Cost and revenue concepts

1. Meaning of cost

Cost of production is the total expenditure a firm incurs on the factors and inputs used to produce a commodity. Economists distinguish several notions of cost:

• Money cost: the money spent on wages, rent, interest, raw materials, power and so on.
• Real cost: Marshall’s term for the efforts and sacrifices of labour and the abstinence of savers involved in production.
• Explicit cost: payments actually made to outsiders (wages to hired workers, rent for a hired building).
• Implicit cost: the value of self-owned factors used in the business (the owner’s own building, his own capital and labour), for which no payment is made. Economic cost = explicit + implicit cost, and includes normal profit.
• Opportunity cost: the value of the next best alternative given up. If a field can grow rice worth Rs. 50,000 or cotton worth Rs. 40,000, the opportunity cost of growing rice is the Rs. 40,000 of cotton forgone. The idea follows from scarcity: resources have alternative uses, so using them one way means sacrificing another. It is also called alternative cost or transfer cost, and was developed by the Austrian economists (Wieser, Davenport).
• Social cost: the cost to society as a whole, including harm such as pollution, which the firm does not pay for.
• Sunk cost: cost already incurred that cannot be recovered.

2. Short-run cost concepts

In the short run some factors (plant, machinery) are fixed; in the long run all factors are variable.

• Total fixed cost (TFC): costs that do not change with output and must be paid even at zero output: rent, interest on capital, salaries of permanent staff, insurance, depreciation. Also called supplementary or overhead costs.
• Total variable cost (TVC): costs that vary with output: raw materials, wages of casual labour, power, fuel. Zero at zero output. Also called prime costs.
• Total cost (TC) = TFC + TVC.
• Average fixed cost (AFC) = TFC / Q.
• Average variable cost (AVC) = TVC / Q.
• Average total cost (ATC or AC) = TC / Q = AFC + AVC.
• Marginal cost (MC): the addition to total cost from producing one more unit. MC_n = TC_n − TC_n−1. Since TFC does not change, MC depends on variable cost only.

3. Worked cost schedule

TFC = Rs. 100. Figures in rupees.

Reading the table: AFC keeps falling as the same Rs. 100 is spread over more units. AVC falls to Rs. 40 and then rises. ATC falls to its minimum of Rs. 64 at 5 units and then rises. MC falls to Rs. 30 at 3 units and then rises; at 4 units MC equals AVC (40), and between 5 and 6 units MC (80) rises above ATC, pulling ATC up.

4. Shapes of the curves (described)

With output on the horizontal axis and cost on the vertical axis:

• TFC is a horizontal straight line at Rs. 100.
• TVC starts from the origin and rises, first at a decreasing rate and then at an increasing rate (an inverse-S shape).
• TC has the same shape as TVC but starts at Rs. 100 on the vertical axis; the vertical gap between TC and TVC is always TFC.
• AFC slopes downward throughout and approaches the horizontal axis without touching it (a rectangular hyperbola).
• AVC, ATC and MC are U-shaped. The U-shape comes from the law of variable proportions: increasing returns at first lower costs, diminishing returns later raise them.
• MC cuts AVC and ATC from below at their minimum points. When MC is below the average, the average falls; when MC is above it, the average rises. The gap between ATC and AVC (which is AFC) narrows as output grows.

In the long run all costs are variable, and the long-run average cost curve is an “envelope” of the short-run ATC curves. It is also U-shaped, but flatter, because of economies and then diseconomies of scale.

5. Revenue concepts

• Total revenue (TR): the total sale proceeds. TR = P × Q.
• Average revenue (AR): revenue per unit sold. AR = TR / Q = P. The AR curve is therefore the firm’s demand curve.
• Marginal revenue (MR): the addition to TR from selling one more unit. MR_n = TR_n − TR_n−1.

Under perfect competition the firm sells any quantity at the market price, so AR = MR = price, and both are one horizontal line. With price Rs. 10, TR is 10, 20, 30, 40... and rises as a straight line from the origin.

Under monopoly and imperfect competition the firm must lower its price to sell more, so AR slopes downward and MR lies below it.

Relationship of TR, AR and MR. While MR is positive, TR rises; when MR is zero (6 units), TR is at its maximum (Rs. 30); when MR is negative, TR falls. MR falls faster than AR: for a straight-line demand curve, the MR curve falls twice as steeply and bisects the horizontal distance between the AR curve and the vertical axis. The link with elasticity is MR = AR × (e − 1) / e: where demand is unit-elastic, MR is zero.

6. Why costs and revenues matter together

A firm maximises profit where MR = MC and MC cuts MR from below. Profit per unit is AR − ATC. These conditions are used throughout the market-structure notes in Unit IV.

How this is examined

“Various cost concepts” was a 6-mark note in January 2026 (80-mark paper); “What is cost? Explain the various concepts of cost” a 10-mark essay in June 2025 (80-mark); and “Cost concepts” a 10-mark note in June 2025 (100-mark paper). Write the definitions with formulae, draw up a short schedule like the one above, and describe the curves. Opportunity cost is often the concept examiners look for, so give it a proper example.