Page 1
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 1
Subject: Microeconomics
Lesson: Theory of Cost and Revenue
Lesson Developer : Shelly Verma
College/Department: Shri Gobind Singh College of
Commerce, University of Delhi
Page 2
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 1
Subject: Microeconomics
Lesson: Theory of Cost and Revenue
Lesson Developer : Shelly Verma
College/Department: Shri Gobind Singh College of
Commerce, University of Delhi
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 2
Table of Contents
Chapter : Theory of Cost and Revenue
? 1: Learning Outcomes
? 2: Introduction
? 3: The Cost Function
? 3.1: Factors determining costs
? 3.2: Different Concepts of costs
? 3.3: Short-run and Long-run Cost Functions
? 4: Short-run Total Cost Curves
? 4.1: Total Fixed Cost
? 4.2: Total Variable Cost
? 4.3: Total Cost
? 5: Short-run Averageand Marginal Cost Curves
? 5.1: Average Fixed Cost (AFC)
? 5.2: Average Variable Cost (AVC)
? 5.3: Average Cost (AC)
? 5.4: Marginal Cost (MC)
? 5.5: Relationship between AC, AVC and MC
? 6: Long-run Cost curves
? 6.1: Long-runTotal Cost
? 6.2: Long-runMarginal Cost
? 6.3: Long-runAverage Cost
? 6.4: Economies and Diseconomies of Scale
? 7: Relationship between Production Function and Cost Curves
? 7.1: Production function and cost curves
? 8: Significance of Cost Analysis in Decision Making
? 8.1: Decision Making and Costs.
? 9: Concept of Revenue
? 9.1: Total Revenue
? 9.2: Average Revenue
? 9.3: Marginal Revenue
? 10: Relationship between TR, AR and MR
? 10.1: Derivation of AR and MR from TR
? 10.2:AR and MR under Perfect Competition
? 10.3: AR and MR under Imperfect Competition
? 11: Relationship between AR, MR and Elasticity
? Summary
? Exercises
? Glossary
? References
? Quiz
1. Learning Outcomes
Page 3
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 1
Subject: Microeconomics
Lesson: Theory of Cost and Revenue
Lesson Developer : Shelly Verma
College/Department: Shri Gobind Singh College of
Commerce, University of Delhi
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 2
Table of Contents
Chapter : Theory of Cost and Revenue
? 1: Learning Outcomes
? 2: Introduction
? 3: The Cost Function
? 3.1: Factors determining costs
? 3.2: Different Concepts of costs
? 3.3: Short-run and Long-run Cost Functions
? 4: Short-run Total Cost Curves
? 4.1: Total Fixed Cost
? 4.2: Total Variable Cost
? 4.3: Total Cost
? 5: Short-run Averageand Marginal Cost Curves
? 5.1: Average Fixed Cost (AFC)
? 5.2: Average Variable Cost (AVC)
? 5.3: Average Cost (AC)
? 5.4: Marginal Cost (MC)
? 5.5: Relationship between AC, AVC and MC
? 6: Long-run Cost curves
? 6.1: Long-runTotal Cost
? 6.2: Long-runMarginal Cost
? 6.3: Long-runAverage Cost
? 6.4: Economies and Diseconomies of Scale
? 7: Relationship between Production Function and Cost Curves
? 7.1: Production function and cost curves
? 8: Significance of Cost Analysis in Decision Making
? 8.1: Decision Making and Costs.
? 9: Concept of Revenue
? 9.1: Total Revenue
? 9.2: Average Revenue
? 9.3: Marginal Revenue
? 10: Relationship between TR, AR and MR
? 10.1: Derivation of AR and MR from TR
? 10.2:AR and MR under Perfect Competition
? 10.3: AR and MR under Imperfect Competition
? 11: Relationship between AR, MR and Elasticity
? Summary
? Exercises
? Glossary
? References
? Quiz
1. Learning Outcomes
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 3
After you have read this chapter, you should be able to
? Understand the determinants of costs incurred by firms in the production of
goods.
? Define the various concepts of costs for firms.
? Understand the relationship between different elements of costs in the short-
run and long-run.
? Appreciate the significance of economies and diseconomies of scale in
determination of shapeof cost curves.
? Apply the knowledge of cost analysis to decision making.
? Define total, average and marginal revenues.
? Derive AR and MR curves from TR curve.
? Understand the relation between TR, AR and MR
? Apply the knowledge of price elasticity to AR and MR
2. Introduction
3: The Cost Function
Value addition1:
Topic 3.1: Factors determining Costs
The purpose of this section is to make you familiar with the relationship between
factors that determine costs.
Cost analysis helps in properly appraising the behaviour of cost in relation to the
scale of operations, size of output and several other factors in the production
process.
Cost is considered to be a multivariate function as it is determined by many factors
simultaneously.
Click on each factor that determines costs to know more.
Plant size: There is an inverse relationship between plant size and cost. So bigger
the plant, higher will be the costs.
Price of inputs: There is a direct relationship between price of inputs and cost. So if
the price of inputs is more, costs will be higher.
Management and administrative efficiency: There is an inverse relationship
between management and administrative efficiency and cost. More the management
and administrative efficiency, lower will be the costs.
State of technology: There is an inverse relationship between state of technology
and cost. Better the technology, lesser will be the costs.
Level of Output: There is a direct relationship between level of output and cost. So
if the outputis larger costs will be more.
3: The Cost Function (Continued)
Value addition 2:
Topic 3.2: Different Concepts of Costs
The purpose of this section is to make you familiar with the different concepts of
costs.
Page 4
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 1
Subject: Microeconomics
Lesson: Theory of Cost and Revenue
Lesson Developer : Shelly Verma
College/Department: Shri Gobind Singh College of
Commerce, University of Delhi
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 2
Table of Contents
Chapter : Theory of Cost and Revenue
? 1: Learning Outcomes
? 2: Introduction
? 3: The Cost Function
? 3.1: Factors determining costs
? 3.2: Different Concepts of costs
? 3.3: Short-run and Long-run Cost Functions
? 4: Short-run Total Cost Curves
? 4.1: Total Fixed Cost
? 4.2: Total Variable Cost
? 4.3: Total Cost
? 5: Short-run Averageand Marginal Cost Curves
? 5.1: Average Fixed Cost (AFC)
? 5.2: Average Variable Cost (AVC)
? 5.3: Average Cost (AC)
? 5.4: Marginal Cost (MC)
? 5.5: Relationship between AC, AVC and MC
? 6: Long-run Cost curves
? 6.1: Long-runTotal Cost
? 6.2: Long-runMarginal Cost
? 6.3: Long-runAverage Cost
? 6.4: Economies and Diseconomies of Scale
? 7: Relationship between Production Function and Cost Curves
? 7.1: Production function and cost curves
? 8: Significance of Cost Analysis in Decision Making
? 8.1: Decision Making and Costs.
? 9: Concept of Revenue
? 9.1: Total Revenue
? 9.2: Average Revenue
? 9.3: Marginal Revenue
? 10: Relationship between TR, AR and MR
? 10.1: Derivation of AR and MR from TR
? 10.2:AR and MR under Perfect Competition
? 10.3: AR and MR under Imperfect Competition
? 11: Relationship between AR, MR and Elasticity
? Summary
? Exercises
? Glossary
? References
? Quiz
1. Learning Outcomes
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 3
After you have read this chapter, you should be able to
? Understand the determinants of costs incurred by firms in the production of
goods.
? Define the various concepts of costs for firms.
? Understand the relationship between different elements of costs in the short-
run and long-run.
? Appreciate the significance of economies and diseconomies of scale in
determination of shapeof cost curves.
? Apply the knowledge of cost analysis to decision making.
? Define total, average and marginal revenues.
? Derive AR and MR curves from TR curve.
? Understand the relation between TR, AR and MR
? Apply the knowledge of price elasticity to AR and MR
2. Introduction
3: The Cost Function
Value addition1:
Topic 3.1: Factors determining Costs
The purpose of this section is to make you familiar with the relationship between
factors that determine costs.
Cost analysis helps in properly appraising the behaviour of cost in relation to the
scale of operations, size of output and several other factors in the production
process.
Cost is considered to be a multivariate function as it is determined by many factors
simultaneously.
Click on each factor that determines costs to know more.
Plant size: There is an inverse relationship between plant size and cost. So bigger
the plant, higher will be the costs.
Price of inputs: There is a direct relationship between price of inputs and cost. So if
the price of inputs is more, costs will be higher.
Management and administrative efficiency: There is an inverse relationship
between management and administrative efficiency and cost. More the management
and administrative efficiency, lower will be the costs.
State of technology: There is an inverse relationship between state of technology
and cost. Better the technology, lesser will be the costs.
Level of Output: There is a direct relationship between level of output and cost. So
if the outputis larger costs will be more.
3: The Cost Function (Continued)
Value addition 2:
Topic 3.2: Different Concepts of Costs
The purpose of this section is to make you familiar with the different concepts of
costs.
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 4
There are different concepts of costs that are used in different contexts by firms.
Click on each Concept of Costs to know more.
Explicit or Direct or Accounting Costs: include the actual expenditure incurred by
a firm to purchase or hire the inputs it needs in the production process. Accounting
costs are the cash payments made by an entrepreneur to the suppliers of various
factors of production.
These inputs do not belong to the firm itself like wages, rent, interest, payment for
power, fuel, insurance, advertising, etc.
Implicit or Imputed Costs: includes the cost of inputs owned by the firm and used
by the firm in its own production process. It includes payment for owned premises,
self-invested capital and depreciation of capital equipment.
Opportunity Cost or alternative cost: includes the cost of alternative opportunity
sacrificed or given up. It arises because resources are scarce and they have
alternative uses.
Economic Costs: includes accounting cost plus normal return on capital invested by
an entrepreneur himself.
The Cost Function
3: The Cost Function(Continued)
Value addition3:
Topic 3.3: Short-run and Long-run Cost Functions
The purpose of this section is to make you familiar with the role of time periods in
determination of costs.
In cost theory time periods, either the short-run or long-run play a significant role.
The short-run costs are the costs over a small period of time; say a few months,
during which some factors of production are fixed like plant, machinery while others
are variable. Production in the short-run can be increased only to the extent possible
by using fixed factors to the full capacity and by increasing the use of variable
factors.
In the short-run the cost function is given as:
C = f (X, T, Pf, K)
where, C = Total Cost, X = Output, T= Technology, Pf = Prices of factors of
production, K = Fixed factor(s) of production.
The long-run costs are the costs over a period of time long enough during which all
factors of production can become variable. Production in the long-run can be
increased by using more of all factors.
Long-run cost function: C = f (X, T, Pf)
Diagrammatically, the cost function is shown as a two-dimensional diagram by
assuming C= f(X), ceteris paribus. So cost is a function only of output, other things
remaining constant.
You must remember that when other factors, like technology (T) and prices of
factors of production (Pf) change then the cost curve will tend to shift.
Page 5
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 1
Subject: Microeconomics
Lesson: Theory of Cost and Revenue
Lesson Developer : Shelly Verma
College/Department: Shri Gobind Singh College of
Commerce, University of Delhi
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 2
Table of Contents
Chapter : Theory of Cost and Revenue
? 1: Learning Outcomes
? 2: Introduction
? 3: The Cost Function
? 3.1: Factors determining costs
? 3.2: Different Concepts of costs
? 3.3: Short-run and Long-run Cost Functions
? 4: Short-run Total Cost Curves
? 4.1: Total Fixed Cost
? 4.2: Total Variable Cost
? 4.3: Total Cost
? 5: Short-run Averageand Marginal Cost Curves
? 5.1: Average Fixed Cost (AFC)
? 5.2: Average Variable Cost (AVC)
? 5.3: Average Cost (AC)
? 5.4: Marginal Cost (MC)
? 5.5: Relationship between AC, AVC and MC
? 6: Long-run Cost curves
? 6.1: Long-runTotal Cost
? 6.2: Long-runMarginal Cost
? 6.3: Long-runAverage Cost
? 6.4: Economies and Diseconomies of Scale
? 7: Relationship between Production Function and Cost Curves
? 7.1: Production function and cost curves
? 8: Significance of Cost Analysis in Decision Making
? 8.1: Decision Making and Costs.
? 9: Concept of Revenue
? 9.1: Total Revenue
? 9.2: Average Revenue
? 9.3: Marginal Revenue
? 10: Relationship between TR, AR and MR
? 10.1: Derivation of AR and MR from TR
? 10.2:AR and MR under Perfect Competition
? 10.3: AR and MR under Imperfect Competition
? 11: Relationship between AR, MR and Elasticity
? Summary
? Exercises
? Glossary
? References
? Quiz
1. Learning Outcomes
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 3
After you have read this chapter, you should be able to
? Understand the determinants of costs incurred by firms in the production of
goods.
? Define the various concepts of costs for firms.
? Understand the relationship between different elements of costs in the short-
run and long-run.
? Appreciate the significance of economies and diseconomies of scale in
determination of shapeof cost curves.
? Apply the knowledge of cost analysis to decision making.
? Define total, average and marginal revenues.
? Derive AR and MR curves from TR curve.
? Understand the relation between TR, AR and MR
? Apply the knowledge of price elasticity to AR and MR
2. Introduction
3: The Cost Function
Value addition1:
Topic 3.1: Factors determining Costs
The purpose of this section is to make you familiar with the relationship between
factors that determine costs.
Cost analysis helps in properly appraising the behaviour of cost in relation to the
scale of operations, size of output and several other factors in the production
process.
Cost is considered to be a multivariate function as it is determined by many factors
simultaneously.
Click on each factor that determines costs to know more.
Plant size: There is an inverse relationship between plant size and cost. So bigger
the plant, higher will be the costs.
Price of inputs: There is a direct relationship between price of inputs and cost. So if
the price of inputs is more, costs will be higher.
Management and administrative efficiency: There is an inverse relationship
between management and administrative efficiency and cost. More the management
and administrative efficiency, lower will be the costs.
State of technology: There is an inverse relationship between state of technology
and cost. Better the technology, lesser will be the costs.
Level of Output: There is a direct relationship between level of output and cost. So
if the outputis larger costs will be more.
3: The Cost Function (Continued)
Value addition 2:
Topic 3.2: Different Concepts of Costs
The purpose of this section is to make you familiar with the different concepts of
costs.
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 4
There are different concepts of costs that are used in different contexts by firms.
Click on each Concept of Costs to know more.
Explicit or Direct or Accounting Costs: include the actual expenditure incurred by
a firm to purchase or hire the inputs it needs in the production process. Accounting
costs are the cash payments made by an entrepreneur to the suppliers of various
factors of production.
These inputs do not belong to the firm itself like wages, rent, interest, payment for
power, fuel, insurance, advertising, etc.
Implicit or Imputed Costs: includes the cost of inputs owned by the firm and used
by the firm in its own production process. It includes payment for owned premises,
self-invested capital and depreciation of capital equipment.
Opportunity Cost or alternative cost: includes the cost of alternative opportunity
sacrificed or given up. It arises because resources are scarce and they have
alternative uses.
Economic Costs: includes accounting cost plus normal return on capital invested by
an entrepreneur himself.
The Cost Function
3: The Cost Function(Continued)
Value addition3:
Topic 3.3: Short-run and Long-run Cost Functions
The purpose of this section is to make you familiar with the role of time periods in
determination of costs.
In cost theory time periods, either the short-run or long-run play a significant role.
The short-run costs are the costs over a small period of time; say a few months,
during which some factors of production are fixed like plant, machinery while others
are variable. Production in the short-run can be increased only to the extent possible
by using fixed factors to the full capacity and by increasing the use of variable
factors.
In the short-run the cost function is given as:
C = f (X, T, Pf, K)
where, C = Total Cost, X = Output, T= Technology, Pf = Prices of factors of
production, K = Fixed factor(s) of production.
The long-run costs are the costs over a period of time long enough during which all
factors of production can become variable. Production in the long-run can be
increased by using more of all factors.
Long-run cost function: C = f (X, T, Pf)
Diagrammatically, the cost function is shown as a two-dimensional diagram by
assuming C= f(X), ceteris paribus. So cost is a function only of output, other things
remaining constant.
You must remember that when other factors, like technology (T) and prices of
factors of production (Pf) change then the cost curve will tend to shift.
Theory of Cost and Revenue
Institute of Lifelong Learning, University of Delhi 5
4: Short-run Total Cost Curves
Value addition1:
Topic 4.1: Total Fixed Costs
The purpose of this section is to make you familiar with the elements of short-run
total fixed cost curve.
In the short-run at least one input is considered to be fixed and its price constitutes
the fixed cost.
Fixed costs have the following features:
? They do not vary with output.
? They are also called overhead costs or unavoidable costs.
? They include costs like salaries, wages, insurance, depreciation of machinery
and buildings, opportunity cost of entrepreneurs.
? They can never be zero even when production is stopped.
? They cannot be changed in the short run.
? They are represented by a straight line parallel to the x-axis or a horizontal
line.
Figure 1:Total Fixed Cost Curve
4: Short run Total Cost Curves(Continued)
Value addition 2:
Topic 4.2: Total Variable Costs
The purpose of this section is to make you familiar with the elements of short-run
total variable cost curve.
Total Variable Costs
In the short-run variable costs are those costs which vary with the quantity of output
produced.
Variable costs have the following features:
? They are also known as prime costs.
? Variable costs include cost of direct labour, cost of raw material, power, fuel,
andrunning expenses.
? They are zero when production stops.
? They can be changed in the short run.
? They are represented by an inverse-S shaped curve due to law of variable
proportions.
Figure 2: Total Variable Cost Curve
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