Module-6 Cost and Revenue Analysis

8/8/2019 Module-6 Cost and Revenue Analysis

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Module 6

COST AND REVENUEFUNCTIONS,

SHORT RUN COSTCURVES,

AND

LONG RUN COST CURVES.


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Cost of ProductionMeaning:

Cost of Production refers to the total money

expenses(both explicit and implicit)

incurred by the producers in the process oftransforming inputs into outputs.

Cost is analyzed from the producers point of view

.Cost estimates are always made in terms of money.


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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 ormental efforts put in by

various people in the production of a

commodity, it is called asreal cost.


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Continued ..

B.Ex

plicit Cost and Implicit CostExplicit cost refer to the actual moneyoutlay orout of pocket expenditure of thefirm to buy orhire the productive resources

it needs in the process of production.The following items of a firms

expenditure are explicit money costs.

1. Cost ofraw materials

2. Wages and Salaries


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3. Powercharges

4. Rent of Factory Premises

5. Interest Payment on Capital6. Insurance premium

7. Property Tax, License Fee etc

8.

Miscellaneous Business expenses likeMarketing and Advertising expenses.


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Implicit costs are payments which are notactually paid by the firm. Such costs arise

when the entrepreneursupplies certain factorsowned by himself.

The implicit money costs are as follows:

1. Wages for labourrendered by the

entrepreneurhimself2. Interest on capital supplied by him.

3. Rent forhis own building used in production

4. Profits of enterpreneur

5. Depreciation


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Continued ..

C. Outlay Costs and Opportunity costsOutlay cost is the actual financial expenditure of

the firm. It isrecorded in the firmsbooks of account.

Forexample, 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.


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Continued ..

D. Short run and Long run Costs

On the basis ofspan of time in production, costs can be classified into short run costsand long run costs.

Short run costs are the costs which varywith 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.


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Cost Output Relationship

Cost-output relationship refers to the

relationship between output and costs and the

behaviourof costs in relation to the change in

output.

The relationship between cost and output isdescribed as the cost function.

TC = f(Q) Where TC --- Total cost

of productionQ --- Quantity of

output produced


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Cost Function

The cost function depends on

the three independent variables:

1. Production function

2. Market prices of inputs

3. Period of time


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Types of Cost Functions

In economic theory there are mainly 2 types ofcost functions. They are:

1. Short run cost function

2. Long run cost function

Cost output relationships orcost behaviour is

discussed for the short period and the long period

separately.

When thisrelationship isrepresented with the helpof diagram we get the short and long run cost

curves.


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Meaning OfShort Run

Short run is a period of time in

which only the variable factors can be

varied. While the fixed factors likeplant, machinery, management, etc

remain constant. The total no of firms

in an industry will remain the same.


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CostOutput Relationship And

The BehaviourOf Cost Curves In

The Short Run

Cost Schedule:A Cost Schedule is a list orstatement showing

variations in costsresulting from variations in thelevels of output.

It shows the response of cost to changes inoutput.

On the basis of the cost schedule we cananalyse the relationship between changes in thelevel of output and cost of production.


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A Hypothetical Cost

ScheduleOutput

unitsTFC 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


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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 hasto incureven when the output is zero.

Mathematically,

TFC = TC TVC

where TVC = Total Variable Cost

TC = Total Cost


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Diagrammatic

RepresentationO

fT

FC Curve


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2. Total Variable Cost

(TVC)Total Variable Cost refers to the

total money expenses incurred on

variable factor inputs like rawmaterials, electricity, fuel,

transportation, advertisement, etc in

the short run. The variable cost vary

directly with the output.

TVC = TC TFC


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Diagrammatic

RepresentationO

fT

VC Curve


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3. Total Cost (TC)

Total cost refers to the aggregate moneyexpenditure 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. Thebehaviourof TFC, TVC & TC are shown in the following

diagram.


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The BehaviourOfTFC, TVC

andT

C Curve


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4. Average Fixed Cost (AFC) is the fixed costperunit 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 characterof AFC is that it goes on

decreasing as output increasessince the amount of total

fixed cost isbeing divided by largerno. of units of output

produced. The greater the output the smallerwill be theaverage fixed cost.


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5. Average variable cost (AVC) is the

variable cost perunit of output. It is foundout by dividing the total variable cost by the

total output.

AVC = TVC

Qwhere Q represents the total output.

An important characterof AVC is that

it will decline in the beginning as output

increase, but when a certain stage isreached it stops declining. This is the stage

when the stage hasreached its full capacity

of production.


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AVC Curve U shaped

Curve


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Diagrammatic

RepresentationO

f AC Curve


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The Behaviourof AFC,AVC

and AC

In the short run the AC curve tends

to be U-shaped. The combined

influence of AFC and AVC curves willshape the nature of AC curve.

AFC begins to fall with an increase

in output.AVC comes down upto a particular

level and then rises.


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The BehaviourOf AFC,AVC

and AC Curves


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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


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Diagrammatic

RepresentationO

F MC Curve


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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


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Relationship Between MC and

AC


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Relationship between MC and

AC1. When AC is falling , MC is also

falling. When AC and MC curves are

falling MC curve is liesbelow the ACcurve.

2. When Ac is minimum, the MC=AC.

3

. Once MC=AC, when both the costsare rising , MC curve will always lie

above the AC curve.


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CostOutput Relationship in

th

e Long Run Long period is a period during which the quantities of

all factors variable as well as fixed factors can bevaried according to the requirements.

In the long run a firm is not tied upto a particularplantcapacity. If the demand increases, it can expandoutput by enlarging its plant capacity.

If the demand for the product declines , a firm can cutdown its production capacity. Hence production cost

comes down to a great extent in the long run.


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Continued

As all costs are variable in the long run , the total ofthese 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= TCOutput

It is the perunit cost of production at different

levels of output by changing the size of the plant.


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Continued

The long run cost output relationship isexplained 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.


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Diagrammatic Representation

of Long Run Cost Curve


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Important Features of LAC

Curve

1. Tangent Curve

2. Envelope Curve3. Planning Curve

4. Flatter U Shaped Curve


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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 flatterU- 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 howeverLMCtends to increase.


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REVENUE CONCEPTS

The amount of money which a firmreceivesby the sale of its output in

the market is known as itsrevenue.The revenue concepts commonlyused in economics are

1. Total revenue

2. Average revenue3. Marginal revenue


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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 perunit of theCommodity


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2. Average Revenue

Average revenue can be obtained bydividing the total revenue by the numberofunitssold.

AR = TR

Q

where AR is the revenue earned perunit ofcommodity sold. AR is the price of the

commodity. The price paid by the consumeris the revenue realised by the producer.


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3. Marginal Revenue

Marginal revenue refers to theadditional revenue earned by sellingthe additional unit of output by theseller.

Mathematically,

MR = TRn TRn-1

OrMR = change in TR

change in Q

R l i hi b TR AR d


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Relationship between TR, AR and

MR:

No . Of unitssold

TR(Rs)

AR(Rs)

MR(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


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Diagrammatic Representation

Documents

Module-6 Cost and Revenue Analysis