COST ANALYSIS CHAPTER # 5

Meaning of Cost  By cost we mean “The total sum of money required for the production of specific quantity of a good or service. OR OR  In other words, cost refers to all the payment which are made to obtain the factors of production, land, labour, capital and management to produce a commodity.

Classifications of Production Costs  Fixed Costs  costs that remain constant as output changes.  Average Fixed Costs (AFC) =  Variable Costs  costs that vary as output changes.  Average Variable Costs (AVC) = Units produced Fixed Cost Units produced Variable Cost

 Total Cost (TC)  the sum of total fixed cost and total variable cost at a particular level of output.  Average Total Cost (ATC) = AFC+AVC ATC=  Marginal Cost (MC)  the change in total cost resulting from production of one more unit of output. Classifications of Production Costs Total units produced Total Cost

TABLE FOR VARIOUS TYPES OF COST

Graphing Total Cost Curves FC Total Cost FC curve is constant TC and VC curves increase as Q increases Q VC TC 12-6

Graphing Per Unit Output Cost Curves AVC MC ATC AFC Q Cost AFC curve decreases MC, ATC, and AVC curves are U-shaped

The Shapes of Cost Curves  The variable and total cost curves have the same shape Increasing output increases VC and TC The average fixed cost curve is downward sloping Increasing output decreases AFC The fixed cost curve is always constant Increasing output doesn’t change FC The marginal cost, average variable cost, and average total cost curves are U-shaped Increasing output initially leads to a decrease in MC, AVC, and ATC but eventually they increase 12-8

The Shapes of Cost Curves  The marginal cost curve goes through the minimum points of the ATC and AVC curves The U-shape of ATC and AVC curves is due to: When output is increased in the short run, it can only be done by increasing the variable input The law of diminishing productivity causes marginal and average productivities to fall As average and marginal productivities fall, average and marginal costs rise 12-9

The Relationship Between Marginal Productivity and Marginal Costs AVC Q MC Q Output per worker Costs per unit If marginal productivity is rising, marginal costs are falling If average productivity is falling, average costs are rising MP of workers AP of workers 12-10

Relationship Between Marginal and Average Costs  The marginal cost and average cost curves are related.  When marginal cost is more than average cost, average cost must be rising.  When marginal cost is less than average cost, average cost must be falling.

Spot Quiz 1 The vertical distance between ATC & AVC measures; a) Marginal cost b) Total Cost c) Average Fixed Cost d) Economic Profit per unit Ans When the marginal cost curves lies a) Above the AVC curve, ATC rises b) Below the AVC curve, total fixed cost increases c) Above the ATC curve, ATC rises d) Below the ATC curve, total fixed cost falls Ans....

REVENUE  MEANING By revenue of a firm we mean the total sale proceeds (earning) or the total money receipts of a firm from the sale of the output. OR Revenue is an income that a company receives from its normal business activities, usually from the sale of goods and services to customers.incomecompanygoods and services

TYPES OF REVENUE  There are three major important types of revenue, which are given as under. 1. Average revenue (AR)  revenue per unit of output sold 2. Total revenue (TR)  amount of revenue received from the sale of a given quantity of goods or services 3. Marginal revenue (MR)  change in TR that results from the sale of one more unit of output

Profit Maximization Approach

Marginal Revenue and Marginal Cost Approach  The Profit maximizing quantity of output can be determined by comparing marginal revenue and marginal cost.  Profit is maximized at the output level where a) Marginal Revenue and Marginal Cost are equal b) and MC curve cuts MR from below  The supply rule is: Produce and offer for sale the quantity at which MR=MC.

Figure 2b: Profit Maximization MC MR –100 –200 Output Dollars

What if MR< MC……???  If MR < MC then  by producing more output, you have a greater addition of cost than you do revenue.  Hence you would not increase production.

What if MR> MC……??? if MR > MC then  by producing more output, you have a greater addition of revenue than you do cost. Hence you would make the change. BUT You would stop increasing output at the point where additional revenue (MR) is just equal to additional costs (MC).

Summary…. OOptimum Marginal Revenue and Marginal Cost IIf MR > MC,  production   profits IIf MR < MC,  production   profits PProfit maximizing level out output: MR = MC

Complete the following table and show graphically the point of profit maximization output for the firm Price =MR (in $) Units Produced TCMCTR = (PXQ) Profit/Loss = TR-TC

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