Module – 6

COST AND REVENUE

FUNCTIONS,
SHORT RUN COST
CURVES,
AND
LONG RUN COST CURVES.
 Cost of Production
Meaning:
Cost of Production refers to the total money
expenses(both explicit and implicit)
incurred by the producers in the process of
transforming inputs into outputs.
Cost is analyzed from the producers point of view
.Cost estimates are always made in terms of money.
 Cost Concepts
A. Money Cost and Real Cost
When cost of production is expressed in
terms of money, it is called as money cost.
If the cost is expressed in terms of
physical efforts or mental efforts put in by
various people in the production of a
commodity, it is called as real cost.
Continued …..
B. Explicit Cost and Implicit Cost
Explicit cost refer to the actual money
outlay or out of pocket expenditure of the
firm to buy or hire the productive resources
it needs in the process of production.
The following items of a firms
expenditure are explicit money costs.
1. Cost of raw materials
2. Wages and Salaries
3. Power charges
4. Rent of Factory Premises

5. Interest Payment on Capital

6. Insurance premium
7. Property Tax, License Fee etc
8. Miscellaneous Business expenses like Marketing
and Advertising expenses.
 Implicit costs are payments which are not actually paid by the firm. Such costs arise when the entrepreneur supplies certain factors owned by himself.
The implicit money costs are as follows:
1. Wages for labour rendered by the entrepreneur himself
2. Interest on capital supplied by him.
3. Rent for his own building used in production
4. Profits of enterpreneur
5. Depreciation
 Continued …..
C. Outlay Costs and Opportunity costs
Outlay cost is the actual financial expenditure of
the firm. It is recorded in the firm’s books of account.
For example, Payment of wages, interest, cost of
raw materials, machines, etc.
Opportunity cost of the given economic
resources is the foregone benefits from the next
best alternative use of that resource.
 Continued …..
D. Short run and Long run Costs
On the basis of span of time in
production , costs can be classified into short
run costs and long run costs.
Short run costs are the costs which vary
with output in the short period when plant,
machinery, etc remain fixed.
Long run costs are the costs which vary
with output when all inputs including plant,
machinery, etc vary.
Cost– Output Relationship
 Cost-output relationship refers to the
relationship between output and costs and the
behaviour of costs in relation to the change in
output.
 The relationship between cost and output is
described as the “ cost function”.
TC = f(Q) Where TC --- Total cost
of production
Q --- Quantity of
output produced
Cost Function

The cost function depends on

the three independent variables:
1. Production function
2. Market prices of inputs
3. Period of time
 Types of Cost Functions
In economic theory there are mainly 2 types of
cost functions. They are:
1. Short run cost function
2. Long run cost function
Cost output relationships or cost behaviour is
discussed for the short period and the long period
separately.
When this relationship is represented with the help
of diagram we get the short and long run cost
curves.
Meaning Of Short Run

Short run is a period of time in

which only the variable factors can be
varied. While the fixed factors like
plant, machinery, management, etc
remain constant. The total no of firms
in an industry will remain the same.
Cost—Output Relationship And
The Behaviour Of Cost Curves In
The Short Run
Cost Schedule:
A Cost Schedule is a list or statement showing
variations in costs resulting from variations in the
levels of output.
It shows the response of cost to changes in
output.
On the basis of the cost schedule we can
analyse the relationship between changes in the
level of output and cost of production.
 A Hypothetical Cost
Schedule
Output
units
TFC TVC TC AFC AVC AC MC
0 300 --- 300 --- --- --- ---
1 300 100 400 300 100 400 100
2 300 180 480 150 90 240 80
3 300 240 540 100 80 180 60
4 300 300 600 75 75 150 60
5 300 450 750 60 90 150 150
6 300 660 960 50 110 160 210
 1. Total Fixed Cost (TFC)
Total Fixed Costs refers to the total money
expenses incurred on fixed inputs like Plant,
machinery , tools and equipments in the short run.
They are fixed in nature. They are the costs a firm has
to incur even when the output is zero.
Mathematically,
TFC = TC – TVC
where TVC = Total Variable Cost
TC = Total Cost
Diagrammatic
Representation Of TFC Curve
2. Total Variable Cost
(TVC)
Total Variable Cost refers to the
total money expenses incurred on
variable factor inputs like raw
materials, electricity, fuel,
transportation, advertisement, etc in
the short run. The variable cost vary
directly with the output.
TVC = TC – TFC
Diagrammatic
Representation Of TVC Curve
3. Total Cost (TC)

Total cost refers to the aggregate money

expenditure incurred by a firm to produce a given
quantity of output.
Mathematically, TC = f(Q)
which means that total cost varies with level of output.
TC = TCF + TVC.
TC varies in the same proportion as in TVC. The
behaviour of TFC, TVC & TC are shown in the following
diagram.
The Behaviour Of TFC, TVC
and TC Curve
4. Average Fixed Cost (AFC) is the fixed cost
per unit of output produced. It is found out by dividing the
total fixed cost by total output.

AFC = TFC
Q
Where ‘Q’ represents output.
An important character of AFC is that it goes on
decreasing as output increases since the amount of total
fixed cost is being divided by larger no. of units of output
produced. The greater the output the smaller will be the
average fixed cost.
Diagrammatic
Representation of AFC Curve
5. Average variable cost (AVC) is the
variable cost per unit of output. It is found
out by dividing the total variable cost by the
total output.
AVC = TVC
Q
where ‘Q’ represents the total output.
An important character of AVC is that
it will decline in the beginning as output
increase, but when a certain stage is
reached it stops declining. This is the stage
when the stage has reached its full capacity
of production.
AVC Curve – U shaped
Curve
6. Average cost (AC) is the cost per unit of the
output. This is found out by dividing the total cost by the
total output. Since the total cost consists of fixed cost &
variable cost, the average cost will be equal to the sum
of average fixed cost & average variable cost.

AC = TC / Q = TC / Total output.
= FC + VC / Total output.
= TFC + TVC / Q
Where ‘Q’ stands for the total output.
= AFC + AVC.
Diagrammatic
Representation Of AC Curve
The Behaviour of AFC,AVC
and AC

In the short run the AC curve tends

to be U-shaped. The combined
influence of AFC and AVC curves will
shape the nature of AC curve.
AFC begins to fall with an increase
in output.
AVC comes down upto a particular
level and then rises.
The Behaviour Of AFC,AVC
and AC Curves
 7. Marginal Cost (MC)
Marginal costs may be defined as the net
addition to the total cost as one more unit of output
is produced.
It implies additional cost incurred to produce an
additional unit.
MC = change in TC
change in TQ
Where TC = Total cost
TQ = Total output.
Or
MC = TCn — TCn-1
Diagrammatic
Representation OF MC Curve
Output TC (Rs) MC (Rs) AC (Rs)
0 5 -- --
1 80 75 80
2 140 60 70
3 185 45 61
4 220 35 55
5 245 25 49
6 276 31 46
7 322 46 46
8 384 62 48
9 468 84 52
10 570 100 57
Relationship Between MC and
AC
Relationship between MC and
AC
1. When AC is falling , MC is also
falling. When AC and MC curves are
falling MC curve is lies below the AC
curve.
2. When Ac is minimum, the MC=AC.
3. Once MC=AC, when both the costs
are rising , MC curve will always lie
above the AC curve.
 Cost–Output Relationship in
the Long Run
 Long period is a period during which the quantities of
all factors variable as well as fixed factors can be
varied according to the requirements.
 In the long run a firm is not tied upto a particular plant
capacity. If the demand increases, it can expand
output by enlarging its plant capacity.
 If the demand for the product declines , a firm can cut
down its production capacity. Hence production cost
comes down to a great extent in the long run.
 Continued…
 As all costs are variable in the long run , the total of
these costs is the total cost of production.
 In the long run only average cost is important and
considered in taking long term output decisions.
 Long run average cost= TC
Output
It is the per unit cost of production at different
levels of output by changing the size of the plant.
 Continued…
 The long run cost output relationship is
explained by drawing a long run cost curve
through short run cost curves.
 The long run cost curve is influenced by the
Laws of Returns To Scale.
 The long run cost curve explains how costs will
change when the scale of production varies.
Diagrammatic Representation
of Long Run Cost Curve
Important Features of LAC
Curve

1. Tangent Curve
2. Envelope Curve
3. Planning Curve
4. Flatter U Shaped Curve
 Long Run Marginal Cost
Curve

The long run marginal cost curve is derived

from long run total cost curve at the various points
relating to the given level of output at each time.
The LMC curve also has a flatter U- shape,
indicating that initially as output expands in the long
run with the increasing scale of production , LMC
tends to decline. At a certain stage however LMC
tends to increase.
Diagrammatic Representation Of
Relation between LMC and LAC
REVENUE CONCEPTS

The amount of money which a firm

receives by the sale of its output in
the market is known as its revenue.
The revenue concepts commonly
used in economics are
1. Total revenue
2. Average revenue
3. Marginal revenue
 1. Total Revenue
Total revenue refers to the total amount of
money that the firm receives from the sale of its
products.
The TR can be calculated by following formula:
TR = Q x P
where TR = Total revenue
Q = Quantity of output
P = Price per unit of the
Commodity
2. Average Revenue

Average revenue can be obtained by

dividing the total revenue by the number of
units sold.
AR = TR
Q
where AR is the revenue earned per unit of
commodity sold. AR is the price of the
commodity. The price paid by the consumer
is the revenue realised by the producer.
3. Marginal Revenue

Marginal revenue refers to the

additional revenue earned by selling the
additional unit of output by the seller.
Mathematically,
MR = TRn – TRn-1
Or
MR = change in TR
change in Q
Relationship between TR, AR and
MR:
No . Of units TR AR MR
sold (Rs) (Rs) (Rs)

1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
Diagrammatic Representation