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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