Lecture 8 - Theory of Cost and Revenue | Microeconomics- Interaction between individual buyer-seller PDF Download

 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