Theory of Cost

Introduction
The firms decision on profit maximizing output depends on the behavior of its costs as well as on the behavior of its revenue. A firms production is commonly thought of as its monetary expenses. In order to produce a good, every firm makes use of various

factor and non factor inputs.

There are various cost like money cost, real cost, opportunity cost, social cost.

Cost analysis
Cost analysis refers to study behavior of cost in relation one or more production criteria like size

of output, scale of production, prices of factors

of production. In other words cost analysis related to financial aspects of producing relation against physical aspects.

Accounting cost
Accounting cost are those cost which are actually incurred & recorded in the books of accounts by the firm in payment for various factors of production.

Ex /:
Wages to workers employed Rent for the building he hires

Prices of the raw material

Fuels & power, etc.,

Also called as explicit cost.

Economic cost
The normal return on money capital invested by the entrepreneur himself in his own business (implicit cost)

Ex :
The wages & salary not paid to the entrepreneur but could have been earned it the services had been sold somewhere

else.
ECONOMIC COST = ACCOUNTING COST + IMPLICIT COST

Outlay cost
Involves actual expenditure of funds
Eg: wages, rent, interest, etc,.

Outlay cost are recorded in the books of

accounts as it involves financial expenditure at

sometimes.

Fixed cost
FIXED COST:
Fixed cost are costs which do not change with changes in the quantity of output In words of FERGUSON total fixed cost is the sum of the short run explicit fixed and the implicit costs incurred by an entrepreneur.

In includes
Rent Salary of administrative staff Interest on fixed capital Insurance Property tax and licence fee Normal profit Depreciation and maintenance etc

Variable cost
Variable cost:
Total variable cost are those costs which are incurred on the use of variable factors of production.

FERGUSON, total variable cost is the sum of amounts spent for

each of the variable inputs used. It includes
Expenses' on raw material. Wages of labour. Electricity changes. Wear and tear expenses.

Fixed cost and variable cost diagram

Total cost

Opportunity cost
Is the cost of any activity measured in terms of the value of the best alternative that is not chosen.

According to LEFTWITCH opportunity cost of a

particular product is the value of the foregone alternative product that resources used in its production , could

have produced.
The opportunity cost is the cost of next best alternative foregone, it is also called alternative cost.

Various cost
Money cost:
The amount spent in terms of money for the production of a commodity is called money cost.

Real cost:
Real cost refers to the pains, the discomfort and disutility involved in supplying the factors of production by their owners.

Accounting cost:
Accounting costs refer to cost payments which firms make for factor and non factor inputs , depreciation and other book keeping entires.

Cost function
The cost function refers to the mathematical relation between of a produce and the various determinants of cost.
C = f (q, T, pf, k)

Where
c = Total cost q = Quantity produced i.e., output T = Technology pf = factory price K = captial

Cost function

Short run cost function c = f(q)

Long run cost function C = f(q, T, pf, k)

7 Cost Concepts (Short-run)

1. 2. 3. 4. 5. 6. 7. Total Fixed Cost (TFC) Total Variable Cost (TVC) Total Cost (TC=TVC+TFC) Average Fixed Cost (AFC=TFC/Q) Average Variable Cost (AVC=TVC/Q) Average Total Cost (AC=AFC+AVC) Marginal Cost (MC= AVC/Q

Short Run Analysis

Total fixed cost (TFC) is more commonly referred to as "sunk cost" or "overhead cost."
Examples: include the payment or rent for land,
buildings and machinery. The fixed cost is independent of the level of output produced. Graphically, depicted as a horizontal line

Short Run Analysis

Total variable cost (TVC) refers to the cost that changes as the amount of output produced is changed.
Examples - purchases of raw materials, payments to
workers, electricity bills, fuel and power costs. Total variable cost increases as the amount of output

increases.
If no output is produced, then total variable cost is zero; the larger the output, the greater the total variable cost.

Short Run Analysis

Total cost (TC) is the sum of total fixed cost and total variable cost
TC=TFC+TVC
As the level of output increases, total cost of the firm also increases.

The Short Run Cost Function

Add ATC = AFC + AVC to the table

The Short Run Cost Function

ATC = AFC + AVC

The Short Run Cost Function

Analysing the Production Function: Long Run

The long run is defined as the period of time taken to vary all factors of production By doing this, the firm is able to increase its total capacity not just

short term capacity

Associated with a change in the scale of production The period of time varies according to the firm and the industry In electricity supply, the time taken to build new capacity could be many years; for a market stall holder, the long run could be as little as a few weeks or months!

Economies and Diseconomies of Scale

Economies of Scale- long run average cost decreases as output increases.
Technological factors Specialization

Diseconomies of Scale: - long run average cost increases as output increases.

Problems with management becomes costly, unwieldy

COST

LAC SAC1 SAC2

Economies of Scale
0 Q1

Diseconomies of Scale
Q

LONG-RUN AVERAGE COST CURVE

Total cost
Total Cost (TC) describes the total economic cost of production and is made up of variable costs. Total cost in economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs.

Total cost
The total cost of producing a specific level of output is the cost of all the factors of input used. total cost=total fixed cost + total variable cost

Average cost
The average cost is the total cost divided by the number of units produced. It is the total cost divided by the quantity of output produced.

Average cost
Average costs affect the supply curve and are a fundamental component of supply and demand.

Marginal cost
The marginal cost of production is the increase in total cost as a result of producing one extra unit.

Marginal cost
The concept of marginal cost in economics is similar to the accounting concept of variable cost. Marginal costs are not constant.

Marginal cost
For example a factory may be operating at the highest capacity it can with all workers working normal full time hours, so increasing production by one more unit would mean paying overtime, so the marginal cost would be higher than the current variable cost per unit.

REVENUE THEORY
Revenue is the income that a firm receives from selling its products, goods and services over a certain period of time Revenue may be measured in three ways: 1. Total Revenue (TR) 2. Average Revenue (AR) 3. Marginal Revenue (MR)

Total Revenue (TR)

TR is the total amount of money that a firm receives from selling a certain quantity of a good or service in a given time period. It is calculated using the formula:
TR = p (the price of the good/service) x q (quantity) Example: If a firm sells 400 pizzas per week, at a price of $6 per pizza than TR = $2400.

Average Revenue (AR)

AR is the revenue that a firm receives per unit of sales. It is calculated using the formula:

AR + TR (Total Revenue p x q) q (Quantity)

Since TR is (p x q), q is common to the top and bottom of the formula, so AR is the same as p. 400 pizzas at $6 each AR= $2400 / 400 = $6

Marginal Revenue (MR)

MR is the extra revenue that a firm gains when it sells one more unit of a product in a given time period. It is calculated by using the formula: MR=__ TR___ where means the change in q

Marginal Revenue (MR) Example

A pizza firms decides to lower the price of pizzas from $6 to $5. Weekly sales increased as follows: MR = $2500 2400 = $100 = $1 100 100 The extra revenue gain from selling an extra unit is $1

Revenue Curves and Outputs

1. Revenue when price does not change with output (elasticity of demand = infinite) If a firm does not have to lower price as output increases and it wishes to sell more of its product, then it faces a perfectly elastic demand curve. This situation only happens in theory, but it is very useful for economists when they are building their models of how markets work and they start with the theoretical market form of perfect competition

Total revenue
Total revenue is the total receipts of a firm from the sale

of any given quantity of

output.

Total revenue
It can be calculated as the selling price of the firm's product times the quantity sold

total revenue = price quantity

Total Revenue
For example:if 100 ice-cream slabs are sold at the rate of 50 rupees per slab, total revenue of the firm will be.. Quantity x price = total revenue 100 x 50 = 5000

Average revenue
Average revenue is the per unit revenue received from the sale of commodity. AR= Total revenue/no of unit sold

Marginal revenue
Marginal revenue is the increase in revenue from

selling one more unit of a

product.

 It differs from the price of the product because it takes into account the effect of changes in price. Marginal revenues and costs can be further broken down into long run and short run