Economics · Lesson 8

Costs and revenue of the firm

JAMBWAECNECO

What the syllabus asks

JAMB: Theory of costs and revenue: concepts of cost (fixed, variable, total, average, marginal); accountant’s and economist’s views of cost; short-run and long-run costs; concepts of revenue (total, average, marginal) and their relationships

WAEC: Cost and revenue concepts: fixed, variable, total, average and marginal costs; short-run and long-run costs; opportunity, explicit and implicit costs; total, average and marginal revenue; relationships between cost curves; profit maximisation (MC = MR); break-even and shut-down points

NECO: Cost and revenue concepts: fixed, variable, total, average and marginal costs; short-run and long-run costs; opportunity, explicit and implicit costs; total, average and marginal revenue; relationships between cost curves; profit maximisation (MC = MR); break-even and shut-down points

What you will learn

Distinguish fixed, variable and total costs and the short run from the long run.
Calculate AFC, AVC, ATC and MC from a cost table and describe the shapes of their curves.
Distinguish the accountant’s view of cost from the economist’s view (explicit, implicit and opportunity cost).
Calculate TR, AR and MR and explain their relationships under perfect and imperfect competition.
Apply the profit-maximising rule MC = MR.
Explain break-even and shut-down points and the long-run average cost curve.

Key points

Short run: at least one factor fixed; long run: all factors variable.
TC = FC + VC; FC is a horizontal line; TC starts at FC.
AFC = FC/Q (always falls); AVC = VC/Q; ATC = TC/Q = AFC + AVC.
MC = TCₙ − TCₙ₋₁; unaffected by FC; U-shaped because of diminishing returns.
MC cuts AVC and ATC at their minimum points.
Economist’s cost includes implicit (opportunity) costs and normal profit.
TR = P × Q; AR = price; MR = ΔTR; MR = AR only if price is constant.
Profit is maximised where MC = MR.
Break-even: P = ATC; shut-down: P = minimum AVC.
LRAC is U-shaped because of economies and diseconomies of scale.

Start here: Meaning of cost; short run and long run

Mrs Adeyemi runs a bakery in Ibadan. Every month she pays rent for the shop, interest on the loan for her oven, wages for her bakers, and buys flour, sugar, yeast and diesel for the generator. All these are costs of production.

Cost of production is the total expense a firm incurs in producing a given output of goods or services.

The short run and the long run

These are not fixed lengths of calendar time; they depend on whether inputs can be changed.

Short run: a period in which at least one factor is fixed (for example the size of the bakery or the number of ovens). Output can be changed only by changing variable factors such as labour and flour.
Long run: a period long enough for all factors to be varied. The bakery can move to a bigger building or install more ovens. There are no fixed costs in the long run.

For a sachet-water firm the long run may be a few months; for a refinery or steel plant it may be several years.

Worked example 8.1

Classify each as a factor that is fixed or variable for the bakery in the short run: (a) the oven; (b) flour; (c) shop rent; (d) bakers paid per batch.

(a) Fixed: cannot be changed quickly.
(b) Variable: more bread needs more flour.
(c) Fixed: paid whatever the output.
(d) Variable: pay rises with batches.

Fixed, variable, fixed, variable

⚠️ Common mistake: defining the short run as "less than one year". It is defined by whether at least one factor is fixed, not by a number of months.

Try it yourself. Are there any fixed costs in the long run?

Show solution

No. In the long run all factors and so all costs can vary.

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Practice questions

1. In the short run, a firm

has at least one fixed factor
can vary all factors
has no fixed costs
cannot produce

Show answer

A: has at least one fixed factor
Long run: all factors variable.

2. Fixed cost is ₦500 and variable cost at 10 units is ₦700. Total cost is

₦200
₦700
₦120
₦1,200

Show answer

D: ₦1,200
TC = FC + VC.

3. Average fixed cost always

stays constant
equals marginal cost
falls as output rises
rises as output rises

Show answer

C: falls as output rises
AFC = FC ÷ Q.

4. TC is ₦900 at 9 units and ₦1,000 at 10 units. The marginal cost of the 10th unit is

₦1,900
₦100
₦1,000
₦10

Show answer

B: ₦100
MC = 1,000 − 900.

5. Marginal cost is NOT affected by

fixed cost
variable cost
output
diminishing returns

Show answer

A: fixed cost
FC does not change with output.

Key words

Cost of production: Expenses incurred by a firm in producing goods or services.
Fixed cost: Cost that does not vary with output in the short run, e.g. rent; also called overhead or supplementary cost.
Variable cost: Cost that varies with output, e.g. raw materials; also called prime or direct cost.
Total cost: Sum of fixed and variable costs at each output.
Average fixed cost: Fixed cost per unit: FC ÷ Q.
Average variable cost: Variable cost per unit: VC ÷ Q.
Average total cost: Total cost per unit: TC ÷ Q.
Marginal cost: Addition to total cost from producing one more unit.
Explicit cost: Actual money payment for inputs bought or hired.
Implicit cost: Value of the owner’s own resources used, which could have earned income elsewhere.
Opportunity cost: The value of the best alternative forgone.
Total revenue: Total receipts from sales: price × quantity.

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