Managerial Economics

Cost Analysis

• 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 is the measuring techniques to understand the business efficiency of the concern. • Profit maximization is also the traditional and narrow approach, which aims at, 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 considers all the possible ways to increase the profitability of the concern. • 3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. • 4. Profit maximization objectives help to reduce the risk of the business.

• Favourable Arguments for Profit Maximization • The following important points are in support of the profit maximization objectives of the business 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.

public shareholders. . etc. etc. suppliers. unfair trade practice.• Unfavourable Arguments for Profit Maximization • The following important points are against the objectives of profit maximization: • (i) Profit maximization leads to exploiting workers and consumers. • (ii) Profit maximization creates immoral practices such as corrupt practice. • (iii) Profit maximization objectives leads to inequalities among the sake holders such as customers.

• (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. Risks may be internal or external which will affect the overall operation of the business concern. • (iii) It ignores risk: Profit maximization does not consider risk of the business concern. It creates some unnecessary opinion regarding earning habits of the business concern.• Drawbacks of Profit Maximization • Profit maximization objective consists of certain drawback also: • (i) It is vague: In this objective. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. profit is not defined precisely or correctly. .

which involves latest innovations • and improvements in the field of the business concern. . • Wealth maximization is also known as value maximization or net present worth • maximization.• Wealth Maximization • Wealth maximization is one of the modern approaches. The term wealth means shareholder • wealth or the wealth of the persons those who are involved in the business concern. This objective is an universally accepted concept in the field of business.

• (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. It provides extract value of the business concern.• Favourable Arguments for Wealth Maximization • (i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. • (v) It ensures the economic interest of the society. • (iii) Wealth maximization considers both time and risk of the business concern. . Total value detected from the total cost incurred for the business operation. • (iv) Wealth maximization provides efficient allocation of resources.

it is also profit maximization. . • (ii) Wealth maximization is nothing. it is the indirect name of the profit maximization. • (vi) Wealth maximization can be activated only with the help of the profitable position of the business concern. • (v) The ultimate aim of the wealth maximization objectives is to maximize the profit.• Unfavourable Arguments for Wealth Maximization • (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. • (iii) Wealth maximization creates ownershipmanagement controversy. • (iv) Management alone enjoy certain benefits.

Profit Maximisation vs Wealth Maximization Profit maximisation is different from wealth maximisation. Whatever may be the firms objectives. the excess of revenues over cost. the latter aims at maximising the net present value of future cash flows that are derived from costs and benefits. that is. the analysis of costs and benefits is the central concern of all managerial decisions . While the former is concerned with profits.

cost is the charge on revenue from which profits are found out.We will study a number of cost concepts and then develop a relationship between cost and output. which is a component of revenue. both in short-run and long-run. on the other. Thus. it also forms the basis of price. While on one hand. . cost plays a pivotal role in determining the profits of the firm.

Cost may include price to be paid for a good. The definition of cost thus varies from decision to decision. Cost is understood differently for different purposes. he must identify the relevant cost. that is. . Since different decisions are affected by different types of costs. storage and handling expenses besides other miscellaneous outflows. its transportation.Cost concepts There are various prevalent cost concepts. it is essential for a manager to understand which decision should consider which cost.

For land. for capital it is interest and so on. they are also called acquisition or accounting costs. Any process of production requires input factors to be used for producing an output. Since these costs are real cash outflows and are generally recorded in the account books.Actual Cost & Opportunity Costs Costs that are actually incurred in acquiring or producing a good or service are known as actual costs. Each factor of production has its price. for labour it is wages. . it is rent.

Cash outflows in the form of the expenditure / payments made by the firm to the suppliers of factors of production are only recorded by the accountant in the account books of the firm. .All these costs form the actual costs.

Had the resources not been put to use in the best alternative. A firm selects the best alternative and implements it. Thus the price of the resource (cost to the firm) must be atleast equal to the . it rejects all the other uses of the resource. In doing so. Normally they can be put to use in a number of alternative ways. they would have gone to the second best alternative.Resources seldom have a single use.

it is the value of a resource in its best alternative use i. . In other words.e the value that must be forgone in putting a resource to one particular use. The opportunity cost is the notional cost of sacrificing the alternatives.Value of the resource in the next best alternative use.

a) or can purchase the factors of production for Producing t-shirts .100.Example Consider a firm that has Rs. With this amount it can either make a fixed deposit with a bank and earn interest of 10% per annum (p.

95 Rs. Thus.Let the cost of land. Producing T-Shirts Lost out opportunity Rs. the actual cost of the production activity be Rs.95. labour. capital and management be Rs.20. 35.10.10 . The opportunity cost will however be Rs. and 10 respectively.

it should be considered in decisionmaking. It should be used as a break-even cost. A firm should continue to be in business only till the time it is able to generate more profits than what it would have made in an alternative . However.Since opportunity cost is a notional concept. it is not recorded in the books of accounts.

Business. in case of two alternatives. in case of many alternatives. . or the next best alternative.

which are volume-related (and are paid per quantity.Fixed Costs & Variable Costs In economics. This is in contrast to variable costs. fixed costs are business expenses that are not dependent on the activities of the business. such as salaries or rents being paid per month. They tend to be timerelated.) .

On other hand. are all fixed costs. . cost of plant and machinery etc.Fixed cost remain constant. They might exist even if no output is produced. costs that vary with changes in output are known as variable costs. The rent of building and factory. interest on borrowed capital.

while the costs of raw material . wages etc are all variable costs. Explicit and Implicit Costs . In other words. costs of fixed assets are all fixed costs and those of current assets are variable costs.

In economics. (For instance. . the explicit cost of a night at the movies includes the moviegoer's ticket and soda. an implicit cost occurs when one foregoes an alternative action but does not make an actual payment.) Implicit costs are related to forgone benefits of any single transaction. but the implicit cost includes the pay he would have earned if he had chosen to work instead.

as opposed to monetary implicit costs. such as wage. rent and materials. Explicit cost are those which the entrepreneur has to pay from his own pocket . It can be transacted in the form of money payment and is lost directly.An Explicit cost is an easy accounted cost.

Discussion on class activity of CSR . AVC. Marginal Cost.Understand Explicit and Implicit cost through examples . AFC.Production Process and Production Function .Short notes .Today .Discussion on Class activity of Opportunity cost of joining an MBA course . FC. . TC.Understanding the graphs of costs .Case Study – Bogus Manufacturing Company . Short-run costs and long-run costs (example: hockey sticks mfg) .Cost analysis continued with Average cost. Total Cost. MC. TVC.Once again.

Explicit Costs. and Total Costs • Implicit Cost + Explicit Cost is a component of Total Cost • .• Implicit Costs.

Since he was building a cabinet he wasn't paid for this time.• A simple example: • Thomas builds a cabinet.25/hr x 2 hrs= Rs.25/hour at his job. • His Explicit Costs are: Rs.50 of foregone pay • His Total Costs are: Rs.50 of foregone pay = Rs. • He spends 2 hours building the cabinet.70 Total Costs .20 in materials + Rs. • He could have been working instead and normally makes Rs.20 in materials • His Implicit Costs are: Rs.20. • The materials to make the cabinet cost him Rs.

the time and effort that an owner puts into the maintenance of the company rather than working on expansion. . For example.Implicit costs are intangible costs that are not easily accounted for or defined clearly at all times.

More examples include the value of an entrepreneur‟s labor and the interest that could be earned were the owners‟ assets (including the values of stock in corporations) not tied up in the business. .

.In entering the software business and creating Windows. Bill Gates dropped out of college and made a conscious decision to surrender what wages he could have made as a college graduate if his endeavor failed. Though it paid off for him. and subsequently Microsoft. similar decisions are made on a daily basis by people all over the world and it doesn‟t always end favorably for everyone.

.Firms must all bear both implicit and explicit costs into consideration to make rational business decisions.

Total costs. explicit and implicit for the entire output. Average cost is the cost per unit of output and is computed by dividing the total cost by the number of units produced. . Marginal cost is the change in total cost due to the production of one additional unit of output. Average Costs and Marginal costs The sum total of all the costs : fixed. variable. is known as total cost.

Case study : Hockey sticks manufacturing . In the long-run all the factors inputs are variable.Short-run costs & Long-run costs Short-run is a period during which one or more inputs of the firm are fixed.

so this is also a variable input. . so we consider raw materials to be a variable input.• • • • • Raw materials such as lumber Labor Machinery A factory Suppose the demand for hockey sticks has greatly increased. • We should be able to order more raw materials with little delay. prompting our company to produce more sticks. but we can likely increase our labor supply by running an extra shift and getting existing workers to work overtime. • We'll need extra labor.

so this would be the fixed input. • It depends how long it would take us to buy and install the equipment and how long it would take us to train the workers to use it. • Adding an extra factory is certainly not something we could do in a short period of time. It may be time consuming to implement the use of additional equipment. may not be a variable input. .• The equipment on the other hand.

including our factory space. we see that the short run is the period in which we can increase production by adding more raw materials and more labor. .• Using the definitions given at the beginning . but in the long run all of our inputs are variable. • In the short run we cannot add another factory.

• In the short run each of the firms will increase their labor supply and raw materials to meet the added demand for hockey sticks. • However we know that in the long run the factor input is variable as well.• The increase in demand for hockey sticks will have different implications in the short run and the long run at the industry level. . • At first only existing firms will be likely to capitalize on the increased demand as they will be the only ones who will have access to the four inputs needed to make the sticks.

• This means that existing firms can change the size and number of factories they own and new firms can build or buy factories to produce hockey sticks. . while we will not in the short run because firms will not be able to acquire all of the inputs they need. • In the long run we will see new firms enter the hockey stick market.

Fixed Rent Depreciation of Plant Depreciation of equipment Costs Wages Insurance Travel Training Fuel Maintenance Supplies Variable .

Discuss your opportunity cost of attending college and opting for MBA as the course. . using the best estimates. calculate. Also.Class Activity “Opportunity cost is not just monetary”.

.Should I go to work today? Should I go to college after high school? Should the government spend money on a new weapon system? These are decisions that are made everyday.

or the cost of not buying that weapon? In economics it is called opportunity cost. or not to go to college? Finally what is the cost of buying that weapon system. or the decision not to go to work? What is the cost of college. .however. what is the cost of our decisions? What is the cost of going to work.

There can be many alternatives that we give up to get something else.Opportunity cost is the cost we pay when we give up something to get something else. but the opportunity cost of a decision is the most desirable alternative we give up to get what we want .

• How do we know that college is such a good thing? How much college do we need? .• Let‟s look at the college example. We are all told to go to college so you can get a good education and that will translate into a good job.

a Master‟s degree • For the society : People with higher education contribute time and money to charitable 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. and an opportunity to meet many different people. the entire college experience will provide you with a lifetime of benefits. Overall. • Benefits include increased self-awareness. (on an average) • Increased level of education.Earning a MBA degree provides the average student with over Rs. . • Higher Earnings .00000 p.3.a in future earnings. • A better all-rounder individual.• “There are distinct benefits of a college education. the ability to think critically. • As we can see there are many benefits to a college education. That is.

. (Rs.80. • I am currently in a job which pays Rs.1.000 a year.1. We could be working and earning money instead of going to college.000 • Finally we will be giving up free time for study time that could be used to do other things. • Also.80.• So what are the costs? • There are monetary costs for sure.000x 2) = 3.60. we will spend two or more years going to classes.

doc .Cost_concepts.

Production is an aspect of the supply side of the market.Production Analysis Production is a process of converting an input into a more valuable output. . For equilibrium . The analysis of demand is mainly used for planning the production processes and determining the level of production. supply should be equal to demand.

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rent a factory and employ workers in order for the football shirts to be made and then sold. • For example a football shirt manufacturer must buy the fabric. . pay someone for a design. invest in machinery.• A firm must purchase all the necessary inputs and then transform them into the product (outputs) that it wishes to sell.

. using the minimum number of inputs as possible to achieve a set amount of output).• How well-organised a firm is at undertaking this transformation process will determine its success.e. • This is known as the productive efficiency of a firm and it will want to be as efficient as possible in transforming its inputs into outputs (i. • This will reduce the cost per unit of production and allow the firm to sell at a lower price.

the objective of the production process is to create goods and services that meet the needs and wants of customers.• Ultimately. in the shortest possible time. . to the best quality and all at a competitive price. • The needs and wants of customers will be met if a business can produce the correct number of products.

570). . • It is the recipe of inputs (factors of production) for the output of a firm or nation and is defined “by a given state of technical knowledge” (Samuelson 1961.Introduction to Production Function • what is the production function of a economy? The concept of the production function is one of the most important and elegant contributions of economics to human thought.

• • • • • • • • • • In symbolic form. in what combinations and under what conditions can ingredients be mixed to produce maximum output and minimize cost? It is also time specific. the state of technical knowledge. 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). it has vintage. is implicit in the „f‟ of the equation. a production function may be stated as: Y = f (K. i. How much of each input.e. It is the recipe. labour (L) and natural resources (N) in a given time period (t). . or technology. In effect..

They have a much wider connotation in economic theory. it will be worthwhile to understand the basic nature of the factors of production. Their meaning is not limited to what is ordinarily understood. will lead to an increase in output. Before moving ahead with the discussion. when the other factors are constant. .An increase in any of these factors of production.

land does not only mean soil.For example in economics. It comprises of all the natural resources that have exchange value and can be used for producing goods. Such resources include air. light. heat .

but a man –made instrument of production. . capital goes beyond money. tools. which yields income. in economic theory. These resources can be renewable or non-renewable. fuel and consumables. While the former capital can be used for production more than once till it finally wears out. It is not an original factor of production.And water besides soil surface. the latter capital is a single –use producers good. Capital can be fixed or working. other than land. Similarly. It is that part of man‟s wealth. It includes a whole stock of wealth consisting of machines. raw material.

Consider two commodities. Management consists of bringing of all these three factors of production together. Production of mobile phone requires larger capital and technology plays more . Generally .Labour denotes all kinds of work done by man for monetary reward. a ball point pen and a mobile phone. Though the determinants may be almost the same. the output of any commodity is related to its inputs. their relative importance varies from commodity to commodity. putting them to work and seeking returns while bearing the associated risks.

Although any two inputs can be considered. Similarly. a diamond polishing process may require larger capital but smaller land as compared to a marble polishing process. Thus Q = f (L.Crucial role in it than compared to a ball point pen. The concept of production function can be better understood by considering two inputs for an output. K) . we take labour and capital since they are the most important variables of all.

The following table illustrates this reasoning for say. Say one unit of labor and one unit of capital produce one unit of output. . More inputs should logically produce more output.Different combinations of the two inputs will produce different quantities of output. The table gives the output matrix for cotton t-shirts for different combinations of inputs. a garment exporting company.

K 1 2 3 4 5 L 1 2 3 2 3 7 3 4 8 5 7 10 8 10 13 12 14 17 .

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

Revision Total Variable Cost .

. Examples of common variable costs include raw materials. rising whenever production expands and falling whenever it contracts. variable costs are a direct function of production volume. which remain constant regardless of output. Unlike fixed costs. packaging.What it is: Variable costs are corporate expenses that vary in direct proportion to the quantity of output. and labor directly involved in a company's manufacturing process.

The formula for calculating total variable cost is: Total Variable Cost = Total Quantity of Output * Variable Cost Per Unit of Output

Class activity

Let's assume XYZ Company has received an order for 5,000 units for a total sales price of Rs.5,000 and wants to determine the gross profit that will be generated by completing the order.

First, the variable costs per commodity must be determined.
Let's assume the following: Annual units Produced - 100,000 Raw Materials Costs - Rs.10,000 Direct Labor Costs - Rs.50,000 Determine Variable cost & Gross Profit

10. Using the formula above.000/100.3.50. . we can conclude that each unit costs 10 paise (Rs.000 .0.000/100.3.Rs.000 gross profit (Rs.50) = Rs.000 units) in direct labor costs.2. the company can reasonably expect to earn a Rs.000 units) in raw materials and 50 paise (Rs.10 + Rs.000 Therefore.000) from the order. we can calculate that XYZ Company's total variable cost on the order is: 5.5.0.From this information.000 * (Rs.

Short Run Total Cost Curve Y TC Cost TVC TFC O Output X .

the total fixed cost curve (TFC) is parallel to the X-axis. . The curve starts from a point on the Y-axis meaning thereby that the total fixed cost will be incurred even if the output is zero. On the other hand. the total variable cost curve (TVC) rises upward showing thereby that as the output is increased. Since Total fixed cost remains constant whatever the level of output. the total variable costs also increase.In figure . output is measured on the X axis.

the greater the output . the greater will be the total cost.The total variable cost (TVC) starts from the origin which shows that when output is zero the variable costs are also nil. we can write TC = f(q) . In symbols. It should be noted that total cost is a function of the total output.

the total fixed cost curve and total variable cost curve because the total cost is the sum of total fixed cost and total variable cost. The shape of the total cost curve (TC) is exactly the same as that of total variable cost curve (TVC) because the same vertical distance always separates the two curves.Total cost curve (TC) has been obtained by adding up “vertically” . .

the distinction made is very useful in decision making. a profit maximising firm will continue its operation so long as its viable cost is covered but in the long run. In the short-run . both fixed as well as variable costs must be covered. Nevertheless. .There are difficulties in classifying fixed and marginal costs. It is essential for forecasting the effect of shortrun changes in volume upon costs and profits.

Cost Function .

w2. Its value is the cost of making that output given those input prices. . y) is the cost of making output quantity y using inputs that cost w1 and w2 per unit. • A common form: • c(w1.Definition of The Cost Function: The cost function is a function of input prices and output quantity.

Marginal Cost .

10. but the marginal cost of the 101st unit is Rs.• Marginal Cost (MC) • The marginal cost of an additional unit of output is the cost of the additional inputs needed to produce that output. • Marginal cost and average cost can differ greatly.1020 to produce 101 units. suppose it costs Rs.1000 to produce 100 units and Rs. More formally.20 . The average cost per unit is Rs. For example. the marginal cost is the derivative of total production costs with respect to the level of output.

Law of diminishing marginal utility .

• What Does Law of Diminishing Marginal Utility Mean? A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product. •

• explains Law of Diminishing Marginal Utility This is the premise on which buffet-style restaurants operate. • They entice you with "all you can eat," all the while knowing each additional plate of food 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 the original.

For example, say you go to a buffet and the first plate 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. Since you'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 even more to a three. If you kept eating, you would eventually reach a point at which your eating makes you sick, providing dissatisfaction, or 'dis-utility'.

Isoquant Curve .

This translates to "equal quantity".• Isoquant Curve • • What Does Isoquant Curve Mean? A graph of all possible combinations of inputs that result in the production of a given level of output. Used in the study of microeconomics to measure the influence of inputs on the level of production or output that can be achieved. The isoquant curve helps firms to adjust their inputs to maximize output and profits. . the returns of adding another worker or piece of equipment will start to hurt output. "iso" means equal and "quant" refers to quantity. • explains Isoquant Curve In Latin. At some point.

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Total Cost, Average Cost & Marginal Cost
Total Cost includes all cash payment made to hired factors of production and all cash charges imputed for the use of the owners factors of production in acquiring or producing a good or service.

Thus, the total cost of a firm is the sum total of the explicit plus implicit expenditure incurred for producing a given level of output.

For example , a shoe makers example cost will include the amount he spends on leather, thread, rent for his workshop , wages, interest on 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 one additional unit. At a given level of output, one examines the additional costs of being incurred in producing one extra unit and this yields the marginal cost.

For example, if the total cost of a firm is Rs.5000 when it produces 10 units of a good but when 11 units of the good are produced , it increases to Rs.5,300 then the marginal cost of the 11th unit is Rs.5300-5000 = Rs.300.

• In other words, marginal cost of “n”th units (MCn) is the difference between total cost of nth unit (TCn) and total cost of n-1th unit (TCn).

• MCn = TCn – TCn-1

AC and TC is shown in the following table .The relationship between MC.

82 462.Units of goods produced 1 Total Cost (TC) Average Cost 3 = 2/1 3 Marginal Cost (TCn.46 425 423.TCn-1) 4 2 10 11 12 13 14 15 5000 5300 5550 5700 5950 6350 500 481.33 300 250 150 250 400 .5 438.

. The marginal and incremental cost concepts are needed in deciding whether a firm needs to expand its production or not. The average cost concept is significant for calculating the per unit profit of a business concern.The total cost concept is useful in break-even analysis and in finding out whether a firm is making profits or not.

.• In fact . the relevant costs to be considered will differ from one situation to the other depending on the problem faced by the manager.

TC = FC + VC ATC = TC/Q AFC = FC/Q AVC = VC/Q ATC = AFC + AVC .

Output 1 4 Fixed Cost (TFC) 2 50 Variable Costs (TVC) 3 50 Total Costs Average Fixed Costs Average Variable Costs Average Costs 5 10 11 17 18 50 50 50 50 50 60 100 106 150 157 21 50 182 .

78 12 10 9.50 21 50 182 232 2.72 22 15 14.05 .Output 1 4 Fixed Cost (TFC) 2 50 Variable Costs (TVC) 3 50 Total Costs 100 Average Fixed Costs 12.50 Average Costs 25 5 10 11 17 18 50 50 50 50 50 60 100 106 150 157 110 150 156 200 207 10 5 4.67 11.18 11.54 2.76 11.94 2.64 8.50 Average Variable Costs 12.82 8.38 8.

the higher will be its production costs and vice versa. etc and if the increase is substantial even fixed inputs like plant and equipments and managerial staff may have to be increased. . This is because increased production requires use of raw materials. labour. Total Cost varies directly with output. The more output a firm produces .Managerial Economics devotes a great deal of attention to the behavior of costs.

The relationship between cost and output is rather important. .

Revisiting 1st Chapter .

.Conventional theory of firm assumes profit maximization is the sole objective of business firms. But recent researches on this issue reveal that the objectives the firms pursue are more than one.

other than profit maximization are: (a) Maximization of the sales revenue (b) Maximization of firm‟s growth rate (c) Making satisfactory rate of Profit (d) Long run Survival of the firm (e) Risk-avoidance .Some important objectives.

• Yet despite the evident importance given to such concept.• Accounting versus Economic Profit • Everyone strives to acquire as much profit as possible. . profit remains to be one of the most misunderstood features of finance. • Profit is the positive gain from an investment or business operation after subtracting all the expenses.

.• Profit was taken from the Latin word "to make progress" which then denotes two thingseconomic and accounting progress. • There is the economic profit which is the increase in wealth that an investor gains from the investment activities he/she has engaged into. taking into considerations all cost associated in the investment.

operating costs. • These costs include the component cost of delivered services and goods. on the other hand. pertains to the difference between the price and the costs of setting up in the market whatever enterprise you have.• These costs may include opportunity cost of capital. . as well as. • Accounting profit.

• In calculating economic profit. • These opportunity costs are the alternative returns forgone by using the selected inputs. .• An economic profit is acquired whenever the revenue exceeds the total opportunity cost of its inputs. the opportunity cost is opportunity cost is deducted from the revenues earned. • The opportunity cost here is the value of opportunity given up.

fuel. • They do it in terms of the sales of firms less costs like wages. • Accounting profits is mainly the company‟s total earnings.• Accountants measure profit differently. interest on loans and depreciation. rent. . calculated based on the Generally Accepted Accounting Principles (GAAP). • Profit is synonymous to income. raw materials.

000 on accounting services and utilities.200. .500.000 of that money is spent on clothes and shipping costs and Rs.000 annual revenue.• To distinguish between economic and accounting profit. • Dana imports clothes from Thailand and sells them from her home. we can look at this little scenario. • She collects around Rs. Around Rs.30.

000. • Now she is working on her garage.100. Dana was making Rs.000 yearly by working in a publication agency. . • Dana‟s accounting profit is Rs.270.• Before she was engaged in this business.

000) + (Rs. we will have to subtract the opportunity cost (the job Dana left to invest in her current endeavor) to the accounting profit gained.000.000 . • That is Rs.270.170.000.30. .000) decreased with expenses [(Rs.100. which then results to Rs.000)].• Accounting profit is equals annual revenue (Rs.500.200.Rs. • In finding the economic profit.

as well as. It didn‟t take much calculation to find the economic and accounting profit. • It is important the traders and investors carefully analyze the economic and accounting profit because these enables them to evaluate their personal investment strategy. fairly easy right.• Well. . prospective markets. performances.

Veblon effect .

such as expensive wines or perfumes are Veblen goods. . The definition does not require that any Veblen goods actually exist. However. it is claimed that some types of highstatus goods. in that decreasing their prices decreases people's preference for buying them because they are no longer perceived as exclusive or high status products.A commodity is a Veblen good if people's preference for buying it increases as a direct function of its price.

who invented the concepts of conspicuous consumption and status-seeking .The Veblen effect is named after the economist Thorstein Veblen. .

A giffen good is a type of inferior good (a good that people buy more of when their income goes down). If their income falls. Giffen goods are goods that are substitutes for a more expensive good. . The classic example of a giffen good is bread for the very poor. and will buy more bread instead to fill themselves up. they will stop buying luxuries such as meat. that people buy more of when they cannot afford a superior good.

Therefore it is a superior good with respect to income.A veblen good is a good that people buy because it is expensive. but if the price falls. as a show of wealth. less of the good will be demanded .

• EA = • Proportionate change in sales • ------------------------------------------------------------• Proportionate change in advertising and other promotional expenditure . The concept of advertisement elasticity is useful in determining the optimum level of advertisement expenditure. but not in the same degree at all levels of the total sales. “the responsiveness of demand to changes in advertising or other promotional expenses”. It may be defined as.• Advertisement elasticity or Promotional elasticity • The expenditure in advertisement and other sales promotion activities does help in promoting sales.

Back to Cost Analysis .

• MARGINAL RETURNS: • The change in the quantity of total product resulting from a unit change in a variable input. • Marginal returns is an older and more generic term for marginal product. . the phrase does persist in a few terms like the law of diminishing marginal returns. holding all other inputs fixed. • While marginal product has largely replaced marginal returns in most discussions of shortrun production.

• Increasing marginal returns typically surface when the first few quantities of a variable input are added to a fixed input. . • Increasing Marginal Returns: Increasing marginal returns occurs during the course of short-run production by a firm if an increase in the variable input results in an increase in the marginal product of the variable input.• Two Returns • Marginal returns can either increase or decrease.

.• Decreasing Marginal Returns: Decreasing marginal returns results with short-run production if an increase in the variable input results in a decrease in the marginal product of the variable input. • Decreasing marginal returns usually emerge only after the first few quantities of a variable input are added to a fixed input and persist throughout production.

.• A Big. Empty Factory • How about an example to illustrate marginal returns?.

This assembly plant is filled with the machinery. . and equipment needed to produce Sports Coupes.Suppose that a car factory is producing the wildly popular Sports Coupe in its two-million square foot assembly plant located on the outskirts of a town. tools.

is fixed. this capital. The vast size of this plant. the assembly plant and related equipment. the factory needs workers. means that car company can easily provide separate productive tasks (installing engines. To produce cars. checking the horn) for several thousand workers .In the short run. painting the exterior.

Increasing Marginal Returns • What happens when workers are added? • The first few hundred workers hired by car company are bound to make increasingly more effective use of this enormous plant. . If car company employs only a dozen or so workers.• First. each performs a wide range of unrelated tasks using a wide range of capital equipment.

.• On a given day. then dash off to horn-testing area to honk the horn. then move off to the painting room to paint the exterior. then amble over to the hoodornament polishing position to polish the hood ornament. one worker might spend time at the engine installation work-station to install an engine.

increasing marginal product. This gives rise to increasing marginal returns. and the upwardsloping segment of the marginal product curve.A relatively small contingent of labor is not able to effectively use the fixed capital. Each worker can concentrate on a specific task. This means that each additional worker employed can use the capital more effectively. .

. as the workforce continues to expand. Some workers might do nothing but assist other workers. the capacity of the fixed capital is approached.• Next. Decreasing Marginal Returns • However. Workers have to share the equipment and substitute for each other on lunch and coffee breaks.

. and the downward-sloping segment of the marginal product curve. decreasing marginal product. the incremental increase declines for each one. decreasing marginal returns is a reflection of the key principle underlying the study of short-run production--the law of diminishing marginal returns. This gives rise to decreasing marginal returns.• While the efforts of these extra workers does increase total production. • Most important.

. average variable cost is the variable cost per unit of output. • TVC • Therefore AVC = -----• Q • Thus.• AVC • Average variable cost is the total variable cost divided by the number of units of output produced.

reaches maximum and then declines. average product initially rises.Due to the first increasing and then decreasing marginal returns to variable input. .

Case Study Output of “Funky Trousers” .

the Marginal Cost Curve. It is the additional cost of producing one more unit and later on will allow us to maximize profits. .Now we get into the most interesting and important cost curve.

Yeahoo! I love profits $$$! As the production of trousers increase. In order to calculate the Marginal Cost we calculate Total Cost between the previous unit and the current unit. The table below calculates the Marginal Cost for Funky Trousers: . determining the additional cost of producing one more pant is crucial since that information will help us decide whether to produce or not that particular pair.

Output (Funky Trousers) Short-Run /Total Cost Short Run /Marginal Cost .

.5. they are graphed at 0. and so on.2.units. In order to reflect that graphically economists graph the MC at mid point to account for the transition. etc. • This is because the MC starts increasing as you start producing the units. This is a bit confusing yet useful in drawing accurate graphs and arriving at accurate conclusions! • . would you sell it at $25? How much did it cost you to sew that particular pair? ($17.1. the marginal cost of producing the first unit is $8 ($44-$36). costs have increased yet you are not finished with the pair of trousers.5. as the cost went from $36 to $44. Suppose someone offers you $25 for the eight pair of trousers. so sell!) The graph below shows why the Marginal Cost is more challenging to understand. notice that the coordinates are not exactly at 1.3.• The calculations start with the first unit.5.2. In this case imagine you got your cloth and you add a zipper. • The arrows illustrate that the marginal cost is the additional cost of producing one more unit. for the second unit the cost is $4.

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the increase in Marginal Cost continues only up to a point. . At a certain point.the additional cost to produce one more unit -. and the equipment is more fully utilized.begins to increase because inefficiencies develop as production increases. However.Marginal cost generally falls as the quantity increases because people learn to do their jobs better as they produce more. marginal cost -.

and the equipment may be inadequate to handle the volume. perhaps. Or there are simply not enough machines to keep all of the people busy. The result is that inventory stacks up at a machine that is the "bottleneck" for the operation. So marginal cost begins to increase.The staff is trying to do more with the same amount of equipment. so people are standing around waiting to get onto a machine. This is called the "law of diminishing returns. or perhaps the machines keep breaking down because they are being operated too intensively without adequate maintenance." .

. beyond some point the extra (marginal) product attributed to each additional unit of the variable resource will decline.The law of diminishing returns states that as additional units of a variable resource such as labor are added to a fixed resource such as equipment.

The reason that marginal product diminishes is not because successive workers do not do as good a job as the other workers.This is not saying that the later units of the resource are of lower quality than the early ones. each successive worker added is assumed to have the same ability. and this leads to inefficiencies. With labor. training and work experience. education. . It is because more workers are being used relative to the amount of plant and equipment available. for example.

Marginal cost decreases and then begins to rise after its lowest point because of the relationship between marginal product and marginal costs. The marginal cost of each additional unit will fall as long as the marginal product of each added variable resource is rising. . marginal cost begins to increase. But when the marginal product of each added variable resource begins to decline.

and during one hour's time. Marginal product is 10 (10 .0). that one worker can produce 10 units of product.One worker can be hired for $20 per hour. The average marginal cost of labor is $______ per unit .

One worker can be hired for $20 per hour. The average marginal cost of labor is $__2____ per unit ($20/ 10) . and during one hour's time.0). Marginal product is 10 (10 . that one worker can produce 10 units of product.

The second worker and the first worker together can produce 25 units per hour. The average marginal labor cost of those additional 15 units is $20 / 15. and the marginal cost is $____ per hour. so marginal product is _______ units per hour .33 per unit. .A second worker is hired. so the total hourly labor cost is now $_____. or $1. also for $20 per hour.

A second worker is hired. so marginal product is 15 units per hour (25 units . so the total hourly labor cost is now $40. or $1. .33 per unit. also for $20 per hour. The average marginal cost of those additional 15 units is $20 / 15.10 units).$20). The second worker and the first worker together can produce 25 units per hour. and the marginal cost is $20 per hour ($40 .

00 per unit. The marginal product in terms of hourly output is rising. . so the average marginal cost per unit of labor is falling. The three workers together can produce 45 units per hour. The average marginal cost of the additional 20 units is $20 / 20. and the hourly cost goes up by another $20.A third worker is hired. or $1. so marginal product is _____ units per hour.

The three workers together can produce 45 units per hour.A third worker is hired. so the marginal cost per unit is falling.25 units).00 per unit. so marginal product is 20 units per hour (45 . or $1. . and the hourly cost goes up by another $20. The average marginal cost of the additional 20 units is $20 / 20. The marginal product in terms of hourly output is rising.

Marginal product per hour is now ______(60 .45 units). because of the law of diminishing returns. . and labor cost per hour increases by another $20. In one hour. the four workers can produce 60 units. Marginal product is now falling.A fourth worker is added.

or $1. Now. because the marginal product is falling. the marginal product will finally become negative because total product will actually decrease when additional workers are hired.33 per unit. Because of increasing inefficiencies. . This will continue until the diminishing marginal returns turn into negtive marginal returns. the marginal cost of labor is rising.The marginal labor cost of these additional 15 units is $20 / 15.

33 per unit.45 units). . In one hour. because of the law of diminishing returns.A fourth worker is added. and labor cost per hour increases by another $20. Marginal product is now falling. or $1. the four workers can produce 60 units. Marginal product per hour is now 15 (60 . The marginal labor cost of these additional 15 units is $20 / 15.

the marginal cost of labor is rising. because the marginal product is falling.Now. . This will continue until the diminishing marginal returns turn into negtive marginal returns. the marginal product will finally become negative because total product will actually decrease when additional workers are hired. Because of increasing inefficiencies.

Indifference Curve Analysis .

• Thus. Allen.R Hicks and R. .e it cannot be measured but can only be ranked or compared. while under the utility analysis it could be said that a person got 10 utils from ice cream and 6 utils from rasgulla.• An theory of consumer demand was put forward by J. • This approach considers utility to be ordinal i. under this approach it can only be said that ice cream gives more utility to the person than rasgulla.G.D.

The income of the consumer is limited and constant.Assumptions The assumptions of the indifference curve analysis are 1. Utility is ordinal 2. The consumer is a rational 4. Utility being subjective is rank able but not measurable 3. .

The tastes and preferences of the consumer remain unchanged .

Consumers generally consume products as part of a group of goods and services rather than as individual products. a wide array of combinations exist. And it is very possible that a number of these combinations will give the same level of satisfaction to the consumer. As a large number of goods and services are available. .

.Indifference Curve The locus of points. each representing a different combination of two goods. The curve derives its name from the fact that a consumer is indifferent to any of these combinations when it comes to making a choice between them. which provide the same level of utility to the consumer is known as the indifference curve.

For the sake of simplicity we assume that there is continuous and not incremental variation in consumption. What results then is a smoothened curve. .

Combination A Apple Mango Y X 1 30 Total Utility (TU) U B C D E F G 2 3 4 5 6 7 24 19 15 12 10 9 U U U U U U .

This data can be represented in a graph .Thus. the consumer is indifferent to choose between any combination of apples and mangoes as all combinations provide the same level of utility U to him.

Indifference Curve y Quantity of Mangoes U x Quantity of Apples .

We can now enumerate certain essential characteristics of indifference curves 1 Indifference curves are downward sloping This is because for the same level of utility if the demand of one commodity increases. the demand for the second commodity has to decrease .

e ) MUy increases. Due to reduced availability of Y. . the consumer will be ready to sacrifice lesser quantity of Y for each additional quantity of X. This is because two goods cannot be perfect substitutes for each other. marginal utility of X decreases. Thus. the marginal utility of Y (i.2 Indifference curves are convex to origin. As the consumer gets larger quantities of one commodity X at the cost of another commodity Y.

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