Cost Concepts

Theory of costs
TOTAL COST:
Total cost of production is the sum of all expenditure incurred in producing a
given volume of output.
Fixed Costs
• The cost that remains fixed at any level of output is known as the fixed cost.

• These costs must be paid whether there is production or not.

• These costs include, depreciation allowance, interest on fixed capital, license
fee, salaries to permanent staff etc.
• These costs are also known as the overhead costs or indirect costs because a
firm has to incur these costs even if it shuts down temporarily
Variable Cost
• Variable costs refer to those costs which change with the change in the volume
of output
• These costs are unavoidable or contractual costs
• Marshall called these costs as “Prime Costs”, “Direct Costs” or “Special Costs”
• Variable costs include expenditure on transport, wages of labour, electricity
charges, price of raw material etc.
AC and MC
Average cost:
Average cost (AC) is of statistical nature, it is not actual cost. It is obtained by dividing the total
cost (TC) by the total output (Q), i.e.
AC = TC / Q = average cost

Marginal cost:
Marginal cost is the addition to the total cost on account of producing an additional unit of the
product. Given the cost function, it may be defined as
MC = TC/ Q or MC = TCn – TCn-1
Numerical example
TC, TVC and TFC – cost curves
Practice Question
AC, AVC and AFC
Relationship between AC and MC
▪ When AC curve is falling, MC curve is below AC

▪ When AC curve is rising after the point of

intersection, MC curve lies above AC
▪ When AC is neither falling nor rising, AC = MC
▪ MC curve cuts the AC curve at the lowest
minimum point
Short-Run and Long-Run Costs
Short-run costs are the costs which vary with the variation in output, the size of
the firm remaining the same
Same as variable costs
Long-run costs are the costs which are incurred on the fixed assets
It is the same as fixed costs
In the long-run, however, even the fixed costs become variable costs as the
size of the firm or scale of production increases
Derivation of LAC
Features of LAC
LAC shows the least possible average cost of producing any output when all productive factors
are variable.
1. Tangent curve: tangential to SAC curves. It does not touch the minimum point of SACs
2. Envelope curve: Envelope of group of SAC curves appropriate for different levels of output.
3. U-shaped curve
References
https://www.economicsdiscussion.net/producers-behavior/relationship-between-ac-and-avc-an
d-between-ac-and-mc/16908
https://www.economicsdiscussion.net/theory-of-cost/different-cost-concepts-an-overview/700
0
https://www.yourarticlelibrary.com/economics/cost-curves/derivation-of-long-run-average-cost
-curve/36985
Gregory Mankiw, Chp. 13
REVENUE CONCEPTS
REVENUE CONCEPTS-
DEFINITIONS
Total revenue: It is the sum of all sales, receipts or income of a firm. In other
words, the income earned by a seller or producer after selling the output is called the
total revenue
TR = P x Q
Average revenue refers to the revenue obtained by the seller by selling the per
unit commodity. It is obtained by dividing the total revenue by total output.
AR = TR/Q
Marginal revenue is the change in total revenue which results from the sale of
one more or one less unit of output.
PERFECT COMPETITION
TR curve is a straight line
from the origin.
Since price is constant, TR
increases at a constant
increasing rate as more units
are sold.
AR = MR = P is a horizontal
line
NUMERICAL
IMPERFECT COMPETITION
TR curve rises as long as MR is
positive
It reaches its highest point when
MR is zero
Starts declining when MR
becomes negative.
NUMERICAL
 PROFIT MAXIMIZATION: TR-TC
APPROACH
According to this approach, the
producer’s equilibrium has two
conditions:
1. The difference between TR and TC
is maximum
2. Even if one more unit of output is
produced, then the profit falls. In
other words, the marginal cost
becomes higher than the marginal
revenue if one more unit is
produced.
IMPERFECT COMPETITION
 MR – MC APPROACH
The two conditions of equilibrium under
the MR-MC approach are:
1. MR = MC
2. MC cuts the MR curve from below
IMPERFECT COMPETITION
Thank You
BREAK EVEN ANALYSIS

https://www.youtube.com/watch?v=r8BIz5I-aDc

BEP = (Overheads or Fixed Cost)/ SPU – CPU

Where SPU = selling price per unit; CPU = variable cost per unit

BEP gives us the volume of sales needed to reach the point where the firms make no profit,
no loss. If sales volumes are lower than that needed to reach BEP, firms make losses and if
its more than that needed to reach BEP, firms make profits. Clearly, the first milestone a
business needs to reach before it starts earning profits is the BEP and each firm would like
to break even as quickly as possible. We can see that BEP can be lowered by either reducing
overheads, or increasing SPU, or decreasing CPU.

Example:

If overheads are $25,000 per year; SPU = $1.00 and CPU = 50 cents or $0.5

BEP = 25,000/(1 -0.5) = 50,000

Implies the firm has to sell 50,000 units to reach the BEP.

Work out the BEP if SPU increase to $1.20

Additionally if CPU is decreased to $0.40
And finally, the overheads are reduced to $20,000 per annum

BEP can also be calculated by using the total revenue-total cost method. BEP occurs when
TR=TC; hence we can either find Profit = TR-TC and equate to zero or make TR = TC to get
the BEP in terms of units of output required to be sold. Since AR=TR/Q and AC=TC/Q we can
derive that BEP occurs where AR=AC.

Example:
R = 55x
C = 30x + 250
Profit = R-C = 0 gives us x = 10

Similarly, R=C, gives us x =10

At x= 10, AR = 55 = 5.5 and AC = 30+25 = 55