THEORY OF COSTS

REVENUE

Revenue refers to the amount receives by a firm from the sale of a given quantity
of a commodity in the market. Revenue has three forms:

Total revenue (TR): TR rates to total receipts from the sale of a commodity. It is
calculated by multiplying the units of the sale with the price.
TR = Q x P
TR = ∑ MR
Q = Quantity of Sale; P = Price.

Average revenue (AR): AR is the price per unit ; It can be obtainted by dividing
total revenue by the quantity sold . Average revenue is allways equal to the price
of the commodity.

AR =
T
R

Q
Marginal revenue (MR): Marginal revenue is the addition to total revenue by the
sale of an additional unit of commodity.
MR= TRn+1 - TRn
TRn+1= Total Revenue of units; TRn= Total Revenue of n units
 THEORY OF COSTS

MR =
∆
T
R

∆
T
Q
RELATIONSHIP BETWEEN TR/MR/AR
 When marginal revenue is positive (i.e, greater than zero), Total Revenue rises
(it is up to 4 units in the schedule);
 When marginal revenue is zero, total revenue becomes maximum;
 When marginal revenue becomes negative, total revenue starts falling;
 When AR and MR both are falling MR falls at a faster rate than AR.

RELATIONSHIP BETWEEN TR/MR/AR

UNITS OF GOODS TR MR AR
1 4 4 4÷1=4
2 7 7–4=3 7 ÷ 2 = 3.5
3 9 9–7=2 9÷3=3
4 10 10 – 9 = 1 10 ÷ 4 = 2.5
5 10 10 – 10 = 0 10 ÷ 5 = 2
6 9 9 – 10 = (-1) 9 ÷ 6 = 1.5
 THEORY OF COSTS

Y
REVENUE

TR

AR
0 X
UNITS OF GOODSMR
COSTS

Costs refer to all sorts of monetary expenditures incurred on the production of the
commodity. It also includes implicit cost for which payment is not made.

In economics cost is the sum total of Explicit and Implicit costs.

Explicit cost: Payment made for the purchase of factors of production, goods and
services from other firms for the production of the commodity is known as
explicit costs. Eg: wages, payment for raw material, rent, interest, expenditure on
transport and advertisement.

Implicit costs: Producer uses his own factor in the processes of production.
Producers generally do not take into account the cost of their own factors while
calculating the expenditures of the firm. But they should definitely be included.
Their cost should be calculated on the market rate and that should be included.
These are called implicit costs because producers do not make payments to
others for them.

Economic costs: Economic costs include all those expenses made on the purchase
or hiring of factors of production and the cost of the factor inputs owned by the
producer himself. It also includes normal profits. Normal profit is a minimum
payment which as an entrepreneur must get in order to stay in business.

Economic cost = Explicit costs + Imputed value of self owned factors of

production + Normal profit
 THEORY OF COSTS

Short run costs: In the short run, there are some factors of production or fixed while
others are variable. Accordingly, money costs are divided into fixed and variable costs.

Fixed costs: Fixed costs are those payments for factors of production in short run.
Fixed costs do not change with the change of quantity of production. They
remain fixed whether the output is increased or decreased or even zero.
Expenses made on fixed factors remain unchanged, irrespective of level of
output.

T
Y Y
V
C
CO
ST
CO
ST

TF
C
0 X(F 0 X
INPUT C) INPUT
Variable costs: Payment to the variable factors of production is called variable
costs. Variable costs vary with the quantity of output. They are also called Price
costs, Special costs or direct costs. Total variable costs goes on increasing with
increasing in the level of output goes on decreasing variable costs. The rate of
increase in the variable costs is determined by the laws of returns.
Total costs: It includes both Total fixed costs and Total Variable costs. It may also
be called as total cost of production.
 THEORY OF COSTS

TC
TV
Y
CO C
ST

TFC

0 X
INPUT

Average cost: Average cost is the cost per unit of output it can be obtained by
dividing total by quantity of output.

AC =
T
C

Q
Marginal: Marginal cost is the addition to total cost by production of an
additional unit of the commodity. it is also known as marginal cost is important
for deciding whether any additional output can be produced or not.

MC= TCn+1 - TCn

TCn+1= Total Costs of units; TCn= Total Costs of n units
 THEORY OF COSTS

MC =
∆
T
C

∆
T
Q
Relations between Marginal Cost and Total Cost

 When total cost rises at a diminishing rate, marginal cost decline;

 When the rate of increase in total cost stops diminishing, the marginal cost is at
its minimum ;
 When total cost rises at an increasing rate, marginal cost increases;
 Marginal cost is calculated from total cost.

OUTPUT TC AC MC
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 36 6 6
7 49 7 13
8 64 8 15
9 81 9 17
 THEORY OF COSTS

10 100 10 19

Y
AC
MC
COS
T

B
A
0
INPUT X
 Both average cost and marginal cost are obtained from total cost;
 When average cost falls with an increase in output marginal cost always remains
lower than Average cost;
 Marginal cost and average cost are equal when average cost is minimum.
Why Average Cost Is U- Shaped?

Ac of a firm will be u shaped it means as output rises, first it falls then rises. The
main reason for this U-shaped Ac curve is the operation of the law of variable
proportions. We know as output increases, law of increasing returns operates in the
initial stages. At this stage, when a firm increases its output, its gets economics, and the
result is decline in average cost. After the point of optimum combination, economics
turn into diseconomies and the result is increase in output and average cost .this is the
stage of law of diminishing returns.

OUTPUT
1
TC
20
Y AC
20
2
3
30
36
15
12 A
CO

4 48 12
C
ST

5 75 15
6 125 20

0 INPUT X
 THEORY OF COSTS

Opportunity Cost: Opportunity cost is cost of the best alternative foregone. When
a firm decides to produce a particular commodity, then it considers the value or
the alternative commodity, which is not produced. The value of the alternative
commodity is the opportunity cost of the good that, the firm is now producing.
Real Cost: The concept of real cost was presented by Marshall, real cost is in
monetary form. Real cost may be defined as all efforts, service, pains, and
sacrifices undertaken to produce the commodity.
PRIVATE AND SOCIAL COST:
Private cost: It is the cost incurred by an individual firm in the production of
goods and services. Private costs are incurred privately by the enterprise. These
costs are borne by individual firm itself. Purchase of raw materials, payment of
wages, salaries direct and indirect expenses etc, are the examples of private
costs.

Private Costs= Social costs – External Cost

Social cost: The cost which is borne by the entire society is known as social cost.
The production of the commodity does not involve exclusively the firm
producing it, but the entire society. The cost which is borne by others, other than
the firm is known as external cost. Social cost as such is the total if private cost
and external cost.

Social Costs= Private Costs + External Cost

L-SHAPED SCALE CURVE

These are distinguished into production costs and managerial costs. All costs are
variable in the long run and they give rise to a long-run cost curve which is roughly L-
shaped.
The production costs fall continuously with increases in output. At very large
scales of output managerial costs may rise.
But the fall in production costs more than offsets the increase in the managerial
costs, so that the total LAC falls with increases in scale.
Production costs:
Production costs fall steeply to begin with and then gradually as the scale of pro-
duction increases. The L-shape of the production cost curve is explained by the technical
economies of large-scale production. Initially these economies are substantial, but after
 THEORY OF COSTS

a certain level of output is reached all or most of these economies are attained and the
firm is said to have reached the minimum optimal scale, given the technology of the
industry. If new techniques are invented for larger scales of output, they must be
cheaper to operate.
But even with the existing known techniques some economies can always be
achieved at larger outputs:
 Economies from further decentralization and improvement in skills;
 Lower repairs costs may be attained if the firm reaches a certain size;
 The firm, especially if it is multiproduct, may well undertake itself the production
of some of the materials or equipment which it needs instead of buying them
from other firms.
Managerial costs:
In the modern management science for each plant size there is a corresponding
organisational-administrative set-up appropriate for the smooth operating of that plant.
There are various levels of management, each with its appropriate kind of management
technique. Each management technique is applicable to a range of output. There are
small-scale as well as large-scale organisational techniques. The costs of different
techniques of management first fall up to a certain plant size. At very large scales of
output managerial costs may rise, but very slowly.
In short Production costs fall smoothly at very large scales, while managerial
costs may rise only slowly at very large scales. Modern theorists seem to accept that the
fall in technical costs more than offsets the probable rise of managerial costs, so that the
LRAC curve falls smoothly or remains constant at very large scales of output.
We may draw the LAC implied by the modern theory of costs as follows. For each
short-run period we obtain the SRAC which includes production costs, administration
costs, other fixed costs and an allowance for normal profit. Assume that we have a
technology with four plant sizes, with costs falling as size increases. We said that in
business practice it is customary to consider that a plant is used ‘normally’ when it
operates at a level between two-thirds and three-quarters of capacity.
Following this procedure, and assuming that the typical load factor of each plant
is two-thirds of its full capacity (limit capacity), we may draw the LAC curve by joining
the points on the SATC curves corresponding to the two-thirds of the full capacity of
each plant size. If we assume that there is a very large number of available plant sizes
the LAC curve will be continuous.
 THEORY OF COSTS

The characteristic of this LAC curve is that (a) it does not turn up at very large
scales of output; (b) it is not the envelope of the SATC curves, but rather intersects them
(at the level of output defined by the ‘typical load factor’ of each plant). If, as some
writers believe, the LAC falls continuously (though smoothly at very large scales of
output), the LMC will lie below the LAC at all scales in the below diagram. If there is a
minimum optimal scale of plant at which all possible scale economies are reaped
beyond that scale the LAC remains constant.

In this case the LMC lies below the LAC until the minimum optimal scale is
reached, and coincides with the LAC beyond that level of output in the above diagram.
The above shapes of costs are more realistic than the U-shaped costs of traditional
theory. As we will see in section VI, most of the empirical studies on cost have provided
evidence which substantiates the hypotheses of a flat-bottomed SAVC and of an L-
shaped LAC.