NOTES ON COST AND REVENUE ANALYSIS (CHAPTER - 08)

CHAPTER – 08

COST AND REVENUE ANALYSIS

What is Cost and Revenue?

ü  Cost – The amount of money spend for the production of goods and services.

ü  Revenue – The amount of money a firm gets by selling the goods and services.

TYPES OF COST

1.      Money Cost

The expenses of a firm in terms of money or cash that is rent, wages, interest etc.

2.      Real Cost

The efforts and sacrifices made by the owners of factors of production used in the production of a commodity.

3.      Explicit Cost

Those costs which are entered in the account book, example, payments of rent, interest, taxes, license fee, power charges, cost of raw materials etc.

4.      Implicit Cost / Imputed Cost

Those costs which are not entered in the account book, example, rent for his own land, interest for his own capital, payment for his own labour.

5.      Opportunity Cost

It refers to the cost of the production of next best alternative good which has sacrificed the production of another.

6.      Private Cost

It refers to the cost of production incurred by an individual firm in producing a commodity.  

7.      Social Cost

It refers to the cost that the society has to bear on account of the production of a commodity.

8.      Fixed Cost

Those costs which are incurred on fixed factors such as salary of the permanent staff, rent of the factory building, property tax, license fee etc. Fixed cost is also known as the ‘supplementary cost’ or ‘overhead cost’.

9.      Variable Cost

Those costs which are incurred on variable fixed factors such as raw materials and labour. It is also known as ‘prime cost’ or ‘direct cost’.

10.   Normal Profit

It is defined as the minimum payment which a producer must get in order to induce him to undertake the risk of production.

BEHAVIOUR OF COST IN THE SHORT-RUN

ü  The short-run costs may be classified as:

TOTAL COST CURVES

Total cost corresponding to fixed and variable factors in the shot-run is divided into TWO parts:

1.      Total Fixed Cost

2.      Total Variable Cost

1.      TOTAL FIXED COST (TFC)

It refers to the total cost incurred by the firm on the use of all fixed factors. It is often known as ‘unavoidable cost’.

2.      TOTAL VARIABLE COST (TVC)

It refers to the total cost incurred by a firm on the use of the variable factors. It is also known as ‘avoidable cost’.

TOTAL COST (TC)

Total cost refers to the sum total of fixed cost and variable cost. That is: TC = TFC+TVC

SCHEDULE OF TFC, TVC AND TC

Output (Units)	TFC	TVC	TC
0 1 2 3 4 5 6	60 60 60 60 60 60 60	0 40 76 102 132 170 222	60 100 136 162 192 230 282

BEHAVIOUR OF SHORT-RUN TOTAL COSTS

TFC curve is a straight line parallel to the horizontal axis indicating the same amount of fixed cost at every level of output. TFC is constant at OA. Note that TFC curve starts from point A on the Y-axis indicating that total fixed cost will be incurred even if output is zero.

The TVC curve is concave downward up to OQ level of output indicating that the total variable cost increases at a decreasing rate, and subsequently it is concave upward indicating that total variable cost increases at an increasing rate.

The shape of TC curve is the same as that of the TVC curve. This means that slopes of the TC curve and TVC curves are identical. Note that TC curve originates not from O, but from A because at zero level of output, TC equals FC since TVC is zero when output is zero. Therefore, like the TVC, TC increases at a decreasing rate first and then at an increasing rate.

Why does TVC increase at a decreasing rate first and at an increasing rate subsequently as the level of output is increased?

ü  Total variable cost increase at a decreasing rate due to increasing returns to the variable inputs arising from the fuller utilization of fixed factors and greater specialization. It increases at an increasing rate due to diminishing returns to the variable inputs arising from difficulty of management and over utilization of fixed factor.

AVERAGE COST CURVES

Average cost corresponding to fixed and variable factors in the shot-run is divided into THREE parts:

1.      Average Fixed Cost

2.      Average Variable Cost

3.      Average Total Cost

1.      AVERAGE FIXED COST (AFC)

It refers to per unit cost of the fixed factors. It is obtained by dividing total fixed cost by the total units of output. Thus:  

1.      AVERAGE VARIABLE COST (AVC)

It refers to per unit cost of the variable factors of production. It is obtained by dividing the total variable cost with the units of output. Thus:

1.      AVERAGE COST (AC) / AVERAGE TOTAL COST (ATC)

It refers to per unit cost of both fixed and variable factors of production. It is obtained by dividing total cost by total units of output. Thus:

SCHEDULE OF AFC, AVC, AC / ATC AND MC

Output (Units)	TFC	TVC	TC	AFC	AVC	AC/ATC	MC
0 1 2 3 4 5 6	60 60 60 60 60 60 60	0 40 76 102 132 170 222	60 100 136 162 192 230 282	0 60 30 20 15 12 10	0 40 38 34 33 34 37	0 100 68 54 48 46 47	0 40 36 26 30 38 52

BEHAVIOUR OF AVERAGE COSTS

AFC curve slopes downward throughout its length from left to right showing continuous fall in average fixed cost with an increase in output. The AVC curve slopes downward up to output OQ₂ showing decrease in the average variable cost, and slopes upward beyond output OQ2 indicating an increase in the average variable cost. In other words, AVC curve is U-shaped.

Why is AVC Curve U-shaped?

ü  U-shaped of AVC follows directly from the law of variable proportions OR the AVC falls up to the optimum capacity level of output due to increasing returns to the variable factor and it increases thereafter due to diminishing returns to the variable factor.

v  Three important observations about ATC Curve

@ The distance between ATC curve and the AVC curve gets smaller as the level of output increases.

@ ATC curve is U-shaped indicating that ATC falls initially, reaches the maximum point and then starts rising.

@ The minimum point of ATC curve is above the maximum point of AVC curve.

MARGINAL COST (MC)

MC is the addition to total cost as more unit of output is produced. In other words, it is the change in total cost as a result of change in output by one unit. It can be written as:

SHORT-RUN MARGINAL COST CURVE

ü  The MC for any level of output can be calculated by taking the slope of the total cost curve corresponding to that level of output.

v  Three important points about MC to be noted

@ MC is independent of the fixed cost, but it is associated with the variable cost and thereby with the total cost.

@ MC curve is common both to AVC curve and ATC curve.

@ MC curve is U-shaped.

RELATIONSHIP BETWEEN AC AND MC

1.      When MC is less than the AC, it means that AC falls with increase in output.

2.      When MC is greater than AC, it means that AC is rising.

3.      When MC is equal to AC, it means that AC is constant.

LONG-RUN COST CURVES

ü  In the long-run all the factors are variable. There are no fixed costs. The long-run cost of a product is the least cost of producing each level of output when all factors of production including the plant are variable.

ü  The long-run costs may be classified as:

 

 

LONG-RUN AVERAGE COST (LAC) CURVE

LAC is the cost per unit of production in the long-run. It is an envelope of various short-run average cost curve. It is obtained by dividing the long-run total cost by the level of output. Thus:

DERIVATION OF LAC CURVE

DERIVATION OF SMOOTH LAC CURVE

LONG-RUN MARGINAL COST (LMC) CURVE

LMC can be derived from the long-run total cost or LAC curve. When LAC curve is U-shaped, LMC curve is also U-shaped.

RELATIONSHIP BETWEEN LAC AND LMC

1.      When LAC curve slopes downward, LMC curve will be below the LAC curve.

2.      When LAC curve is at its minimum, LMC will be equal to LAC curve

3.      When LAC curve rises, LMC curve will be above the LAC curve.

Why is LAC Curve U-Shaped? – Economies and Diseconomies of Scale.

ü  The U-shaped of the long-run average cost curve is explained by the economies and diseconomies of scale.

@ Economies refer to reducing the cost of production or some advantages as output increases.

@ Diseconomies refer to increasing the cost of production or some disadvantages as output increases.

ü  The economies and diseconomies of scale are of TWO kinds:

1.      Internal economies and diseconomies.

2.      External economies and diseconomies.

Internal Economies	Internal Diseconomies
@ The followings are the main internal economies: 1.      Technical Economies 2.      Managerial Economies 3.      Marketing Economies 4.      Financial Economies 5.      Economies in Transport and storage 6.      Research and Development Economies 7.      Risk and survival Economies	@ The followings are the main internal diseconomies: 1.      Managerial Diseconomies 2.      Labour inefficiency 3.      Technical Diseconomies
External economies	External Diseconomies
@ The followings are the main external economies: 1.      Cheaper Inputs 2.      Technological Economies 3.      Supply of skilled Labour 4.      Growth of Ancillary Industry 5.      Constant Flow of Information 6.      Economies of localization	@ The followings are the main external diseconomies: 1.      Rise in Input Prices 2.      Higher Wages 3.      Costlier Transport

SHIFT OF LAC CURVE

ü  The shift of the LAC curve is due to external economies and diseconomies. The external economies lead to fall in the cost of production as a result the cost curve shift downward from LAC to LAC_1.

The external diseconomies lead to increase in cost of production and upward shift of the cost curve from LAC to LAC_2.

CONCEPT OF REVENUE

@ REVENUE means the income earned by the firm from the selling of goods and services. The concept of revenue can be divided into THREE:

1.      Total Revenue

2.      Average Revenue

3.      Marginal Revenue

TOTAL REVENUE (TR)

@ It refers to the total amount of income received by the firm from selling a given amount of its output. It can be calculated by multiplying the price of the commodity with the total number of units sold. Thus:

                                          TR = P × Q

AVERAGE REVENUE (AR)

@ It refers to the revenue earned from the sale of each unit of output. It is obtained by dividing total revenue by unit of output sold. AR is always equal to the price. Thus:

MARGINAL REVENUE (MR)

@ It is defined as the addition to total revenue which results from the sale of one additional unit of output. It is calculated as the ratio of change in total revenue to change in units of output sold. Thus:

BEHAVIOR OF REVENUE UNDER DIFFERENT MARKET STRUCTURES

Behaviour of and Relationship between TR, AR and MR under Perfect Competition

Units of Output  (Q)	Price  (P)	TR (P×Q)	AR (TR÷Q)	MR (TRn – TR n-1)
1 2 3 4 5	15 15 15 15 15	15 30 45 60 75	15 15 15 15 15	15 15 15 15 15

@ Since a firm under perfect competition is not require to reduce the price selling more units of output, the average revenue is constant at all levels of output. This is because AR is same as price and price under perfect competition is constant.

If the price or the AR remains the same when more units of a product are sold, this means that the MR and AR are equal. Under perfect competition AR and MR is a horizontal line parallel to X axis.

TR increases at a constant rate with a change in output. TR curve under perfect competition is a straight line from the origin and its slope is constant as determined by the price.

Behaviour of and Relationship between TR, AR and MR under Imperfect Competition

Output (Units)	Price  P=AR	TR (P×Q)	AR (TR÷Q)	MR (TRn – TR n-1)
1 2 3 4 5 6 7	20 18 16 14 12 10 8	20 36 48 56 60 60 56	20 18 16 14 12 10 8	20 16 12 8 4 0 - 4

@@ TR under imperfect competition increases initially, but at a diminishing rate with increase in output. AR falls continuously as output increases because under imperfect competition, a firm required to reduce price to sell more output. However it cannot be negative as price cannot be negative. MR falls continuously, eventually it become negative.

RELATIONSHIP BETWEEN TR AND MR

1. When TR increases with an increase in output, the MR is positive.

2. When TR reaches maximum, the MR becomes zero.

3. When TR falls with an increase in output, the MR becomes negative.

RELATIONSHIP BETWEEN AR AND MR

1.      So long as AR curve is falling, MR is less than AR for every level of output.

2.      When AR curve is a straight line, the MR curve is also straight line, but the rate of fall of MR curve is twice as much as the rate of fall of AR curve.