ECONOMICS STANDARD XII (ISC) Chapter 8: Cost and Revenue Analysis

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1 ECONOMICS STANDARD XII (ISC) Chapter 8: Cost and Revenue Analysis Q1) Define the following: i. Money cost Money cost refers to money expenses which the firm has to incur in purchasing or hiring factor services. These expenses include expenditures on wages paid to labour, on machinery and equipment. It is also known as accounting cost, explicit cost or business cost. ii. Implicit cost Implicit cost refers to the imputed or estimated value of inputs owned by the firm and used by it in its own production unit Eg- Besides purchasing or hiring resources from others, a producer may also use his own factor services in the process of production. iii. Normal profit Normal profit is the minimum payment which a producer must get in order to induce him to undertake the risk of production. iv. Economic cost Economic cost is the sum total of both explicit and implicit cost including normal profit. Economic cost= Explicit cost + Implicit cost (including normal profit). v. Opportunity cost The opportunity cost of producing any good is the next best alternative good that is given to produce this good. Eg- If a given amount of resources can produce 1 meter of cloth or 20 loaves of bread, then the cost of 1 meter cloth is 20 loaves of bread which need to be sacrificed in order to produce 1 meter of cloth. Opportunity cost can be expressed as economic cost in money terms. vi. Real cost Real cost refers to the efforts and sacrifices made by the owners of factors of production used in the production of a commodity. E.g pain, disease etc vii. Private cost Private cost refers to the cost of production incurred by an individual in producing a commodity. viii. External cost External cost is the cost that is not borne by the firm, but is incurred by other members of the society or the entire society.e.g pollution ( 1 )

2 ix. Social cost Social cost on the other hand, refers to the cost that the society has to bean on account of the production of a commodity. Social cost= Private cost + External cost x. Total fixed cost Total fixed cost refers to the cost incurred by the firm on the use of all fixed factors, those factors. It does not change with output. E.g interest on capital invested, rent, machinery, etc. These are fixed obligations of the firm which must be incurred by the firm, whether the output is small or large. xi. Total variable cost Total variable cost refers to the total cost incurred by a firm on the use of variable factors, those factors, the supply of which can be easily changed in the desired quantity in the shortrun. E.g payments for raw materials, fuel, power, transportation, etc. These costs vary directly with change in the volume of output; rising as more is produced and falling when less is produced. xii. Total cost Total cost is the cost incurred on all types of inputs- fixed as well as variable inputs- incurred in producing a given amount of output. TC= TFC + TVC Since total cost has total variable cost has one of the components which varies with a change in output, the total cost will also change directly with the change in output. Also, since total fixed cost by definition remains constant, the changes in total cost are entirely due to changes in total variable cost. xiii. TFC Curve TFC curve is a straight line parallel to the horizontal axis indicating the same amount of fixed cost at every level of output. xiv. TVC curve The TVC curve is concave downward up to a point indicating that it increases at a decreasing rate and subsequently it is concave upward indicating that total variable cost increases at an increasing rate. The reason for this follows the law of variable proportions. Total variable cost increases at a diminishing rate due to increasing returns to the variable inputs arising from the fuller utilization of fixed factors and greater specialization. It increases at an increasing rate due to diminishing returns to variable inputs arising from difficulty of management and overutilization of fixed factors. xv. Average fixed cost is the per unit cost of the fixed factors. AFC= TFC Q It slopes downward throughout its length from left to right showing continuous fall in average fixed cost with an increase in output. ( 2 )

3 The curve is asymptotic to the axes. xvi. Average variable cost Average variable cost is the per unit cost of the variable factors of production. AVC= TVC Q The U-shape of the AVC follows directly from the law of variable proportions. Initially, there us too little of variable input in comparison to the fixed input, resulting in underutilization of the fixed input. Therefore as the quantity of variable input increases, fixed input is better utilized, resulting in an increase in the efficiency of the variable factors. Efficiency of variable input increases also because of specialization and division of labour. Therefore the AVC curve is negatively sloped over early levels of production. Subsequently, however, as the quantity of variable input goes on increasing, the variable input becomes too much in relation to the fixed inputas the fixed input has been fully utilized. Therefore efficiency of the variable factor declines. The efficiency also declines because of the indivisibility of certain inputs. Therefore, AVC curve Is sloped positively at higher levels of output since the average efficiency of variable inputs are added on a given amount of fixed factors. In short, the average variable cost falls up to the optimum capacity level of output die to increasing returns to the variable factor and it increases thereafter die to diminishing returns to the variable factor. xvii. Average total cost Average total cost is the per unit cost of both fixed and variable factors of production. ATC= TC Q ATC= AVC + AFC xviii. Marginal cost Marginal cost is the addition to total cost as one more unit of output is produced. MC n = TC n TC n-1 MC= TC Q Diagrammatically, the marginal cost for any level of output can be calculated by taking the slope of the total cost curve corresponding to that level of output. xix. Relationship between average and marginal cost When marginal cost is less than the average cost, average cost falls with an increase in output. When marginal cost is greater than the average cost, average cost is rising. When marginal cost is equal to average cost, the average cost is constant. ( 3 )

4 Define Total Revenue, Average revenue, Marginal Revenue Total Revenue: refers to the total amount of income received by the firm from selling a given amount of its output. TR = P x Q Where TR is total revenue, P is price per unit, Q is quantity of output sold over some time period. e.g if a firm sells 15 units of a product at Rs 20 per unit, he total revenue is 20x15 = 300. Average revenue: is the revenue per unit of the product sold. It is total revenue divided by the number of units of the product sold AR = TR / Q =PxQ / Q =P e.g If TR is Rs300 and 15 units are sold. AR = 300 / 15 = 20. Marginal Revenue: is defined as the addition to total revenue which results from the sale of one additional unit of output. MR n = TRn TR n-1 e.g. Total revenue is Rs 300 units for sale of 15 units and Total revenue is Rs 304 for the sale of 16 units. MR is = 4. Explain the behavior of average cost curves of a firm in the short run. AFC Decreases as output increases AVC Falls with increase in production and then increases (U-shape) ATC Falls with increase in production and then increases (U-shape) ATC gets closer to AVC as output increases BUT ATC never touches AVC because the element of AFC is present Explain the behavior of Total, Average and Marginal Revenue under Imperfect Competition. A firm under imperfect competition is required to reduce the price if it wants to sell more output. Total Revenue: increases initially, but at a diminishing rate, with increase in output, reaches the maximum and remains constant at that level and then starts falling. This is because the producer under imperfect competition as it increases output, it must reduce the price more and more to sell additional output and this causes an increase in the total revenue to get smaller. As price falls to very low levels, the total revenue actually falls. ( 4 )

5 Average Revenue: falls continuously as output increases because under imperfect competition, a firm is required to reduce the price to sell more It can fall at the most to zero when the commodity becomes free but it cannot be negative as price cannot be negative. Marginal Revenue falls continuously. It becomes zero and becomes negative. Explain the relationship between TR and MR under Imperfect Competition 1. When Total Revenue increases with an increase in output, the marginal revenue is positive. 2. When total revenue is maximum and constant, marginal revenue is zero. 3. When total revenue falls, marginal revenue is negative. Relationship between Average revenue and Marginal revenue under imperfect competition 1. So long as the AR curve is falling, marginal revenue must be less than average revenue for every level of output (except for the first level where it is equal. The reason for this is that price is reduced not only for additional unit but for all the units sold. MR the firm gets from selling one more unit equals the price it receives from the sale of one additional unit minus loss in revenue from the price reduction on all other units. 2. When AR is a straight line, MR is also a straight line but the rate of fall of MR will be twice as much as the rate of fall of AR. ( 5 )

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