Theory of Cost and

Revenue

1
 What is a basic
assumption in economics?
The motivation for
business decisions is
profit maximization

2
 To understand Profit,
what is necessary?
To distinguish between the
way economists measure
costs and the way
accountants measure costs
3
What are Explicit Costs?
Payments to nonowners of
a firm for their resources

4
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
worked for someone else.

5
 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
6
How is Accounting
Profit defined?
Total revenue minus
total explicit costs

7
 What are Total
Opportunity Costs?
Explicit costs + Implicit costs

8
What is Economic Profit?
Total revenue minus
total opportunity costs

9
Computech’s Accounting Versus Economic Profit
Item Accounting Profit Economic Profit
Total Revenue $500,000 $500,000
Less Explicit costs:
Wages & salaries $400,000 $400,000
Materials $50,000 $50,000
Interest paid $10,000 $10,000
Other payments $10,000 $10,000
Less implicit costs:
Foregone salary 0 50,000
Foregone rent 0 10,000
Foregone interest 0 5,000
Equals profit $30,000 -$30,000 10
Exhibit 1
What is Normal Profit?
The minimum profit
necessary to keep a
firm in operation

11
When economists use the
term “Profit”, which
profit do they mean?
Economic profit which,
unlike accounting profit,
includes implicit costs

12
What is a Fixed Input?
Any resource for which the
quantity cannot change
during the period of time
under consideration

13
What is the Short Run?
A period of time so
short that there is at
least one fixed input

14
What is the Long Run?
A period of time so long
that all inputs are variable

15
What is a Variable Input?
Any resource for which the
quantity can change
during the period of time
under consideration

16
 What is
Total Fixed Cost?
Costs that do not vary
as output varies and
that must be paid even
if output is zero
17
 What is
Total Variable Cost?
Costs that are zero when
output is zero and vary
as output varies

18
 What is Total Cost?
The sum of total fixed cost
and total variable cost at
each level of output

19
20
21
 What is
Average Fixed Cost?
Total fixed cost divided
by the quantity of
output produced

22
23
24
• 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.

25
 What is Average
Variable Cost?
Total variable cost
divided by the quantity
of output produced

26
27
AVC curve derivation

28
 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
➢It is clear from figure 4.5 that the slope of a ray
through the origin declines continuously until the
ray becomes tangent to the TVC
curve at c. 29
30
 What is
Average Total Cost?
Total cost divided by the
quantity of output produced

31
32
Derivation of ATC

33
What is Marginal Cost?
The change in total cost
when one unit of
output is produced

34
35
MC derivation

36
Illustrating cost curves

37
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
the A VC and ATC curves
38 of
 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.
The MC falls and then rises –a U shaped- because
the marginal product of labour rises and then falls

39
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
40
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
MC curve
41
12 Marginal Product Curve
10
8
Total Output

6
Maximum
4
2
Quantity of Labor
1 2 3 4 5 6
42
 Short-Run Cost Curves
$80
$70 Minimum MC
$60 Cost per unit
$50
ATC
$40 AVC
$30
$20
$10
1 2 3 4 5 6 7 8 9
Q
43