Theory of Cost and
Revenue
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What is a basic
assumption in economics?
The motivation for
business decisions is
profit maximization
To understand Profit, what is necessary?
To distinguish between the
way economists measure
costs and the way
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What are Explicit Costs?
Payments to nonowners of
a firm for their resources
What are Implicit Costs?
• The opportunity costs of using resources owned by the firm
• Implicit costs are non-monetary opportunity costs, such as the
wages that the owner of a firm
could have earned if he or she
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What is an example of Implicit Costs?
When you invest your nest
egg in your own enterprise, you give up earning
interest on that money
How is Accounting Profit defined?
Total revenue minus
total explicit costs
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What are Total
Opportunity Costs?
Explicit costs + Implicit costs
What is Economic Profit?
Total revenue minus
total opportunity costs
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Computech’s Accounting Versus Economic Profit
Total Revenue Less Explicit costs:
Wages & salaries Materials
Interest paid Other payments Less implicit costs:
Foregone salary Foregone rent Foregone interest
Equals profit
$500,000
$400,000
$50,000
$10,000
$10,000 00
0
$30,000
Item Accounting Profit Economic Profit
Exhibit 1
$500,000
$400,000
$50,000
$10,000
$10,000 50,000 10,000 5,000 -$30,000
What is Normal Profit?
The minimum profit
necessary to keep a
firm in operation
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When economists use the term “Profit”, which
profit do they mean?
Economic profit which,
unlike accounting profit,
includes implicit costs
What is a Fixed Input?
Any resource for which the quantity cannot change
during the period of time
under consideration
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What is the Short Run?
A period of time so
short that there is at
least one fixed input
What is the Long Run?
A period of time so long
that all inputs are variable
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What is a Variable Input?
Any resource for which the quantity can change
during the period of time
under consideration
What is
Total Fixed Cost?
Costs that do not vary as output varies and
that must be paid even
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What is
Total Variable Cost?
Costs that are zero when
output is zero and vary
as output varies
What is Total Cost?
The sum of total fixed cost
and total variable cost at
each level of output
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TC = TFC + TVC
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What is
Average Fixed Cost?
Total fixed cost divided by the quantity of
output produced
AFC = TFC / Q
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• The AFC curve is a rectangular hyperbola regardless of the shapes of the other cost curves.
• The fixed cost is spread over a larger number of units as output is expanded.
• Therefore AFC declines monotonically
• The vertical distance between the ATC and AVC curves equals AFC and hence
decreases as output is increased.
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What is Average Variable Cost?
Total variable cost
divided by the quantity
of output produced
AVC = TVC / Q
AVC curve derivation
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AVC curve derivation
Graphically the AVC at each level of output is derived from the slope of a line drawn from the
origin to the point on the TVC curve corresponding to the particular level of output.
For example, in figure 4.5 the AVC at X 1 is the slope of the ray Oa, the A VC at X 2 is the slope of the ray Ob, and so on
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What is
Average Total Cost?
Total cost divided by the
quantity of output produced
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ATC = AFC + AVC = TC/Q
Derivation of ATC
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What is Marginal Cost?
The change in total cost when one unit of
output is produced
MC = TC/Q = TVC/Q
MC derivation
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Illustrating cost curves
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Q TFC TVC AFC AVC TC AC MC
0 500 0 - - 500 - -
1 500 100 500 100 600 600 100
2 500 180 250 90 680 340 80
3 500 250 167 83 750 250 70
4 500 310 125 78 810 202 60
5 500 380 100 76 880 176 70
6 500 470 83 78 970 162 90
7 500 580 71 83 1080 154 110
8 500 730 63 91 1230 154 150
9 500 930 56 103 1430 159 200
The Area under MC curve
Illustrating cost curves
The geometry of cost curves
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The geometry of cost curves
The geometry of cost curves
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ATC
AVC MC
C os t p er u n it
AFC
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COSTS IN THE SHORT RUN
FIGURE 8.8 Average Total Cost = Average Variable Cost + Average Fixed Cost
COSTS IN THE SHORT RUN
Total cost is a cubic function of output
ATC, AVC, and MC are all second-degree curves which first decline and then increase as output is expanded
MC reaches its minimum before ATC and AVC, and AVC reaches its minimum
before ATC
The reader may verify that the MC curve
passes through the minimum points of both
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COSTS IN THE SHORT RUN
MC is very important for determining optimal output
ATC is very important for determining profitability
AVC is especially important for
determining whether or not a money losing
firm will shut down
What is the Marginal- Average Rule?
When MC < AC, AC falls When MC > AC, AC rises
If MC = AC, AC at minimum
When the MPL is rising, the marginal cost of output will be falling.
When the MPL is falling , the marginal cost of production will be rising.
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What is the relationship between slopes of the
MC and MP curves?
The rising portion of the
MP curve corresponds to
the declining portion of the
MC curve, and vice versa
What is the relationship between the minimum and maximum points of the MR and MP curves?
The maximum point of the
MP curve corresponds to
the minimum point of the
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8
2
1 2 4
Marginal Product Curve
6 4
5
10
6 3
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T ot al O u tp u t
Quantity of Labor
Maximum
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ATC
AVC MC
C os t p er u n it Minimum
Costs in the long-run
• There are no fixed costs in the long run
• Total cost equals variable cost
• Managers of firms decide how they can run their current store or office in the short run
• In the long run, they decide whether the firm would be more profitable if the store or
office were made larger or smaller.
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What is the Long-run Average Cost Curve?
A long-run average cost curve shows the lowest cost per unit at
which a firm can produce any level
of output when the firm can build
any desired plant size [when no
inputs are fixed]
• The long-run average cost (LAC) curve shows the minimum per-unit cost of
producing each level of output when any desired scale of plant can be built.
• Suppose that four of the alternative scales of plant that the firm could build in the long run are given by SAC1, SAC2 , SAC3 , and SAC4
• If the firm expected to produce 2 units of output per unit of time, it would build the scale of plant given by SAC1 and operate it at point A, where SAC is $17…..
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• We could have drawn many more SAC
curves in Fig. 7-4, one for each of the many alternative scales of plant that the firm
could build in the long run.
• By then drawing a tangent to all of these SAC curves, we would get the LAC curve.
• The SAC curves decline at first, but
eventually rise because of the operation of the law of diminishing returns
• In the long run there are no fixed inputs,and the shape of the LAC curve is determined by economies and diseconomies of scale
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What are
Economies of Scale?
A situation in which the
long-run average cost
curve declines as the
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What are Constant Returns to Scale?
A situation in which the long-run average cost
curve does not change as
the firm increases output
Minimum efficient scale
Minimum efficient scale
The level of output at which all economies of scale have been exhausted.
It is the minimum point on the long run
average cost curve.
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What are
Diseconomies of Scale?
A situation in which the
long-run average cost
curve rises as the firm
increases output
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Long-run Average Cost CurveConstant returns to scale
Diseconomies of scale
Economies of scale
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• Assume three methods of production, each with a different plant size: a small plant, medium plant and large plant
• The small plant operates with costs denoted by the curve SAC1 , the medium-size plant operates with the costs on SAC2 and the large-size plant gives rise to the costs shown on SAC3
• If the firm plans to produce output X1 it will choose the small plant.
• If it plans to produce X2 it will choose the medium
• If the firm starts with the small plant and its demand gradually increases, it will produce at lower costs (up to level
• Beyond that point costs start increasing.
• If its demand reaches the level ; the firm can either continue to produce with the small plant or it can
install the medium-size plant.
• The decision at this point depends not on costs but on the firm's expectations about its future demand.
• If the firm expects that the demand will expand further than ; it will install the medium plant, because with this plant outputs larger than are produced with a lower cost.
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• Similar considerations hold for the decision of the firm when it reaches the level
• If it expects its demand to stay constant at this level, the firm will not install the large plant, given that it
involves a larger investment which is profitable only if demand expands beyond
• The long-run cost curve is a planning curve, in the sense that it is a guide to the entrepreneur in his decision to plan the future expansion of his output.
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Chapter’s Quiz
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1. Explicit costs are payments to a. hourly employees.
b. insurance companies.
c. utility companies.
d. all of the above.
2. Implicit costs are the opportunity costs of using the resources of
a. outsiders.
b. owners.
c. banks.
d. retained earnings.
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3. Which of the following equalities is true?
a. Economic profit = total revenue - accounting profit.
b. Economic profit = total revenue - explicit costs - accounting profit.
c. Economic profit = total revenue - implicit costs - explicit costs.
d. Economic profit = opportunity costs + accounting costs.
4. Fixed inputs are factors of production that a. are determined by a firm’s size.
b. can be increased or decreased quickly as output changes.
c. cannot be increased or decreased quickly as output changes.
d. none of the above.
C. In the short run, there are two types of inputs, fixed and variable. Because a firm
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5. An example of a variable input is a. raw materials.
b. energy.
c. hourly labor.
d. all of the above
8. The total fixed cost curve is a. upward sloping.
b. downward sloping.
c. upward, and then downward sloping.
d. unchanged with the level of output.
Refer to the graph below. How much is the value of total fixed cost?
a. 2 400 b. 3 400 c. 5 800
d. TFC cannot be
computed using this graph.
15. Each potential short-run average total cost curve is tangent to the long-run
average cost curve at
a. the level of output that minimizes short-run average total cost.
b. the minimum point of the average total cost curve.
c. the minimum point of the long-run average cost curve.
d. a single point on the short-run average total cost curve.
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2 4 6 8
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10 12 14 16 18
Short and Long-run Average Cost Curves
Short-run average total cost curves
Long-run average cost curve
Q
16. Suppose a typical firm is producing X units of output per day. Using any other plant size, the long-run average cost would increase. The firm is operating at a point which its
a. long-run average cost curve is at a minimum.
b. short-run average total cost curve is at a minimum.
c. both (a) and (b) are true.
d. neither (a) nor (b) is true.
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17. The downward-sloping segment of the long- run average cost curve corresponds to
a. diseconomies of scale.
b. both economies and diseconomies of scale.
c. the decrease in average variable cost.
d. economies of scale.
D. Economies of scale takes place when a firm increases its efficiency by producing more units of output.
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Long-run Average Cost CurveConstant returns to scale
Diseconomies of scale
Economies of scale
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18. Long-run diseconomies of scale exist when the
a. short-run average total cost curve falls.
b. long-run marginal cost curve rises.
c. long-run average cost curve falls.
d. short-run average cost curve rises.
e. long-run average cost curve rises.
E. Diseconomies of scale are evident when increasing output leads to inefficiencies.
19. Long-run constant returns to scale exist when the
a. short-run average total cost curve is constant.
b. long-run average cost curve rises.
c. long-run average cost curve is flat.
d. long-run average cost curve falls.
C. Constant returns to scale are
evident when there is no change in
1. (a) Define profit. Clarify the concepts of normal profit, abnormal profit and negative profit. (Marks: 4)
(b) How would you distinguish between economic profit and accounting profit? (Marks:4)
(c) Draw the short-run ATC, AVC, and MC curves in a single diagram and explain. Describe the necessity of these curves.(Marks: 7)
(d) What does the long-run average cost (LRAC) curve show? Draw a LRAC curve and locate the economies of scale and diseconomies of scale. (Marks: 5)
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