Chapter 6: Cost and Revenue Curve

Very Short Question Answer

Define 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.

Distinguish between implicit cost and explicit 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 where as explicit cost is defined the payment made by a firm for the use of inputs purchased or hired from outside or others.

Define economic cost.

The total sum of implicit and explicit cost is called economic cost. Economic cost = Implicit cost + Explicit cost.

What is meant by total cost?

Total cost is defined as the total expenditure incurred in the production of given quantities of a commodity. It is the total sum of total variable cost and total fixed cost.

What is fixed cost?

Fixed cost is defined as the cost of production that does not change with change in quantity of output. This cost is incurred by fixed factors of production like machineries, land etc.

What is variable cost?

Variable cost is defined as the cost of production that changes with change in quantity of output. This cost is incurred by variable factors of production like raw materials, labour etc.

Write any two differences between fixed and variable cost.

The any two differences between fixed and variable cost are as follows:

1. Fixed cost is the expenses incurred by fixed factors of production where as variable cost is the expenses incurred by variable factors of production.
2. Fixed cost remains constant whatever be the level of output but variable cost changes with change in output

Short Question Answer

Define cost. Explain various concepts of costs.

Cost is defined as the 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.

The various concepts of costs are as follows:

i. Actual and opportunity cost: Actual cost is defined as the expenditure, which is actually incurred by the firm in payment for labour, raw materials, plant, building, machinery, equipment, traveling & transport, fuel, etc. On the other hand, 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.

ii. Implicit and explicit 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. On the other hand, explicit cost is defined the payment made by a firm for the use of inputs purchased or hired from outside or others. In other words, it is the cost of inputs, which requires an expense of money by the firm.

iii. Accounting and economic cost: Accounting cost is defined as the cost that involves direct payment of money by entrepreneur to the various factors of production. Accounting cost is same like explicit cost. On the other hand economic cost is defined as the total sum of explicit and implicit cost. Hence accounting cost is a part of economic cost.

Economic Costs = Implicit costs + Explicit cost

iv. Historical and replacement 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. On the other hand, replacement cost is defined as the expenditure that would have incurred if that asset was purchased now.

v. Separable and common cost: Separable cost is defined as the cost that can be easily known to a product, a division or a process. On the other hand common cost is defined as the cost that cannot be known to any one unit of operation.

vi. Fixed cost and variable cost: Fixed cost is defined as the expenses incurred on fixed factors of production. Fixed factors of production are those factor. which cannot be in the short-run. On the other hand, variable cost is defined # the expenses incurred on variable factors of production. Variable factors production can be changed even in the short run.

Explain the concept of economies and diseconomies of scale.

A firm experiences economies and diseconomies of scale when it increases its level of production. The LAC curve is ‘U’ shaped due to economies and diseconomies of scale. The concept of economies and diseconomies of scale is explained as follows:

i. Economies of scale: Economies of scale are defined as the decrease in long run average cost of production due to increase in size of the firm. In other words, it refers to the property whereby long-run average total cost falls as the quantity of output increases. In the initial stage of production, when output increases by increasing variable factors of production, the different types of economies of scale accrue in production. The causes of economies of scale are as follows:

1. Economies in production: Economies of scale in production arise due to operation of increasing returns to scale in the beginning stage of production. Production economies are of two types i.e., technical economies and labor economies.
2. Technical economies: Technical economies arise due to the advantage of opportunity for using specialized kind of machinery. The use of specialized technology reduces per- unit cost of production.
3. Labor economies: Under division of labor, a work is divided into different parts. The workers are placed where they are best fitted. It increases output and reduces cost of production.
4. Marketing economies: Marketing economies arise from the large-scale purchase of raw materials and other inputs and large scale selling of firms own products. In the large-scale purchase, the firm can get certain discount. It reduces the cost of material inputs.
5. Managerial economies: Managerial economies arise from specialization in management and mechanization of management functions. This increases efficiency of management at all levels because of decentralization of decision making. Managerial cost increases less than proportionately with the increase in production up to certain level. It reduces cost of production.
6. Economies in transportation and storage: Economies in transportation & storage costs arise from fuller utilization of transport & storage facilities, which reduces cost of production.

ii. Diseconomies of scale: Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. With the expansion of output, the different types of difficulties appear which increases average cost of production. As a result, LAC starts to increase. The causes of diseconomies of scale as follows:

1. Managerial inefficiency: Managerial inefficiency arises from the expansion of output. With the expansion of output, personal contact & communication between owners & managers and managers & labor rapidly reduced. Close control & supervision is replaced by remote control. With the increase in managerial personnel, decision-making becomes complex & delayed. Implementation of decision is also delayed due to coordination problem. It creates managerial inefficiency. Managerial inefficiency leads to increase in cost of production.
2. Labor inefficiency: Increase in the number of workers encourages labor union activities, which means simply the loss of output per-unit of time and hence increase in the cost of production.

Explain the concept of economies of scope.

Or, Define economies of scope. Explain its causes.

Economies of scope are the situation in which it is cheaper to produce various products jointly by a firm than by the separate firms independently. In other words, production is said to exhibit economies of scope if the cost of a single firm producing two or more different products is less than the costs of the outputs produced separately by two or more firms independently. Symbolically,

TC (QA QB)<TC (QA) + TC (QB)

where

TC (QA, QB) = Total cost of producing good- A and B by a single firm

TC( QA) +TC(QB) = Total cost of producing good- A and B by two firms

Economies of scope exist if the total cost of jointly producing two commodities A and B by a firm is smaller than by two firms independently in the real world, firms produce more than one product rather than a single product. For example, sugar industry produces sugar and sprit, automobile companies produce car and truck, medical college produce teaching and medical treatment, and chicken firms produce poultry and eggs. Firms add new products as economies of scope increase, or drop them as economies of scope decrease.

The main causes of economies of scale are as follows:

i. Common production facilities: Economies of scope may arise when products are produced with common production facilities or inputs. For example, car and trucks can be produced with the same metal sheet and engine. Two or more products by a firm lead to a better utilization production facilities. Consequently, total cost of production falls. When two firms (firm A and firm B) produce these two products independently, the total cost of production will be high.

ii. Use of by-products: Economies of scope also arise when a firm produces second product by utilization of by-products. For example, sugar industries produce spirit by using by-product of sugar.

iii. Common marketing and administration: Economies of scope also arise from the utilization of common marketing strategies and administration. For id a example, Microsoft can simultaneously advertise all of its office, products at lower cost than if it advertised each separately.

Why LAC is less pronounced or flatter than SAC? Explain.

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 & the use of technologically more efficient machines or factors. The increasing returns to scale operate because of the indivisibility of factors of production. Further, when the scale of the firm expands, there is wide scope for specialization of labor 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, procure the service of more efficient manager & workers, etc. 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, labor & transport arise so that the LAC curve begins to rise. As the industry continuously expands production, the demand for skilled labor, 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 & equipment can be worked fully and more efficiently so that both the average fixed costs & 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.

Explain the shape of long run average cost curve according to modern theory of cost. Or, What is the theoretical reason and empirical evidence on shape of long run average cost curve. Explain.

According to the modern theory of cost, long run average curve is L-shapes not U-shaped. The empirical studies on cost have proved U-shaped cou curves to be wrong. According to George Stigler, 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 shaped. This is also known as the modern theory of cost. The L-shaped long run average cost curve is shown in the figure:

The main causes behind L- shaped long run average cost curve are as follows:

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 technical 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.

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 an L shaped curve.

Long Question Answer

Define cost. Explain various concepts of costs And concept of economies of scope.

Cost is defined as the 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.

The various concepts of costs are as follows:

i. Actual and opportunity cost: Actual cost is defined as the expenditure, which is actually incurred by the firm in payment for labour, raw materials, plant, building, machinery, equipment, traveling & transport, fuel, etc. On the other hand, 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.

ii. Implicit and explicit 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. On the other hand, explicit cost is defined the payment made by a firm for the use of inputs purchased or hired from outside or others. In other words, it is the cost of inputs, which requires an expense of money by the firm.

iii. Accounting and economic cost: Accounting cost is defined as the cost that involves direct payment of money by entrepreneur to the various factors of production. Accounting cost is same like explicit cost. On the other hand economic cost is defined as the total sum of explicit and implicit cost. Hence accounting cost is a part of economic cost.

Economic Costs = Implicit costs + Explicit cost

iv. Historical and replacement 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. On the other hand, replacement cost is defined as the expenditure that would have incurred if that asset was purchased now.

v. Separable and common cost: Separable cost is defined as the cost that can be easily known to a product, a division or a process. On the other hand common cost is defined as the cost that cannot be known to any one unit of operation.

vi. Fixed cost and variable cost: Fixed cost is defined as the expenses incurred on fixed factors of production. Fixed factors of production are those factor. which cannot be in the short-run. On the other hand, variable cost is defined # the expenses incurred on variable factors of production. Variable factors production can be changed even in the short run.

Or, Define economies of scope. Explain its causes.

Economies of scope are the situation in which it is cheaper to produce various products jointly by a firm than by the separate firms independently. In other words, production is said to exhibit economies of scope if the cost of a single firm producing two or more different products is less than the costs of the outputs produced separately by two or more firms independently. Symbolically,

TC (QA QB)<TC (QA) + TC (QB)

where

TC (QA, QB) = Total cost of producing good- A and B by a single firm

TC( QA) +TC(QB) = Total cost of producing good- A and B by two firms

Economies of scope exist if the total cost of jointly producing two commodities A and B by a firm is smaller than by two firms independently in the real world, firms produce more than one product rather than a single product. For example, sugar industry produces sugar and sprit, automobile companies produce car and truck, medical college produce teaching and medical treatment, and chicken firms produce poultry and eggs. Firms add new products as economies of scope increase, or drop them as economies of scope decrease.

The main causes of economies of scale are as follows:

i. Common production facilities: Economies of scope may arise when products are produced with common production facilities or inputs. For example, car and trucks can be produced with the same metal sheet and engine. Two or more products by a firm lead to a better utilization production facilities. Consequently, total cost of production falls. When two firms (firm A and firm B) produce these two products independently, the total cost of production will be high.

ii. Use of by-products: Economies of scope also arise when a firm produces second product by utilization of by-products. For example, sugar industries produce spirit by using by-product of sugar.

iii. Common marketing and administration: Economies of scope also arise from the utilization of common marketing strategies and administration. For id a example, Microsoft can simultaneously advertise all of its office, products at lower cost than if it advertised each separately.

Distinguish between implicit cost and explicit cost. Explain the concept of economies and diseconomies of scale.

Implicit cost is defined as the value of factor inputs owned and used by the firm or the entrepreneur in its own production process where as explicit cost is defined the payment made by a firm for the use of inputs purchased or hired from outside or others.

A firm experiences economies and diseconomies of scale when it increases its level of production. The LAC curve is ‘U’ shaped due to economies and diseconomies of scale. The concept of economies and diseconomies of scale is explained as follows:

i. Economies of scale: Economies of scale are defined as the decrease in long run average cost of production due to increase in size of the firm. In other words, it refers to the property whereby long-run average total cost falls as the quantity of output increases. In the initial stage of production, when output increases by increasing variable factors of production, the different types of economies of scale accrue in production. The causes of economies of scale are as follows:

1. Economies in production: Economies of scale in production arise due to operation of increasing returns to scale in the beginning stage of production. Production economies are of two types i.e., technical economies and labor economies.
2. Technical economies: Technical economies arise due to the advantage of opportunity for using specialized kind of machinery. The use of specialized technology reduces per- unit cost of production.
3. Labor economies: Under division of labor, a work is divided into different parts. The workers are placed where they are best fitted. It increases output and reduces cost of production.
4. Marketing economies: Marketing economies arise from the large-scale purchase of raw materials and other inputs and large scale selling of firms own products. In the large-scale purchase, the firm can get certain discount. It reduces the cost of material inputs.
5. Managerial economies: Managerial economies arise from specialization in management and mechanization of management functions. This increases efficiency of management at all levels because of decentralization of decision making. Managerial cost increases less than proportionately with the increase in production up to certain level. It reduces cost of production.
6. Economies in transportation and storage: Economies in transportation & storage costs arise from fuller utilization of transport & storage facilities, which reduces cost of production.

ii. Diseconomies of scale: Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. With the expansion of output, the different types of difficulties appear which increases average cost of production. As a result, LAC starts to increase. The causes of diseconomies of scale as follows:

1. Managerial inefficiency: Managerial inefficiency arises from the expansion of output. With the expansion of output, personal contact & communication between owners & managers and managers & labor rapidly reduced. Close control & supervision is replaced by remote control. With the increase in managerial personnel, decision-making becomes complex & delayed. Implementation of decision is also delayed due to coordination problem. It creates managerial inefficiency. Managerial inefficiency leads to increase in cost of production.
2. Labor inefficiency: Increase in the number of workers encourages labor union activities, which means simply the loss of output per-unit of time and hence increase in the cost of production.