Cost curves in the short and long run, opportunity cost, and revenue curves

1. Concepts of cost

• Money cost: the money spent on wages, rent, interest, raw materials, power, transport and taxes.
• Real cost: Marshall’s term for the toil and sacrifice of workers and the abstinence of savers behind production.
• Explicit cost: payments to outside suppliers of inputs, recorded in the accounts.
• Implicit cost: the value of the owner’s own factors (his building, capital, labour) for which no payment is made. Economic cost = explicit + implicit cost, and includes normal profit, the minimum return needed to keep the entrepreneur in the business.
• Private and social cost: social cost adds the costs a firm imposes on others (pollution, congestion) which it does not pay.
• Fixed, variable, total, average and marginal cost: section 3.

2. Opportunity cost

Opportunity cost is the value of the next best alternative forgone. Because resources are scarce and have alternative uses, using them for one purpose means sacrificing another. The idea was developed by the Austrian economists (F. von Wieser) and by H.J. Davenport, and is also called alternative cost or transfer cost.

Examples: a law graduate who could earn Rs. 60,000 a month in a firm but chooses to practise independently has an opportunity cost of Rs. 60,000 a month. An acre that can yield ragi worth Rs. 30,000 or groundnut worth Rs. 25,000: the opportunity cost of ragi is the Rs. 25,000 of groundnut forgone.

Uses: it explains the production possibility curve (Unit I); it decides factor prices, since a factor must be paid at least its transfer earnings to stay in a use (the modern theory of rent, Unit V); and it guides business choices between projects. Limits: it assumes factors are mobile and that the next best use can be valued; specific factors (a specialised machine) may have no alternative use, so their opportunity cost is near zero.

3. Short-run costs

In the short run some factors (plant, machinery, top management) are fixed.

• Total fixed cost (TFC): does not vary with output and must be met even at zero output (rent, interest, insurance, salaries of permanent staff). Also called overhead or supplementary cost.
• Total variable cost (TVC): varies with output (raw material, casual wages, power). Zero at zero output. Also called prime cost.
• TC = TFC + TVC; AFC = TFC/Q; AVC = TVC/Q; ATC = TC/Q = AFC + AVC; MC_n = TC_n − TC_n−1.

TFC = Rs. 60 (figures in rupees):

Reading it: AFC falls continuously (60, 30, 20 … 10). MC is lowest at 3 units (Rs. 20). AVC is lowest at 3–4 units (Rs. 30), and MC equals AVC at 4 units. ATC is lowest at 4 units (Rs. 45); at 5 units MC (50) is above ATC, and ATC rises to 46.

4. Shapes of the short-run curves (described)

• TFC: horizontal line at Rs. 60.
• TVC: starts at the origin, rises first at a decreasing and then an increasing rate (inverse-S).
• TC: same shape as TVC, starting at Rs. 60; the vertical gap between TC and TVC is TFC throughout.
• AFC: slopes downward throughout, approaching but never touching the quantity axis (a rectangular hyperbola, since AFC × Q is always 60).
• AVC, ATC, MC: U-shaped, because of the law of variable proportions: increasing returns lower cost at first, diminishing returns raise it later.
• MC cuts AVC and ATC from below at their minimum points. While MC is below an average, the average falls; once MC is above it, the average rises. The gap between ATC and AVC (= AFC) narrows as output grows.

5. Long-run costs

In the long run all factors are variable and there is no fixed cost. The firm can choose any plant size. Each plant size has its own short-run ATC curve (SAC₁, SAC₂, SAC₃ …). The long-run average cost (LAC) curve is the curve tangent to all of them, the lowest cost of producing each output when the plant can be adjusted. It is called the envelope curve (it envelops the SACs) and the planning curve (the firm uses it to decide which plant to build).

• LAC is also U-shaped, but flatter than the SACs. It falls because of economies of scale and rises because of diseconomies of scale (see the Principles of Economics note on economies of scale).
• LAC is tangent to the SACs to the left of their minima while it is falling, and to the right while it is rising. Only at its own minimum does it touch the minimum point of an SAC: that plant is the optimum plant.
• The long-run marginal cost (LMC) curve cuts LAC at the lowest point of LAC.

6. Revenue curves

• Total revenue (TR) = P × Q.
• Average revenue (AR) = TR / Q = price. The AR curve is the firm’s demand curve.
• Marginal revenue (MR) = TR_n − TR_n−1.

Perfect competition: the firm is a price-taker at, say, Rs. 8. TR = 8, 16, 24, 32 …, a straight line from the origin; AR = MR = Rs. 8, a single horizontal line.

Monopoly and imperfect competition: the firm must cut price to sell more.

Relationships: AR and MR both slope downward, and MR lies below AR (falling twice as fast for a straight-line AR). While MR is positive TR rises; when MR is zero (7 units) TR is maximum (Rs. 42); when MR is negative TR falls. With elasticity e, MR = AR × (e − 1) / e: where e = 1, MR = 0; where e = 2 and AR = Rs. 10, MR = Rs. 5. A monopolist therefore never produces where demand is inelastic, because MR would be negative.

How this is examined

January 2026 (80-mark) asked “Explain the different concepts of cost” (10 marks); February 2025 (100-mark) asked “Explain types of short run cost with diagram” (16 marks), with “Revenue curves” (10 marks, Q.9) and “Opportunity cost” (8 marks, Q.8) in the same paper. For the short-run question, define each cost with its formula, give the schedule, describe each curve and end with the MC-cuts-from-below point. For revenue, give both schedules and the TR–AR–MR relationship with the elasticity formula. Principles of Economics covers the basics in cost and revenue.