Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)

Unit 4: Cost and Revenue Curves Sub: - Applied Economics

Unit: 4 (Four)
Cost and Revenue Curves
4.1 Concept of Cost: Actual Cost and Opportunity Cost, Implicit cost and
Explicit Cost, Accounting and Economic Cost, Replacement Cost,
Separable Cost.
Cost is defined as the money expenditure incurred on factors of production while producing
a commodity. In order to produce goods and services, a firm uses raw materials and various
factors of production, which are called inputs. The expenditure incurred on these inputs is
called cost. In other words, cost refers to all sorts of monetary expenditures incurred in the
production of a commodity.

4.1.1 Cost Function

Cost function shows the relationship between cost of production and the level of
production. Cost of production is influenced by various variables like level of output, price
of inputs technology, etc. The cost function is expressed as
C = f (Q, Pf, T)
Where, C = Cost of Production, T = Technology
Pf = Price of inputs or factors of production, Q = Quantity of Output
Although, cost of production is influenced by various factors, for simplicity we assume that
cost of production is the function of level of output. It is expressed as
C = f (Q)

4.1.2 Different Concepts of Cost

1. Opportunity Cost: Opportunity cost is defined as the loss of income due to
opportunity foregone. In other words, opportunity cost refers to what an input could
earn in its next best alternative job. It arises due to scarcity and alternative uses of
from the same piece of land. If he expects higher price of wheat in coming year, he
will produce more wheat by sacrificing the production of potato. In this example,
the opportunity cost of wheat is the quantity of output of potato sacrificed while
producing wheat.
2. Money and Real Cost
a. Money Cost: Money costs are the cost which the firm has to incur in purchasing or
hiring productive services. Money cost is also known as the nominal cost. It is

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
nothing but the expenses incurred by a firm to produce a commodity. For instance,
the cost of producing 200 chairs is Rs. 10000, and then it will be called the money
cost of producing 200 chairs. These expenses include:
i. All types of rental expenses incurred on land, machines and buildings.
ii. Wages and salaries paid to labour
iii. All types of expenses made on purchasing machinery, equipment and raw
materials
iv. Interest on borrowings and
v. Other monetary expenses.
The actual monetary expenses made on the factors of production are recorded by
the firm on its debit items of accounting books.
b. Real Cost: It is a philosophical concept which refers to all those efforts and
sacrifices undergone by various members of the society to produce a commodity.
Like monetary costs, real costs do not tell us anything what lies behind these costs.
Prof. Marshall has called these costs as the “Social Costs of Production.”
According to Marshall, “Real costs are the exertion of all the different kinds of
labour that are directly or indirectly involved in making it together with the
abstinence rather than the waiting required for saving the capital used in making
it, all these efforts and sacrifices together will be called the real cost of production
of the commodity.”
In this way, real cost means the trouble, sacrifice of factors in producing a
commodity. Though, this concept gained momentum for sometime, it has been
relegated to the background in modern times due to its impracticability.
3. Implicit and Explicit Cost
a. Implicit Cost: Implicit cost is defined as the value of factor inputs owned and used
by the firm or the entrepreneur in its own production process. Such cost does not
appear in the accounting system or book of accounts because does not require
expense of money by the firm. For example, the entrepreneur may have invested
his own capital or he may have worked there as a manager for which direct payment
is not made. If he lends out these factor to others, he will receive payments. How
much he would get from others is the implicit cost. The concept of implicit cost is
similar to the concept of opportunity cost. Hence, it must be taken into account
while calculating economic profit.

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
b. Explicit Cost: Explicit cost is defined as the payment made by a firm for the use of
inputs purchased or hired from outside or others. In other word, it is the cost of
inputs, which requires and expense of money by the firm. It is also a cost of inputs
used in production, which are not owned by the firm. This cost includes wages to
hire labour, interest on borrowed capital, rent on land and buildings, expenditure on
raw materials etc. Such costs appear in the accounting system or book of accounts.
The concept of explicit cost is similar to the concept of actual cost or money cost or
accounting cost.
4. Accounting and Economic Cost
a. Accounting Cost: Accounting cost is defined as the cost that involves direct
payment of money by entrepreneur to the various factors of production. The cost of
factors of production which the entrepreneur hires from outside constitutes the
accounting cost. In other words, accounting costs are recordable on book of account.
Such cost includes money cost like wages and salaries, prices of raw materials and
all such payment that needs to be recorded on book of account. The concept of
accounting cost is similar to the concept of explicit cost.
b. Economic Cost: The accountants consider those costs, which involve cash payment
by the entrepreneur or the firm to others. But the economists take into account not
only these accounting costs, but in addition, they also take into account the amount
of money the entrepreneur could have earned if he economic cost is the sum of
implicit and explicit cost (Accounting cost).
Economic Cost = Implicit Cost + Explicit Cost
5. Historical and Replacement Cost
a. Historical Cost: Historical cost is defined as the actual monetary value of inputs
like raw materials, machineries, etc. At the time they were purchased or produced
rather than their current value. In other words, it is the expenditure made to produce
a commodity at some point in the past. It is also known as the past cost. For example,
100 units of on input were purchased one month back for Rs.100 per unit. The price
today is Rs.110 per unit. The cost will appear on balance sheet a6 Rs.10,000 and
not at Rs.11,000. In this example, Rs.10,000 is the historical cost.
b. Replacement Cost: Replacement cost is defined as the expenditure that would have
incurred if that asset was purchased now. In other words, it is the amount that would
cost to replace the revenue generating ability of an asset with one that has same
future abilities. Tis is also defined as the cost to replace missing or stolen property
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
of a firm. For example, ten years back a machine of Rs.10 million was installed by
a firm. If now same machine costs Rs.15 million, then replacement cost at present
is Rs.15 million.
6. Separable and Common Cost
a. Separable cost: Separable cost is defined as the cost that can be easily known to a
product a division or a process. For example, in multiple product firm, cost of raw
materials may be separable product wise but electricity charges may not be
separable product wise. In a college, the salary of principal is not separable
department wise but salary of teachers can be separable department wise. Therefore,
salary of teachers in separable cost.
b. Common cost: Common cost is defined as the cost that cannot be known to any
one unit of operation. In other words, it is the cost shared by the different
departments, products, or jobs, etc. It is also called joint cost. For example, salary
of college principal is common cost because it is common to each department.
Similarly, electricity charge in a multiple product firm may also be common cost.
7. Total, Average and Marginal Cost
a. Total Cost: It refers to the total expenditure made by firm to purchase the all
kinds of variable and fixed factors of production for the production of
commodities. In other word it is the summation of TFC and TVC.
TC = TFC+TVC
b. Average Cost (AC): It refers to the total cost spend per unit output produced.
It is obtained by dividing total cost (TC) by quantity.
AC = TC / Q

c. Marginal Cost (MC): It refers to the change in total cost due to change in
additional unit of output produced.
MC = ∆TC / ∆Q
Where, MC = marginal cost, ∆TC = change in total cost
∆Q = change in quantity of output produced
8. Fixed Cost and Variable Cost
a. Concept of Fixed Cost: Fixed cost are those cost which are incurred on fixed
factors of production such as capital equipment, plant, building, land, salary of
permanent staff, etc. Fixed costs don’t change with the level of output in the short
run. It remains same even at zero level of output.

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
Fixed Cost = Cost on Capital Equipment + Cost on Plant + Cost on Building Cost
on Land + Salary of Permanent Staff
b. Concept of Variable Cost: Variable costs are those cost which are incurred on
variable factors of production. Variable cost changes with the change in level of
output in the short run. For example the expenditure made on raw materials, wages
and salaries of casual (temporary) workers, running expenses like charges of water
supply, electricity, tax is variable cost. Variable cost is zero if there is no production
of output.
Variable Cost = Expenditure made on raw materials + Wages and Salaries of
Casual (temporary) workers + Running expenses (Charges of
water supply + electricity + tax).

 Difference between Fixed and Variable Cost

S.N. Fixed Cost Variable Cost
i. Those cost which are included on Those cost which are included on variable
fixed factors of production is called factors of production is called variable
fixed cost. cost.
ii. Fixed factors of production are Variable factors of production are
capital equipment, machines, plant, expenses on raw materials, wages and
building salary of permanent staff, salary for casual workers, running
etc. expenses, etc.
iii. Fixed costs do not change with the Variable cost changes with the changes in
level of output in short run. output in short run.
iv. It remains same even at zero level Variable cost is zero only if there is no
of output. production of output.
v. It remains constant. It changes at different level of production.

4.2 Derivation of Short-run and Long-run Curve (Total, Average and

Marginal) and Shape of short-run and long-run average cost curve,
Relationship between short-run and long-run AC and MC Curves
4.2.1 Short-run Cost and Derivation of Short-run Cost Curves
Short run is short period where producer uses variable factors as well as fixed for
production. So the expenditure made for the variable factors and fixed factors consists short
run cost. So, in short run

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
TC = TFC + TVC
Where,
TC = total cost, TFC = total fixed cost, TVC = total variable cost

1. Total Fixed Cost (TFC): It refers to the total expenditure made by a firm or
industry to purchase the fixed factors of production for the production of
commodity. In short run, it remain constant whatever change in output. We know,
TC = TFC + TVC
TFC = TC – TVC

2. Total Variable Cost (TVC): It refers to the total expenditure made by a firm or
industry increased on the variable factor of production for production of
commodity. In short-rum it is variable whatever change in output. It remains zero
if there is no production. We know,
TC = TFC + TVC
TVC = TC – TFC

3. Total Cost (TC): It refers to the total expenditure made by firm to purchase the all
kinds of variable and fixed factors of production for the production of
commodities. In other word it is the summation of TFC and TVC.
TC = TFC+TVC
We can explain the concept of cost and can derive total cost curve by the help of
given table:
Output Production TFC TVC TC = TFC + TVC
0 70 0 70
1 70 30 100
2 70 40 110
3 70 45 115
4 70 55 125
5 70 75 145
6 70 125 195
Note: All the amounts are in lakhs.
In the above table, TFC is same at every level of output. TVC is zero at zero level of
production and rises as output rises. TC is equal to TFC and TVC. On the basis of above
table we can derive the total cost curves. We can describe with the help of given figure:

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
220
200
180
160
TFC, TVC and TC

140
120 TFC
100 TVC
80 TC
60
40
20
0
0 1 2 3 4 5 6
Output

On the above figure, output and cost are measured on x and y-axis respectively. TFC curve
is parallel to x-axis indicating that it remains constant at any quantity of output produced.
TVC curve increases S-shaped, due to operation of law of variable proportion in
production. TVC starts from origin which shows TVC is zero when output is zero.
TC curve is derived by adding the TFC and TVC curve. Since, TFC remains constant even
if output is zero. TC curve has same shape as that of TVC.

4.2.1.2Concepts of Short Run Marginal and Average Cost Curves:

1. Average Fixed Cost (AFC): AFC refers to the fixed cost spend per unit of output
produced. It is obtained by dividing total fixed cost by total quantity of output produced.
AFC = TEC / Q
where, AFC = average fixed cost, TFC = total fixed cost
Q = total quantity of output produced
2. Average Variable Cost (AVC): AVC refers to the variable cost spend per unit of
output produced. It is obtained by dividing total variable cost by total quantity of output
produced.
AVC = TVC / Q
where, AVC = average variable cost, TVC = total variable cost
Q = quantity of output produced
3. Average Total Cost (ATC): It refers to the total cost spend per unit output produced.
It is obtained by dividing total cost (TC) by quantity.
ATC = TC / Q

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
4. Marginal Cost (MC): It refers to the change in total cost due to change in additional
unit of output produced.
MC = ∆TC / ∆Q
Where, MC = marginal cost, ∆TC = change in total cost
∆Q = change in quantity of output produced
On the basis of these we can derive AFC, AVC, and MC curves by the help of given table.
Output Produced (Q) TFC TVC TC AFC AVC AC MC
0 70 0 70 - - - 70
1 70 30 100 70 30 100 30
2 70 40 110 35 20 55 10
3 70 45 115 23.33 15 38.33 5
4 70 55 125 17.5 13.75 31.25 10
5 70 75 145 14 15 29 20
6 70 125 195 11.66 20.83 32.5 50
On the given figure, output is measured on x-axis and average cost, MC, AVC, AFC are
measured on y-axis. With the increment of output production AFC tends to decline sharply.
As a result, AFC curve is downward sloping. It takes the shape of rectangular hyperbola.

With the increment of

output production, initially
AVC declines then reaches
to the minimum point and
starts to increase because of
the operation. So, AVC
curve is U-shaped.
In initial, AC also declines
sharply reaches to the
minimum point then starts to
increase. So, AC curve is
also U-shaped.
Initially, MC declines sharply reaches to the minimum point then start to increase. As a
result, MC curve is also U-shaped. MC always cuts to the minimum point AVC and AC.
4.2.1.3 Why ATC Curve is 'U' shaped?
Average total cost curve (ATC) is 'U' shaped. It means that in the beginning, it falls and
after reaching the minimum point, it starts to rise upward. It gets “U” shaped due to the
following reasons.
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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics

1. Basis of AFC and AVC: In the short run, ATC includes AFC and AVC Therefore,
the behavior of ATC curve depends upon the behavior of AFC and AVC curves.
Geometrically, ATC curve is obtained by adding AFC and AVC curves and as a
result, ATC curve gets U-shape as shown in figure. In the figure, over the range of
values for which both AFC and AVC falls continuously with the increase in output,
ATC must decline as well. Once AVC has reached its minimum point, it starts
rising, its rise is initially of set by the fall in the AFC. It means that the rate of
decline in AFC is more than the rate of increase in AVC. The result is that ATC
continuously falls. Ultimately, the rate of increase in AVC becomes greater than the
rate of decline in AFC so that ATC starts rising.
Therefore, ATC curve reaches its minimum points and thereafter it starts increasing.
Thus, ATC curve takes U-shape.
2. Basis of the law of variable proportions: The U-shape of ATC curve can be
explained by the help of the law of variable proportion. In the beginning with the
increase in output, average cost falls due to the operation of the law increasing
returns. There is a best combination of fixed and variable factors at point M2 on the
ATC curve. That is why, point M2 is the minimum point of ATC curve. After
reaching the minimum point of ATC curve, when we increase the output, average
cost starts increasing because of operation of the law of diminishing returns. Thus,
due to the operation of the law of variable proportion, the ATC curve takes U-shape.
3. Indivisibility of the factors: The U-shape of ATC curve is also due to the
invisibility of the factors of production. In the short run when a firm increases the
output, it enjoys certain internal economies due to indivisibilities of some fixed
factors of production. These economies result in the fall in ATC curve in the
beginning. The firm generally enjoys three types of economies: technical
economies, marketing economies and managerial economies, which help to bring

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
down the ATC curve. After the optimum point, with the increase in output, the
economies are over weighted by the diseconomies, which result the ATC curve to
rise. Thus, ATC curve gets U-shape.

4.2.1.4 Relationship between AC and MC in the Short-Run

There is close relationship between AC and MC, MC is the change in TC resulted from the
change in production of one unit of output whereas AC is total cost divided by the output.
It means that both AC and MC are derived from TC, Thus,
∆𝑇𝐶 𝑇𝐶
𝑀𝐶 = , 𝐴𝐶 =
∆𝑄 𝑄
In general, both AC and MC are U-shaped and MC=AC when AC is minimum. The
relationship between AC and MC can be explained by the help of the Figure.

In the given Figure, MC represents marginal cost curve and AC represents average cost
curve. The minimum point of AC is M1
and the minimum point of MC is M2 when
the MC curve lies below the AC curve, the
AC curve is falling. This is so because AC
includes both AVC and AFC. But MC is
addition made only to variable cost when
one more units of output is produced. That
is why, the fall in the AC is less and the MC is more. When the MC curve lies above the
AC curve, the AC curve is rising. At the point of intersection M1 MC and AC are equal.
That is, at point M1, the AC has just ceased to fall but has not yet started to rise Beyond
point M1 the MC curve lies above the AC curve. At this point, AC and MC are equal. After
minimum point of the AC curve, the MC curve lies above the AC curve.
The relationship between AC and MC can be summarized as below:
i. Both AC and MC are calculated from total cost.
ii. Both AC and MC are U shaped.
iii. When AC is falling, the MC curve is always below the AC curve and the MC
falls faster than AC.
iv. When the AC is rising, the MC curve lies above the AC curve and the MC rises
faster than the AC.
v. When the AC is minimum, the MC equals to AC.
vi. MC intersect is at the minimum point of AC.

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
Note: The relation between AVC and MC is same as the relation between AC (ATC) and
MC, MC and AVC are equal when AVC is minimum. Beyond minimum point of AVC,
MC > AVC and before reaching minimum point of AVC, MC < AVC.

4.3 Long-run Cost and Derivation of Long-run Cost Curves

Long-run is a period of time during which the quantities of all factors of production are
variable. Thus, in the long-run, output can be increased by increasing capital equipment or
by increasing the size of existing plant or by building a new plant. The long-run costs are
the costs incurred during a period, which is sufficiently large to allow the variation in all
factors of production including capital equipment, land and managerial staff to produce a
level of output.

4.3.1 Derivation of long-run Cost Curves: U-shaped and L-shaped with reasons
4.3.1.1 Long-Run Average Cost Curve (LAC): Long-run average cost is obtained by
dividing the long run total cost by the level of output. A long-run cost curve depicts
the functional relationship between output and the long run cost of production.
𝑳𝑻𝑪
𝑳𝑨𝑪 =
𝑸
Where, Q = Output, LAC = Long-run average Cost, LTC = Long-run total cost
Long-run average cost curve is obtained from the short-run average cost curves (SACs). In
order to understand how the long-run average cost curve is derived, consider the three short-
run average cost curves as show in the Figure.

In the given Figure, output is measured on X-axis and average cost on Y-axis, in the short-
run, the firm can be operating on any short run average cost curve given the size of the
plant. Suppose that only these three size plants are technically possible and no any other
size of the plant can be built. Given the size of plant or short run average cost curve, the
firm will increase or decrease its output by varying the amount of variable factors (inputs).

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
But in the long-run, the firm can choose among the three possible size of plant as depicted
by short-run average cost curves SAC1, SAC2 and SAC3. In the long-run, the firms will
examine with which size of plant or on which short-run average cost curve it should operate
to produce a given level of output at the minimum possible cost.

In the Figure, up to OQ2 amount of output, the firm will operate on short-run average cost
curve SAC1 occurs lower cost than on SAC2. If the firm plants to production on SAC1
occurs lower cost than on SAC2. If the firm plants to produce an output greater than OQ2
(but less than OQ4), then it will be economical to produce on SAC2. If the firm has to
produce an output more than OQ4, then the average cost per-unit will be lower on SAC3
than on SAC2. Therefore, for output larger than OQ4, the firm will employ plant
corresponding to the short-run average cost curve SAC3. Thus, in the long-run, the firm
uses that plant which yields minimum possible average cost for producing given level of
output.
In the long run, a firm can change the size of its plant. It can choose any size of plant
according to its requirements. Therefore, the number of plants as well as the number of
SACs is infinite in the long run. In such case, long-run average cost curve (LSC) will be a
regular and smooth line without any scallops. Such a smooth long run average cost curve
has been shown in Figure below.

In Figure above, SAC1, SAC2, SAC3, SAC4 and SAC5 are five short run average cost
curves. A long run average cost curve is so drawn as to be tangent to each of the shot-run
average cost curves. In other words, LAC envelops short run average cost curves from
below. Therefore, it is also called envelop curve. When LAC declines, it is tangent to the
falling portion of the SACs. When the LAC rises, it will tangent to the rising portion of the
SACs.

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
In Figure above, the falling portion of the LAC curve is tangent to the falling portion of the
SAC1 and SAC2 curves at points G and K. The rising portion of the LAC curve is tangent
to the rising portion of SAC4 and SAC5 curves at point H and T. The lowest point of the
LAC curve is tangent to the lowest point of the SAC3 curve at point E. hence, SAC3 is the
optimum size of the plant. The firm will choose plant size SAC3 in the long run.

Thus, the long-run average cost curve first falls and then beyond a certain point it rises.
Therefore, the LAC curve is 'U' shaped, but more flatter than short-run average cost curves
(SACs). In other words, LAC is less pronounced than the U-shape of short run average cost
curve. It is because of operation of the laws of returns to scale (economies and diseconomies
of Scale) in the long-run.

 Why is SAC3 Optimum Size Plant?

In the above Figure, the plant SAC3 is optimum plant because its minimum cost of
production is the lowest. If the size of plants is increased beyond SAC3, it results in higher
average cost of production. Similarly, if the size of the plant is smaller than SAC3, average
cost of production is higher. Thus, the optimum output (least cost output) of the plant SAC3
is OQ3. Now if the firm produces output OQ3 with the optimum plant SAC3, it is said to
have achieved the optimum size. Thus, and optimum firm is that firm which is producing
optimum output withy the optimum plant. The firm is of optimum size if it employs plant
SAC3 and uses it to produce OQ3, output. The output OQ3 is also regarded as the socially
optimum output.

 Why is LAC Less Pronounced (Flatter) than SAC?

Though the LAC curve is 'U' shaped, it is less pronounced (flatter) than SAC curves. It
means that the LAC curve first falls slowly and then rises gradually after a minimum point
is reached.
Initially, the LAC curve gradually slopes
downwards due to the operation of certain
economies of scale like the economical use
of individual factors, increased
specialization and the use of
technologically more efficient machines or
factors. The returns to scale increase because of the indivisibility of factors of production.
When a business unit expands, the returns to scale increase because the indivisible factors

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
are utilized to their maximum capacity. Further, when the scale of the firm expands, there
is wide scope for specialization of labour and capital. Work can be divided into small parts
and workers can be concentrated on narrower ranges of process. For this, specialized
equipment can be installed. With the specialization, efficiency increases and increasing
returns to scale occurs. Further as the firm expands, it enjoys internal economies of scale.
It may be able to install better machines, sell its products more easily, borrow money
cheaply, and procure the service of more efficient manager and workers, tec. All these
economies help in increasing the returns to scale more than proportionately.
After the minimum point of the LAC is reached, the LAC curve may flatten out over a
certain range of output with the expansion of his scale of production. In such situation, the
economies and diseconomies balance each other and the LAC curve has a disc size.
With the further expansion of output, the diseconomies of scale like the difficulties of
coordination, management, labour and transport arise so that the LAC curve begins to rise.
As the industry continuously expands production, the demand for skilled labour, land,
capital, raw materials, etc. increases. Consequently, these factors of production become
expensive. Transport and marketing difficulties also emerge. All these factors lead to
diminishing returns to scale and tend to raise costs. As a result LAC also raises and hence
LAC curve slopes upward.
In either case, the LAC curve falls or rises more slowly than the SAC curve because in the
long run all costs become variable. The plant and equipment can be worked fully and more
efficiently so that both the average fixed costs and average variable costs are lower in the
long run than in the short run. That is why, the LAC curve is flatter than the SAC curve.

 Why is LAC Curve called planning Curve?

Long run average cost curve is often called the planning curve of the firm by the some
economists because firm plans to produce any output in the long run by choosing a plant
on the long run average cost curve corresponding to the given output. The long run average
cost curve reveals to the firm that how large should be the plant for producing a certain
output at the least possible cost.

4.3.1.2 Derivation of Long run Marginal Cost Curve (LMC)

Long run marginal cost (LMC) is the change in long run total cost as a result of one unit
change in output.
∆𝐿𝑇𝐶
𝐿𝑀𝐶 =
∆𝑄

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
Where, LMC = Long-run Marginal cost
ΔQ = Change in Total Output, ΔLTC = Change in long run Total Cost
Long run marginal cost curve is derived from short run marginal cost curves. The derivation
of LMC is given in Figure.

To derive the LMC, lets us consider the points of tangency between SACs and LAC i.e.
points A, B and C. We draw perpendiculars from points A, B and C to the X-axis, the
corresponding output levels will be determined at OQ1, OQ2 and OQ3. The perpendicular
AQ1 intersects SMC1 at point M. It means that at output OQ1, LMC is MQ1. When output
increases to OQ2, LMC will be BQ2. Similarly, the marginal cost will be NQ3 when the
output is OQ3. If a curve is drawn through the points M, B and N as shown in figure, the
curve represents the behavior of marginal cost in the long run. This curve is known as the
long run marginal cost curve (LMC).

4.3.2 L-Shaped and Continuously Falling Long-run Average Cost Curve (L-Shaped
LAC: Modern Theory of cost)
The U-shaped cost curves of the traditional theory have been questioned by various
economists both on theoretical and empirical grounds. The empirical studies on cost have
proved U-shaped cost curves to be wrong. In 1939 A.D. George Stigler said that firms also
look into flexibility while producing.
According to him, short-run variable
cost curve also contains a flat stretch in
it. The main reason pointed out by him
is the flexibility required by the firm to
cope with the change in demand. So,
according to him, long run average cost
curve is 'L' shaped rather than 'U'

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Unit 4: Cost and Revenue Curves Sub: - Applied Economics
shaped. This is also known as the modern theory of cost. The L-shaped long-run average
cost curve is shown in Figure.

In respect of LAC behavior, the modern theory of cost distinguishes between production
costs and managerial costs. Both these costs are variable in the long run. The behavior of
these cost determines the slope of long run average cost curve (LAC)
1. Production cost behavior: Production cost decreases steeply in the beginning with
the increase in scale of production but the rate of decreases in cost slows down as
the scale increase beyond a certain level of production. The decrease in the cost of
production is caused by the technical economies, which taper off when scale of
production reaches its technically optimum scale.
2. Managerial cost behavior: The modern theory of cost assumes that, in modern
management technology, there is a fixed managerial or administrative set up with a
certain scale of production. When a scale of production increases, the management
set up has to be expended accordingly. It implies that there is a link between the
scale of production and cost of management. According to modern theory of cost,
managerial cost first decreases but begins to increase as the scale of production is
expended beyond a certain level.
 What makes LAC L-Shaped?
The net effect of decreasing production cost and increasing managerial cost determines the
shape of long run average cost. In the initial stage of production. LAC decreases very
steeply because of continuous decrease in cost of production. Beyond a certain scale,
managerial cost begins to rise. According to modern theory of cost, rise in managerial cost
is more than offset by the decrease in production costs. Therefore, LAC is continuous to
fall but very slowly. In case the decrease in production cost is just sufficient to offset rise
in managerial cost, the LAC becomes constant. This makes LAC and L-shaped curve.

 Derivation of LAC Curve

Long-run average cost is obtained by dividing the long run total cost by the level of output.
The derivation of LAC curve has been shown in Figure. The figure shows the decreasing
or downward sloping LAC curve. In the modern theory of cost, LAC curve is also derived
from the SAC curves. In the figure, there are four plants with short-run average cost curves
SAC1, SAC2, SAC3 and SAC4. The empirical studies have found that firms use normally
2/3 to 3/4 of the plant size. This is called reserve capacity. Based on reserve capacity, the
producer can meet the seasonal and cyclical changes in the demand for his goods. Each

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Unit 4: Cost and Revenue Curves Sub: - Applied Economics
producer thinks that the demand
for his product will rise in future.
Therefore, it is possible only if
the producer is having reserve
capacity. If a producer does not
have reserve capacity, his rivals
will take the advantages of
increased demand. The points A,
B, C and D on the short-run
average cost curves SAC1, SAC2, SAC3 and SAC4, respectively show the reserve capacity
of the plants. By drawing the curve through the points A, B, C and D, we get the LAC
curve. The LAC curve is smooth and L-Shaped.

According to the modern theory of cost and theoretical as well as empirical evidence of the
cost curve, we can draw following conclusions:
 LAC is roughly L-shaped.
 LAC does not envelop short-run cost curves.
 It interests certain points of SAC.
 It never turns up with the increase in output.
4.4 Concept of Revenue: Total Revenue, Average and Marginal
Revenue
Income earned by the firm or industry by selling the produced output in the market is known
as revenue.
According to prof. Dooly, “The revenue of a firm is its sell receipts or money receipts from
the sale of products.” The revenue of a firm can be divided into three parts.
1. Total revenue (TR): It refers to the total amount of income received by a firm by
selling the total number of output. It is obtained by multiplying the per unit price of
commodity with total number of quantity of output sold in market.
Total revenue = Price per unit × Total quantity of output sold
Or, TR = P × Q
2. Average revenue (AR): Average revenue refers to the revenue earned per unit of
output sold. It is obtained by dividing the total revenue by total quantity of output sold.
Average revenue = total revenue (TR) / total quantity sold (Q)
Or, AR = TR /Q

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Unit 4: Cost and Revenue Curves Sub: - Applied Economics
= (P × Q) / Q = P
AR = P =Demand
3. Marginal revenue (MR): Marginal revenue refers to the change in total revenue sue
to the change in an additional unit of output sold.
MR = ∆TR / ∆Q
Where,
MR = marginal revenue
∆TR = change in total revenue
∆Q = change in quantity of output sold
4.5 Revenue Curve under perfect and Imperfect Competition Markets
4.5.1 Derivation of TR, AR and MR Curves Under the perfect competition market:
Under the perfect competition market there are large no. of buyers and sellers. Producers
are homogenous. Market price is determined by market forces i.e. demand and supply. So,
any individual consumer and seller can’t influence in the market price. Price of any
particular commodity remains constant everywhere in an economy. On the basis of this
concept, by the help of given table we can derive TR, AR and MR curves.
Output Sold (Q) Price (P) TR = P × Q AR = TR / Q MR = ∆TR / ∆Q
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
On the above table, when output sold increases at equal rate, price remains constant. We
calculate average, total and marginal revenue accordingly using formula. After calculation
we can observe that TR increases at the equal rate but AR and MR remains constant during
the production period.
On the basis of given table, we can derive figure as:
Y

TR
Price, TR, AR, & MR

AR= MR=P

X
Output
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Unit 4: Cost and Revenue Curves Sub: - Applied Economics
On the above figure, output sold is on x-axis and TR, AR, MR is on y-axis. With the
increase in sale output increases at constant rate so TR slope is positively sloped but AR
abs MR are equal with price with any quantity of output sold so that both are coincide with
each other and parallel to x-axis.

4.5.2 Derivation of TR, AR and MR curves under monopoly or Imperfect Market:

In monopoly market there is only one producer or seller and large no. of consumers. There
is lack of production of close substitutable commodities. Price of commodity is determined
by the producer. So, firm is price maker and consumers are price taker. To increase the sale
of output producer must reduce the price of the commodity. On the basis of this concept
we can derive TR, AR and MR curves.
Output sold (Q) Price (P) TR = P × Q AR = TR / Q MR = ∆TR / ∆Q
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4

On the given table, output sold is gradually increasing at equal rate from 1 to 8. About TR,
at initial stage, TR increases then remains constant after certain output sold and decreases
at increasing rate. AR gradually declines at equal rate as per increasing rate of output sold.
About MR, it decreases at constant rate.
On the basis of given table we can derive following graph:

Y
Price, TR, AR, & MR

TR

AR=P
X
MR

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Unit 4: Cost and Revenue Curves Sub: - Applied Economics
On the given figure, output sold and revenue are measured along x and y-axis respectively.
With the increase of output sold, TR curve increases at decreasing rate reaches to maximum
and remains constant. When 6 units of output sold, TR starts to decline at increasing rate.
AR curve gradually decreases but never touches x-axis. MR curve declines sharply than
AR. It cuts to the x-axis when TR is at maximum and declines negatively when TR starts
to decrease.

4.6 Relationship between Average and Marginal Revenue

The relationship between AR and MR depends upon the nature of market. Therefore, the
relationship between AR and MR is explained under perfect competition and imperfect
competition respectively.
 Relationship between AR and MR curves under perfect competition: under
perfect competition, seller cannot influence price of the product. He has to sell at
the ruling price prevailing in the market. Thus, average revenue or price is same
throughout. Marginal revenue curve coincides with the average revenue curve
because additional units are sold at the same price as before. This is shown in
Figure.

 Relationship between AR and MR curves under the Monopoly/ Imperfect

Competition
1. When both AR and MR Curves are Straight Line: When both AR and MR
curves are downward
sloping and straight line,
the MR curve cuts any
perpendicular line to the
Y-axis at halfway from
the AR curve. This is
shown in Figure.

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 4: Cost and Revenue Curves Sub: - Applied Economics
In above figure, AR and MR represent average and marginal revenue curves. MR
curve cuts a perpendicular line AB drawn to the Y-axis at its middle point C, i.e.
AC=CB.
2. When both AR and MR Curves are Convex to the Origin: When both AR and
MR curves are convex to the origin, the MR curve cuts any perpendicular line to
the Y-axis at more than half-way from the AR curve to the Y-axis. This is shown in
Figure.
In the Figure, both MR and
AR curves are convex to the
origin. AB is the
perpendicular drawn from
AR to Y-axis and point C is
mid-point of the
perpendicular. MR curve
cuts the perpendicular line
AB at more than midpoint at D where AD < DB.
3. When both AR and MR Curves are Concave to the Origin: When both AR and
MR curves are concave to the origin, the MR curve cuts any perpendicular line to
the Y-axis at less than half-way form the AR curve. This is shown in Figure.

In above Figure, both MR and AR curves are concave to the origin. Perpendicular
line AB is drawn from AR to Y-axis and point C is the mid-point of the
perpendicular. MR curve cuts the perpendicular AB at less than mid-point at D
where AD > DB.

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Unit 4: Cost and Revenue Curves Sub: - Applied Economics

4.7 Relationship between Price elasticity and Marginal Revenue and

Total Revenue
There is very useful relationship between price elasticity of demand and concept of revenue.
This relationship can be studied as follows:
4.7.1 Relationship between price elasticity of demand and marginal revenue
Marginal revenue is the addition in total revenue as a results of increase in sales by
one additional unit. Then,
𝑑(𝑇𝑅)
𝑀𝑅 =
𝑑𝑄
𝑑(𝑃 × 𝑄)
𝑂𝑟, 𝑀𝑅 = (∵ 𝑇𝑅 = 𝑃 × 𝑄)
𝑑𝑄
𝑑𝑄 𝑑𝑃
𝑂𝑟, 𝑀𝑅 = 𝑃. + 𝑄.
𝑑𝑄 𝑑𝑄
𝑑𝑃
𝑂𝑟, 𝑀𝑅 = 𝑃. 1 + 𝑄.
𝑑𝑄
𝒅𝑷
∴ 𝑴𝑹 = 𝑷 + 𝑸.
𝒅𝑸
Taking P Common, We get
𝑸 𝒅𝑷
𝑴𝑹 = 𝟏 + . … (𝒊)
𝑷 𝒅𝑸
dP Q
In the above equation . is the reciprocal of coefficient of price elasticity of
dQ P
demand. It means that,
𝒅𝑷 𝑸 −𝟏
. =
𝒅𝑸 𝑷 𝑬𝑷
−𝟏
By Substituting (𝑬 ) in the above equation (I), we get,
𝑷
𝟏
𝑴𝑹 = 𝑷 (𝟏 − )
𝑬𝑷
𝑬𝑷 − 𝟏
𝑴𝑹 = 𝑷 ( ) … (𝒊𝒊)
𝑬𝑷
The above equation (ii), gives the relationship between price elasticity of demand
and marginal revenue. Given the relationship between marginal revenue (MR) and
price elasticity of demand EP, we can draw following conclusion:
i. When EP = 1, MR = 0. It means that total revenue remains constant for both
rise and fall in price.
ii. When EP > 1, MR > 0. It means that increase in price results decrease in
total revenue and vice-versa.
iii. When EP < 1, MR < 0. It means that increase in price results increase in total
revenue and vice-versa.
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4.7.2 Relationship between price elasticity of demand and average revenue
We know that price is same as average revenue in all market condition. Therefore,
substituting P= AR in the above equation, (ii) we get,
𝐸𝑃 − 1
𝑀𝑅 = 𝐴𝑅 ( )
𝐸𝑃
𝐸𝑃 − 1
𝑂𝑟, 𝐴𝑅 = 𝑀𝑅 ( )
𝐸𝑃
𝐴𝑅. 𝐸𝑃 − 𝐴𝑅 = 𝑀𝑅. 𝐸𝑃
𝑂𝑟, 𝑀𝑅. 𝐸𝑃 = 𝐴𝑅. 𝐸𝑃 − 𝐴𝑅
𝑂𝑟, 𝑀𝑅. 𝐸𝑃 − 𝐴𝑅. 𝐸𝑃 = −𝐴𝑅
𝑂𝑟, 𝐸𝑃 (𝑀𝑅 − 𝐴𝑅) = −𝐴𝑅
−𝐴𝑅
𝑂𝑟, 𝐸𝑃 =
𝑀𝑅 − 𝐴𝑅
−𝐴𝑅
𝑂𝑟, 𝐸𝑃 =
−(𝐴𝑅 − 𝑀𝑅)
𝑨𝑹
∴ 𝑬𝑷 = ( ) … (𝑖𝑖𝑖)
𝑨𝑹 − 𝑴𝑹
The above equation (iii) gives the relationship between average revenue (AR) and
Price elasticity of demand (EP).
Alternative Method (Graphical Geometrical Proof)
The above equation (iii) gives the relationship between AP and MR and between
AR and EP. The relationship can also be derived geometrically as follows:

In the above figure, X-axis represents quantity and Y-axis represents average
revenue, marginal revenue and price. The downward sloping curve AM represents
average revenue curve (AR) and AN represents marginal revenue curve (MR).

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Let us suppose that price is given OP (=QB). According to point elasticity of
demand, price elasticity of demand at point B lower segment of the demand curve
(AR Curve) divided by upper segment of the demand curve (AR curve).
𝐿𝑜𝑤𝑒𝑟 𝑆𝑒𝑔𝑚𝑒𝑛𝑡
𝐸𝑃 𝑎𝑡 𝐵 =
𝑈𝑝𝑝𝑒𝑟 𝑆𝑒𝑔𝑚𝑒𝑛𝑡
𝐵𝑀
= … (𝑖)
𝐴𝐵
Since, ΔAPB and ΔQBM are equiangular,
𝐵𝑀 𝐵𝑄
𝐸𝑃 𝑎𝑡 𝐵 = = … (𝑖𝑖)
𝐴𝐵 𝐴𝑃
Again, in congruent triangles, APC and DBC,
AP = BD … (iii)
From equation (i), (ii) and (iii), We get,
𝐵𝑀 𝐵𝑄 𝐵𝑄
𝐸𝑃 𝑎𝑡 𝐵 = = = [∵ 𝐴𝑃 = 𝐵𝐷]
𝐴𝐵 𝐴𝑃 𝐵𝐷
𝐵𝑄
= [∵ 𝐵𝐷 = 𝐵𝑄 − 𝐷𝑄]
(𝐵𝑄 − 𝐷𝑄)
𝐴𝑅
𝐸𝑃 𝑎𝑡 𝐵 = ( ) [∵ 𝐵𝑄 = 𝐴𝑅 𝑎𝑛𝑑 𝐷𝑄 𝑀𝑅]
𝐴𝑅 − 𝑀𝑅
Hence by graphical or geometrical method also we can establish the relationship
between EP, AR and MR.
4.7.3 Relationship between price elasticity of demand and total revenue
Since, the total revenue (TR), marginal revenue (MR) and price elasticity of demand
(EP) are interrelated, the relationship between TR and EP can be traced through the
relationship between MR and EP. Given the relation between MR and EP in the
1
equation, MR = P (1 − ), the relationship between TR and EP can be summed
EP

up as follows:
i. If EP = 1, MR = 0, TR does not change with change in price.
ii. If EP < 1, MR < 0, TR decreases with decreases in price and increases with
increase price.
iii. If EP > 1, MR > 0, TR decreases with increase in price and increases with
decrease in price.

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