Theory of Cost & Revenue

Chapter 7
Theory of Costs and Revenue
Introduction
Main objective of a firm : Profit Maximisation
Profit = Revenue Cost of Production
Cost of production is the expenditure incurred
by a firm when producing a given level of
output
Revenue is the total income earned by a firm
when it sells a given level of output
Types of Costs
Economic Costs
Private vs Social
Time Element & Costs
Economic Costs
Explicit Costs
Implicit Costs
Incurred when
a firm hires or
purchases a
factor of
production
Imputed costs
of a firm when
it uses its own
factors of
production
Termed as
Money Costs
Calculated
based on
opportunity
cost
Normal Profits
Minimum
profits
required to
keep the
entrepreneur
in production
in the long
run
Economic Costs
Explicit cost
Fast Fans Ltd
borrows money
from the bank @
8% p.a. to buy a
machine
V
S
Implicit cost
Fast Fans Ltd
uses its own
money (reserves
and surplus) to
buy a machine
Opportunity cost
of using the
firms own
money is
the Implicit Cost
Private vs Social Costs

Private Costs : incurred by a firm when it
produces a commodity
Eg: cost of raw material
Social Costs : borne by society as a whole

when a firm produces a commodity
Eg: loss of marine life from pollutants from
production process
Time Element and Costs

Very Short Run
All factors are
fixed
Costs remain
constant
Fixed costs

Very Short Run
All factors are
fixed
Costs remain
constant
Fixed costs
Short Run
One factor is
variable; others
fixed
Cost changes to
the extent of
variable factor
Variable cost &
Fixed cost

Very Short Run
All factors are
fixed
Costs remain
constant
Fixed costs
Short Run
One factor is
variable; others
fixed
Cost changes to
the extent of
variable factor
Variable cost &
Fixed cost
Long Run
All factors are
variable
Costs changeable
Variable costs
Costs in the Short Run

Total Fixed Cost (TFC)
Costs that do not change with the change in
output
Total Variable Cost (TVC)

Costs that change with the change in output
Total Cost
TC = TFC + TVC
Total Fixed Cost (Rs)
Total Fixed Costs
TFC
Output
Output TFC
(Q) (Rs)
0
1
2
3
4
5
6
100
100
100
100
100
100
100
Total Variable Cost

(Rs)
Output TFC
(Q) (Rs)
0
1
2
3
4
5
6
7
100
100
100
100
100
100
100
100
TVC
(Rs)
Total Variable Cost
0
20
30
35
45
60
80
126
TVC
TFC
Output
Total Cost
Output
(Q)
TFC
(Rs)
TVC
(Rs)
TC = TFC + TVC
(Rs)
0
1
2
3
4
5
6
7
100
100
100
100
100
100
100
100
0
20
30
35
45
60
80
126
100
120
130
135
145
160
180
226
TC
Total Cost (Rs)
Total Cost
TVC
TFC
Output
Total Cost (Rs)
Total Cost
TC
TVC
TFC
TFC
Output
Distinction between fixed costs and

variable costs
Fixed costs
Variable costs
Do not vary with the quantity

of output produced
Vary with the quantity of

output produced

variable costs
Fixed costs
Variable costs

of output produced

output produced
Can never be zero in the

short run. Have to be incurred
even if production falls to
zero
Can fall to zero in the short

run, as they are directly
related to the level of output
produced

variable costs
Fixed costs
Variable costs

of output produced

output produced

zero

produced
In the short run a firm can

continue production even if
fixed costs are not met
In the short run a firm will

stop production if variable
costs are not met

variable costs
Fixed costs
Variable costs

of output produced

output produced

zero

produced
In the short run a firm can

continue production even if
fixed costs are not met
In the short run a firm will

stop production if variable
costs are not met
Related to the fixed factors of

production
Related to the variable

factors of production
Eg: rent
Eg: wage
Points to Remember
TC is obtained by adding TVC and TFC
Shape of the TC is dependent upon the
shape of the TVC
Vertical distance between the TFC and TC
gives the TVC

Average cost per unit cost of production
average fixed cost (AFC)
AFC = TFC
Q
average variable cost (AVC)
AVC = TVC
Q
average total cost (ATC)
ATC = TC
Q
ATC = AFC + AVC
Average Fixed Cost (AFC)
Average Fixed Cost
As output
increases, AFC
falls continuously
AFC tends towards
the x-axis, but
does not touch it
AFC
O
Quantity of output
AFC is never equal

to zero, as TFC is
never zero
Average Variable Cost

U-shaped curve
Average Variable Cost
AVC
Reflects the law of

variable proportions
Downward sloping
part of curve
Increasing Returns to
a factor
Quantity of output
Upward sloping part

of curve
Decreasing returns to
a factor
Average Total Cost

Cost incurred per unit of output
ATC = AVC +AFC
Schedule of AFC, AVC, ATC

Output AFC
AVC
ATC
0
1
100
20 120
2
50 15 65
3
33.3
11.7
45
4
25 11.25* 36.25
5
20 12 32
6
16.6
13.3
29.9*
7
14.3
18 32.3
* - min.pt.
Average Total Cost

AFC: Average Fixed Cost
AVC
Costs
AVC: Average Variable Cost
AFC
0
Output (Q)
Average Total Cost

Uptil output oa:
AFC falls
ATC
AVC falls
AVC
Costs
ATC falls
AFC
0
a
Output (Q)
Average Total Cost

Between output ab:
AFC fall > AVC rise
ATC
ATC falls
Costs
AVC
AFC
0
a
Output (Q)
Average Total Cost

Beyond output ob:
AFC fall < AVC rise
ATC
ATC rises
Costs
AVC
AFC
0
a
Output (Q)
Average Total Cost

As AFC tends to zero,
ATC tends to AVC
ATC
Costs
AVC
AFC
0
a
Output (Q)

Marginal cost
additional cost incurred in producing an
additional unit of the output
MC = TC
Q
Suppose the cost of producing 3 fans is Rs 135
and the cost of producing 2 fans is Rs 130
Marginal Cost of the 3rd fan is Rs 5
Marginal Cost
Output
of fans
0
1
2
3
4
5
TC
(in Rs)
100
120
130
135
145
160
TVC
(in Rs)
20
30
35
45
60
MC
(in Rs)
20
10
5
10
15
Marginal Cost
Schedule of TC, TVC and MC
MC is U-shaped
Reflects the change in TVC
Area under MC gives TVC
MC
Quantity of output
Relationship between TC and MC

TC
Prior to point A, MC
is falling. TC
increases at a
diminishing rate.
O
Quantity of output
MC
Quantity of output
(Law of Diminishing
Costs)

TC
At point A, MC is at
its minimum. TC is at
point of inflexion
O
Quantity of output
MC
Quantity of output

TC
Quantity of output
MC
Quantity of output
Beyond point A, MC
is increasing. TC is
increasing at an
increasing rate. (Law
of Increasing Costs)

TC
Quantity of output
Prior to point A, MC is
falling. TC is increasing at
a diminishing rate. (Law of
Diminishing Costs)
At point A, MC is at its
minimum. TC is at point of
inflexion
MC
Quantity of output
Beyond point A, MC is
increasing. TC is increasing
at an increasing rate. (Law
of Increasing Costs)
Relationship between AVC and MC
Costs (Rs)
MC
Output
AVC
Prior to point A, MC <

AVC;
AVC
Costs (Rs)
MC
AVC

AVC;
AVC
Between points A and B,
MC < AVC; AVC
Output
Costs (Rs)
MC
AVC

AVC;
AVC
MC < AVC; AVC
Output
At point B , MC = AVC;
AVC is at its minimum
Costs (Rs)
MC
AVC

AVC;
AVC
MC < AVC; AVC
Output
At point B , MC = AVC;
AVC is at its minimum
After point B , MC > AVC;
AVC starts to rise
Relationship between ATC and MC
Costs (Rs)
MC
Output
ATC

ATC;
ATC
Costs (Rs)
MC
ATC

ATC;
ATC
Between points A and C,
MC < ATC; ATC
Output
Costs (Rs)
MC
ATC

ATC;
ATC
MC < ATC; ATC
Output
At point C , MC = ATC;
ATC is at its minimum
Costs (Rs)
MC
ATC

ATC;
ATC
MC < ATC; ATC
Output
At point C , MC = ATC;
ATC is at its minimum
After point C , MC > ATC;
ATC starts to rise
Relationship between ATC, AVC and

MC
MC
ATC
Costs (Rs)
AVC
C
B
A
Output
MC cuts ATC and AVC at their respective minimum points
Costs in the Long Run

Long Run Total Cost (LTC)
Long Run Average Cost (LAC)
Long Run Marginal Cost (LMC)
No distinction between fixed and variable
costs
Long Run Average Cost

LAC = Long Run Total Cost
Output
Saucer shaped
Based on returns to
scale
Costs (Rs)
LAC
Output

Output
Saucer shaped
Costs (Rs)
Based on returns to
Scale
LAC
IRS
Output
Downward sloping part

due to increasing
returns to sale
(Decreasing Average
Cost)

Output
Saucer shaped
Costs (Rs)
Based on returns to Scale
LAC
IRS
S
DR
CRS
Output
Downward sloping part due

to increasing returns to
sale (Decreasing Average
Cost)
Upward sloping part due to
diminishing returns to scale
(Increasing Average Cost)

Output
Saucer shaped
Costs (Rs)
Based on returns to Scale
LAC
IRS
S
DR
CRS
Output
Downward sloping part due

to increasing returns to
sale (Decreasing Average
Cost)
Upward sloping part due to
diminishing returns to scale
(Increasing Average Cost)
Long Run Marginal Cost
Costs (Rs)
LMC =
LMC
LAC
Output
Long Run Cost

Factor Inputs
Also U - shaped
Cuts LAC at its
minimum point
Theory of Revenue
Total Revenue
Total money
earned by a firm
when it sells a
given amount of
output
TR = p x q,
where:
p is the per unit
price
q is the quantity
of output sold
Total Revenue Schedule

Output of fans
0
Total Revenue (Rs)

0
1
2
10
18
3
4
24
28
5
6
28
24
Total Revenue
Uptil point A, TR is
increasing
Total revenue
A
TR
At point A, TR is
maximum
Beyond point A, TR
starts declining
O
Quantity of fans sold
Average Revenue
Total Revenue
AR =
Output sold
Average Revenue
Total Revenue
AR =
Output sold
pxq
=p
=
q
AR = per unit price of the
commodity
Average Revenue
Average Revenue
Output Total
Average
Revenue (Rs)
0
10
10
18
24
28
28
5.6
24
Revenue (Rs)
Average Revenue
Average Revenue
Average
Revenue (Rs)
0
10
10
18
24
28
28
5.6
24
Revenue (Rs)
Average revenue
Output Total
AR
AR Curve downward
sloping
Average Revenue
Average Revenue
Average
Revenue (Rs)
0
10
10
18
24
28
28
5.6
24
Revenue (Rs)
Average revenue
Output Total
AR
As more units of output sold, price must fall

AR
as Q
AR curve is the demand curve faced by the
Marginal Revenue
MR =
MR =
Change in Total Revenue

Change in units of output sold
TR
Q
Marginal Revenue
MR =
MR =

TR
Q
Marginal Revenue Schedule

Output
Revenue
Total Revenue
Marginal
10
10
18
24
28
28
MR =
MR =

TR
Q

Output
Revenue
Total Revenue
Marginal revenue
Marginal Revenue
Marginal
10
10
18
24
28
28
MR
MR =
MR =

TR
Q

Output
Revenue
Total Revenue
Marginal revenue
Marginal Revenue
Marginal
MR Curve
10
10
18
24
28
28
Downward
sloping
Could be
negative
MR
Relationship between TR & MR

Total revenue
A
TR
Output sold
Marginal revenue
Prior to point A, MR is
positive but falling, TR
increases at a
diminishing rate
At point A, MR = 0 and
TR is maximum
Beyond point A, MR is
falling and negative; TR
starts falling
MR Output sold
Relationship between AR and MR

When MR = AR, AR is
at its maximum
Revenue (Rs)
When MR is
decreasing and is less
than AR, AR is falling
AR
MR Output sold
MR can be 0; AR can
never be 0
Relationship of TR, MR & AR under

perfect competition
TR / AR / MR
TR
Units of output sold
TR rises at a constant
rate

perfect competition
TR / AR / MR
TR
AR = MR
rate
AR is constant
MR is constant
AR = MR

Perfect Competition
TR / AR / MR
TR
AR = MR
rate
AR is constant
MR is constant
AR = MR
TR, AR and MR under perfect competition

Units sold
Market Price per unit (Rs)
TR(Rs)
AR(Rs)
MR(Rs)
Relationship of TR, AR & MR under

Imperfect Competition
Total revenue
A
TR
Output sold
Firm retains some flexibility to

determine price
As price falls quantity sold
increases => AR curve is
downward sloping
MR / AR
MR also reduces
AR
Output sold
MR
TR increases at an diminishing
rate and then falls
Producers Equilibrium
That level of output produced and sold,
whereby a firm maximises profits
Profits = Revenue Cost
2 methods of determining produces
equilibrium
Gross Profit Approach
Marginal Revenue Marginal Cost Approach

Profit = Revenue Cost
TC = TFC + TVC
TFC is constant
Gross profit = Revenue
TVC
Area under MC curve = TVC
Area under MR curve = TR

MC
Costs / revenue (Rs)
P = MR
P = MR: Initial
Price Line
MC: Marginal
Cost Curve
O
Quantity of output
MC
P = MR
At Output OQ:
P= MC
TR = OAEQ
TVC= OBEQ
Profit = AEB
Q
Quantity of output
MC
P = MR
At Output
OQ*:
P > MC
TR = OAFQ*
TVC= OBGQ*
G
Q*
Quantity of output
Profit = AFGB
MC
P = MR
At Output
OQ*:
Profit is LESS
than at OQ by
FEG
Q*
Quantity of output
Firm could still

earn this profit

MC
P = MR
D
At Output OQ:
P < MC
TR = OADQ
TVC= OBCQ
Profit = AEB
minus ECD
Q
Quantity of output

MC
C
Firm loses profits

by this area
E
P = MR
D
Ql
Quantity of output
At Output OQ:
Profit is LESS
than at OQ by
ECD
MC
P = MR
Profits are
maximised at
OQ, where
P = MC
Q
Quantity of output
Marginal Cost Marginal Revenue

Approach
MC
P = MR
P = MR: Initial
Price Line
MC: Marginal
Cost Curve
O
Quantity of output

Approach
MC
P = MR
At point E, P =
MC
Output
produced OQ
Q
Quantity of output

Approach
MC
P = MR
At output OQ:
P > MC
MR: AQ
MC: BQ
Q
Quantity of output

Approach
MC
Marginal Profit
A
P = MR
At output OQ:
P > MC
MR: AQ
MC: BQ
Q
Quantity of output

Approach
MC
Marginal Profit
A
P = MR
Increase
output
as long as
P>MC
Q
Quantity of output

Approach
MC
P = MR
At output OQ:
P < MC
MR: DQ
MC: CQ
Q
Quantity of output

Approach
MC
C
Marginal Loss
E
P = MR
At output OQ:
P < MC
MR: DQ
MC: CQ
Q
Quantity of output

Approach
MC
C
Marginal Loss
E
P = MR
Reduce output
as long as
P<MC
Q
Quantity of output

Approach
MC
P = MR
Profits are
maximised at
OQ, where
P = MC
Q
Quantity of output
Break Even Analysis

Defined as the level of output where TR =
TC
Costs include: Fixed, Variable, Normal
Profits
At break even, firm earns normal profit
Break Even Analysis

Break-even chart
Output
TVC
Profit/Loss
TFC
20
TC
20
AR = P
TR
Profit/Loss
-20
Loss
Break Even Analysis

Break-even chart
Output
TVC
Profit/Loss
0
10
TFC
TC
AR = P
TR
Profit/Loss
20
20
-20
Loss
12
20
32
20
-12
Loss
Break Even Analysis

Break-even chart
Output
TVC
Profit/Loss
TFC
TC
AR = P
TR
Profit/Loss
20
20
-20
Loss
10
12
20
32
20
-12
Loss
20
Even
20
20
40
40
Break-
Break Even Analysis

Break-even chart
Output
TVC
Profit/Loss
TFC
TC
AR = P
TR
Profit/Loss
20
20
-20
Loss
10
12
20
32
20
-12
Loss
20
Even
20
20
40
40
30
24
20
44
60
16
BreakProfit
Break Even Analysis

Break-even chart
Output
TVC
Profit/Loss
TFC
TC
AR = P
TR
Profit/Loss
20
20
-20
Loss
10
12
20
32
20
-12
Loss
20
Even
20
20
40
40
30
24
20
44
60
16
Profit
40
26
20
46
80
34
Profit
Break-
Break Even Analysis

Break-even chart
Output
TVC
Profit/Loss
TFC
TC
AR = P
TR
Profit/Loss
20
20
-20
Loss
10
12
20
32
20
-12
Loss
20
Even
20
20
40
40
30
24
20
44
60
16
Profit
40
26
20
46
80
34
Profit
Break-
Costs and revenue (Rs)
Break Even Analysis

At breakeven:
TR = TC
TR
TC
=> TR
q
B
Supernormal profit
Break-even or Normal profit
Loss
Output
TC
= q
=> AR = ATC

Theory of Cost &amp; Revenue

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Chapter 7

Theory of Costs and Revenue

Private vs Social Costs

Social Costs : borne by society as a whole

Time Element and Costs

Time Element and Costs

Time Element and Costs

Costs in the Short Run

Total Variable Cost (TVC)

Total Fixed Cost (Rs)

Total Fixed Costs

Total Variable Cost

Total Variable Cost

Total Cost (Rs)

Total Cost (Rs)

Distinction between fixed costs and

Do not vary with the quantity

Vary with the quantity of

Distinction between fixed costs and

Do not vary with the quantity

Vary with the quantity of

Can never be zero in the

Can fall to zero in the short

Distinction between fixed costs and

Do not vary with the quantity

Vary with the quantity of

Can never be zero in the

Can fall to zero in the short

In the short run a firm can

In the short run a firm will

Distinction between fixed costs and

Do not vary with the quantity

Vary with the quantity of

Can never be zero in the

Can fall to zero in the short

In the short run a firm can

In the short run a firm will

Related to the fixed factors of

Related to the variable

Costs in the Short Run

Average Fixed Cost (AFC)

Average Fixed Cost

AFC is never equal

Average Variable Cost

Reflects the law of

Upward sloping part

Average Total Cost

Schedule of AFC, AVC, ATC

Average Total Cost

AVC: Average Variable Cost

Average Total Cost

Average Total Cost

Average Total Cost

Average Total Cost

Costs in the Short Run

Schedule of TC, TVC and MC

Relationship between TC and MC

Relationship between TC and MC

Relationship between TC and MC

Relationship between TC and MC

Relationship between AVC and MC

Prior to point A, MC <

Relationship between AVC and MC

Theory of Cost & Revenue

Theory of Cost & Revenue