FINC304

MANAGERIAL ECONOMICS

Session 6– Cost and Revenue

Lecturer: Dr. Agyapomaa Gyeke-Dako, UGBS

Contact Information: agyeke-dako@ug.edu.gh

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
 Session Overview
• Now that we have understood production, we are in a better
position to understand cost and revenue. In this session, we
seek to establish a relationship between output and cost and
output and revenue. Specifically, we seek to establish how
cost and revenue vary with output. We particularly look at
cost in the short run and cost in the long run. We also look at
firms producing multiple products and examine how their cost
varies with output. We examine how the revenue measures of
price takers and price makers vary with output.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 2

 Session Outline
The key topics to be covered in the session are as follows:
• Cost in the Short Run
• Cost in the Long Run
• Cost Structure for firms producing multiple products
• Revenue of Price Takers
• Revenue of Price Makers

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 3

 Reading List
• Baye Michael and Price Jeffery: Managerial
Economics and Business Strategy, 8th Edition

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 4

 Cost Analysis
• Types of Costs
• Fixed costs (FC)
• Variable costs (VC)
• Total costs (TC)
• Sunk costs
• Fixed vs sunk cost
fixed costs are costs that do not change with
Output. Sunk costs are costs that are lost forever
after they have been paid
Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 5
 Cost in the Short Run
• In the short run, there are both fixed inputs and
variable inputs which means there will be fixed cost and
variable cost
• Total cost C(Q) is the minimum total cost of
producing alternative levels of output:
• C(Q) = VC(Q) + FC
• the cost function is obtained from the firm’s cost minimization
problem
• Variable Cost(Q): Costs that vary with
output
• Fixed Costs: Costs that do not vary with
output.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 6

 Different Cost Measures and
Relationship with output
C (Q ) = V C + F C

FC

Q
Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 7
Dr. Agyapomaa Gyeke-Dako
 I r d11 11
11
Prod II<t1on dnd ( o"t Cost

Other Measures of Cost

$ = Q0 x AFC

ATC
AVC

l)r / \ "'I Illi I l l D r L v t kt> D.ko & D r It M anagen al Economics Lect ure t h r ee
l h Dr. Agyapomaa Gyeke-Dako 4/27/2018

Agyapomaa Gyeke-Dako(PhD) Slide 8

 Rev1ew ! ) t L:: o:t11

COST IN THE LONG RUN

Economies of Scale
$

LRAC

Economies Diseconomies
of Scale of Scale
Q
Agyapomaa Gyeke-Dako(PhD) Slide 9
Dr. Agyapomaa Gyeke-Dako 4/27/2018
 Cost in the Long Run
• Economies of Scale: Average Cost of a firm declines
as output increases
• Diseconomies of Scale: Average Cost of a firm
increases as output increases

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 10

 Multi Product Cost Function
• C(Q1, Q2): Cost of jointly producing two
outputs. General functional form:
• C(Q1Q2) = f + aQ1Q2 + b(Q1) 2 + c(Q) 2
• C(Q1, 0) + C(0, Q2) > C(Q1, Q2).
• It is cheaper to produce the two outputs jointly instead of
separately. This when a firm enjoys economies of scope

• Example:
It is cheaper for UNILEVER to produce soap
And toothpaste jointly than separately

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 11

 Multi Product Cost Function
• Cost Complementarity
A firm enjoys cost complementarity if the Marginal Cost
of producing good 1 declines as we increase the
production of good 2 or vice versa

• Quantitatively this means:

Δ MC1(Q 1,Q2) < 0

ΔQ2

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 12

 Numerical Example
• C (Q1Q2) = 90 − 2Q1Q2 + (Q1)2 + (Q2)2
• Cost Complementarity?
Yes. Show how you arrive at your answer

• MC1(Q1Q2) = 2Q2 + 2Q1

• Economies of Scope?
Yes. Show how you arrive at your answer

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 13

 Revenue
• Industries are different. A car industry is totally different
from a food industry in the way they are structured and
even in their operations.

• Some industries will have so many firms that each firm

will be so small to change the price of a product (price
takers)

• Other industries will have large firms and be able to

influence price (price makers)
• This means their revenues will vary differently with
output varies

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 14

 Revenue Measures: Price Takers
Price Quantity Total Revenue Average Marginal
Revenue Revenue
5 1 5 5 -
5 2 10 5 5
5 3 15 5 5
5 4 20 5 5
5 5 25 5 5
5 6 30 5 5
5 7 35 5 5

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 15

 Revenue: Price Makers

Price Quantity Total Revenue Average Marginal

Revenue Revenue
10 1 10 10 -
9 2 18 9 8
8 3 24 8 6
7 4 28 7 4
6 5 30 6 2
5 6 30 5 0
4 7 28 4 -2
3 8 24 3 -4

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 16

 Observations with the Different
Measures of Revenue
• Price Takers: Average Revenue=Marginal
Revenue=Price=Demand Curve
These are horizontal and so do not vary with output.
Refer to table
• Price Makers: Average Revenue=Demand Curve=
Price>Marginal Revenue
• These are downward sloping and so will decline as
output declines.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 17

 Condition for Profit Maximisation
• MC = MR and MC should be rising afterwards

Why is this so? If MC>MR, firm will be adding more to

cost than to revenue. If MC<MR, firm will be adding
more to revenue than to cost so will continue product

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 18