Cost and Revenue | ISC Class 12 Economics Notes

This note covers the cost and revenue of a firm: the kinds of cost, including opportunity cost and accounting cost; fixed, variable, total, average and marginal cost and their relationships; the short run and long run cost curves; total, average and marginal revenue under perfect and imperfect competition; and producer's equilibrium by the TR and TC approach and the MR and MC approach.

What does cost of production mean in economics?

Production is the process by which a firm transforms inputs into output. A firm acquires inputs such as labour, machines, land and raw materials, and it has to pay for them. This payment is the cost of production.

The firm sells its output and earns revenue. The difference between revenue and cost is its profit, which the firm is assumed to maximise.

Definition: Cost of production is the expenditure a firm incurs to purchase or hire the factors of production and other inputs it needs in order to produce a product.

What is a cost function?

A given level of output can usually be produced with more than one combination of inputs. For example, 50 units of output may be produced with 6 units of labour and 3 of capital, with 4 of each, or with 3 of labour and 6 of capital. With input prices given, the firm chooses the least expensive combination.

The cost function therefore describes the least cost of producing each level of output, given the prices of the factors of production and the technology. Cost is a function of output: it rises or falls as output rises or falls.

In economics the cost of production has three elements: explicit costs, implicit costs and normal profit. In business accounts, by contrast, only explicit costs are treated as cost.

What are explicit costs, implicit costs and normal profit?

Explicit costs are the actual payments a firm makes to purchase or hire the goods and services used in production. They include rent for a hired building, wages and salaries, interest on borrowed money, and payments for raw materials and electricity. Explicit costs are also called money costs.

Some inputs are supplied by the entrepreneur himself. He may use his own building, invest his own money or manage the firm himself, and a farmer may cultivate his own land. No payment is made for these inputs, yet each has a market value.

The estimated value of such self-owned inputs is the implicit cost, also called the imputed cost. It equals the opportunity cost of these inputs and is estimated at prevailing market prices.

The imputed rent of a self-owned factory building equals the rent paid for a similar building. Imputed interest and imputed wages are found in the same way.

Why is normal profit treated as a cost?

Normal profit is the minimum level of profit needed to keep a firm in its existing business. A firm that does not make normal profit is not going to continue in the business, so normal profit is part of its total costs. It can be thought of as an opportunity cost for entrepreneurship.

A publisher who could publish either commerce books or science books chooses commerce books for their higher return. He stays with them only if he earns at least the profit science books would have given him. That minimum is his normal profit. Profit over and above normal profit is super-normal profit.

How are a farmer's costs divided?

A rice farmer's explicit costs include fertilisers, wages of hired workers and rent for a tractor. His implicit costs include his own land, seeds saved from his last crop and his family's labour. His normal profit is the minimum return that makes him grow rice rather than another product.

How do money, real, private, social and economic costs differ?

Private cost and social cost

Private cost is the expenditure of an individual firm in producing a commodity: payments for raw material, wages of workers and rent of a building. Social cost is the cost to society as a whole of producing the commodity.

Factories emit smoke from their chimneys. This may not appear in their own cost records, but the community bears it as additional washing bills for clothes and money spent on medical bills. Air pollution, water pollution and noise pollution are forms of social cost.

Money cost and real cost

Explicit costs and private costs are incurred in money terms, so they are also called money costs: wages paid to labour, rent for a building and interest on borrowed funds.

Real cost has no definite money value and cannot be measured in monetary terms. It is the sacrifice, discomfort, disutility, toil and effort of the owners of factors in supplying them, such as the stress and strain a producer undergoes in setting up a business.

Economic cost

Opportunity cost is so widely used in economics that it is sometimes also called economic cost. Measured this way, cost includes implicit costs and normal profit as well as the explicit costs that are paid out.

What is opportunity cost, and how is it different from accounting cost?

Definition: The opportunity cost of an activity is the gain forgone from the second best activity, that is, the value of the next best alternative that is given up.

A farmer can produce either rice or wheat on a piece of land. If he produces wheat, the value of the rice forgone is the opportunity cost of producing wheat.

The idea applies to society too. If an economy uses more resources to produce corn, less cotton can be produced, and the cotton given up is the opportunity cost of the extra corn.

Worked example 1: opportunity cost of using your own money. You have Rs 1,000 and invest it in your family business. The alternatives were a house-safe, which gives zero return, or a deposit in bank-1 at 10 per cent or bank-2 at 5 per cent interest. What is the opportunity cost of investing in the business?

Reasoning: the maximum benefit from the alternatives is the interest from bank-1, and that opportunity is lost once the money goes into the business.

Answer: the opportunity cost is the interest forgone from bank-1. At 10 per cent on Rs 1,000, that is Rs 100 for a year.

How does accounting cost differ from opportunity cost?

An accountant normally takes into account only the actual money expenditure as cost. Accounting cost therefore consists of explicit costs. Opportunity cost looks at what is given up, so it also counts the owner's land, building, money and labour, for which no money is paid.

What are fixed, variable and total costs in the short run?

In the short run, at least one factor of production cannot be varied and remains fixed. In the long run, all factors can be varied. A period is short run or long run according to whether all inputs can be varied, not according to a number of days, months or years.

The cost of employing the fixed inputs is the total fixed cost (TFC). It remains fixed whatever the output, even at zero output. Rent of Rs 1,000 a month on a hired factory building must be paid whether the producer produces or not. Fixed costs are also called supplementary costs.

The cost of employing the variable inputs is the total variable cost (TVC). It is zero at zero output and rises as output rises, because more variable inputs are needed. Variable costs are also called prime costs or direct costs. Adding the two gives total cost (TC):

TC = TFC + TVC

At zero output, TC equals TFC. As output increases, TVC and TC both increase, and every change in TC is due to the change in TVC.

Output is on the x-axis and costs on the y-axis. TFC is a horizontal line cutting the cost axis at c₁. TVC rises from the origin. TC starts from c₁ and is the vertical sum of TFC and TVC; at q₁, TVC is c₂ and TC is c₃.

How are average and marginal costs calculated?

Average costs are costs per unit of output. Average fixed cost (AFC) is TFC per unit, average variable cost (AVC) is TVC per unit, and short run average cost (SAC) is TC per unit. All three are undefined at zero output.

• AFC = TFC ÷ q
• AVC = TVC ÷ q
• SAC = TC ÷ q
• SAC = AFC + AVC

Short run marginal cost (SMC) is the change in total cost per unit of change in output: SMC = ΔTC ÷ Δq. When output rises one unit at a time, MCₙ = TCₙ − TCₙ₋₁.

MC is undefined at zero output. Fixed cost cannot change in the short run, so SMC is the increase in TVC from one extra unit and is not affected by fixed cost.

The table is the cost schedule of a typical firm whose total fixed cost is Rs 20.

Worked example 2: reading the cost schedule. From the schedule, find AFC, AVC, SAC and SMC at 4 units, and check that TVC equals the sum of the marginal costs.

Working: AFC = 20 ÷ 4 = 5. AVC = 29 ÷ 4 = 7.25. SAC = 49 ÷ 4 = 12.25, which equals 5 + 7.25. SMC = 49 − 44 = 5.

Answer: AFC is Rs 5, AVC Rs 7.25, SAC Rs 12.25 and SMC Rs 5. The marginal costs of the first four units add up to 10 + 8 + 6 + 5 = Rs 29, the TVC at 4 units.

Worked example 3: finding fixed cost from AFC. A firm's TC is Rs 50, 65, 75, 95, 130 and 185 at outputs of 1 to 6 units, and its AFC at 4 units is Rs 5. Find TFC and the AVC and SAC schedules.

Working: TFC = AFC × q = 5 × 4 = Rs 20. TVC = TC − 20, giving Rs 30, 45, 55, 75, 110 and 165.

Answer: TFC is Rs 20. AVC is Rs 30, 22.5, 18.33, 18.75, 22 and 27.5. SAC is Rs 50, 32.5, 25, 23.75, 26 and 30.83. AVC is lowest at 3 units, SAC at 4 units.

What shapes do the short run cost curves take, and why?

Why does the AFC curve keep falling?

AFC is TFC divided by q, and TFC is constant, so AFC decreases as q increases. Close to zero output, AFC is arbitrarily large; as output moves towards infinity, AFC moves towards zero. The AFC curve is a rectangular hyperbola: any output multiplied by its AFC always gives the same constant, TFC.

Output is on the horizontal axis and cost on the vertical axis. The AFC curve falls steeply and then flattens out towards the output axis. At output q₁, AFC is OF, at point C, and the area of the rectangle OFCq₁ is the total fixed cost.

AFC can also be read from the horizontal TFC line. At output q₀, if A is the point on TFC, then AFC = Aq₀ ÷ Oq₀ = tan θ, the slope of the line from O to A.

Why is the SMC curve U-shaped?

By the law of variable proportions, the marginal product of a factor first increases as its employment increases, and after a certain point decreases. So each extra unit of output first needs less and less of the variable factor, then more and more.

With the factor price given, SMC first falls and then rises: the SMC curve is U-shaped. TVC at any output is the area under the SMC curve up to that output.

Why are the AVC and SAC curves U-shaped?

For the first unit, SMC and AVC are the same. As output rises, SMC falls and AVC, the average of the marginal costs, falls by less. After a point SMC rises, but AVC keeps falling while SMC is below it. Once SMC rises above AVC, AVC rises, so AVC is U-shaped.

SAC is the sum of AVC and AFC. At first both fall, so SAC falls. Later AVC rises while AFC keeps falling; SAC falls while the fall in AFC is larger, and rises once the rise in AVC is larger. SAC is therefore U-shaped.

SAC lies above AVC by a vertical gap equal to AFC, and its minimum point lies to the right of the minimum point of AVC.

U-shaped SMC, SAC and AVC curves are drawn, with SAC above AVC. SMC cuts AVC from below at P, the minimum of AVC, at output q₁. SMC cuts SAC from below at S, the minimum of SAC, at output q₂, to the right of q₁.

How are total, average and marginal costs related?

Total cost and marginal cost

In the short run, the sum of the marginal costs up to any output gives the total variable cost at that output; in the long run it gives total cost. AVC at any output is the average of all the marginal costs up to that output.

Where the TC curve rises at a diminishing rate, MC is falling. Where it rises at an increasing rate, MC is rising.

Average cost and marginal cost

The same rules link marginal cost with both AVC and SAC:

1. When MC is less than the average cost, the average cost falls as output increases.
2. When MC equals the average cost, the average cost is at its minimum.
3. When MC is greater than the average cost, the average cost rises as output increases.
4. So the MC curve cuts the AVC and SAC curves from below, at their minimum points.

Note: A rising MC does not mean a rising average cost. After its minimum, SMC rises while AVC is still falling, because AVC keeps falling for as long as SMC is below it. The average turns upwards only when the marginal cost rises above it.

Total cost and average cost

Average cost is total cost divided by output. On a total cost curve, the average at any output is the slope of the straight line from the origin to that point on the curve; AVC, for example, is the slope of such a line drawn to the TVC curve. On an average cost curve, the total at any output is the area of the rectangle under that point; TVC, for example, equals AVC × output, the rectangle under the AVC curve.

What do the long run cost curves look like?

In the long run all inputs are variable, so there are no fixed costs, and total cost and total variable cost coincide. Long run average cost (LRAC) is cost per unit of output: LRAC = TC ÷ q.

Long run marginal cost (LRMC) is the change in total cost per unit of change in output. The LRMC of the q₁th unit is the TC at q₁ units minus the TC at q₁ − 1 units.

Why is the LRAC curve U-shaped?

The shape comes from returns to scale. Under increasing returns to scale (IRS), output rises by a larger proportion than inputs, so with input prices given, cost rises by a smaller proportion than output and average cost falls. Under decreasing returns to scale (DRS), average cost rises. Under constant returns to scale (CRS), average cost stays constant.

In a typical firm, IRS is observed at the initial level of production, followed by CRS and then DRS. So the LRAC curve is U-shaped: its falling part corresponds to IRS, its rising part to DRS, and CRS is observed at its minimum point.

What does the LRMC curve look like?

For the first unit, LRMC and LRAC are the same. While LRAC falls, LRMC is below it; while LRAC rises, LRMC is above it. The LRMC curve is also U-shaped and cuts LRAC from below at the minimum point of LRAC.

Output is on the horizontal axis and cost on the vertical axis. LRAC and LRMC are both U-shaped. LRMC cuts LRAC from below at M, the minimum point of LRAC, at output q₁.

What are total, average and marginal revenue under perfect competition?

A firm earns revenue by selling its output, and it is assumed to sell whatever it produces.

The three revenue concepts

Total revenue (TR) is the market price (p) multiplied by the firm's output (q). Average revenue (AR) is total revenue per unit of output. Marginal revenue (MR) is the increase in total revenue for a one-unit increase in output.

• TR = p × q
• AR = TR ÷ q
• MR = ΔTR ÷ Δq

Since TR = p × q, AR = (p × q) ÷ q = p. Average revenue is the price of the product whenever every unit sells at the same price.

When output rises one unit at a time, MR is the TR at that output minus the TR at one unit less. TR is the sum of the marginal revenues of all units sold.

Revenue curves of a price-taking firm

A perfectly competitive market has many buyers and sellers, a homogeneous product, free entry and exit, and perfect information. Each firm is a price taker. Above the market price it sells nothing, and at the market price it can sell as much as it wants, so it sells every unit at the market price.

If a box of candles sells for Rs 10, TR is zero for no boxes, Rs 10 for one, Rs 20 for two, and so on. MR from the 3rd box is (30 − 20) ÷ (3 − 2) = Rs 10, equal to the price. In general, MR = (pq₂ − pq₁) ÷ (q₂ − q₁) = p, so MR = AR = p.

Output is on the x-axis and revenue on the y-axis. TR is an upward rising straight line through the origin O. At one unit of output, Oq₁, total revenue is the height Aq₁, so the slope of the line, Aq₁ ÷ Oq₁, is the market price p.

Output is on the x-axis and price on the y-axis. A horizontal price line cuts the y-axis at height p. It is the firm's AR curve under perfect competition, and it also shows MR. It is the demand curve facing the firm, which is perfectly elastic.

How do revenue curves behave under imperfect competition?

Under imperfect competition, as in monopoly and monopolistic competition, a firm faces a downward sloping demand curve. A monopolist has full control over price, so he can sell more by lowering the price. Under monopolistic competition the demand curve also slopes downwards but is less steep, showing greater price elasticity of demand.

Average and marginal revenue

AR is still the price, so the firm's AR curve is its demand curve, sloping downwards. To sell one more unit the firm lowers the price on all the units it sells, so the gain from the extra unit is partly offset by the lower price on the others.

MR is therefore less than AR after the first unit, and falls faster than AR.

When the AR curve is a straight line, the MR curve is a straight line starting from the same point on the price axis and falling twice as steeply. It cuts the output axis halfway between the origin and the point where AR meets that axis.

Total revenue

While MR is positive, TR rises at a diminishing rate. TR is at its maximum where MR is zero, and falls when MR becomes negative, so the TR curve is shaped like an inverted U.

Worked example 4: revenue with a falling price. Suppose a firm can sell 1 unit at Rs 10 and must lower the price by Rs 1 for each extra unit. Find TR and MR up to 7 units and the output at which TR is highest.

Working: TR = price × quantity, for example 3 × 8 = 24. MR of the 3rd unit = 24 − 18 = 6.

Answer: TR is highest, at Rs 30, at 5 and 6 units. The MR of the 6th unit is Rs 0 and of the 7th unit −Rs 2, so TR falls to Rs 28.

In an upper panel, draw TR rising from the origin at a diminishing rate to a peak, then falling. Below it, draw a straight AR line sloping downwards and a straight MR line from the same point on the y-axis, twice as steep. TR peaks at the output where MR cuts the x-axis.

What is producer's equilibrium, and how does the TR and TC approach find it?

Producer's equilibrium is the level of output at which a firm earns maximum profit, so it has no reason to change its output. Profit, denoted by the Greek letter π, is the difference between total revenue and total cost:

Profit = TR − TC

When TR is greater than TC, the firm earns super-normal profit. When TR equals TC, it earns only normal profit, sometimes called zero profit. When TC is greater than TR, it makes a loss.

The TR and TC approach

By the TR and TC approach, the firm produces the output at which total revenue exceeds total cost by the largest amount, that is, where TR − TC is maximum. At that output the slope of the TC curve equals the slope of the TR curve, so a tangent to TC there is parallel to TR.

Quantity is on the horizontal axis and revenue and cost on the vertical axis. TR is a straight line from the origin. TC starts at 15 and rises, slowly at first and then faster, meeting TR at A (Q = 2) and B (Q = 6). The gap is greatest at Q = 4: TR is 40 at C and TC is 25 at D, a profit of 15.

See Fig. 23.3 in your NIOS textbook

Worked example 5: the TR and TC approach. A competitive firm sells its good at Rs 10. Its TC is Rs 5, 15, 22, 27, 31, 38, 49, 63, 81, 101 and 123 at outputs of 0 to 10 units. Find the profit at each output and the profit-maximising output.

Working: TR = 10 × q. Profit = TR − TC, for example 50 − 38 = 12 at 5 units.

Answer: profit is highest, at Rs 12, at 5 units of output. The table gives the profit at each output, with MR and MC for Worked example 6.

How does the MR and MC approach find producer's equilibrium?

The MR and MC approach compares the extra revenue and the extra cost of each unit. For profit to be maximum at a positive output q₀, three conditions must hold.

Condition 1: MR equals MC

As long as MR is greater than MC, each extra unit adds more to revenue than to cost, so profit keeps increasing. When MR is less than MC, profit falls. Profit is therefore maximum where MR = MC. For a perfectly competitive firm MR = p, so the condition becomes p = MC.

Condition 2: MC cuts MR from below

For a competitive firm, MC must be non-decreasing at the profit-maximising output. More generally, MC must cut MR from below, so that the next unit would cost more than it earns. Under imperfect competition, where MR slopes downwards, equilibrium is again where MR = MC and MC cuts MR from below.

A horizontal price line at p cuts a U-shaped MC curve at A (output q₁), where MC is falling, and at B (output q₄), where MC is rising. At q₂ and q₃ price exceeds MC; at q₅ and q₆ MC exceeds price. Only q₄ can be the profit-maximising output.

Condition 3: price must cover AVC

In the short run, price must be at least equal to AVC; in the long run, at least equal to AC. If price is below minimum AVC in the short run, TVC exceeds TR at every positive output, so the firm is better off producing nothing and losing only its TFC.

The point of minimum AVC, where SMC cuts AVC, is the firm's short run shut down point; in the long run it is the minimum of LRAC. The point of minimum average cost, where the firm earns only normal profit, is its break-even point.

The price line at p cuts the rising part of SMC at A, giving output q₀, where p exceeds AVC. TR is the rectangle OpAq₀ and TC is the rectangle OEBq₀, with B on SAC. Profit is the area of the rectangle EpAB.

Worked example 6: the MR and MC approach. Use the firm in Worked example 5, whose MR is Rs 10 at every output. Find the equilibrium output by comparing MR and MC.

Working: MC = MR = 10 at the 1st unit, but MC is falling there (10, then 7, 5 and 4), so condition 2 fails. For units 2 to 5, MR exceeds MC, so each adds to profit. The 6th unit has MC of 11, above MR, so it would cut profit by Rs 1.

Answer: the firm produces 5 units, the last output at which MR is not less than MC, and earns the maximum profit of Rs 12, the same answer as the TR and TC approach.

Glossary

• Explicit cost — Actual payments made for inputs bought or hired from the market, such as wages, rent and interest; also called money cost.
• Implicit cost — The estimated market value of inputs owned and supplied by the entrepreneur himself, such as the imputed rent of his own building.
• Normal profit — The minimum level of profit needed to keep a firm in its existing business; it is treated as part of total cost.
• Opportunity cost — The gain forgone from the second best activity, that is, the value of the next best alternative given up.
• Social cost — The cost to society as a whole of producing a commodity, for example in the form of air, water or noise pollution.
• Total fixed cost — The cost of the fixed inputs, which stays the same at every level of output in the short run, even at zero output.
• Marginal cost — The change in total cost per unit of change in output; in the short run it equals the change in total variable cost.
• Average revenue — Total revenue per unit of output sold; it equals the price of the product.
• Marginal revenue — The increase in total revenue from a one-unit increase in the quantity sold.
• Producer's equilibrium — The level of output at which a firm earns maximum profit and so has no reason to change its output.

Common errors and misconceptions

• Misconception: Once marginal cost starts rising, average cost must also be rising. Correct: Average cost keeps falling as long as marginal cost is below it, even while marginal cost is rising.
• Misconception: A firm that produces nothing has no costs. Correct: In the short run, total fixed cost is still incurred at zero output, so total cost then equals total fixed cost.
• Misconception: The AFC curve eventually touches the output axis. Correct: AFC moves towards zero as output grows, but AFC multiplied by output is always TFC, so AFC stays above zero while TFC is positive.
• Misconception: SAC and AVC reach their minimum at the same output. Correct: The minimum point of SAC lies to the right of the minimum point of AVC. Just after AVC starts to rise, AFC is still falling by more, so SAC keeps falling for a while.
• Misconception: Accounting cost and economic cost are the same thing. Correct: Accounting cost counts only explicit costs. Cost in economics also includes implicit costs and normal profit.
• Misconception: Profit is maximum at any output where MR equals MC. Correct: MC must also cut MR from below, and price must cover AVC in the short run and AC in the long run.

Exam-style questions with model answers

Q1. Define marginal cost. How is it calculated? [2 marks]

1. Marginal cost is the change in total cost per unit of change in output, that is, the additional cost of producing one more unit.
2. It is calculated as MCₙ = TCₙ − TCₙ₋₁. In the short run it also equals TVCₙ − TVCₙ₋₁, because fixed cost does not change.

Q2. Distinguish between explicit cost and implicit cost, with one example of each. [2 marks]

1. Explicit cost is the actual payment made for inputs bought or hired from the market, for example wages paid to hired workers.
2. Implicit cost is the estimated market value of inputs supplied by the entrepreneur himself, for example the imputed rent of his own factory building.

Q3. Distinguish between accounting cost and opportunity cost. [3 marks]

1. Accounting cost is the actual money expenditure on inputs, which an accountant records as cost. It consists of explicit costs only.
2. Opportunity cost is the value of the next best alternative forgone. It includes implicit costs, such as interest forgone on the owner's own money, and normal profit.
3. For example, if Rs 1,000 invested in a family business could have earned 10 per cent in a bank, the forgone interest is an opportunity cost that does not appear as an accounting cost.

Q4. A competitive firm's TR is Rs 0, 5, 10, 15, 20, 25, 30 and 35, and its TC is Rs 5, 7, 10, 12, 15, 23, 33 and 40, at outputs of 0 to 7 units. Find the market price and the profit-maximising output. [3 marks]

1. Market price = AR = TR ÷ q = 5 ÷ 1 = Rs 5, the same at every output.
2. Profit = TR − TC at outputs 0 to 7 is −5, −2, 0, 3, 5, 2, −3 and −5 (in Rs).
3. Profit is highest, at Rs 5, at 4 units, so 4 units is the profit-maximising output.

Q5. Explain the relationship between TR, AR and MR under perfect competition and under imperfect competition. [5 marks]

1. AR = TR ÷ q is the price in both markets, and MR is the change in TR from selling one more unit.
2. Under perfect competition the firm is a price taker, so every unit sells at price p. Therefore MR = AR = p, shown by one horizontal price line.
3. TR = p × q rises at a constant rate, so the TR curve is a straight line from the origin with slope p.
4. Under imperfect competition the firm must lower its price to sell more, so the AR curve slopes downwards. MR is less than AR and falls faster.
5. TR rises at a diminishing rate while MR is positive, is highest where MR = 0, and falls when MR is negative, giving an inverted U-shaped TR curve.

Q6. A firm's TC is Rs 10, 30, 45, 55, 70, 90 and 120 at outputs of 0 to 6 units. Find its TFC, TVC, AFC, AVC, SAC and SMC schedules. [6 marks]

1. TFC is the total cost at zero output, Rs 10, and it is the same at every output.
2. TVC = TC − TFC: Rs 0, 20, 35, 45, 60, 80 and 110 at outputs 0 to 6.
3. AFC = TFC ÷ q: Rs 10, 5, 3.33, 2.5, 2 and 1.67 at outputs 1 to 6.
4. AVC = TVC ÷ q: Rs 20, 17.5, 15, 15, 16 and 18.33 at outputs 1 to 6.
5. SAC = TC ÷ q: Rs 30, 22.5, 18.33, 17.5, 18 and 20 at outputs 1 to 6.
6. SMC = TCₙ − TCₙ₋₁: Rs 20, 15, 10, 15, 20 and 30 for units 1 to 6.
7. Check: SAC = AFC + AVC, for example 3.33 + 15 = 18.33 at 3 units. At zero output, AFC, AVC, SAC and SMC are undefined.

Q7. Explain producer's equilibrium by the MR and MC approach, with a diagram. [6 marks]

1. Producer's equilibrium is the output at which the firm's profit, TR − TC, is maximum.
2. Condition 1: MR = MC. While MR is greater than MC, each extra unit adds to profit; while MR is less than MC, profit falls. For a competitive firm MR = p, so the condition is p = MC.
3. Condition 2: MC must be non-decreasing, cutting MR from below. If MC is falling where it equals MR, producing more raises profit, so that point is not the equilibrium.
4. Condition 3: price must be at least equal to AVC in the short run and to AC in the long run; otherwise the firm produces zero output.
5. Diagram: draw a U-shaped MC curve and a horizontal price line at p (AR = MR). The line cuts MC at A, where MC is falling, and at B, where MC is rising. The equilibrium is at B, and the output directly below B on the x-axis is the profit-maximising output.

Key takeaways

• Cost in economics includes explicit costs, implicit costs and normal profit, whereas accounting cost includes only the explicit costs actually paid out.
• Opportunity cost is the value of the next best alternative forgone; because of its importance it is sometimes also called economic cost.
• In the short run, TC = TFC + TVC; fixed cost is incurred even at zero output, and every change in total cost comes from variable cost.
• AFC falls continuously and its curve is a rectangular hyperbola, while the SMC, AVC and SAC curves are all U-shaped.
• SMC cuts AVC and SAC from below at their minimum points, and the minimum of SAC lies to the right of the minimum of AVC.
• In the long run there is no fixed cost; LRAC is U-shaped because of increasing, then constant, then decreasing returns to scale.
• AR = TR ÷ q = price; under perfect competition MR = AR = p, while under imperfect competition AR slopes downwards, MR lies below it and TR peaks where MR is zero.
• Producer's equilibrium is where profit is maximum: TR − TC is greatest, MR = MC with MC cutting MR from below, and price covers AVC.

Test yourself

What is the shape of the AFC curve, and why?

It is a rectangular hyperbola. TFC is constant, so AFC falls as output rises, and AFC multiplied by output always equals TFC.

Why is the SMC curve U-shaped?

By the law of variable proportions, the marginal product of the variable factor first rises and then falls, so with the factor price given, SMC first falls and then rises.

What is the imputed rent of a self-owned factory building?

It is an implicit cost, estimated as the rent that would be paid for a similar building hired from the market.

How is social cost different from private cost?

Private cost is the expenditure of the firm itself, while social cost is the cost to society as a whole, such as extra medical bills caused by factory smoke.

At what output is total revenue highest under imperfect competition?

At the output where marginal revenue is zero; beyond it MR is negative and total revenue falls.

What is the short run shut down point of a firm?

It is the point of minimum AVC, where SMC cuts AVC. At any price below it, the firm produces nothing.