UNIT – 3
Cost
There are various concepts of cost. A firm may use different concepts depending upon a particular situation and the type of business decision to be made. An understanding of these concepts will be helpful to the firm.
A. Money Cost – Implicit and Explicit
Implicit costs (IC) are due to the factors which the entrepreneur himself owns and employs in the firm. In other words they are the imputed value of the entrepreneurs own resources and services. The wage or salary for the services of the entrepreneur, interest on the money capital invested by him and the money rewards for other factors owned and used by him in the firm are known as implicit costs. If these services or factors are sold elsewhere by the entrepreneur he would have earned an income. Thus, implicit costs are the opportunity costs of the factors owned and used by the entrepreneur. Since direct cash payments are not made by them, these costs are called implicit costs. Implicit cost is also called indirect cost.
IC = Imputed cost of resources owned by the entrepreneur
= Opportunity cost of resources owned by the entrepreneur
= Indirect Cost
= Implicit Cost
Explicit costs (EC) are the contractual cash payments made by the firm for purchasing or hiring the various factors. In other words, explicit costs refer to the actual expenditures of the firm to hire, rent, or purchase the inputs its requires in production. They include wages and salaries, payments for raw materials, power, light, fuel, advertisements, transportation and taxes. Explicit money cost is the accounting cost, because an accountant takes into account only the payments and charges made by the firm to the suppliers of various productive factors. Explicit cost also refer to out-of-pocket cost or direct cost.
EC = Expenditure on hiring or purchasing inputs
= Out of pocket cost = Direct cost
B. Accounting Cost and Economic Cost
Accounting cost refers only to the firm’s actual expenditures or explicit costs. Accounting costs are important for financial reporting by the firm and for tax purposes. However, for managerial decision making purposes economic cost is the relevant cost concept.
An economist would include both explicit and implicit costs in the cost of production. Therefore, economic costs equal to explicit costs plus implicit costs. Thus, we can make a distinction between economic cost and accounting cost.
This distinction between explicit and implicit costs is important in analyzing the concept of profit. From the economist’s point of view profit is the difference between total revenue and economic costs. On the other hand, accounting profit, that is, accountant’s concept of profit, is the difference between total revenue and accounting costs.
Accounting Cost = Explicit Cost
Economic Cost = Implicit + Explicit Cost
Accounting Profit = Total Revenue – Explicit Cost
Economic Profit = Total Revenue – Total Cost (Implicit + Explicit Cost)
C. Social Cost and Private Cost
Private Costs are those that accrue directly to the individuals or private firms engaged in relevant activity. On the other hand, social or external costs are passed on to persons not involved in the activity in any direct way. They are passed on to the society at large. For instance, if the firms producing paper dump polluting wastes into river, it will adversely affect the people located down-stream. They are likely to incur higher costs in terms of treating the water for their use, or having to travel longer to fetch potable water. While the private cost for the firm’s dumping wastes is zero or negligible, it is definitely positive to the society. If these external costs are included in the production costs of the producing firm we will obtain social costs of the output. For instance, the cost to society for producing paper may be not only the private cost incurred by the firms producing it but also the cost to those people living downstream who suffer when these firms dump wastes into the river. Ignoring external cost may lead to an inefficient and undesirable alloction of resources in society.
Social cost may be in the form of externalities. They accrue to the public who are not associated with a project. They are in the form of negative externalities when private investment leads to pollution and other harmful effects or problems for the society.
Private cost is equal to economic cost or money cost involved in a private enterprise.
Private Cost = Total cot incurred by private firm
Social Cost = Borne by the society in the form of pollutions and other problems
D. Historical Cost and Replacement
The historical cost of an asset refer to actual cost incurred when the asset was purchased. Historical costs are the accounting costs. On the other hand, replacement cost refers to the cost which must be incurred when the same asset has to be replaced after some years. These two concepts differ due to variations in price over the period. Since the prices have a tendency to rise the replacement cost is likely to be higher than the historical cost. The management should be concerned with the replacement cost of the asset. They will have to make appropriate provisions, so that they are able to replace the asses at the required time. Provision for replacement is made through depreciation fund.
Historical Cost = Original cost to establish the business
Replacement Cost = Cost incurred to replace business assets
Historical Cost = Replacement cost if prices do not change
E. Sunk Cost and Incremental Cost
Sunk cost is the initial cost incurred by a firm to enter the market. It may be in the form of advertisement to make the public aware about the new product. Besides the above, a firm may require to incur other expenditure to set up a new business. Such expenses are called sunk cost of entry. It is the cost that a firm subsequently decides to exit. Expenditure incurred in a business that cannot be recovered or items on which such expenditure is incurred, have no resale value, is treated as sunk cost.
Sunk Cost = Cost that cannot be recovered
= Cost on assets which have no resale value
Incremental cost can be explained by making a distinction between marginal cost and incremental cost. Marginal cost refer to the change in total cost for a 1-unit change in output. For example, if total cost is Rs.150 to produce 10units of output and Rs.160 to produce 11 units of output, the marginal cost of the eleventh unit is Rs.10. On the other hand, incremental cost is a broader concept and refers to the change in total costs from implementing a particular management decision, such as the introduction of a new product line or the undertaking of anew advertising campaign. In other words, incremental cost refers to additional total cost associated with the additional batch of output. This concept is more relevant than the marginal cost because the firm does not increase output by one by one unit but in batches.
Marginal Cost = Cost to produce an additional unit
Incremental Cost = Cost to produce additional batch of output
F. Fixed, Variable and Total Cost
Fixed Cost
Total cost of production consists of fixed cost and variable cost.
Fixed costs are those which are independent of output. They must be paid even if the firm produces no output. They will not change even if output changes. They remain fixed whether output is large or small. Fixed costs are also called “overhead costs” or “supplementary costs”. They include such payments as rent, interest, insurance, depreciation charges, maintenance costs, property taxes, administrative expense like manager’s salary and so on. In the short period, the total amount of these fixed costs will so on. In the short period, the total amount of these fixed costs will not increase or decrease when the volume of the firms output rises or falls
Fixed Cost = Overhead Cost = supplementary cost
Variable Cost
Variable cost are those which are incurred on the employment of variable factors of production. They vary with the level of output. They increase with the rise in output and decrease with the fall in output. By definition variable costs remain zero when output is zero. They include payments for wages, raw materials, fuel, power, transport and the like. Marshall called these variable costs as “Prime Costs” of production.
The relation between total variable cost and output may not be linear, that is, variable cost may not increase by the same amount for every unit increase in output.
Variable Cost = Prime Cost
Total Cost
The total cost (TC) of the firm is a function of output(q). It will increase with the increase with the increase in output, that is, it varies directly with the output. In symbols, it can be written as
TC = f(q)
Since the output is produced by fixed and variable factors, the total cost can be dividend into two components: total fixed cost (TFC) and total variable cost (TVC).
TC = TFC + TVC
SHORT RUN COST-OUTPUT
In the earlier chapter we have discussed various concepts of cost. We are now familiar with money cost and its various categories such as fixed cost, variable cost , total cost and marginal cost. These costs behave in different ways as production changes. In this chapter we explain cost-output relationship in the short-run and long-run.
Short-run is a period where a firm produces its output within a given capacity. Its cost is divided between fixed and variable cost. Production is varied by changing variable cost. In the short-run, production is subject to law of variable proportion.
With a hypothetical example we explain behaviour of output and costs as shown in table
A Schedule of Short Run Costs-Output
All Costs in Rupees
Quantity q | Total fixed cost TFC | Total variable cost TVC | Total cost TC=TFC+TVC | Marginal cost MC | Average fixed cost AFC=TFC/q | Average variable cost AVC=TC/q | Average total cost ATC=TC/q ATC(AC)=AVC+AFC |
1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
0 | 100 | 0 | 100 |
|
|
|
|
1 | 100 | 25 | 125 | 25 | 100 | 25 | 125 |
2 | 100 | 40 | 140 | 15 | 50 | 20 | 70 |
3 | 100 | 50 | 150 | 10 | 33.3 | 16.7 | 50 |
4 | 100 | 70 | 170 | 20 | 25 | 17.5 | 42.5 |
5 | 100 | 100 | 200 | 30 | 20 | 20 | 40 |
6 | 100 | 145 | 245 | 45 | 16.6 | 24.2 | 40.8 |
7 | 100 | 205 | 305 | 60 | 14.3 | 29.3 | 43.6 |
8 | 100 | 285 | 385 | 80 | 12.5 | 35.6 | 48.1 |
9 | 100 | 385 | 485 | 100 | 11.1 | 42.8 | 53.9 |
10 | 100 | 515 | 615 | 130 | 10 | 51.5 | 61.5 |
In table, output (q) in column 1 ranges from 0 to 10.
Total fixed cost (TFC) in column 2 remains the same (Rs.100) throughout production.
Total Variable Cost (TVC) Change from 0 to 515. When there is n production TVC is zero and as the output increases, TVC also increases.
Total Cost (TC) in column 4 is equal to TFC+TVC, which also increase as the output increases. Given the constant TC, change in TC is due to change in TVC. TVC can be obtained by deducing TFC from TC(TVC=TC-TFC).
Marginal Cost (MC) is the additional cost to produce an additional unit of output which is equal to a change in TVC or a change in TC, as ∆TVC=∆TC.
Average Fixed Cost (AFC) is equal to TFC/q. It decline continuously till the last unit of output. This is result of a constant sum (rs.100) which is divided by an increasing denominator.
Average Variable Cost (AVC) declines till output 5 (rs.20) and thereafter increases are more units are produced.
Average Total Cost (ATC) is equal to AFC+AVC. It declines till the 5th unit and thereafter increases.
LONG-RUN COST OUTPUT
The long-run is a period of time during which the firm can alter its size and organisation to changing demand conditions. In other words, in the long-run the firm can adjust its scale of operations or size of plant to produce any required output in the most efficient way. Thus, in the long run the fixed factors can be altered. Management can be reorganized to run a firm of a different size. Capital can also be used differently. In short, all factors are variable in the long run and therefore the scale of operations can be altered.
Thus, in the long-run all costs are variable (i.e. the firm faces no fixed costs). The length of time of the long run depends on the industry. In some services industries, such as dry-cleaning, the period of the long-run may be only a few months or weeks. For capital intensive industries, such as electricity-generating plant, the construction of a new plant may take many years and hence long-run may be many years. The length of time of the long-run depends upon the time required for the firm to be able to vary all inputs.
The long-run is often referred to as the planning horizon because the firm can build the plant that minimizes the cost of producing any anticipated level of output. Once the plant has been built, the firm operates I the short-run. Thus, the firm plans for the long-run and operates in the short-run.
Basic Concepts of Revenue
In order to understand markets and economic activities, it is important to have a good grip on the basic concepts of revenue. In this article, we will talk about the basic concepts of revenue and its types.
Total Revenue
This is simple. The Total Revenue of a firm is the amount received from the sale of the output. Therefore, the total revenue depends on the price per unit of output and the number of units sold. Hence, we have
TR = Q x P
Where,
TR – Total Revenue
Q – Quantity of sale (units sold)
P – Price per unit of output
Average Revenue
Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold. Therefore, you can get the average revenue when you divide the total revenue with the total units sold. Hence, we have,
AR=TRQ
Where,
AR – Average Revenue
TR – Total Revenue
Q – Total units sold
Marginal Revenue
Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit. In other words, it is the additional revenue that a firm receives when an additional unit is sold. Hence, we have
MR = TRn – TRn-1
Basic Concepts of Revenue
In order to understand markets and economic activities, it is important to have a good grip on the basic concepts of revenue. In this article, we will talk about the basic concepts of revenue and its types.
Total Revenue
This is simple. The Total Revenue of a firm is the amount received from the sale of the output. Therefore, the total revenue depends on the price per unit of output and the number of units sold. Hence, we have
TR = Q x P
Where,
TR – Total Revenue
Q – Quantity of sale (units sold)
P – Price per unit of output
Average Revenue
Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold. Therefore, you can get the average revenue when you divide the total revenue with the total units sold. Hence, we have,
AR=TRQ
Where,
AR – Average Revenue
TR – Total Revenue
Q – Total units sold
Marginal Revenue
Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit. In other words, it is the additional revenue that a firm receives when an additional unit is sold. Hence, we have
MR = TRn – TRn-1
Or
MR=ΔTRΔQ
Where,
MR – Marginal Revenue
ΔTR – Change in the Total revenue
ΔQ – Change in the units sold
TRn – Total Revenue of n units
TRn-1 – Total Revenue of n-1 units
MR pertains to a change in TR only on account of the last unit sold. On the other hand, AR is based on all the units that the firm sells. Therefore, even a small change in AR causes a much bigger change in MR. In fact, when AR reduces, MR reduces by a far greater margin.
Similarly, when AR increases, MR increases by a greater extent too. AR and MR are equal only when AR is constant. It is also important to note that the firm does not sell any unit if the TR or AR becomes either zero or negative. However, there are times when the MR is negative (especially if the fall in price is big).
The relationship between TR, AR, and MR
In order to understand the basic concepts of revenue, it is also important to pay attention to the relationship between TR, AR, and MR. When the first unit is sold, TR, AR, and MR are equal.
Therefore, all three curves start from the same point. Further, as long as MR is positive, the TR curve slopes upwards.
However, if MR is falling with the increase in the quantity of sale, then the TR curve will gain height at a decreasing rate. When the MR curve touches the X-axis, the TR curve reaches its maximum height.
Further, if the MR curve goes below the X-axis, the TR curve starts sloping downwards.
Any change in AR causes a much bigger change in MR. Therefore, if the AR curve has a negative slope, then the MR curve has a greater slope and lies below it.
Similarly, if the AR curve has a positive slope, then the MR curve again has a greater slope and lies above it. If the AR curve is parallel to the X-axis, then the MR curve coincides with it.
Here is a graphical representation of the relationship between AR and MR:
Basic concepts of revenue
In the left half, you can see that AR has a constant value (DD’). Therefore, the AR curve starts from point D and runs parallel to the X-axis. Also, since AR is constant, MR is equal to AR and the two curves coincide with each other.
In the right half, you can see that the AR curve starts from point D on the Y-axis and is a straight line with a negative slope. This basically means that as the number of goods sold increases, the price per unit falls at a steady rate.
Similarly, the MR curve also starts from point D and is a straight line as well. However, it is a locus of all the points which bisect the perpendicular distance between the AR curve and the Y-axis. In the figure above, FM=MA
Or
MR=ΔTRΔQ
Where,
MR – Marginal Revenue
ΔTR – Change in the Total revenue
ΔQ – Change in the units sold
TRn – Total Revenue of n units
TRn-1 – Total Revenue of n-1 units
MR pertains to a change in TR only on account of the last unit sold. On the other hand, AR is based on all the units that the firm sells. Therefore, even a small change in AR causes a much bigger change in MR. In fact, when AR reduces, MR reduces by a far greater margin.
Similarly, when AR increases, MR increases by a greater extent too. AR and MR are equal only when AR is constant. It is also important to note that the firm does not sell any unit if the TR or AR becomes either zero or negative. However, there are times when the MR is negative (especially if the fall in price is big).
The relationship between TR, AR, and MR
In order to understand the basic concepts of revenue, it is also important to pay attention to the relationship between TR, AR, and MR. When the first unit is sold, TR, AR, and MR are equal.
Therefore, all three curves start from the same point. Further, as long as MR is positive, the TR curve slopes upwards.
However, if MR is falling with the increase in the quantity of sale, then the TR curve will gain height at a decreasing rate. When the MR curve touches the X-axis, the TR curve reaches its maximum height.
Further, if the MR curve goes below the X-axis, the TR curve starts sloping downwards.
Any change in AR causes a much bigger change in MR. Therefore, if the AR curve has a negative slope, then the MR curve has a greater slope and lies below it.
Similarly, if the AR curve has a positive slope, then the MR curve again has a greater slope and lies above it. If the AR curve is parallel to the X-axis, then the MR curve coincides with it.
Here is a graphical representation of the relationship between AR and MR:
Basic concepts of revenue
In the left half, you can see that AR has a constant value (DD’). Therefore, the AR curve starts from point D and runs parallel to the X-axis. Also, since AR is constant, MR is equal to AR and the two curves coincide with each other.
In the right half, you can see that the AR curve starts from point D on the Y-axis and is a straight line with a negative slope. This basically means that as the number of goods sold increases, the price per unit falls at a steady rate.
Similarly, the MR curve also starts from point D and is a straight line as well. However, it is a locus of all the points which bisect the perpendicular distance between the AR curve and the Y-axis. In the figure above, FM=MA
Concepts of Total Revenue, Average Revenue and Marginal Revenue
Revenue is the income earned by a firm by the sale of goods and services. We may also say that the sale value of the goods. Revenue is different from profit. Profit is equal to revenue less cost. Here, we shall discuss the total revenue, average revenue and marginal revenue.
Concepts of Total Revenue, Average Revenue and Marginal Revenue
- Total revenue
- Average revenue
- Marginal revenue
1. Total revenue
It refers to the total income of a firm or producer or seller from the sale of total goods and services. Total revenue is also equal to the sum of all the marginal revenues. Thus,
TR = P x Q Or TR = ∑MR
2. Average revenue
Average revenue is the revenue per unit of output sold in the market. In simple words, it is the price per unit of the commodity. We calculate the Average revenue by dividing the Total revenue with the number of units of output to be sold in the market. Thus,
AR=TRQ
3. Marginal revenue
Marginal revenue refers to the additional revenue that a firm or producer obtains by selling every additional unit of the commodity in the market. In other words, the change in total revenue is marginal revenue. Thus,
MR=ΔTRΔQ
Or MR = TRn – TRn-1
Revenue Curves under Different Markets
There are different types of revenue curves in different markets. Thus, the revenue curve in the perfect competition market is different from that in the imperfect competition market. Let us study each of these.
1. Revenue curve under Perfect competition market
In the perfect market competition, there are a large number of small buyers and sellers. Thus, the firm is the price taker. Also, in this situation all the firms sell homogeneous goods.
Thus, the price remains constant but the revenue changes. Here, Average revenue curve is a straight line parallel to X-axis. Also, in this situation AR = MR.
2. Revenue curve under Imperfect competition market
In the imperfect competition market, the price is not constant. It may increase or decrease due to market forces.
In order to increase sales, the seller will have to reduce the price of the commodity. But, when the price decreases, Average Revenue and Marginal Revenue also decrease.
In the imperfect competition market, both Average revenue curve and Marginal revenue curve slope downwards from left to right
Also, the Marginal revenue curve is always below the Average Revenue curve. At some point, marginal revenue may also be zero and then negative.
However, Average revenue will always be positive.
Note: In all the market situations, the price is always equal to the Average revenue. Thus, AR = P.
