CH.

4
COSTS, REVENUE
AND
PROFIT
• Cost- A cost is an expenditure required to produce or sell a product or get an asset
ready for normal use. In other words, it's the amount paid to manufacture a product,
purchase inventory, sell merchandise, or get equipment ready to use in a business
process.
• Revenue- Fees earned from providing services and the amounts of merchandise sold.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned,
Interest Revenue, Interest Income. ... Revenue accounts are credited when services
are performed/billed and therefore will usually have credit balances.
• Profit- A profit is money you make, as opposed to money you lose. ... Businesses need
to make a profit — money — or they'll have to fire employees, cut expenses, and
maybe go out of business entirely. If more money is coming in than going out, that's a
profit. Profit also means a benefit.
PRODUCTION FUNCTION IN THE SHORT
RUN

The short run production assumes there is at least one fixed factor input
• Production Functions
• The production function relates the quantity of factor inputs used by a business to the amount of output that result.
We use three measures of production and productivity:
Total product (total output). In manufacturing industries such as motor vehicles, it is straightforward to measure how much output
is being produced. In service or knowledge industries, where output is less “tangible" it is harder to measure productivity.
Average product measures output per-worker-employed or output-per-unit of capital.
Marginal product is the change in output from increasing the number of workers used by one person, or by adding one more
machine to the production process in the short run.
The length of time required for the long run varies from sector to sector. In the nuclear power industry for example, it can take
many years to commission new nuclear power plant and capacity. This is something the UK government has to consider as
it reviews our future sources of energy.
SHORT RUN PRODUCTION
FUNCTION
• The short run is a time period where at
least one factor of production is in fixed
supply
• A business has chosen its scale of
production and sticks with this in the short
run
• We assume that the quantity of plant and
machinery is fixed and that production can
be altered by changing variable inputs such
as labour, raw materials and energy
DIMINISHING RETURNS

• In the short run, the law of diminishing returns states that as more

units of a variable input are added to fixed amounts of land and
capital, the change in total output will first rise and then fall
• Diminishing returns to labour occurs when marginal product of
labour starts to fall. This means that total output will be increasing at
a decreasing rate
WHAT MIGHT CAUSE MARGINAL PRODUCT
TO FALL?

One explanation is that, beyond a certain point, new workers will not have as much capital
equipment to work with so it becomes diluted among a larger workforce I.e., there is less capital
per worker.
In the following numerical example, we assume that there is a fixed supply of capital (capital =
20 units) to which extra units of labour are added to the production process.
•Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds
28 and the 6th worker increases output by 29.
•Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20
added units. At this point production demonstrates diminishing returns.
•Total output will continue to rise as long as marginal product is positive
•Average product will rise if marginal product > average product
NUMERICAL EXAMPLE OF THE LAW OF
DIMINISHING RETURNS
Capital Input Labour Input Total Output Marginal Product Average Product of
Labour
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18
Diminishing returns and marginal cost
CRITICISMS OF THE LAW OF DIMINISHING RETURNS

• How realistic is this assumption of diminishing returns? Surely ambitious and successful
businesses will do their level best to avoid such a problem emerging?
• It is now widely recognized that the effects of globalization and the ability of trans-national
businesses to source their inputs from more than one country and engage in transfers of
business technology, makes diminishing returns less relevant
• Many businesses are multi-plant meaning that they operate factories in different locations –
they can switch output to meet changing demand
LONG RUN PRODUCTION FUNCTION

Long run production function shows relationship between inputs and outputs under
the condition that both the inputs, capital and labour, are variable factors. Long run
production function connotes the time period, in which all the factors
of production are variable.
Long-run production function - Returns to Scale
In the long run, all factors can be changed. Returns to scale studies the changes in output when all
factors or inputs are changed. An increase in scale means that all inputs or factors are increased in
the same proportion.
•Three phases of returns to scale
The changes in output as a result of changes in the scale can be studied in 3 phases. They are
1. Increasing returns to scale- If the increase in all factors leads to a more than proportionate increase in output, it
is called increasing returns to scale. For example, if all the inputs are increased by 5%, the output increases by more
than 5% i.e. by 10%. In this case the marginal product will be rising.
2. Constant returns to scale- If If we increase all the factors (i.e. scale) in a given proportion, the output will
increase in the same proportion i.e. a 5% increase in all the factors will result in an equal proportion of 5% increase in
the output. Here the marginal product is constant.
 
3. Decreasing returns to scale- If we increase all the factors (i.e. scale) in a given proportion, the output will
increase in the same proportion i.e. a 5% increase in all the factors will result in an equal proportion of 5% increase in
the output. Here the marginal product is constant.
 
DIFFERENCE BETWEEN SHORT RUN AND
LONG RUN PRODUCTION FUNCTION
SHORT-RUN PRODUCTION LONG-RUN PRODUCTION
BASIS FOR COMPARION
FUNCTION FUNCTION
Meaning Short run production function Long run production function
alludes to the time period, in which connotes the time period, in which
at least one factor of production is all the factors of production are
fixed. variable.
Law Law of variable proportion Law of returns to scale
Scale of production No change in scale of production. Change in scale of production.
Factor-ratio Changes Does not change.
Entry and Exit There are barriers to entry and the Firms are free to enter and exit.
firms can shut down but cannot
fully exit.
SHORT-RUN PRODUCTION LONG-RUN PRODUCTION
BASIS FOR COMPARION
FUNCTION FUNCTION
PRODUCTION
FUNCTION
13
PRODUCTION FUNCTION

Production: Any activity leading to value addition –

Transformation of inputs into output

Q= f (L,K)

14
PRODUCTION FUNCTION

Short term : Time when one input (say, capital) remains constant and an addition to output can
be obtained only by using more labour.
Long run: Both inputs become variable.

15
PRODUCTION FUNCTION
Production process is subject to various phases-
Laws of production state the relationship between output and input.

16
LAWS OF PRODUCTION

Short run :

Relationship between input and output are studied by varying one input , others being held
constant.
Law of Variable Proportions brings out relationship between varying proportions of factor
inputs and output

17
LAWS OF PRODUCTION

Long run:
Production function is subject to different phases described under the Law of Returns to Scale
– Studied assuming that all factor inputs are variable.

18
LAW OF VARIABLE PROPORTIONS

Law of Variable Proportions (Short run Law of Production)

Assumptions:
• One factor (say, L) is variable and the other factor (say, K) is constant
• Labour is homogeneous
• Technology remains constant
• Input prices are given

19
LAW OF VARIABLE PROPORTIONS
No of Workers Total Product Marginal Average Stages of
L Returns
(TPl) Product (MPl ) Product (APl )
1 24 24 24 I)
2 72 48 36 Increasing
Returns
3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II)
8 528 66 66 Diminishing
Returns
9 576 48 64
10 600 24 60
11 594 -6 54 III) Negative
Returns
12 552 -42 46
20
LAW OF VARIABLE PROPORTIONS
TP rises at an increasing rate till
Panel A the employment of the 5th
worker.
T TPl Beyond the 6th worker until 10th
o worker TP increases but rate of
t increase begins to fall
Total Product

a
TP turns negative from 11th
l
worker onwards.
t
c
u
d
o
r
P

l
a
t
o
T

p This shows Law of Diminishing

r Marginal returns
o
d
Labour
u
c
t
21
LAW OF VARIABLE PROPORTIONS
Panel B
Panel B represents
Marginal and average
productivity curves of
labour
AP/MP

APL

M MPL
labour
P
L 22
LAW OF VARIABLE PROPORTIONS

Increasing Returns- Stage I:

TPl increases at an increasing rate.
Fixed factor (K) is abundant and variable factor is inadequate. Hence K gets utilised better with
every additional unit of labour

23
Stage II- TPl continues to increase but at a diminishing rate.
stage III- TPl begins to decline –Capital becomes scarce as compared
to variable factor. Hence over utilisation of capital and setting in of
diminishing returns
Causes of 3 stages: Indivisibility and inelasticity of fixed factor and
imperfect substitutability between K and L

24
LAW OF VARIABLE PROPORTIONS

Significance of Law of Diminishing Marginal Returns:

- Empirical law, frequently observed in various production activities
- Particularly in agriculture where natural factors (say land), which play an important role, are
limited.
- Helps manager in identifying rational and irrational stages of operation

25
LAW OF VARIABLE PROPORTIONS

- It provides answers to questions such as:

a) How much to produce?
b) What number of workers (and other variable factors) to employ in order to maximize output
In our example, firm should employ a minimum of 7 workers and maximum of 10 workers
(where TP is still rising)

26
LAW OF VARIABLE PROPORTIONS

- Stage III has very high L-K ratio- as a result, additional workers not only prove unproductive
but also cause a decline in TPl.
- In Stage I capital is presumably under-utilised.
- So a firm operating in Stage I has to increase L and that in Stage III has to decrease labour.

27
LAW OF RETURNS TO SCALE

In the long run, all factors are variable.

• Production can be increased by adding both L and K.
• Relationship between inputs and output is depicted in the form of isoquant curves.
• Isoquant curves represent different combinations of K and L that lead to the same level of
output.

28
TOTAL PRODUCT, AVERAGE PRODUCT
AND MARGINAL PRODUCT

Production Function
The function that explains the relationship between physical inputs and physical output (final
output) is called the production function. We normally denote the production function in the
form:
Q = f(X1, X2)
where Q represents the final output and X1 and X2 are inputs or factors of production.
Total Product
In simple terms, we can define Total Product as the total volume or amount of
final output produced by a firm using given inputs in a given period of time.
Marginal Product
The additional output produced as a result of employing an additional unit of
the variable factor input is called the Marginal Product. Thus, we can say that
marginal product is the addition to Total Product when an extra factor input is
used.
Marginal Product = Change in Output/ Change in Input
Thus, it can also be said that Total Product is the summation of Marginal
products at different input levels.
Total Product = Ʃ Marginal Product
Average Product
It is defined as the output per unit of factor inputs or the average of the total
product per unit of input and can be calculated by dividing the Total Product
by the inputs (variable factors).
Average Product = Total Product/ Units of Variable Factor Input
RELATIONSHIP BETWEEN MARGINAL PRODUCT AND
TOTAL PRODUCT

The law of variable proportions is used to explain the relationship between

Total Product and Marginal Product. It states that when only one variable factor
input is allowed to increase and all other inputs are kept constant, the following
can be observed:
• When the Marginal Product (MP) increases, the Total Product is also increasing at an
increasing rate. This gives the Total product curve a convex shape in the beginning as variable
factor inputs increase. This continues to the point where the MP curve reaches its maximum.
• When the MP declines but remains positive, the Total Product is increasing but at a decreasing
rate. This give ends the Total product curve a concave shape after the point of inflexion. This
continues until the Total product curve reaches its maximum.
• When the MP is declining and negative, the Total Product declines.
• When the MP becomes zero, Total Product reaches its maximum.
RELATIONSHIP BETWEEN AVERAGE PRODUCT AND
MARGINAL PRODUCT

There exists an interesting relationship between Average Product and Marginal

Product. We can summarize it as under:
• When Average Product is rising, Marginal Product lies above Average Product.
• When Average Product is declining, Marginal Product lies below Average
Product.
• At the maximum of Average Product, Marginal and Average Product equal
each other.
ISOCOSTS AND ISOQUANTS.
WHAT IS ISOQUANT AND ISOCOST LINE IN
PRODUCTION THEORY?
• A firm’s bank objective is profit maximisation. If, in the short run, its total output remains fixed (due to
capacity constraint) and if it is a price-taker (i.e., cannot fix the price or change price on its own as in a
purely competitive market) its total revenue will also remain fixed. Therefore, the only way to maximise
profit is to minimise cost. Thus, profit maximisation and cost minimisation are the two sides of the same
coin.
• Moreover, supply depends on cost of production. The decision to supply an extra unit depends on the
marginal cost of producing that unit. Perhaps the most important determinant of the firm’s price-output
decision in any market is its cost of production.
The firm’s cost, in its turn, depends on two key factors, viz.:
(1) The technical relation between inputs and output (i.e., how outputs vary as inputs vary), and
(2) Factor prices (i.e., the price of labour or the wages, the price of capital or the interest rate and so on).
The long-run production function of a firm involving the usage of two factors, say, capital and labour is
represented by equal-product curve or isoquant. This curve is also known as a producer’s indifference curve.
An isoquant traces out the combinations of any two inputs which yield the same level of output.
This combinations must be the most efficient ones — i.e., any point on an isoquant shows the minimum
quantities of the inputs required to produce a given output. Isoquants are typically drawn as being curved to
the origin because of the assumed substitutability of inputs.
ISOQUANT
Isoquant is also called as equal product curve or production
indifference curve or constant product curve. Isoquant indicates
various combinations of two factors of production which give the
same level of output per unit of time. The significance of factors
of productive resources is that, any two factors are substitutable
e.g. labour is substitutable for capital and vice versa. No two
factors are perfect substitutes. This indicates that one factor can
be used a little more and other factor a little less, without
changing the level of output.
Table 1 illustrates, by using hypothetical numbers,
seven alternative methods of producing six units of
output. These alternatives are shown also in Fig. 5,
as represented by the curve Q = 6. Thus, the firm
could choose combination a (18K + 2L), combination
g (2K + 18L) or any other combination shown in
Table 1.
Fig. 5 shows two other isoquants, each
corresponding to particular (fixed) level of output,
viz., Q = 8 and Q = 10. Each curve shows the
alternative combinations of labour and capital that
would produce 8 and 10 units of output,
respectively. We could draw as many isoquants as
we like.
ISOCOST LINES

• An isoquant shows what a firm is desirous of producing. But, the desire to produce a
commodity is not enough. The producer must have sufficient capacity to buy necessary
factor inputs to be able to reach its desired production level. The capacity of the
producer is shown by his monetary resources, i.e., his cost outlay (or how much money
he is capable of spend­ing) on capital and labour, the prices of which are taken as
constant, i.e.’, given in the market place.
• So, like the consumer the producer has also to operate under a budget (resource)
constraint. This is picturised by his budget line called isocost line. To find the least cost
combination of inputs to produce a given output, we need to construct such equal cost
lines or isocost lines.
• An isocost line is a locus of points showing the alternative combinations of factors that can be purchased
with a fixed amount of money. In fact, every point on a given isocost line represents the same total cost.
To construct isocost lines we need information about the market prices of the two factors. For example,
suppose, the price of labour is Re. 1 per unit and the price of capital is Rs. 4 per unit.
• Then an outlay of Rs. 36 could buy 9K + 0L, 36L + 0K, or other combinations such as 5K + 16L. All these
and other various combinations are shown in Fig. 2 by isocost line C = Rs. 36. Isocost lines C = Rs. 12, C
= Rs. 24 and C = Rs. 48 show the alternative combinations of capital and labour that can be purchased
or hired by spending Rs. 12, Rs. 24 and Rs. 48, respectively.
• These lines are straight lines because factor prices are constant and they have a negative slope equal to
the factor-price ratio, i.e., the ratio of labour price to capital price (i.e., the wage ratio -5- the rate of
interest).
 COST MINIMISATION
• Here, the firm seeks to minimise its cost of producing a
given level of output. To find the least-cost combination
of factors for fixed level of output we combine Fig. 5 and
Fig. 6 in Fig. 7. Suppose, the producer wants to produce
six units of output. He could do so using the combination
represented by points A, B or C in Fig. 3.

For example, the cost would be Rs. 48 at C, Rs. 36 at B and Rs. 24 at A. The cheapest method
is at A, where the iso­quant for output of six (Q = 6) is tangent to an isocost line (C = Rs. 24).
In Fig. 3 the firm tries to find out the least ex­pensive factor combination along its isoquant. It
looks for that factor combination that is on the lowest of the isocost lines. Where the isoquant
touches (but does not cross) the lowest isocost line is the least cost position.
The tangency point shows that optimisation in production is reached when factor prices and
marginal product are proportional, with equalised mar­ginal product per rupee. The
minimum-cost points are A, D and E. Each such point shows the equilibrium factor
combination for maximising output subject to cost constraint, i.e., subject to fixed factor
prices and fixed outlay (on resources).
• We may now speak a few words about the slopes of isoquant and an isocost line. The slope of an
isoquant gives the marginal rate of technical substitution (MKTS) defined as the increase in the
quantity of one factor that is required to replace a unit decrease in another factor, when output
is held constant along any isoquant. It is also known as the desired rate of factor substitution,
i.e., the rate at which the producer wants to substitute one factor by the other.
• MKTS is, in fact, the ratio of the marginal products of the factors. To see this, consider an
example. Assume that output is such that the MP L and the MPK are both equal to 2 (units of
output), i.e., MPK = MPL. If the firm is to maintain the same level of output while reducing
capital by one unit, it needs to replace one unit of capital by one unit of labour. If at another
point on the same isoquant, the MP L = 2, while the MPK = 1, the firm needs to replace a unit of
capital with only half unit of labour.
• An isocost line shows the alternative quantities of two factors viz., capital and labour
that can be purchased or hired with a fixed sum of money. Its slope is given by the ratio
of the prices of the two factors. It is known as the actual rate of factor substitution, the
rate at which the firm can substitute labour by capital in the market place.
• Thus, in Fig. 3, given the prices of labour and capital at Re 1 and Rs. 4 per unit,
respectively, the slope of C = Rs. 12 is determined by drawing the line joining points 3K
+ 0L (which represents outlay of Rs. 12 entirely on capital) and 12L + OK (Rs. 12 spent
entirely on labour). All the isocost lines in the diagram have the same slope because
the relative prices of labour and capital are the same. If labour were relatively more
expensive, the isocost lines would be steeper in Fig. 2.
 COSTS

© 2004 Thomson Learning/South-Western

BASIC CONCEPTS OF COSTS

• Opportunity cost is the cost of a good or service as measured by the

alternative uses that are foregone by producing the good or service.
– If 15 bicycles could be produced with the materials used to produce an
automobile, the opportunity cost of the automobile is 15 bicycles.
• The price of a good or service often may reflect its opportunity cost.

43
BASIC CONCEPTS OF COSTS

• Accounting cost is the concept that goods or services cost what was paid
for them.
• Economic cost is the amount required to keep a resource in its present
use; the amount that it would be worth in its next best alternative use.

44
LABOR COSTS

• Like accountants, economists regard the payments to labor as an explicit cost.

• Labor services (worker-hours) are purchased at an hourly wage rate (w): The cost of hiring
one worker for one hour.
• The wage rate is assumed to be the amount workers would receive in their next best alternative
employment.

45
CAPITAL COSTS

• While accountants usually calculate capital costs by applying some depreciation rule to the
historical price of the machine, economists view this amount as a sunk cost.
• A sunk cost is an expenditure that once made cannot be recovered.
• These costs do not focus on foregone opportunities.

46
CAPITAL COSTS

• Economists consider the cost of a machine to be the amount someone else would be willing to
pay for its use.
• The cost of capital services (machine-hours) is the rental rate (v) which is the cost of hiring
one machine for one hour.
• This is an implicit cost if the machine is owned by the firm.

47
STRANDED COSTS AND ELECTRICITY DEREGULATION

• Until the mid 1990s, the electric power industry in the United States was heavily regulated.
• The expected decline in the wholesale price of electricity resulting from deregulation has
sparked a debate over “stranded costs”.

48
THE NATURE OF STRANDED COSTS

• When the average costs of generating electricity exceed the price of electricity in the open
market, the generating facilities become “uneconomic.”
• The historical costs of these facilities have been “stranded” by deregulation.

49
THE NATURE OF STRANDED COSTS

• To economists, these are sunk costs.

• Generating facilities that have become “uneconomic” have zero market value, a situation that
occurs frequently in many other business
• Economist Joseph Schumpeter coined such situations, “creative destruction.”

50
ENTREPRENEURIAL COSTS

• Owners of the firm are entitled to the difference between revenue and costs which is generally
called (accounting) profit.
• However, if they incur opportunity costs for their time or other resources supplied to the firm,
these should be considered a cost of the firm.

51
TWO SIMPLIFYING ASSUMPTIONS

• The firm uses only two inputs: labor (L, measured in labor hours) and
capital (K, measured in machine hours).
– Entrepreneurial services are assumed to be included in the capital costs.
• Firms buy inputs in perfectly competitive markets so the firm faces
horizontal supply curves at prevailing factor prices.

52
AVERAGE COSTS

TC
Average cost  AC 
q
• Average cost is total cost divided by output; a common measure of cost
per unit.
• If the total cost of producing 25 units is $100, the average cost would be

$100
AC   $4
25
53
MARGINAL COST

Change in TC
Marginal cost  MC 
Change in q
• The additional cost of producing one more unit of output is marginal
cost.
• If the cost of producing 24 units is $98 and the cost of producing 25
units is $100, the marginal cost of the 25th unit is $2.

54
DISTINCTION BETWEEN THE SHORT
RUN AND THE LONG RUN
• The short run is the period of time in which a firm must consider some inputs to be absolutely
fixed in making its decisions.
• The long run is the period of time in which a firm may consider all of its inputs to be variable
in making its decisions.

55
REVENUE

• Total revenue (TR): This is the total income a firm receives. This will equal price ×
quantity.
• Average revenue (AR) = TR / Q.
• Marginal revenue (MR) = the extra revenue gained from selling an extra unit of a good.
Profit = Total revenue (TR) – total costs (TC) or (AR – AC) × Q
CASE STUDY: MASTERJI’S GROCERY SHOP

Masterji’s shop is very popular and stocks all kinds of goods- from rice and wheat to processed
food, imported chocolates and cheese. There is a small section which has a photocopying
machine and a STD booth. Masterji runs the shop with the help of his children.

57
CASE STUDY: MASTERJI’S GROCERY SHOP

• The family noticed that the Morn After Even

number of shoppers varied noon
between times and days (See
table) Mon- 50 40 65
• During weekdays, masterji could Fri
manage with his children, but not
in week ends. Sat/ 165 85 30
Sun

58
CASE STUDY: MASTERJI’S GROCERY SHOP

• Sunday morning buyers were ‘ value crowd’- bulk buyers, spent extra on something new and
attractive but wanted a pleasant experience and were upset at the overcrowded shop
• At certain times there were not many shoppers
Question:-
1. Come up with some solution to handle the customers on week ends specially during morning
and afternoon?
2. What can be done to increase the footfall during weekdays?

59