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 in terms of money.

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 or mental efforts put in by various people 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 firm to 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 materials

2. Wages and Salaries

3. Power charges

4. 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 the entrepreneur supplies certain factors owned by himself.

The implicit money costs are as follows:

Wages for labour rendered by the entrepreneur himself

Interest on capital supplied by him.

Rent for his own building used in production

Profits of enterpreneur

Depreciation C. Outlay Costs and Opportunity costs

Outlay cost is the actual financial expenditure of the firm. It is recorded in the firm’s books 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 the next 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 costs and 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 produced

Cost Function

The cost function depends on the three independent variables:

1. Production function

2. Market prices of inputs

3. Period of time

Types of Cost FunctionsIn economic theory there are mainly 2 types of cost functions. They are:

Short run cost function

Long run cost function

Cost output relationships or cost behaviour is discussed for the short period and the long period separately.

When this relationship is represented with the help of diagram we get the short and long run cost curves.

Meaning Of Short Run

Short run is a period of time in which only the variable factors can be varied. While the fixed factors like plant, machinery, management, etc remain constant. The total no of firms in an industry 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 from variations 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 in the 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 like Plant, machinery , tools and equipments in the short run. They are fixed in nature. They are the costs 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 – TFC

3. 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 are

shown in the following diagram.

4. Average Fixed Cost (AFC) is the fixed cost per unit 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 character of AFC is that it goes on decreasing as output increases since

the amount of total fixed cost is being divided by larger no. of units of output produced. The greater 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 dividing the 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 output

increase, but when a certain stage is reached it stops declining. This is the stage when the stage 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 total cost by the total output. Since the total cost consists of fixed cost & variable cost, the average cost 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 AFC and 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 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

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 demand increases, 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 of the 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 Curve

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 flatter U- 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 however LMC tends to increase.

REVENUE CONCEPTS

The amount of money which a firm receives by the sale of its output in the market is known as its revenue.

The revenue concepts commonly used in economics are

1. Total revenue

2. Average revenue

3. Marginal revenue

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 per unit of the Commodity

2. Average Revenue

Average revenue can be obtained by dividing the total revenue by the number of units sold.

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