managerial economicsiii

7/31/2019 Managerial EconomicsIII

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Managerial Economics

Cost Analysis


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Profit Maximization Main aim of any kind of economic activity is earning profit. A business

concern is also functioning mainly for the purpose of earning profit. Profit isthe measuring techniques to understand the business efficiency of theconcern.

Profit maximization is also the traditional and narrow approach, which aimsat, maximizes the profit of the concern.

Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It

leads to maximize the business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considersall the possible ways to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the businessconcern. So it shows the entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business.


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Favourable Arguments for ProfitMaximization

The following important points are in support ofthe profit maximization objectives of thebusiness concern:

(i) Main aim is earning profit.

(ii) Profit is the parameter of the business

operation. (iii) Profit reduces risk of the business concern.

(iv) Profit is the main source of finance.

(v) Profitability meets the social needs also.


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Unfavourable Arguments for ProfitMaximization

The following important points are against theobjectives of profit maximization:

(i) Profit maximization leads to exploiting

workers and consumers. (ii) Profit maximization creates immoral

practices such as corrupt practice, unfair tradepractice, etc.

(iii) Profit maximization objectives leads toinequalities among the sake holders such ascustomers, suppliers, public shareholders, etc.


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Drawbacks of Profit Maximization

Profit maximization objective consists of certaindrawback also:

(i) It is vague: In this objective, profit is not definedprecisely or correctly. It creates some unnecessaryopinion regarding earning habits of the businessconcern.

(ii) It ignores the time value of money: Profitmaximization does not consider the time value ofmoney or the net present value of the cash inflow. Itleads certain differences between the actual cashinflow and net present cash flow during a particularperiod.

(iii) It ignores risk: Profit maximization does notconsider risk of the business concern. Risks may beinternal or external which will affect the overall

operation of the business concern.


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Wealth Maximization

Wealth maximization is one of the modernapproaches, which involves latest innovations

and improvements in the field of the businessconcern. The term wealth means shareholder

wealth or the wealth of the persons those whoare involved in the business concern.

Wealth maximization is also known as valuemaximization or net present worth

maximization. This objective is an universallyaccepted concept in the field of business.


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Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profitmaximization because the main aim of the business

concern under this concept is to improve the value orwealth of the shareholders.

(ii) Wealth maximization considers the comparison ofthe value to cost associated with the business

concern. Total value detected from the total costincurred for the business operation. It provides extractvalue of the business concern.

(iii) Wealth maximization considers both time and risk

of the business concern. (iv) Wealth maximization provides efficient allocation

of resources.

(v) It ensures the economic interest of the society.


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Unfavourable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea ofthe business concern but it may not be suitable to

present day business activities. (ii) Wealth maximization is nothing, it is also profitmaximization, it is the indirect name of the profitmaximization.

(iii) Wealth maximization creates ownership-management controversy.

(iv) Management alone enjoy certain benefits.

(v) The ultimate aim of the wealth maximization

objectives is to maximize the profit. (vi) Wealth maximization can be activated only with

the help of the profitable position of the businessconcern.


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Profit Maximisation vs WealthMaximization

Profit maximisation is different from wealthmaximisation.

While the former is concerned with profits, that

is, the excess of revenues over cost, the latteraims at maximising the net present value offuture cash flows that are derived from costsand benefits.

Whatever may be the firms objectives, theanalysis of costs and benefits is the central

concern of all managerial decisions


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We will study a number of cost concepts and thendevelop a relationship between cost and output,both in short-run and long-run.

While on one hand, cost is the charge on revenuefrom which profits are found out, on the other, italso forms the basis of price, which is acomponent of revenue.

Thus, cost plays a pivotal role in determining theprofits of the firm.

C


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Cost concepts

There are various prevalent cost concepts. Cost is

understood differently for different purposes. Thedefinition of cost thus varies from decision to decision.

Cost may include price to be paid for a good, its

transportation, storage and handling expensesbesides other miscellaneous outflows.

Since different decisions are affected by different typesof costs, it is essential for a manager to understandwhich decision should consider which cost, that is, hemust identify the relevant cost.


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Actual Cost & Opportunity Costs

Costs that are actually incurred in acquiring or

producing a good or service are known asactual costs.

Since these costs are real cash outflows and are

generally recorded in the account books, theyare also called acquisition or accounting costs.

Any process of production requires input factorsto be used for producing an output. Each factorof production has its price. For land, it is rent,for labour it is wages, for capital it is interest

and so on.


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All these costs form the actual costs.

Cash outflows in the form of the expenditure /payments made by the firm to the suppliers offactors of production are only recorded by theaccountant in the account books of the firm.


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Resources seldom have a single use. Normallythey can be put to use in a number ofalternative ways.

A firm selects the best alternative and implementsit. In doing so, it rejects all the other uses of theresource.

Had the resources not been put to use in the bestalternative, they would have gone to the second

best alternative. Thus the price of the resource(cost to the firm) must be atleast equal to the


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Value of the resource in the next best alternativeuse. The opportunity cost is the notional cost ofsacrificing the alternatives.

In other words, it is the value of a resource in itsbest alternative use i.e the value that must beforgone in putting a resource to one particularuse.


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Example

Consider a firm that has Rs.100. With thisamount it can either make a fixed depositwith a bank and earn interest of 10% per

annum (p.a) or can purchase the factors ofproduction for Producing t-shirts


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Let the cost of land, labour, capital andmanagement be Rs.20, 35, and 10 respectively.

Thus, the actual cost of the production activity beRs.95.

The opportunity cost will however be Rs.10.

Producing T-Shirts Lost out opportunityRs.95 Rs.10


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Since opportunity cost is a notional concept, it isnot recorded in the books of accounts.

However, it should be considered in decision-making. It should be used as a break-even cost.

A firm should continue to be in business only tillthe time it is able to generate more profits thanwhat it would have made in an alternative


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Business, in case of two alternatives, or thenext best alternative, in case of manyalternatives.


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Fixed Costs & Variable CostsIn economics, fixed costs are business

expenses that are not dependent on theactivities of the business. They tend to be time-related, such as salaries or rents being paid permonth.

This is in contrast to variable costs, which are

volume-related (and are paid per quantity.)

Fi d t i t t Th i ht i t
http://en.wikipedia.org/wiki/Expenseshttp://en.wikipedia.org/wiki/Variable_costshttp://en.wikipedia.org/wiki/Variable_costshttp://en.wikipedia.org/wiki/Expenses


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Fixed cost remain constant. They might existeven if no output is produced.

On other hand, costs that vary with changes inoutput are known as variable costs.

The rent of building and factory, interest onborrowed capital, cost of plant and machineryetc. are all fixed costs,

hil th t f t i l t ll


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while the costs of raw material , wages etc are allvariable costs.

In other words, costs of fixed assets are all fixedcosts and those of current assets are variablecosts.

Explicit and Implicit Costs

I i i li it t h
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Economics


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In economics, an implicit cost occurs when oneforegoes an alternative action but does notmake an actual payment.

(For instance, the explicit cost of a night at themovies includes the moviegoer's ticket andsoda, but the implicit cost includes the pay hewould have earned if he had chosen to work

instead.) Implicit costs are related to forgonebenefits of any single transaction.
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Explicit_costhttp://en.wikipedia.org/wiki/Explicit_costhttp://en.wikipedia.org/wiki/Economics


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An Explicit cost is an easy accounted cost,such as wage, rent and materials. It canbe transacted in the form of money

payment and is lost directly, as opposed tomonetary implicit costs.

Explicit cost are those which theentrepreneur has to pay from his ownpocket

Today
http://en.wikipedia.org/wiki/Implicit_costhttp://en.wikipedia.org/wiki/Implicit_cost


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Today

- Understand Explicit and Implicit cost through examples

- Cost analysis continued with Average cost, Marginal Cost, TotalCost, Short-run costs and long-run costs (example: hockeysticks mfg)

- Discussion on Class activity of Opportunity cost of joining anMBA course

- Discussion on class activity of CSR

- Once again, MC, TC, FC, TVC, AVC, AFC,

- Case Study Bogus Manufacturing Company- Short notes

- Production Process and Production Function

- Understanding the graphs of costs

I li it C t E li it C t d T t l


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Implicit Costs, Explicit Costs, and TotalCosts

Implicit Cost + Explicit Cost is a component ofTotal Cost

A simple example:


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A simple example:

Thomas builds a cabinet.

He spends 2 hours building the cabinet.

He could have been working instead and normally

makes Rs.25/hour at his job. Since he was building acabinet he wasn't paid for this time.

The materials to make the cabinet cost him Rs.20.

His Explicit Costs are: Rs.20 in materials His Implicit Costs are: Rs.25/hr x 2 hrs= Rs.50 of

foregone pay

His Total Costs are: Rs.20 in materials + Rs.50 of

foregone pay = Rs.70 Total Costs


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Implicit costs are intangible costs that are noteasily accounted for or defined clearly at alltimes.

For example, the time and effort that an ownerputs into the maintenance of the companyrather than working on expansion.

More e amples incl de


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More examples include

the value of an entrepreneurs labor and theinterest that could be earned were the owners

assets (including the values of stock incorporations) not tied up in the business.

In entering the software business and creating


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In entering the software business and creatingWindows, and subsequently Microsoft, BillGates dropped out of college and made a

conscious decision to surrender what wages hecould have made as a college graduate if hisendeavor failed.

Though it paid off for him, similar decisions aremade on a daily basis by people all over the

world and it doesnt always end favorably foreveryone.


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Firms must all bear both implicit and explicitcosts into consideration to make rationalbusiness decisions.

T t l t A C t d


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Total costs, Average Costs andMarginal costs

The sum total of all the costs : fixed, variable,explicit and implicit for the entire output, isknown as total cost.

Average cost is the cost per unit of output and iscomputed by dividing the total cost by the

number of units produced.

Marginal cost is the change in total cost due tothe production of one additional unit of output.

Short run costs & Long run costs


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Short-run costs & Long-run costs

Short-run is a period during which one ormore inputs of the firm are fixed. In thelong-run all the factors inputs are

variable.

Case study : Hockey sticks manufacturing

Raw materials such as lumber


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Raw materials such as lumber

Labor

Machinery

A factory

Suppose the demand forhockey sticks hasgreatly increased, prompting our company to

produce more sticks. We should be able to order more raw materials

with little delay, so we consider raw materials to

be a variable input. We'll need extra labor, but we can likelyincrease our labor supply by running an extrashift and getting existing workers to work

overtime, so this is also a variable input.


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The equipment on the other hand, may not be avariable input. It may be time consuming toimplement the use of additional equipment.

It depends how long it would take us to buy andinstall the equipment and how long it would takeus to train the workers to use it.

Adding an extra factory is certainly notsomething we could do in a short period of time,so this would be the fixed input.

Using the definitions given at the beginning we


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Using the definitions given at the beginning , wesee that the short run is the period in which wecan increase production by adding more raw

materials and more labor.

In the short run we cannot add another factory,

but in the long run all of our inputs are variable,including our factory space.

The increase in demand for hockey sticks will


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The increase in demand for hockey sticks willhave different implications in the short run andthe long run at the industry level.

In the short run each of the firms will increasetheir labor supply and raw materials to meetthe added demand for hockey sticks.

At first only existing firms will be likely tocapitalize on the increased demand as theywill be the only ones who will have access to

the four inputs needed to make the sticks.

However we know that in the long run the

factor input is variable as well.

This means that existing firms can change the


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This means that existing firms can change thesize and number of factories they own and newfirms can build or buy factories to produce

hockey sticks.

In the long run we will see new firms enter the

hockey stick market, while we will not in theshort run because firms will not be able toacquire all of the inputs they need.

Rent


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Rent

Fixed Depreciation of Plant

Depreciation of equipment

Costs

WagesInsurance

Variable Travel

TrainingFuel

Maintenance

Supplies

Cl A ti it


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Class Activity

Opportunity cost is not just monetary. Discussyour opportunity cost of attending college and

opting for MBA as the course.

Also, calculate, using the best estimates.

Should I go to work today?


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Should I go to work today?

Should I go to college after high school?

Should the government spend money on a newweapon system?

These are decisions that are made everyday;


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however, what is the cost of our decisions?

What is the cost of going to work, or the decisionnot to go to work?

What is the cost of college, or not to go tocollege?

Finally what is the cost of buying that weapon

system, or the cost of not buying that weapon?

In economics it is called opportunity cost.

Opportunity cost is the cost we pay when we


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Opportunity cost is the cost we pay when wegive up something to get something else.

There can be many alternatives that we give upto get something else, but the opportunity costof a decision is the most desirable alternativewe give up to get what we want

Lets look at the college example We are all


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Let s look at the college example. We are all

told to go to college so you can get a goodeducation and that will translate into a good

job.

How do we know that college is such a good

thing? How much college do we need?

There are distinct benefits of a college education.


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Higher Earnings - Earning a MBA degree provides the average student withover Rs.3,00000 p.a in future earnings. (on an average)

Increased level of education. That is, a Masters degree

For the society : People with higher education contribute time and money tocharitable causes at a higher rate than those with less education.

Increased levels of education are associated with the increased likelihood of

voting or registering to vote.

A better all-rounder individual.

Benefits include increased self-awareness, the ability to think critically, and

an opportunity to meet many different people. Overall, the entire collegeexperience will provide you with a lifetime of benefits.

As we can see there are many benefits to a college education.

So what are the costs?


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So what are the costs?

There are monetary costs for sure.

I am currently in a job which pays Rs.1,80,000a year.

Also, we will spend two or more years going toclasses. We could be working and earningmoney instead of going to college.(Rs.1,80,000x 2) = 3,60,000

Finally we will be giving up free time for studytime that could be used to do other things.


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Cost_concepts.doc

Production Analysis


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Production AnalysisProduction is a process of converting an input

into a more valuable output. The analysis ofdemand is mainly used for planning theproduction processes and determining the levelof production.

For equilibrium , supply should be equal todemand. Production is an aspect of the supply

side of the market.


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A firm must purchase all the necessary inputs


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A firm must purchase all the necessary inputsand then transform them into the product(outputs) that it wishes to sell.

For example a football shirt manufacturermustbuy the fabric, pay someone for a design, invest

in machinery, rent a factory and employworkers in order for the football shirts to bemade and then sold.

How well-organised a firm is at undertaking this


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How well organised a firm is at undertaking thistransformation process will determine itssuccess.

This is known as the productive efficiency ofa firm and it will want to be as efficient aspossible in transforming its inputs into outputs

(i.e. using the minimum number of inputs aspossible to achieve a set amount of output).

This will reduce the cost per unit of production

and allow the firm to sell at a lower price.

Ultimately, the objective of the production


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Ultimately, the objective of the productionprocess is to create goods and servicesthat meet the needs and wants of

customers.

The needs and wants of customers will be met

if a business can produce the correct numberof products, in the shortest possible time, tothe best quality and all at a competitive price.

Introduction to Production Function


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Introduction to Production Function

what is the production function of a

economy? The concept of the productionfunction is one of the most important andelegant contributions of economics to human

thought.

It is the recipe of inputs (factors of production)

for the output of a firm or nation and is definedby a given state of technical knowledge(Samuelson 1961, 570).

In symbolic form, a production function may be stated as:


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Y = f(K, L, N) t

where:

Y = output

f= some function of K = capital

L = labour

N = natural resources

t = time This reads: Output (Y) is some function (f) of capital (K), labour

(L) and natural resources (N) in a given time period (t). Ineffect, the state of technical knowledge, or technology, is

implicit in the f of the equation. It is the recipe. How much ofeach input, in what combinations and under what conditionscan ingredients be mixed to produce maximum output andminimize cost? It is also time specific, i.e., it has vintage.

An increase in any of these factors of production,


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y p ,when the other factors are constant, will lead toan increase in output.

Before moving ahead with the discussion, it willbe worthwhile to understand the basic nature ofthe factors of production.

Their meaning is not limited to what is ordinarilyunderstood. They have a much wider

connotation in economic theory.

For example in economics, land does not only


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p , ymean soil.

It comprises of all the natural resources thathave exchange value and can be used forproducing goods. Such resources include air,

light, heat

And water besides soil surface. These resources


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can be renewable or non-renewable. Similarly,in economic theory, capital goes beyond

money.It is that part of mans wealth, other than land,

which yields income. It is not an original factorof production, but a manmade instrument of

production. It includes a whole stock of wealthconsisting of machines, tools, raw material, fueland consumables. Capitalcan be fixed or

working. While the former capital can be usedfor production more than once till it finally wearsout, the latter capital is a singleuse producersgood.

Labour denotes all kinds of work done by man for


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ymonetary reward. Management consists ofbringing of all these three factors of production

together, putting them to work and seekingreturns while bearing the associated risks.

Generally , the output of any commodity is relatedto its inputs. Though the determinants may bealmost the same, their relative importance

varies from commodity to commodity. Considertwo commodities, a ball point pen and a mobilephone. Production of mobile phone requires

larger capital and technology plays more

Crucial role in it than compared to a ball point


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p ppen. Similarly, a diamond polishing processmay require larger capital but smaller land as

compared to a marble polishing process.

The concept of production function can be better

understood by considering two inputs for anoutput. Although any two inputs can beconsidered, we take labour and capital since

they are the most important variables of all.

Thus Q = f (L, K)

Different combinations of the two inputs will


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pproduce different quantities of output. Moreinputs should logically produce more output.

Say one unit of labor and one unit of capitalproduce one unit of output.

The following table illustrates this reasoning forsay, a garment exporting company. The tablegives the output matrix for cotton t-shirts for

different combinations of inputs.


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K

L

1 2 3 4 5

1 2 3 5 8 12

2 3 4 7 10 14

3 7 8 10 13 17


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The production function is basically a tool toanalyse the input-output relationship.


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Revision

Total Variable Cost

What it is:


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Variable costs are corporate expenses that vary indirect proportion to the quantity of output.

Unlike fixed costs, which remain constant regardless ofoutput, variable costs are a direct function ofproduction volume, rising whenever production

expands and falling whenever it contracts.

Examples of common variable costs include raw

materials, packaging, and labor directly involved in acompany's manufacturing process.

The formula for calculating total variable cost is:


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Total Variable Cost = Total Quantity of Output *

Variable Cost Per Unit of Output


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Class activity

Let's assume XYZ Company has received an order for5 000 units for a total sales price of Rs 5 000 and


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5,000 units for a total sales price of Rs.5,000 andwants to determine the gross profit that will begenerated by completing the order.

First, the variable costs per commodity must bedetermined.

Let's assume the following:

Annual units Produced - 100,000Raw Materials Costs - Rs.10,000

Direct Labor Costs - Rs.50,000

Determine Variable cost & Gross Profit


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From this information, we can conclude that each unit costs10 paise (Rs.10,000/100,000 units) in raw materials and50 paise (Rs.50,000/100,000 units) in direct labor costs.Using the formula above, we can calculate that XYZCompany's total variable cost on the order is:

5,000 * (Rs.0.10 + Rs.0.50) = Rs.3,000

Therefore, the company can reasonably expect to earn aRs.2,000 gross profit (Rs.5,000 - Rs.3,000) from theorder.


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Cost

Output

Short Run Total Cost Curve

TC

TVC

TFC

Y

O X

In figure , output is measured on the X axis.


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Since Total fixed cost remains constant whatever

the level of output, the total fixed cost curve(TFC) is parallel to the X-axis.

The curve starts from a point on the Y-axismeaning thereby that the total fixed cost will beincurred even if the output is zero.

On the other hand, the total variable cost curve(TVC) rises upward showing thereby that as theoutput is increased, the total variable costs also

increase.

The total variable cost (TVC) starts from the


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origin which shows that when output is zerothe variable costs are also nil.

It should be noted that total cost is a function ofthe total output, the greater the output , the

greater will be the total cost. In symbols, wecan write

TC = f(q)

Total cost curve (TC) has been obtained by


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adding up vertically , the total fixed cost curve

and total variable cost curve because the total

cost is the sum of total fixed cost and totalvariable cost.

The shape of the total cost curve (TC) is exactlythe same as that of total variable cost curve(TVC) because the same vertical distance

always separates the two curves.

There are difficulties in classifying fixed and


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marginal costs. Nevertheless, the distinctionmade is very useful in decision making.

It is essential for forecasting the effect of short-run changes in volume upon costs and

profits.

In the short-run , a profit maximising firm will

continue its operation so long as its viablecost is covered but in the long run, both fixedas well as variable costs must be covered.


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Cost Function

Definition of The Cost Function: The cost


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function is a function of input prices and outputquantity. Its value is the cost of making that

output given those input prices. A common form:

c(w1, w2, y) is the cost of making output

quantity y using inputs that cost w1 and w2 perunit.


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Marginal Cost

Marginal Cost (MC)


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The marginal cost of an additional unit of outputis the cost of the additional inputs needed to

produce that output. More formally, themarginal cost is the derivative of totalproduction costs with respect to the level of

output. Marginal cost and average cost can differ

greatly. For example, suppose it costs Rs.1000

to produce 100 units and Rs.1020 to produce101 units. The average cost per unit is Rs.10,but the marginal cost of the 101st unit is Rs.20


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Law of diminishing marginal utility


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What Does Law of Diminishing MarginalUtilityMean?

A law of economics stating that as a personincreases consumption of a product - whilekeeping consumption of other products constant- there is a decline in the marginal utility thatperson derives from consuming each additional

unit of that product.

explains Law of Diminishing MarginalUtility


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UtilityThis is the premise on which buffet-style

restaurants operate. They entice you with "all you can eat," allthe while knowing each additional plate offood provides less utility than the one

before. And despite their enticement, most people

will eat only until the utility they derive from

additional food is slightly lower than theoriginal.

For example say you go to a buffet and the first


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For example, say you go to a buffet and the firstplate of food you eat is very good. On a scale

of ten you would give it a ten.Now your hunger has been somewhat tamed,but you get another full plate of food. Sinceyou're not as hungry, your enjoyment rates at a

seven at best.Most people would stop before their utility drops

even more, but say you go back to eat a third

full plate of food and your utility drops evenmore to a three. If you kept eating, you wouldeventually reach a point at which your eatingmakes you sick, providing dissatisfaction,

or 'dis-utility'.


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Isoquant Curve

Isoquant Curve


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What Does Isoquant CurveMean?A graph of all possible combinations of inputs thatresult in the production of a given level of output. Usedin the study of microeconomics to measure theinfluence of inputs on the level of production or outputthat can be achieved.

explains Isoquant CurveIn Latin, "iso" means equal and "quant" refers toquantity. This translates to "equal quantity". Theisoquant curve helps firms to adjust their inputs tomaximize output and profits. At some point, thereturns of adding another worker or piece ofequipment will start to hurt output.


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Total Cost, Average Cost &


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Total Cost, Average Cost &Marginal Cost

Total Cost includes all cash payment madeto hired factors of production and all cashcharges imputed for the use of the owners

factors of production in acquiring orproducing a good or service.

Thus, the total cost of a firm is the sum total ofthe explicit plus implicit expenditure incurred


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the explicit plus implicit expenditure incurredfor producing a given level of output.

For example , a shoe makers example cost willinclude the amount he spends on leather,

thread, rent for his workshop , wages, intereston borrowed capital, salaries of employees etc.and the amount he charges for his services and

his own funds invested in the business.

Marginal cost is the extra cost of producing oneadditional unit


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additional unit.

At a given level of output, one examines theadditional costs of being incurred in producingone extra unit and this yields the marginal cost.

For example, if the total cost of a firm is Rs.5000when it produces 10 units of a good but when11 units of the good are produced , it increases

to Rs.5,300 then the marginal cost of the 11thunit is Rs.5300-5000 = Rs.300.

In other words, marginal cost of nth units(MC ) is the difference between total cost of nth


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(MCn) is the difference between total cost of nthunit (TCn) and total cost of n-1th unit (TCn).

MCn = TCn TCn-1


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The relationship between MC, AC and TC isshown in the following table

Units of goodsproduced

Total Cost (TC) Average Cost

3 = 2/1

Marginal Cost

(TCn- TCn-1)


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1 2 3

( n n-1)

4

10 5000 500 -

11 5300 481.82 300

12 5550 462.5 250

13 5700 438.46 150

14 5950 425 250

15 6350 423.33 400

The total cost concept is useful in break-evenanalysis and in finding out whether a firm is


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analysis and in finding out whether a firm ismaking profits or not.

The average cost concept is significant forcalculating the per unit profit of a business

concern.

The marginal and incremental cost concepts are

needed in deciding whether a firm needs toexpand its production or not.


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In fact , the relevant costs to beconsidered will differ from one situation tothe other depending on the problem faced

by the manager.

TC = FC + VC


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ATC = TC/Q

AFC = FC/Q

AVC = VC/Q

ATC = AFC + AVC

O t t Fi d C t V i bl T t l A A A


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Output

1

Fixed Cost

(TFC)

2

VariableCosts (TVC)

3

TotalCosts

AverageFixed Costs

AverageVariableCosts

AverageCosts

4 50 50

5 50 60

10 50 100

11 50 106

17 50 150

18 50 157

21 50 182


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Managerial Economics devotes a great deal ofattention to the behavior of costs


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attention to the behavior of costs.

Total Cost varies directly with output. The moreoutput a firm produces , the higher will be itsproduction costs and vice versa,

This is because increased production requiresuse of raw materials, labour, etc and if the

increase is substantial even fixed inputs likeplant and equipments and managerial staff mayhave to be increased.


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The relationship between cost and output israther important.

Revisiting 1st Chapter


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Revisiting 1st Chapter

Conventional theory of firm assumes profitmaximization is the sole objective of business


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maximization is the sole objective of businessfirms.

But recent researches on this issue reveal thatthe objectives the firms pursue are more thanone.

Some important objectives, other than profitmaximization are:


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maximization are:

(a) Maximization of the sales revenue

(b) Maximization of firms growth rate

(c) Making satisfactory rate of Profit

(d) Long run Survival of the firm

(e) Risk-avoidance

Accounting versus Economic Profit

Everyone strives to acquire as much profit as


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Everyone strives to acquire as much profit aspossible.

Profit is the positive gain from an investment orbusiness operation after subtracting all the

expenses.

Yet despite the evident importance given tosuch concept, profit remains to be one of themost misunderstood features of finance.


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These costs may include opportunity cost ofcapital


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capital.

Accounting profit, on the other hand, pertainsto the difference between the price and thecosts of setting up in the market whatever

enterprise you have.

These costs include the component cost of

delivered services and goods, as well as,operating costs.

An economic profit is acquired whenever therevenue exceeds the total opportunity cost of its


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pp yinputs.

The opportunity cost here is the value ofopportunity given up.

In calculating economic profit, the opportunitycost is opportunity cost is deducted from therevenues earned.

These opportunity costs are the alternativereturns forgone by using the selected inputs.

Accountants measure profit differently. They do it in terms of the sales of firms less


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They do it in terms of the sales of firms lesscosts like wages, rent, fuel, raw materials,

interest on loans and depreciation.

Profit is synonymous to income.

Accounting profits is mainly the companys total

earnings, calculated based on the Generally

Accepted Accounting Principles (GAAP).

To distinguish between economic andaccounting profit, we can look at this little


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accounting profit, we can look at this littlescenario.

Dana imports clothes from Thailand and sellsthem from her home.

She collects around Rs.500,000 annualrevenue. Around Rs.200,000 of that money is

spent on clothes and shipping costs andRs.30,000 on accounting services and utilities.

Before she was engaged in this business,Dana was making Rs.100,000 yearly by


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Dana was making Rs.100,000 yearly byworking in a publication agency.

Now she is working on her garage.

Danas accounting profit is Rs.270,000.

Accounting profit is equals annual revenue(Rs.500,000) decreased with expenses


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(Rs.500,000) decreased with expenses[(Rs.200,000) + (Rs.30,000)].

In finding the economic profit, we will have tosubtract the opportunity cost (the job Dana left

to invest in her current endeavor) to theaccounting profit gained.

That is Rs.270,000 - Rs.100,000, which thenresults to Rs.170,000.

Well, fairly easy right. It didnt take muchcalculation to find the economic and accounting


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calculation to find the economic and accountingprofit.

It is important the traders and investorscarefully analyze the economic and accounting

profit because these enables them to evaluatetheir personal investment strategy, prospectivemarkets, as well as, performances.


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Veblon effect

A commodity is a Veblen good if people'spreference for buying it increases as a direct


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p y gfunction of its price. The definition does not

require that any Veblen goods actually exist.

However, it is claimed that some types of high-

status goods, such as expensive wines orperfumes are Veblen goods, in thatdecreasing their prices decreasespeople's

preference for buying them because they areno longer perceived as exclusive or highstatus products.
http://www.economicexpert.com/a/Wine.htmhttp://www.economicexpert.com/a/Perfume.htmhttp://www.economicexpert.com/a/Perfume.htmhttp://www.economicexpert.com/a/Wine.htm


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The Veblen effect is named after theeconomist Thorstein Veblen, who inventedthe concepts ofconspicuous consumption

and status-seeking .

A giffen good is a type of inferior good (a goodthat people buy more of when their income
http://www.economicexpert.com/a/Thorstein:Veblen.htmhttp://www.economicexpert.com/a/Conspicuous:consumption.htmhttp://www.economicexpert.com/a/Conspicuous:consumption.htmhttp://www.economicexpert.com/a/Thorstein:Veblen.htm


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p p ygoes down).

Giffen goods are goods that are substitutes for amore expensive good, that people buy more ofwhen they cannot afford a superior good.

The classic example of a giffen good is bread forthe very poor. If their income falls, they will stop

buying luxuries such as meat, and will buy morebread instead to fill themselves up.

A veblen good is a good that people buybecause it is expensive, as a show of wealth.


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p ,

Therefore it is a superior good with respect toincome, but if the price falls, less of the goodwill be demanded

Advertisement elasticity or Promotional elasticity The expenditure in advertisement and other sales


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promotion activities does help in promoting sales, butnot in the same degree at all levels of the total sales.The concept of advertisement elasticity is useful indetermining the optimum level of advertisementexpenditure. It may be defined as, the

responsiveness of demand to changes in advertisingor other promotional expenses.

EA =

Proportionate change in sales

-------------------------------------------------------------

Proportionate change in advertising and otherpromotional expenditure


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Back to Cost Analysis

MARGINAL RETURNS: The change in the quantity of total product


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The change in the quantity of total productresulting from a unit change in a variable input,

holding all other inputs fixed. Marginal returns is an older and more generic

term for marginal product.

While marginal product has largely replacedmarginal returns in most discussions of short-

run production, the phrase does persist in a fewterms like the law of diminishing marginalreturns.

Two Returns Marginal returns can either increase or


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Marginal returns can either increase ordecrease.

Increasing Marginal Returns: Increasingmarginal returns occurs during the course ofshort-run production by a firm if an increase in

the variable input results in an increase in themarginal product of the variable input.

Increasing marginal returns typically surfacewhen the first few quantities of a variable inputare added to a fixed input.

Decreasing Marginal Returns: Decreasingmarginal returns results with short-run


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gproduction if an increase in the variable input

results in a decrease in the marginal product ofthe variable input.

Decreasing marginal returns usually emergeonly after the first few quantities of a variableinput are added to a fixed input and persist

throughout production.

A Big, Empty Factory How about an example to illustrate marginal


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How about an example to illustrate marginalreturns?.

Suppose that a car factory is producing thewildly popular Sports Coupe in its two-million


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square foot assembly plant located on the

outskirts of a town.This assembly plant is filled with the machinery,

tools, and equipment needed to produce

Sports Coupes.

In the short run, this capital, the assembly plantand related equipment, is fixed.


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To produce cars, the factory needs workers.The vast size of this plant, means that carcompany can easily provide separate

productive tasks (installing engines, paintingthe exterior, checking the horn) for severalthousand workers

First, Increasing Marginal Returns

What happens when workers are added?


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What happens when workers are added?

The first few hundred workers hired by carcompany are bound to make increasingly moreeffective use of this enormous plant. If carcompany employs only a dozen or so workers,each performs a wide range of unrelated tasksusing a wide range of capital equipment.


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A relatively small contingent of labor is not able toeffectively use the fixed capital.


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This means that each additional worker employed

can use the capital more effectively.

Each worker can concentrate on a specific task.

This gives rise to increasing marginal returns,increasing marginal product, and the upward-

sloping segment of the marginal product curve.

Next, Decreasing Marginal Returns However, as the workforce continues to


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,expand, the capacity of the fixed capital is

approached. Workers have to share theequipment and substitute for each other onlunch and coffee breaks. Some workers might

do nothing but assist other workers.

While the efforts of these extra workers doesincrease total production, the incremental


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increase declines for each one. This gives rise

to decreasing marginal returns, decreasingmarginal product, and the downward-slopingsegment of the marginal product curve.

Most important, decreasing marginal returns isa reflection of the key principle underlying thestudy of short-run production--the law ofdiminishing marginal returns.

AVC


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Average variable cost is the total variable cost

divided by the number of units of outputproduced.

TVC

Therefore AVC = ------

Q

Thus, average variable cost is the variable costper unit of output.


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Due to the first increasing and thendecreasing marginal returns to variableinput, average product initially rises,

reaches maximum and then declines.


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Case Study

Output of Funky Trousers

Now we get into the most interesting andimportant cost curve, the Marginal Cost Curve.


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It is the additional cost of producing one more unitand later on will allow us to maximize profits.


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Output (FunkyTrousers)

Short-Run /TotalCost

Short Run/Marginal Cost


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The calculations start with the first unit, as the cost went from$36 to $44, the marginal cost of producing the first unit is $8($44-$36), for the second unit the cost is $4, and so on.


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The arrows illustrate that the marginal cost is the additionalcost of producing one more unit. Suppose someone offers

you $25 for the eight pair of trousers, would you sell it at$25? How much did it cost you to sew that particular pair?($17, so sell!) The graph below shows why the Marginal Costis more challenging to understand, notice that the coordinatesare not exactly at 1,2,3..units, they are graphed at 0.5,1.5,2.5,etc.

This is because the MC starts increasing as you startproducing the units. In this case imagine you got your clothand you add a zipper, costs have increased yet you are not

finished with the pair of trousers. In order to reflect thatgraphically economists graph the MC at mid point to accountfor the transition. This is a bit confusing yet useful in drawingaccurate graphs and arriving at accurate conclusions!


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Marginal cost generally falls as the quantityincreases because people learn to do their jobsb tt th d d th


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better as they produce more, and the

equipment is more fully utilized.

However, the increase in Marginal Cost

continues only up to a point. At a certain point,marginal cost -- the additional cost to produceone more unit -- begins to increase because

inefficiencies develop as production increases.

The staff is trying to do more with the same amount of

equipment, perhaps, and the equipment may bei d h dl h l


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inadequate to handle the volume.

The result is that inventory stacks up at a machine thatis the "bottleneck" for the operation, or perhaps themachines keep breaking down because they arebeing operated too intensively without adequate

maintenance.

Or there are simply not enough machines to keep all ofthe people busy, so people are standing around

waiting to get onto a machine. So marginal costbegins to increase. This is called the "law ofdiminishing returns."

The law of diminishing returns states that as


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additional units of a variable resource such as

labor are added to a fixed resource such asequipment, beyond some point the extra(marginal) product attributed to each additional

unit of the variable resource will decline.

This is not saying that the later units of the resource areof lower quality than the early ones.

With labor for example each successive worker added


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With labor, for example, each successive worker addedis assumed to have the same ability, education,training and work experience.

The reason that marginal product diminishes is not

because successive workers do not do as good a jobas the other workers. It is because more workers arebeing used relative to the amount of plant andequipment available, and this leads to inefficiencies.

Marginal cost decreases and then begins to riseafter its lowest point because of the relationshipbetween marginal product and marginal costs


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between marginal product and marginal costs.

The marginal cost of each additional unit will fallas long as the marginal product of each addedvariable resource is rising.

But when the marginal product of each added

variable resource begins to decline, marginalcost begins to increase.

One worker can be hired for $20 per hour, andduring one hour's time, that one worker canprod ce 10 nits of prod ct


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produce 10 units of product.

Marginal product is 10 (10 - 0).

The average marginal cost of labor is $______per unit

One worker can be hired for $20 per hour, andduring one hour's time, that one worker canproduce 10 units of product


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produce 10 units of product.

Marginal product is 10 (10 - 0).

The average marginal cost of labor is $__2____per unit($20/ 10)

A second worker is hired, also for $20 per hour,so the total hourly labor cost is now $_____,and the marginal cost is $ per hour


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and the marginal cost is $____ per hour.

The second worker and the first worker togethercan produce 25 units per hour, so marginal

product is _______ units per hour .

The average marginal labor cost of those

additional 15 units is $20 / 15, or $1.33 per unit.

A second worker is hired, also for $20 per hour,so the total hourly labor cost is now $40, andthe marginal cost is $20 per hour ($40 $20)


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the marginal cost is $20 per hour ($40 - $20).

The second worker and the first worker togethercan produce 25 units per hour, so marginal

product is 15 units per hour (25 units - 10 units).

The average marginal cost of those additional 15

units is $20 / 15, or $1.33 per unit.

A third worker is hired, and the hourly cost goesup by another $20.


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The three workers together can produce 45units per hour, so marginal product is _____units per hour.

The average marginal cost of the additional 20units is $20 / 20, or $1.00 per unit.

The marginal product in terms of hourly output isrising, so the average marginal cost per unit oflabor is falling.

A third worker is hired, and the hourly cost goesup by another $20.


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The three workers together can produce 45 unitsper hour, so marginal product is 20 units perhour (45 - 25 units).

The average marginal cost of the additional 20units is $20 / 20, or $1.00 per unit.

The marginal product in terms of hourly output isrising, so the marginal cost per unit is falling.

A fourth worker is added, and labor cost per


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A fourth worker is added, and labor cost perhour increases by another $20.

In one hour, the four workers can produce 60units.

Marginal product per hour is now ______(60 - 45units).

Marginal product is now falling, because of thelaw of diminishing returns.

The marginal labor cost of these additional 15units is $20 / 15, or $1.33 per unit.


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Now, the marginal cost of labor is rising, becausethe marginal product is falling.

This will continue until the diminishing marginalreturns turn into negtive marginal returns.Because of increasing inefficiencies, the

marginal product will finally become negativebecause total product will actually decreasewhen additional workers are hired.

A fourth worker is added and labor cost per


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A fourth worker is added, and labor cost per

hour increases by another $20.

In one hour, the four workers can produce 60

units.

Marginal product per hour is now 15 (60 - 45

units). Marginal product is now falling, becauseof the law of diminishing returns. The marginallabor cost of these additional 15 units is $20 /

15 or $1 33 per unit

Now, the marginal cost of labor is rising,because the marginal product is falling.


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This will continue until the diminishing marginalreturns turn into negtive marginal returns.

Because of increasing inefficiencies, themarginal product will finally become negativebecause total product will actually decrease

when additional workers are hired.


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Indifference Curve Analysis

An theory of consumer demand was putforward by J.R Hicks and R.G.D. Allen.


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This approach considers utility to be ordinal i.eit cannot be measured but can only be rankedor compared.

Thus, while under the utility analysis it could besaid that a person got 10 utils from ice cream

and 6 utils from rasgulla, under this approach itcan only be said that ice cream gives moreutility to the person than rasgulla.

Assumptions


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The assumptions of the indifference curveanalysis are

1. Utility is ordinal2. Utility being subjective is rank able but not

measurable

3. The consumer is a rational4. The income of the consumer is limited and

constant.


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The tastes and preferences of the consumerremain unchanged


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Consumers generally consume products aspart of a group of goods and servicesrather than as individual products.

As a large number of goods and servicesare available, a wide array of combinationsexist. And it is very possible that a number

of these combinations will give the samelevel of satisfaction to the consumer.

Indifference Curve

Th l f i t h ti diff t


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The locus of points, each representing a different

combination of two goods, which provide thesame level of utility to the consumer is knownas the indifference curve.

The curve derives its name from the fact that aconsumer is indifferent to any of these

combinations when it comes to making a choicebetween them.


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For the sake of simplicity we assume thatthere is continuous and not incrementalvariation in consumption.

What results then is a smoothened curve.

Combination AppleX

Mango Y Total Utility(TU)

A 1 30 U


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A 1 30 U

B 2 24 U

C 3 19 U

D 4 15 U

E 5 12 U

F 6 10 U

G 7 9 U


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We can now enumerate certain essentialcharacteristics of indifference curves


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1 Indifference curves are downward sloping

This is because for the same level of utility if the

demand of one commodity increases, thedemand for the second commodity has todecrease

2 Indifference curves are convex to origin.

Thi i b t d t b f t


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This is because two goods cannot be perfect

substitutes for each other.As the consumer gets larger quantities of one

commodity X at the cost of another commodity

Y, marginal utility of X decreases.

Due to reduced availability of Y, the marginal

utility of Y (i.e ) MUy increases. Thus, the

managerial economicsiii

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