Keyboard shortcuts

Press ← or → to navigate between chapters

Press S or / to search in the book

Press ? to show this help

Press Esc to hide this help

Chapter 12: Cost and Revenue

Theory of Cost

Cost refers to the expenditure incurred by a producer on the factors of production to produce a given quantity of output.

Short-Run Costs

In the short run, costs are classified into fixed and variable costs.

  • Total Fixed Cost (TFC): Costs that do not change with the level of output (e.g., rent, insurance). It remains constant even if output is zero.
  • Total Variable Cost (TVC): Costs that vary directly with the level of output (e.g., raw materials, wages of casual labor).
  • Total Cost (TC): \( TC = TFC + TVC \)

Average and Marginal Costs

  • Average Fixed Cost (AFC): \( AFC = \frac{TFC}{Q} \). It continuously falls as output increases, forming a rectangular hyperbola curve.
  • Average Variable Cost (AVC): \( AVC = \frac{TVC}{Q} \). It is U-shaped.
  • Average Total Cost (AC): \( AC = \frac{TC}{Q} = AFC + AVC \). It is also U-shaped.
  • Marginal Cost (MC): Addition made to total cost by producing one more unit. (\( MC = TC_n - TC_{n-1} \)). MC is strictly U-shaped due to the Law of Variable Proportions.

Relationship Between AC and MC

  1. When \(MC < AC\), AC falls.
  2. When \(MC = AC\), AC is minimum and constant.
  3. When \(MC > AC\), AC rises.
  4. The MC curve cuts the AC curve from below at its minimum point.
0 Output Cost AC MC MC = Min AC

Theory of Revenue

Revenue refers to the total money receipts of a firm from the sale of its output.

  • Total Revenue (TR): \( TR = P \times Q \)
  • Average Revenue (AR): \( AR = \frac{TR}{Q} = P \). Thus, AR is simply the price of the commodity.
  • Marginal Revenue (MR): Additional revenue generated from selling one more unit. (\( MR = TR_n - TR_{n-1} \)).

Competency-Based Questions

Case-Based Question

Q1. A firm’s Total Fixed Cost is ₹500. At an output level of 10 units, its Total Variable Cost is ₹1,500. Calculate the firm’s Average Fixed Cost (AFC) and Average Total Cost (AC) at this output level.

Answer: Given: TFC = ₹500 TVC = ₹1500 Output (\(Q\)) = 10 units

  1. \( AFC = \frac{TFC}{Q} = \frac{500}{10} = \text{₹}50 \)
  2. \( TC = TFC + TVC = 500 + 1500 = \text{₹}2000 \)
  3. \( AC = \frac{TC}{Q} = \frac{2000}{10} = \text{₹}200 \) Therefore, AFC is ₹50 and AC is ₹200.

Conceptual Question

Q2. Why does the Average Fixed Cost (AFC) curve never touch the X-axis, even at extremely high levels of output?

Answer: AFC is calculated as \( TFC / Q \). Because Total Fixed Cost (TFC) is a positive constant number (e.g., rent must be paid regardless of output), dividing it by continuously increasing output (\(Q\)) makes the resulting AFC smaller and smaller. However, as long as TFC is greater than zero, the division result can never mathematically reach exactly zero. Therefore, the curve approaches the X-axis asymptotically but never actually touches it.