MODULE 3

Concept of Costs-marginal, average, fixed, variable costs-cost curves-shut down point-

long run and short run curves-Break even analysis

Concept of Cost

 In business and accounting, cost is the monetary value that a company has spent in
order to produce something

 Cost denotes the amount of money that a company spends on the creation or
production of goods or services. It does not include the mark-up for profit.

 From a seller’s point of view, cost is the amount of money that is spent to produce a
good or product. From a buyer’s point of view the cost of a product is also known as
the price.

 This is the amount that the seller charges for a product, and it includes both the
production cost and the mark-up, which is added by the seller in order to make a
profit.

Different Types of Costs

 Opportunity Cost

 Money Cost and Real Cost

 Fixed Cost, Variable Cost, Average Cost and Marginal Cost

In short run there are fixed and variable costs while in long run all costs are variable

Opportunity Costs

 The resources of any firm are limited, thus the firm has to decide or select only those
investment opportunities/options which provide the firm with the best return or best
income on investment.

 Opportunity cost is the cost of a foregone alternative. If the firm chooses one
alternative over another, then the cost of choosing that alternative is an opportunity
cost.

 This means that if a firm can invest money/ resources only in one investment option
then the firm will select that investment option which promises best return on
investment to the firm.

EXPLICIT & IMPLICIT COST

Explicit cost of production is the actual expenditure made by company in the production
process. Money cost thus includes all the business expenses which involve outlay of money
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to support business operations. For example the expenditure on purchase of raw material,
payment of wages and salaries, payment of rent and other charges of business etc can be
termed as Money Cost.

Implicit cost on other hand includes all such expenses/costs of business which may
or may not involve actual expenditure. For example if owner of a business uses his personal
land and building for running the business and he does not charge any rent for the same
then such cost will not be considered/included while computing the Money Cost but this
head will be part of Real Cost computation.

Fixed Cost (FC)

Fixed Cost is that cost which does not change irrespective of whether the firm is operating
or not. Even when the plant is not operating the Firm still has to bear such expenses.
Examples- Rent of the factory premises, Salary of employees etc.

Variable Cost (VC)

Variable cost is directly proportional to the production. The variable expenses vary with the
business operations. Examples raw material, packing expenses etc, as more and more units
are produced the variable costs increase

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Total Cost (TC)

It is the sum of Total Fixed Costs and Total Variable Costs.

TC=TFC+TVC

Average fixed Cost (AFC)

Average variable cost (AVC)

Average Cost (AC)

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Marginal Cost (MC)

SHORT RUN COST TABLE

Output TFC TVC TC AFC AVC AC MC

0 12 0 12 - 0 - -
1 12 10 22 12 10 22 22
2 12 16 28 6 8 14 6
3 12 21 33 4 7 11 5
4 12 24 36 3 6 9 3
5 12 30 44 2.4 6 8.4 8
6 12 44 56 2 7.3 9.3 12
7 12 60 72 1.7 8.5 10.2 16
8 12 78 90 1.5 9.7 11.2 18

SHORT RUN COST CURVES

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Why Average cost (AC) ‘U’ in Shape?

1. Affect of Average Fixed and Variable Costs

As the Average Cost is the sum of Average fixed and Average Variable cost
(AC=AFC+AVC), hence AC Curve is a combination of both AFC and AVC curves.
Initially AFC starts at a high and gradually reduces as more units are produced, at this point
the AVC curve is minimal and it rises up as more units are produced. Decreasing AFC
curve pulls the AC curve down and AVC curve later pulls the AC curve up

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 2. Diminishing returns operate

In the short run there are fixed and variable factors that affect the output. Initially
there is less variable factors in comparison to fixed factors and as the variable factor is
increased it becomes equal to fixed factor and later variable factors are more compared to
fixed factors. This eventually gives increasing, constant and diminishing returns. Thus the
costs will be exactly in reverse to output i.e., it will decrease, then become constant and then
rise up

Relationship between AC and MC curves?

Both average and marginal costs are related together. When the average cost is falling, the
marginal cost is less than the average cost. When average cost is rising, the marginal cost is
higher than the average cost. But if marginal cost neither goes up nor comes down, the
average and marginal costs are equal.

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LONG RUN COST CURVES

In the short run some input are fixed and other costs vary with the level of output produced
by the firm during that time period. The firm will have different short run cost curves for
different plant sizes, such as SAC1, SAC2, SAC3…etc.

SAC 1

SAC 2

SAC 3

In Long run all factors are variable. Long run average cost is derived from short run cost
curves. LAC curve is the locus of points denoting the least cost of producing the
corresponding output. Long run Average cost curve is composite(combination of Short
run curves) It is also called ‘envelope’ curve

CONCEPTS OF REVENUE (PRICE)

The term revenue refers to the income obtained by a firm through the sale of goods at
different prices. In the words of Dooley, ‘the revenue of a firm is its sales, receipts or
income’.

Revenue Types: Total, Average and Marginal Revenue!

Total Revenue

The income earned by a seller or producer after selling the output is called the total revenue.
In fact, total revenue is the multiple of price and output. The behavior of total revenue
depends on the market where the firm produces or sells.

TR=Price X Output

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TR=Pq

Average Revenue

Average revenue refers to the revenue obtained by the seller by selling the per unit
commodity. It is obtained by dividing the total revenue by total output.
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑃𝑞
𝐴𝑅 = = =𝑃
𝑞 𝑞

Average Revenue is also called as Price and it is also the demand curve of the seller

Marginal Revenue

Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results from the sale of
one more or one less unit of output

Revenue Curves

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Forms of Market

Market is a place where buyers and sellers interact’

 Types of Markets

 Perfect Competition

 Monopoly

 Monopolistic Competition

 Oligopoly

Perfect Competition

 A market situation where there are a large number of buyers and sellers.
 The products sold are homogenous (almost identical)
 Under perfect competition, there is no restriction on entry or exit of firms.
 In perfect competition, sellers and buyers are fully aware about the current market
price of a product.
 Therefore, none of them sell or buy at a higher rate. As a result, the same price
prevails in the market under perfect competition.
 Under perfect competition, the buyers and sellers cannot influence the market price
by increasing or decreasing their purchases.
 In perfect competition, the market price of products is determined by taking into
account two market forces, namely market demand and market supply.
 Examples –Fish markets, vegetable markets etc.

PRICE AND OUTPUT DETERMINATION IN PERFECT COMPETION

• In Figure the total demand curve MD intersects supply curve at point E. Thus point
E is the equilibrium point and OP is the equilibrium price.

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 • Figure b refers to firms demand curve. The firm will have to sell all its output at the
prevailing price OP.

• It may sell more units or fewer units, but it will charge OP price only. The firm can
neither increase nor decrease the price, since the price is determined by the industry
and by the firm.

• Firm is a price taker and not a price maker and as such firms demand curve will run
parallel to OX axis signifying that the firm can sell any number of units at OP price.

• A firm under conditions of perfect competition attains maximum profit when MC =

MR. In the given figure (B) at point E , MR=MC and AR=MR

Monopoly

 Monopoly refers to a market structure in which there is a single producer or seller

that has a control on the entire market.

 This single seller deals in the products that have no close substitutes.

 In monopoly, there is only one producer of a product, who influences the price of the
product by making changes in supply.

 The producer under monopoly is called monopolist.

 If the monopolist wants to sell more, he/she can reduce the price of a product. On
the other hand, if he/she is willing to sell less, he/she can increase the price.

Types of Monopolies:

 Natural monopoly- Natural monopoly arise on account of the limited supplies of raw
materials in particular region. Eg, monopoly of diamonds in South Africa
 Social Monopoly-State monopolies such as railways, harbors and banks etc are social
monopolies
 Legal Monopoly-Patents, Trademarks are legal monopolies given to certain firms
 Service Monopoly-Services of Doctors in specialized functions are service
monopolies

PRICE AND OUTPUT DETERMINATION IN MONOPOLY

 Under monopoly the MR curve lies below the AR curve. The equilibrium is attained
at that level of output where MR=MC.

 The producer will continue to produce/sell as long as MR is greater than MC. At the
point where MR is equal to MC the profits will be the maximum and beyond this
point the producer will stop producing.

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  It can be seen from the diagram that, till OQ output, MR is greater than MC, but
beyond OQ the MR is less than the MC. Therefore the producer will be at
equilibrium at output OQ where MR=MC.

 The corresponding price in the diagram is OP. It can be seen from the diagram that
at output OQ, while QP is the average revenue, QL is the average cost; therefore P’L
is the profit per unit. Therefore the total profit is equal to P’L (profit per unit) X OQ
(total output).

Monopolistic Competition

 Monopolistic competition refers to a market situation where there are many firms
selling a differentiated product(non identical).

 “There is competition which is keen, though not perfect, among many firms making
very similar products.”

 No firm can have any influence on the price-output policies of the other sellers nor
can it be influenced much by their actions.

 Thus monopolistic competition refers to competition among many firms selling

closely related but not identical products.

 Examples-Manufacturers of Refrigerators, TVs, ACs etc

PRICE AND OUTPUT DETERMINATION IN MONOPOLISTIC COMPETITION

In Monopolistic completion profits are maximized at a point where Marginal Revenue
equals the Marginal Cost.
• If the marginal revenue of a seller is greater than the marginal cost the firm may try
to expand the output. On the other hand if the marginal revenue is less than the
marginal cost the firm will reduce the output to a level where marginal revenue
equals marginal cost.

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 • It can be seen from the diagram that at output OQ, while OP’ is the Average
Revenue, QL is the Average cost, and therefore, P’L is the profit per unit. Now the
total profit is equal to P’L (profit per unit) X OQ (total output).

Oligopoly

 Oligopoly is a market situation in which there are a few firms selling homogeneous
or differentiated products.

 It is difficult to pinpoint the number of firms in the oligopolistic market. There may
be three, four or five firms.

 It is also known as competition among the few. With only a few firms in the market,
the action of one firm is likely to affect the others.

 An oligopoly industry produces either a homogeneous product or heterogeneous

products.

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PROBABLE QUESTIONS

1. How is price and output determined under perfect competition? (Answered previously)

2. The demand curve facing a perfect competitor is perfectly elastic explain.

Answer:-

Perfect competition describes a market structure where competition is at its greatest possible
level. To make it more clear, a market which shows the following characteristics in its
structure is said to show perfect competition.

1. Large number of buyers and sellers

2. Homogeneous product
3. Free entry and exit of firms
4. Perfect knowledge of markets by consumers and sellers
5. Every firm is a price taker, no firm can influence the price of the product

Explanation of the demand curve:-

Let us consider an example of fish market where some of the vendors (shops) are selling
sardine fish, all the vendors are selling identical sardines hence the price will generally be the
same in each shop. Let us also assume that all the shops are selling the fish at 10/- per kilo.
Thus the TR(Total Revenue) , AR(Average Revenue) and MR(Marginal Revenue) can be
determined as follows:-

From the table it is clear that TR Units TR AR MR

increases as the quantity sold sold(kg)
increases, but AR and MR is same 1 10 10 10
throughout (10/-). This is because the 2 20 10 10
price is same, and the seller can 3 30 10 10
neither increase nor decrease the 4 40 10 10
price. 5 50 10 10

Revenue (AR & MR)

AR=MR

Units sold

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 As it is evident from the figure that AR and MR is a horizontal line and AR as we know is
equal to price(AR=Price)therefore as the seller tries to decrease the price the quantity
demanded can go up to infinity and increase in price may bring the demand to Zero. This is
a situation of perfectly elastic demand, hence the demand curve facing a perfect competitor
is perfectly elastic.

3. The demand curve facing a monopolist is relatively elastic demand explain.

Answer:

Under, the Monopolistic Competition, there are a large number of firms that produce
differentiated products which are close substitutes for each other. In other words, large
sellers selling the products that are similar, but not identical and compete with each other on
other factors besides price.

Following are some of the features of the market:

1. Product differentiation

2. Large number of buyers and sellers

3. Free entry and exit of firms

4. The sellers have some control over the price

Explanation of the demand curve:-

Unlike perfect competition where the sellers sell homogeneous or identical products, in
monopolistic competition the sellers sell differentiated products that are similar but not
identical. Let us consider a case of mineral water being sold by a seller. As we all know
mineral water is manufactured by different sellers and each manufacturer can slightly
influence the price with different packing / schemes or other factors. Suppose a
manufacturer fixes the price of his product at 15/- per bottle and he can charge different
prices as the quantity demanded changes, then TR (Total Revenue) , AR(Average
Revenue) and MR(Marginal Revenue) can be determined as follows:-

Units TR AR MR
sold
Revenue (AR & MR) 1 15 15 15
2 28 14 13
3 40 13.3 12
AR
4 50 12.5 10
5 55 11 5
Units sold
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In the above figure the AR and MR curve decreases due decreasing revenues as more and
more quantity of bottles are sold. The suppliers generally offer higher discounts or schemes
as they get higher quantity orders are received. The total revenue (TR) increases but AR and
MR decreases, since AR=Price therefore the demand curve facing a monopolistic seller is
relatively elastic.

SHUT DOWN POINT

A shut down point is a point of

operations where a company
experiences no benefit for continuing
operations. This happens when the
market price for the product is equal to
Average Variable cost (P=AVC) in the
short run. At this point the firm can
minimize losses only by not producing.
As long as the market price is above the
AVC, inspite of making losses the firm
will cover all its variable costs and will
wait and hope to cover the fixed costs.
Point A in the figure shows the shut
down point

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