COST AND REVENUE CURVES

The firm’s costs are the expenses incurred

In producing goods and services during the
Period. Cost is derived from the production
function. The sum of payments made for the
labour, capital, land, raw materials etc in
production process is called cost.
i.e. C=f(Q) …………..(1)
where C=cost, f=function, Q= output, i.e. cost is
the increasing function of output.
1
 VARIOUS CONCEPTS OF COSTS
• OPPORTUNITY COST
• The opportunity cost is also called alternative
cost. It is the cost of any good is the next best
alternative good that is sacrificed. The
opportunity cost of anything is only the next
best alternative foregone. For ex. the factors
which are used for the production of cloth
may also be used for the production of car.
Therefore the opportunity cost of the
production of cloth is the output of the car
foregone.
2
• Thus the opportunity cost of anything is the
best next alternative that could be produced
instead by same factors or by any equivalent
group of factors, costing the same amount of
money.
• It’s importance is in the determination of
relative price of goods, Determination of
normal price of factor, Efficient resource
allocation.

3
 MONEY COST AND REAL COST
• Money cost is the amount of money that the
producer spends directly in the purchases of
the inputs of production. It is the total amount
of money spent on the production of
commodity.
• Real cost means the efforts made by the
workers and producer to produce goods and
services. Thus the effort and sacrifices
undergone by the producer in providing a
commodity are called the real cost of
production.
4
 EXPLICIT COST AND IMPLICIT COST
• Cost of production can be classified as explicit
and implicit costs.
EXPLICIT COST
Explicit costs are also called paid out costs.
These costs are paid by the firm to the owners of
various factors services. It is the monetary
payments which a firm makes to those outsiders
who supply labour, services, raw materials,
powers etc. So it is the payments made by the
firm on the purchase of factor services
5
 IMPLICIT COST
• Implicit costs are costs which have not to be paid
out to others but the costs which the producer
pays to himself. He himself is the owner of the
business premises, he may have invested his
own capital, he may be a whole time workers in
the business, for which he may not be drawing
any salary. If he use out these factors to others,
he would have received certain amount of
money from them. Hence they must be taken in
to account while calculating profit. But they are
not actually paid out to anybody, they are called
implicit cost.
6
ACCOUNTING COST AND ECONOMIC COST
• Accounting cost involve direct payment of
money by the entrepreneur to the various
factors of production. The payments made for
labour, land, capital, raw materials, fuel and
power in the production process are cost of
production. An account will take in to account
only the payment and charges made by
entrepreneur to the supplier of various
productive factors which is called accounting
cost.
7
Thus, the accountants consider those costs which
involves cash payments by the entrepreneur of
the firm to the others.
ECONOMIC COST
Economic cost is the sum of all accounting cost
and other money value of entrepreneur could
have earned if he had invested his money capital
and sold his own services and others factors in
next best alternatives uses.
Thus economic cost is the sum of accounting cost
and implicit cost.
I.e. economic cost= accounting cost+ implicit cost
8
 Short run and long run cost
• Short run is a period of time in which one or
more factors of production is fixed so that the
firm can change its output by changing the
variable factors only. In short run producer has
no sufficient time to change all factor of
production. Thus short run costs are those
costs which are incurred by the firm during a
period in which some factors are held
constant.

9
• The long run costs are the costs incurred
during a period which is sufficient large to
allow the variation in all factors of production
to produce a level of capital.
Short run total costs
1. Total Fixed cost(TFC)
Total fixed cost refers to the all of money
payments made for fixed factor of production
in the production process. It is independent
of output. The expenditure made on land,
building, machinery, minimum charge of
telephone, electricity salary of permanents
employed are the fixed cost.
10
 Total variable cost
• The expenditure made on variable factors is
called variable cost. It is incurred on the
employment of variable factors of production
whose amount can be changed in the short
term . It is depend on the amount of output. It
is also called prime cost or direct cost.
total cost
The sum of total fixed cost and variable
cost is called total cost
i.e. TC= TFC+TVC ……….(1) 11
• It is the total cost incurred for both fixed
factors and variable factors.
• The following table shows the TFC,TVC&TC

output TFC TVC TC

1 50 5 55
2 50 9 59
3 50 12 62
4 50 16 66
5 50 25 75
6 50 40 90

12
• The TVC TFC& TC can be explained by the
following fig.

TFC

O X
Output

13
 AVERAGE COST
Short run average cost is the per unit of output.
In short run there are two types of factor of
production, fixed factor and variable. i.e. average
cost is also divided in to average variable cost
and average fixed cost.
Average Fixed Cost
The average fixed cost is defined as total fixed
cost divided by the level of output produced.
i.e. AFC= TFC
Q

14
• As total fixed cost remains fixed, dividing it by
an increasing output would gradually reduce
the AFC. This would give a downward sloping
AFC cost which is shown in following fig.

AFC
O X
Quantity produced
15
 AVERAGE VARIABLE COST
Average variable cost is defined as the total
variable cost divided by the level of output
produced.
TVC
i.e. AVC  Q
The AVC will gradually falls as the output
increases from zero to normal capacity, due to
the occurrence of increasing returns. After
normal capacity output the average variable
cost will rise because of the operation of
diminishing returns.
16
• Y
AVS

O X
Output produced

• AVC curve represents the average variable cost

curve. It slopes downward in the beginning
reaches the minimum point and rises upward
thereafter. The AVC curve is U shaped.

17
 AVERAGE COST
• The sum of AVC &AFC is called AC.
• Where, TC= TVC+TFC………..(1)
• TC TVC TFC
 
• Q Q Q
• i.e. AC = AVC+ AFC
• Where AC= total average cost, AVC= average
variable cost , AFC = average fixed cost.

18
• The average cost curve is also u shaped curve
due to law of variable proportion.
Y

AC

O OUTPUT PRODUCED X

19
 SHROT RUN MARGINAL COST
• Marginal cost is addition to the total cost
caused by producing one more unit of output.
It is the ratio of change in total cost to change
in output. i.e. MC= TC where, MC= marginal
Q
cost, ∆TC= change in total cost, ∆Q= change in
output. Marginal cost curve is also u shaped
curve due to operation of law of variable
proportion.

20
 MC
Y

O Output produced X

• In fig MC first falls, reaches the minimum point

and increase thereafter.

21
 RELATION BETWEEN MC AND AC

• The relationship between AC and MC can be

explained by the following fig.
MC AC
Y
AC&MC

O X
OUTPUT PRODUCED

22
• The relationship between AC and MC is very
important for economic analysis. With the help
of this relationship, a firm can decide its level
of output. Both cost falls reach the minimum
point, then after rise.MC cuts AC at its
minimum point. When MC is less than AC, AC
falls and when MC is greater than AC, Ac rise.
• When MC is below AC, AC is falling
• when MC is above, AC is rising
• When MC equals AC, AC neither falls nor rises
• MC equals AC when AC is at its minimum point. 23
 Relationship of AC with AVC AND AFC
• Relationship of AC with AVC and AFC can be
explained by the following schedule:-
output TFC TVC TC AFC AVC AC MC
0 50 0 50 - - - -
1 50 10 60 50 10 60 10
2 50 18 68 25 9 34 8
3 50 24 74 16.67 8 24.67 6
4 50 32 82 12.5 8 20.5 8
5 50 50 100 10 10 20 18
6 50 80 130 8.33 13.3 21.63 30
7 50 124 174 7.14 17.7 24.84 44
8 50 180 230 6.25 22.5 28.75 56
24
• AC is the sum of AFC and AVC , AC falls when
AFC and AVC fall. The above table shows that
up to the output 3 units, AC, AFC &AVC all fall
continuously.
• Change in AC depends on change in AFC
&AVC, when AFC falls but AVC increases i.e.
the rate of change between them are as
follows:-
• a) If decreasing rate of AFC >AVC,AC falls. In
table up to the 5 units of output AC

25
• b) when the decreasing rate of AFC=AVC, AC
remains constant. In table output 5to 6.
• c) If the decreasing rate of AFC< AVC, Ac starts
to rise. In table after output 6units.
• Relationship of TVC & AVC
• In the beginning TVC increasing at decreasing
rate(in table up to output 4units), AVC
decreases. When TVC increasing at a
increasing rate, AVC rise( after output 5units)
• Thus AVC is U shaped curve.

26
 Relationship between TC(TVC) & MC
• Short run MC depends upon TVC not TC. It
can be proved with following mathematical
expression:-
Let MC = TCn- TCn-1
• OR, MC  (TFC  TVC )  (TFC  TVC )
n n 1

• OR, MC = TFC + TVCn –TFC - TVCn-1

• .: MC = TVCn – TVCn-1

27
 COST SCHEDULE
output TVC TC MC= TVCn- TVC n-1 Mc=TCn- TCn-1
o o 100 - -
1 10 110 1o-0= 10 110-100= 10
2 18 118 18-10=8 118-110= 8
3 24 124 24-18= 6 124- 118 = 6
4 32 132 32 – 24 =8 132- 124= 8
5 50 150 50- 32 = 18 150- 132= 18
6 80 180 80 – 50 =30 180- 150= 30
7 124 224 124- 80= 44 224- 180 = 44
8 180 280 180- 124= 56 280- 224= 56

when TC increasing at decreasing rate mc

decreases.(up to 3 unit of output)
28
• When the rate of increase in TC or TVC stop
diminishing, MC is minimum.( at output 3)
• When TC or TVC start to increase at increasing
rate MC start to rise (at output 4to9 ).

29
 Long run average cost and cost curve
• LAC = LTC/LQ …….(1)
• Where, LTC = long run total cost,
LQ = long run output,
LAC= long run average cost.
• Thus LAC is the per unit cost of output
production in the long run.
• The following fig. shows the process for
derivation of LAC.

30
• Suppose there are three different plants with
different production capacities in a given
state of technology at a particular point of
time . They are: small plant(SAC1), medium
plant(SAC2), and large plant (SAC3),
Y SAC3
SAC2
SAC1
COST

d
c
a

O X
Q1 Q2Q3 Q4 Q5
OUTPUT
• In fig. suppose the firm plans to produce OQ1
units of output, the firm has to select small
plant and SAC is equal to Q1a.
• if the market demand increased up to Q3 firm
operates medium plant.
if firm use small plant at output Q3,SAC will be
Q3d and if the firm use medium plant, SAC will
be Q3c.
Thus Q3d > Q3 c, (firm use medium plant). If
firm produce Q4 output, firm can either use
medium plant or large plant depend upon the
future market demand.

32
• From the above analysis it can conclude that
the firm will operate the plant only on the
portions below the intersection of various SAC
curve because above the intersection
represent the greater cost . Thus LAC is the
locus of points denoting the least cost of
producing the corresponding output. Thus if
we draw a tangent a continuous curve which
is LAC curve of the firm. The LAC curve is U
shaped curve like SAC. The difference is that
LAC curve is flatter than the SAC curve.

33
• The U shape of LAC curve is determined by the
law of returns to scale. According to this law
when output increases, production per unit
cost decreases due to the economic of scale.
• The economic of scale exist only up to optimum
plant size. Once the plant size further increases
than optimum level diseconomies of scale start.
Cost per unit starts rising with every expansion
of level of output. Thus LAC is u shape.

34
 LAC curve

Y
SAC3
SAC3 LAC

c
o
s SAC1
t

Q3 X
O Q1 Q2 Output

35
 L shaped LAC curve
• The empirical study has found that LAC curve
is L shaped. Empirical studies show that
marginal diseconomies can be avoided in the
long run. The technological progress along
with a sustained production practice makes it
possible for the firm to maintain the cost of
production at minimum level in the long run.
This makes the LAC curve L shaped.
• The LAC curve falls due to economic of scale.

36
• When output increases the economic of scale
declines. This leads to operate the constant
returns to scale in the production process.
Y
Cost

LAC

O Output

37
• The main causes of L shaped LAC are as follows:-
1. Management learn better allocation technique
with passage of time.
2. Engineers and designers use better and more
specialized tools to organize production in an
efficient and effective manners.
3. Learning by doing.
4. Initially labours take comparatively longer time
to perform a given task. But their speed
increases as they become more adopt to a
given technique of production.
38
Derivation of long run marginal cost curve
• The long run MC can be derived from the LAC
curve and SMC curve. The LMC curve is
derived from points of intersection of the
SRMC curves with vertical line to the X- axis,
drawn from the points of tangency of the
corresponding SAC curve. The LMC must be
equal to the SMC for the output at which the
corresponding SAC is tangent to the LAC.

39
 Concept of revenue & revenue curve
• Revenue is the firm’s earnings from the sale of
its output at given price.
• Revenue is of three types:-
1. Total revenue(TR) :-Total revenue refers to
the total sales value received by the seller
from selling a given amount of output at
given price.
i.e. TR = PX Q
where, P = per unit price of goods,
Q= quantity sold, TR= total revenue.
40
• Similarly, TR is the aggregate of marginal revue.
• Thus TR=  MR = ( MR1+ MR2 ………+MRn)
• MR1, MR2 are the marginal revenue from 1st
and 2nd unit of output.
• 2) Average revenue (AR) :- Average revenue is
the total revenue divided by the quantity sold.
• i.e. AR = TR/ Q
• 3) Marginal revenue (MR) :-Marginal revenue is
the change in total revenue resulting from one
unit increase in the sales

41
• Thus , MR = ∆TR\∆Q
• Where, MR = marginal revenue
• ∆ TR = change in total revenue.
• ∆ Q = change in quantity sold.

Revenue under perfect competition.

Perfect competition is the market in which
there are large number of buyers and sellers
of homogeneous product.

42
 Characteristics of perfect competition

1. Large number of buyers and sellers.

2. Homogeneous product.
3. Free entry and exit of firm.
4. Perfect mobility of factors of production.
5. Profit maximization.
6. No government intervention.
7. Perfect knowledge.

43
• At constant price, TR varies positively &
proportionately with output. Thus AR & MR
remains constant at any level of output.
• TR increasing at constant rate.
Revenue schedule
Units sold Per unit price TR = PXQ AR =TR/Q MR=∆TR/∆Q

1 5 5 5 5
2 5 10 5 5
3 5 15 5 5
4 5 20 5 5
5 5 25 5 5

44
• If we plot this above table in graph we get TR
AR & MR curve
Y

R
E
V MR=AR
E
N
U

O X
OUTPUT

45
• In fig. TR increasing at constant rate. Thus AR
and MR curve are parallel to X axis.
Relation between TR & MR
TR increasing at constant rate with output, MR
remains constant.
MR shows the constant rate of change in TR
with respect to change in output.

46
 Revenue under imperfect competition

• Features of monopoly
1. Single seller and large number of buyers.
2. No close substitute.
3. No provision to entry the new firm.
4. Imperfect knowledge.
5. Profit maximization.

47
• In monopoly market there is inverse
relationship between price and output.
• Total revenue increasing at a decreasing rate.
• AR and MR continuously decreases as output
increases.
Revenue schedule
Sales output Per unit price TR= PXQ AR = TR/Q MR= ∆TR/∆Q
Q P
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2

48
• If we plot the above schedule in graph we get
TR , AR & MR curve in monopoly market.
Y Y

REVENUE
REVENUE

TR

AR
MR
X
O X O
OUTPUT

49
 RELATION BETWEEN AR AND MR

• When AR & MR curves both are straight line

downward slope, the MR curves lies exactly in
the middle of the distance between AR curve
and Y axis. In fig. distance of AC= CD.
Y

A C D

AR
O MR X

50
• When AR and MR curves are convex to the
origin, the MR curve curs any line perpendicular
to the Y-axis more than half way from the AR
curve to the y-axis. In fig. MR and AR both are
• Y convex to the origin. AB perpendicular
• is drawn from origin c is the mid point
• A D c B AR
of the perpendicular. i.e.BD>AD.
MR

O X

51
• When AR and MR curves are concave to the
origin. The MR curves cuts any line
perpendicular to the Y-axis less than halfway
from the AR curve. In fig.
• distance of BD is less
than the distance A D B

of AD. Thus AD> BD. AR

MR

52
 Relationship between ep & revenue(TR, AR &MR)

• The relationship between price elasticity of

demand and revenue at level of output is very
useful.
• Average revenue curve of a firm is the same as
a demand curve of consumers . Thus price
elasticity of demand at any point of consumers
demand curve is the same as the elasticity of
demand on firm’s average revenue curve.

53
• In fig. price elasticity of demand
at point E on AR curve is Y

EB/EA………..(1)
ep = EQ/EQ- MQ A

ep at c= AR/ AR- MR p k E
or, ep = A/A-M AR
m
or e A-eM =A, o Q
B
X
output
eA –A =eM, A (e- 1) = eM, A= eM/ e-1
MR

A= M( e-1/e ) and M= A( e-1/e)

54
1. From the above expression if e= 1, m= A( 1-1/1)
i.e. M= 0. hence at MR zero or at maximum TR
ep is one.
2. If e>1, say 2, M= A(2-1/2) or, M =A(1/2) or M>0.
3. if e<1, say 0.5 M will be negative.
revenue schedule
Sales unit Price(per unit) TR AR MR
1 8 8 8 8
2 7 14 7 6
3 6 18 6 4
4 5 20 5 2
5 4 20 4 0
6 3 18 3 -2
7 2 14 2 -4

55
• At the output range 1to 4 units, ep or AR curve
is greater than unity.TR & MR continuously
rise.
• At output range 4to 5 ep is one.TR curve is
maximum and MR is zero.
• At output range 5 to 7 ep is less than one. Thus
MR is negative and TR is continuously
decrease.

56