choices. For example, the entrepreneur could have earned a salary had he worked
for others instead of spending time on his own business. These costs calculate the missed opportunity and
calculate income that we can earn by following some other policy.

Concept of Costs in terms of Traceability

1. Direct costs : Direct costs are related to a specific process or product. They are also called traceable costs as
we can directly trace them to a particular activity, product or process. They can vary with changes in the activity
or product. Examples of direct costs include manufacturing costs relating to production, customer acquisition
costs pertaining to sales, etc.

2. Indirect costs : Indirect costs, or untraceable costs, are those which do not directly relate to a specific activity
or component of the business. For example, an increase in charges of electricity or taxes payable on income.
Although we cannot trace indirect costs, they are important because they affect overall profitability.

Concept of Costs in terms of the Purpose

1. Incremental costs : These costs are incurred when the business makes a policy decision. For example,
change of product line, acquisition of new customers, upgrade of machinery to increase output are incremental
costs.

2. Sunk costs : Suck costs are costs which the entrepreneur has already incurred and he cannot recover them
again now. These include money spent on advertising, conducting research, and acquiring machinery.

Concept of Costs in terms of Payers

1. Private costs : These costs are incurred by the business in furtherance of its own objectives. Entrepreneurs
spend them for their own private and business interests. For example, costs of manufacturing, production, sale,
advertising, etc.

2. Social costs : As the name suggests, it is the society that bears social costs for private interests and expenses
of the business. These include social resources for which the firm does not incur expenses, like atmosphere,
water resources and environmental pollution.

4. Explain the Behaviour of Cost curves in Short run and the Long run.
Ans : Short Run Costs
A short-run cost curve shows the minimum cost impact of output changes for a specific plant size and in a
given operating environment. Such curves reflect the optimal or least-cost input combination for producing
output under fixed circumstances. Wage rates, interest rates, plant configuration, and all other operating
conditions are held constant.
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Any change in the operating environment leads to a shift in short-run cost curves. For example, a general rise in
wage rates leads to an upward shift; a fall in wage rates leads to a downward shift. Such changes must not be
confused with movements along a given short-run cost curve caused by a change in production levels. For an
existing plant, the short-run cost curve illustrates the minimum cost of production at various output levels under
current operating conditions. Short-run cost curves are a useful guide to operating decisions.

Short-Run Cost Categories

Both fixed and variable costs affect short-run costs. Total cost at each output level is the sum of total fixed cost
(a constant) and total variable cost. Using TC to represent total cost, TFC for total fixed cost, TVC for total
variable cost, and Q for the quantity of output produced, various unit costs are calculated as follows:

These cost categories are portrayed in Table. Using these data, it is possible to identify the various cost relations
as well as to examine cost behavior. Table shows that AFC declines.

continuously with increases in output. AC and AVC also decline as long as they exceed MC, but increase when
they are less than MC. Alternatively, so long as MCis less than AC and AVC, both average cost categories will

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decline. When MC is greater than AC and AVC, both average cost categories will rise. Also note that TFC is
invariant with increases in output and that TVC at each level of output equals the sum of MC up to that output.
Marginal cost is the change in cost associated with a one-unit change in output. Because fixed costs do not vary
with output, fixed costs do not affect marginal costs. Only variable costs affect marginal costs. Therefore,
marginal costs equal the change in total costs or the change in total variable costs following a one-unit change
in output:

Short-Run Cost Relations

Relations among short-run cost categories are shown in Figure. Figure illustrates total cost and total variable
cost curves. The shape of the total cost curve is determined entirely by the total variable cost curve. The slope of
the total cost curve at each output level is identical to the slope of the total variable cost curve. Fixed costs
merely shift the total cost curve to a higher level. This means that marginal costs are independent of fixed cost.

The shape of the total variable cost curve, and hence the shape of the total cost curve, is determined by the
productivity of variable input factors employed. The variable cost curve in Figure increases at a decreasing rate
up to output level Q1, then at an increasing rate.
Assuming constant input prices, this implies that the marginal productivity of variable inputs first increases,
then decreases. Variable input factors exhibit increasing returns in the range from 0 to Q1 units and show
diminishing returns thereafter. This is a typical finding. Fixed

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the range of increasing productivity and rises thereafter. This imparts the familiar U-shape to average variable
cost and average total cost curves. At first, marginal cost curves also typically decline rapidly in relation to the
average variable cost curve and the average total cost curve.
Near the target output level, the marginal cost curve turns up and intersects each of the AVC and AC short-run
curves at their respective minimum points.3
Long Run Cost
In the long run, all the factors of production used by an organization vary. The existing size of the plant or
building can be increased in case of long run. There are no fixed inputs or costs in the long run. Long run is a
period in which all the costs change as all the factors of production are variable.

There is no distinction between the Long run Total Costs (LTC) and long run variable cost as there are no
fixed costs. It should be noted that the ability of an organization of changing inputs enables it to produce at
lower cost in the long run.

1. Long Run Total Cost:

Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be produced.
According to Leibhafasky, “the long run total cost of production is the least possible cost of producing any
given level of output when all inputs are variable.” LTC represents the least cost of different quantities of
output. LTC is always less than or equal to short run total cost, but it is never more than short run cost.

As shown in Figure-10, short run total costs curves; STC1, STC2, and STC3 are shown depicting different plant
sizes. The LTC curve is made by joining the minimum points of short run total cost curves. Therefore, LTC
envelopes the STC curves.

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2. Long Run Average Cost:
Long run Average Cost (LAC) is equal to long run total costs divided by the level of output. The derivation of
long run average costs is done from the short run average cost curves. In the short run, plant is fixed and each
short run curve corresponds to a particular plant. The long run average costs curve is also called planning curve
or envelope curve as it helps in making organizational plans for expanding production and achieving minimum
cost.

Suppose there are three sizes of the plant and no other size of the plant can be built. In short run, the plant sizes
are fixed thus, organization increase or decrease the variable factors. However, in the long run, the organization
can select among the plants which help in achieving minimum possible cost at a given level of output.

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From Figure-11, it can be noted that till OB amount of production, it is beneficial for the organization to operate
on the plant SAC2 as it entails lower costs than SAC1. If the plant SAC2 is used for producing OA, then cost
incurred would be more. Thus, in the long run, it is clear that the producer would produce till OB on plant
SAC2. On SAC2, the producer would produce till OC amount of output. If an organization wants to exceed
output from OC, it will be beneficial to produce at SAC3 than SAC2.

Thus, in the long run, an organization has a choice to use the plant incurring minimum costs at a given output.
LAC depicts the lowest possible average cost for producing different levels of output. The LAC curve is
derived from joining the lowest minimum costs of the short run average cost curves.

It first falls and then rises, thus it is U- shaped curve. The returns to scale also affect the LTC and LAC. Returns
to scale implies a change in output of an organization with a change in inputs. In the long run, the output
changes with respect to change in all inputs of production.

In case of increasing returns to scale (IRS), organizations can double the output by using less than twice of
inputs. LTC increases less than the increase in the output, thus, LAC falls. In case of constant returns to scale
(CRS), organizations can double the output by using inputs twice.

LTC increases proportionately to the output; therefore, LAC becomes constant. On the other hand, in case of
decreasing returns to scale (DRS), organizations can double the output by using inputs more than twice. Thus,
LTC increases more than the increase in output. As a result, LAC increases.

As shown in Figure-12, up to M, LAC slopes downward. This is because at this stage IRS is applied. On the
other hand, at M, LAC becomes constant. After M, LAC slopes upwards implying DRS.

3. Long Run Marginal Cost:

Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a commodity when
all inputs are variable. This cost is derived from short run marginal cost. On the graph, the LMC is derived from
the points of tangency between LAC and SAC.

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If perpendiculars are drawn from point A, B, and C, respectively; then they would intersect SMC curves at P, Q,
and R respectively. By joining P, Q, and R, the LMC curve would be drawn. It should be noted that LMC
equals to SMC, when LMC is tangent to the LAC.

Therefore it can be seen,

SAC2 = SMC2 = LAC = LMC

We can also draw the relation between LMC and LAC as follows:
When LMC < LAC, LAC falls

When LMC = LAC, LAC is constant

5. Explain the relationship between LAC and LMC.

Ans: In the long-run, the ability to change capital input allows the firm to reduce costs along its expansion
path as we can look at the long-run average (LRAC) and marginal cost curves. The most important
determinant of the shape of the LRAC and LMC curves is whether there are increasing, constant, or
decreasing returns to scale.
Suppose that the firm’s production process exhibits constant returns to scale, and, thus, the average cost of
production must be the same for all levels of output.

Suppose instead, that the firm’s production process is subject to increasing returns to scale and the average cost
of production falls as output increases. Similarly, when there are decreasing returns o scale the average cost of
production must be increasing with output. Fig. 7.6 shows a typical LRAC and LRMC.

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 The LAC curve is U-shaped, just like the SAC curve but the source of the U-shape is increasing and decreasing
returns to scale, rather than diminishing returns to a factor of production. In the long-run, it may be in the firm’s
interest to change the input propositions as the level of output changes. When input proportions do change, the
concept of returns to scale no longer applies.

6. What is Modern Theory of Costs?

Ans : Empirical evidence about the long-run average cost curve reveals that the LAC curve is L-shaped rather
than U-shaped. In the beginning, the LAC curve rapidly falls but after a point “the curve remains flat, or may
slope gently downwards, at its right-hand end.” Economists have assigned the following reasons for the L-shape
of the LAC curve.

1.Production and Managerial Costs: In the long run, all costs being variable, production costs and managerial
costs of a firm are taken into account when considering the effect of expansion of output on average costs. As
output increases, production costs fall continuously while managerial costs may rise at very large scales of
output. But the fall in production costs outweighs the increase in managerial costs so that the LAC curve falls
with increases in output. We analyse the behaviour of production and managerial costs in explaining the L-
shape of the LAC curve.
2. Production Costs: As a firm increases its scale of production, its production costs fall steeply in the
beginning and then gradually. The is due to the technical economies of large scale production enjoyed by the
firm. Initially, these economies are substantial. But after a certain level of output when all or most of these
economies have been achieved, the firm reaches the minimum optimal scale or mini mum efficient scale
(MES).

Given the technology of the industry, the firm can continue to enjoy some technical economies at outputs
larger than the MES for the following reasons:

(a) from further decentralisation and improvement in skills and productivity of labour;

(b) from lower repair costs after the firm reaches a certain size; and

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(c) by itself producing some of the materials and equipment cheaply which the firm needs instead of buying
them from other firms.

Managerial Costs: In modern firms, for each plant there is a corresponding managerial set-up for its smooth
operation. There are various levels of management, each having a separate management technique applicable
to a certain range of output. Thus, given a managerial set-up for a plant, its managerial costs first fall with the
expansion of output and it is only at a very large scale output, they rise very slowly.

To sum up, production costs fall smoothly and managerial costs rise slowly at very large scales of output. But
the fall in production costs more than offsets the rise in managerial costs so that the LAC curve falls smoothly
or becomes flat at very large scales of output, thereby giving rise to the L-shape of the LAC curve.

Relation between LAC and LMC Curves:

In the modern theory of costs, if the LAC curve falls smoothly and continuously even at very large scales of
output, the LMC curve will lie below the LAC curve throughout its length, as shown in Figure 12.

If the LAC curve is downward sloping up to the point of a minimum optimal scale of plant or a minimum
efficient scale (MES) of plant beyond which no further scale economies exist, the LAC curve becomes
horizontal. In this case, the LMC curve lies below the LAC curve until the MES point M is reached, and
beyond this point the LMC curve coincides with the LA С curve, as shown in Figure 13.

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 Conclusion:
The majority of empirical cost studies suggest that the U-shaped cost curves postulated by the traditional
theory are not observed in the real world. Two major results emerge predominantly from most studies. First,
the SAVC and SMC curves are constant over a wide-range of output.

Second, the LAC curve falls sharply over low levels of output, and subsequently remains practically constant
as the scale of output increases. This means that the LAC curve is L-shaped rather than U-shaped. Only in
very few cases diseconomies of scale were observed, and these at very high levels of output.

7. What is Cost Benefit Analysis? Explain the use and constraints of cost Benefit Analysis.
Ans : Definition: It can be explained as a procedure for estimating all costs involved and possible profits to
be derived from a business opportunity or proposal.

Description: It takes into account both quantitative and qualitative factors for analysis of the value for money
for a particular project or investment opportunity. Benefits to costs ratio and other indicators are used to
conduct such analyses.

The objective is to ascertain the soundness of any investment opportunity and provide a basis for making
comparisons with other such proposals. All positives and negatives of the project are first quantified in
monetary terms and then adjusted for their time-value to obtain correct estimates for conduct of cost-benefit
analysis. Most economists also account for opportunity costs of the investment in the project to get the costs
involved.

The Use of Cost-Benefit Analysis:

The technique of cost-benefit analysis is particularly used when a long and wider view of the effects of a
particular project or expenditure programme is needed. As in case of capital budgeting by private firms cost-
benefit analysis is generally used in case when the economic effects of a project or investment expenditure
programme or policy change accrue in future years. However, unlike the capital budgeting by private firms, the
cost-benefit analysis attempts to estimate all direct economic effects as well as indirect spill-over effects.

Cost-benefit analysis is used to assess whether a particular project or specific public expenditure programme
should be accepted or rejected. In order to do so, benefits, both direct and indirect, of the project or specific
public expenditure programme and similarly the costs to be incurred on the project over the years are estimated.
Then the present value of both the benefits and costs over the future years are estimated using an appropriate
discount rate from social points of view.

It follows from above that cost-benefit analysis is a method of evaluating public projects and investment
programmes for making decisions regarding the desirability of the projects to be undertaken. Accordingly, it is
used to assess big public investment schemes such as building dams and airports, controlling diseases (for
example, malaria control programme), planning for defence and safety, and spending for health, education and
research.

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Demerits:
(i) The government is not completely aware of all the costs and benefits associated with the programme.
(ii) This approach does not clearly state that who should bear the pollution control costs.
(iii) The method of collecting data for this analysis is generally biased.
(iv) The people will have different value system and there will always be loser in the process.

Problems in Cost-Benefit Analysis

1. Physical constraints due to the extent of availability of technology, production possibility due to input output
relations.
2. Legal constraints due to domestic and international laws.
3. Adminstrative constrains of improper mix of technical and administrative skills.
4. Distributional constraints.
5. Political constraints
6. Budget of financial Constraints
7. Social and religious constraints.

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