COST AND REVENUE FUNCTIONS, SHORT RUN COST CURVES, AND LONG RUN COST CURVES.Cost of Production Meaning: Cost of Production refers to the total money expenses(both explicit and implicit) incurred by the producers in the process of transforming inputs into outputs. Cost is analyzed from the producers point of view .Cost estimates are always made interms of money.Cost ConceptsA. 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 or mental efforts put in by variouspeople in the production of a commodity, it is called as real cost.B. Explicit Cost and Implicit Cost Explicit cost refer to the actual money outlay or out of pocket expenditure of the firmto buy or hire the productive resources it needs in the process of production. The following items of a firms expenditure are explicit money costs.1. Cost of raw materials2. Wages and Salaries3. Power charges4. Rent of Factory Premises 5. Interest Payment on Capital 6. Insurance premium 7. Property Tax, License Fee etc 8. Miscellaneous Business expenses like Marketing and Advertising expenses.
Implicit costs are payments which are not actually paid by the firm. Such costs arise when theentrepreneur supplies certain factors owned by himself. The implicit money costs are as follows:Wages for labour rendered by the entrepreneur himselfInterest on capital supplied by him.Rent for his own building used in productionProfits of enterpreneurDepreciation C. Outlay Costs and Opportunity costs Outlay cost is the actual financial expenditure of the firm. It is recorded in the firm’sbooks of account. For example, Payment of wages, interest, cost of raw materials, machines, etc. Opportunity cost of the given economic resources is the foregone benefits from thenext best alternative use of that resource.D. Short run and Long run Costs On the basis of span of time in production , costs can be classified into short run costsand long run costs. Short run costs are the costs which vary with 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.Cost– Output Relationship Cost-output relationship refers to the relationship between output and costs and the behaviour of costs in relation to the change in output. The relationship between cost and output is described as the “ cost function”.TC = f(Q) Where TC --- Total cost of production Q --- Quantity of output producedCost Function The cost function depends on the three independent variables:
1. Production function2. Market prices of inputs3. Period of timeTypes of Cost FunctionsIn economic theory there are mainly 2 types of cost functions. They are:Short run cost functionLong run cost function Cost output relationships or cost behaviour is discussed for the short period and thelong period separately. When this relationship is represented with the help of diagram we get the short and long runcost curves.Meaning Of Short Run Short run is a period of time in which only the variable factors can be varied. While thefixed factors like plant, machinery, management, etc remain constant. The total no of firms in anindustry will remain the same.Cost—Output Relationship And The Behaviour Of Cost Curves In The Short Run Cost Schedule: A Cost Schedule is a list or statement showing variations in costs resulting fromvariations in the levels of output. It shows the response of cost to changes in output. On the basis of the cost schedule we can analyse the relationship between changes inthe level of output and cost of production.
1. Total Fixed Cost (TFC) Total Fixed Costs refers to the total money expenses incurred on fixed inputs likePlant, machinery , tools and equipments in the short run. They are fixed in nature. They are thecosts a firm has to incur even when the output is zero. Matthematically, TFC = TC – TVC where TVC = Total Variable Cost TC = Total Cost
2. Total Variable Cost (TVC) Total Variable Cost refers to the total money expenses incurred on variable factor inputs like raw materials, electricity, fuel, transportation, advertisement, etc in the short run. The variable cost vary directly with the output. TVC = TC – TFC3. Total Cost (TC) Total cost refers to the aggregate money expenditure 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. The behaviour of TFC, TVC & TC areshown in the following diagram.4. Average Fixed Cost (AFC) is the fixed cost per unit of output produced. It is found out bydividing the total fixed cost by total output. AFC = TFC QWhere ‘Q’ represents output. An important character of AFC is that it goes on decreasing as output increases sincethe amount of total fixed cost is being divided by larger no. of units of output produced. Thegreater the output the smaller will be the average fixed cost.
Average variable cost (AVC) is the variable cost per unit of output. It is found out by dividingthe total variable cost by the total output. AVC =TVC Q where ‘Q’ represents the total output. An important character of AVC is that it will decline in the beginning as outputincrease, but when a certain stage is reached it stops declining. This is the stage when thestage has reached its full capacity of production.
6. Average cost (AC) is the cost per unit of the output. This is found out by dividing the totalcost by the total output. Since the total cost consists of fixed cost & variable cost, the averagecost will be equal to the sum of average fixed cost & average variable cost. AC = TC / Q = TC / Total output.= FC + VC / Total output. = TFC + TVC / QWhere ‘Q’ stands for the total output. = AFC + AVC.
The Behaviour of AFC,AVC and AC In the short run the AC curve tends to be U-shaped. The combined influence of AFCand AVC curves will shape the nature of AC curve. AFC begins to fall with an increase in output. AVC comes down upto a particular level and then rises.
7. Marginal Cost (MC) Marginal costs may be defined as the net addition to the total cost as one more unitof 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
Relationship between MC and AC 1. When AC is falling , MC is also falling. When AC and MC curves are falling MC curve is lies below the AC curve. 2. When Ac is minimum, the MC=AC. 3. Once MC=AC, when both the costs are rising , MC curve will always lie above the AC curve.Cost–Output Relationship in the Long Run Long period is a period during which the quantities of all factors variable as well as fixed factors can be varied according to the requirements. In the long run a firm is not tied upto a particular plant capacity. If the demandincreases, it can expand output by enlarging its plant capacity. If the demand for the product declines , a firm can cut down its production capacity. Hence production cost comes down to a great extent in the long run. As all costs are variable in the long run , the total of these 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= TC
Output It is the per unit cost of production at different levels of output by changing the size ofthe plant. The long run cost output relationship is explained 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. Important Features of LAC Curve 1. Tangent Curve 2. Envelope Curve 3. Planning Curve 4. Flatter U Shaped CurveLong Run Marginal Cost Curve The long run marginal cost curve is derived from long run total cost curve at thevarious points relating to the given level of output at each time.
The LMC curve also has a flatter U- shape, indicating that initially as output expands inthe long run with the increasing scale of production , LMC tends to decline. At a certain stage howeverLMC tends to increase.REVENUE CONCEPTS The amount of money which a firm receives by the sale of its output in the market isknown as its revenue. The revenue concepts commonly used in economics are1. Total revenue2. Average revenue3. Marginal revenue1. Total Revenue Total revenue refers to the total amount of money that the firm receives from the saleof its products. The TR can be calculated by following formula: TR = Q x P where TR = Total revenue Q = Quantity of output P = Price per unit of the Commodity
2. Average Revenue Average revenue can be obtained by dividing the total revenue by the number of unitssold. AR = TR Q where AR is the revenue earned per unit of commodity sold. AR is the price of the commodity.The price paid by the consumer is the revenue realised by the producer.3.Marginal Revenue Marginal revenue refers to the additional revenue earned by selling the additional unit of output by the seller. Mathematically, MR = TRn – TRn-1 Or MR = change in TR change in Q