Faculty: Prof. Sunitha Raju Cost Analysis-1 Session Date: 27.1.2013 Economics of Pricing Strategies

Faculty:Prof. Sunitha Raju

Cost Analysis-1

Session Date: 27.1.2013

Economics of Pricing Strategies

EPGDIB(VSAT) 2012-13

Business Economics/Session:6Economics of Pricing Strategies

PGDIBS 2012-13

Cost Related Decision at Firm Level

(i) What are the cost implications of production/supplydecisions?

(ii) Should a profit maximizing firm always supply at costminimizing level of output?

(iii) How do costs influence the size and location of production plants/units?



PGDIBS 2012-13

Economic Definition of Cost

(i) Cost Components Factor inputs (Land, Labour, Capital, Entrepreneurship)

(ii) Relevant Cost Historical vs. Current Cost

Incremental vs. Sunk Cost

Explicit and Implicit Costs.



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Defining Total Cost

(i) Economic cost of inputs Explicit + Implicit costs

(ii) Why Implicit costs? Resources being scarce, any input used (whether

purchased or owned) for production activity should reflect its true cost

Owned resources have alternate uses

(iii) How to value implicit costs? Opportunity cost principle wherein costs are imputed

based on alternate uses of the ‘owned’ resource



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Defining Profits

‘Entrepreneurship’ is a factor input.

As such, factor costs or production costs will include the returns to ‘Entrepreneurship’ i.e. normal profits.

If a production activity results in only normal profits thenTR - TC = 0

If a production activity results in supernormal profits, thenTR > TC positive profits

Profit maximization implies maximize Supernormal profits

Normal vs Supernormal Profits



PGDIBS 2012-13

Gopal Banerjee & Co.

Business Decision

To continue with the operations or not

Will continue only if profits are earned

π = TR – TC


Business Economics/Session:6


Particulars Rs. Rs.

Net Profit as per Trading Profit & Loss Account

22,000

Less: Implicit costs not accounted:

a) Manager’s Salary (600 x 12) 7,200*

b) Building rent (800x12) 9,600**

c) Interest on capital (2,00,000@9%)

18,000*** 34,800

Net loss as per Business Economist (12,800)

Profit & Loss Statement

* Earning Rs. 600/- per month as manager in a jewellery shop

** Rent of Rs. 800/- per month if the space let out*** Interest of Rs. 1,500/- per month if the amount is invested



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Assume the following

(i) interest rate falls to 5%(ii) rent increases to Rs. 1000(iii) Mr. Banerjee was unemployed before starting the

business

What would be the implications on profits?



PGDIBS 2012-13

Cost Determinants in the Short Run

Total costs (TC) are determined by output (Q)

As Q increases, TC also increasesTC = f (Q)

As Q produced depends on inputs used [i.e. Labour (L) and Capital (K)], TC = PL . L + PK . K

→ PL . L is Variable costs

→ PK . K is Fixed costs

Variable costs determine supply decisions



PGDIBS 2012-13

Q TC

1 $120

2 138

3 151

4 162

5 175

6 190

7 210

8 234

9 263

10 300

Short Run Cost – Output Relations



Short Run Cost – Output Relations

Q TC TFC TVC TC

1 $120 $100 $20 -

2 138 100 38 18

3 151 100 51 13

4 162 100 62 11

5 175 100 75 7

6 190 100 90 15

7 210 100 110 20

8 234 100 134 24

9 263 100 163 29

10 300 100 200 37



PGDIBS 2012-13

Output-Cost Decisions in the Short Run

Cost implications of output decisions by firms is based onAverage Cost i.e. cost per unit of output

AC =

Output (Q) corresponding to minimum AC is cost efficientoutput/production

Q

TC



Q/ TC TC ATC

1 $120 - $120.0

2 138 18 69.0

3 151 13 50.3

4 162 11 40.5

5 175 7 35.0

6 190 15 31.7

7 210 20 30.0

8 234 24 29.3

9 263 29 29.2

10 300 37 30.0

Average Cost Relations



Q/ TFC TVC TC ATC AFC AVC MC

1 $ 100 $20 $120 $120.0 $100.0 $20

2 100 38 138 69.0 50.0 19.0 18

3 100 51 151 50.3 33.3 17.0 13

4 100 62 162 40.5 25.0 15.5 11

5 100 75 175 35.0 20.0 15.0 13

6 100 90 190 31.7 16.7 15.0 15

7 100 110 210 30.0 14.3 15.7 20

8 100 134 234 29.3 12.5 16.8 24

9 100 163 263 29.2 11.1 18.1 29

10 100 200 300 30.0 10.0 20.0 37

Average Cost Relations



Cost Analysis for Efficient Production Decisions

(i) TC = TFC + TVC = PK . K + PL . L

(ii)

AC inversely related to APL and APK.

(iii) Cost Efficient output = AC minimum behaviour of average fixed cost (AFC) as output increases behaviour of average variable cost (AVC) as output increases

AVCAFCQ

TVC

Q

TFC

Q

TCAC

Q

LP

Q

KP LK ..

LL

KK AP

PAP

P1

.1

.



PGDIBS 2012-13

(i) Should a firm produce at cost efficient level of output (min. AC)

(ii) Under what market conditions can a firm deviate from this level.

Efficient Production Decision at Firm Level



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Cost Efficient vs Profit Maximizing Output

(i) Is it profitable to always produce cost efficient output?

Recession and Excess Capacity conditions

Excess capacity

ACAC

QQx



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Boom conditions and AC curveAC

AC

QQx

→ only if P > MC

(ii) Profit maximizing output

MR = MC

Cost Efficient vs Profit Maximizing Output



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Decisions on how much to Supply

Depends on incremental cost and the market price

P > MC increase supply

P < MC decrease supply



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Problem Solving

Airway express has an evening flight from Los Angeles to New

York with an average of 80 passengers and a return flight the next

afternoon with an average of 50 passengers. The one-way ticket for

the flight is $200. The operating cost of the plane for each flight is

$11,000. The fixed costs for the plane are $3,000 per day whether it

flies or not.

(a) Should the airline remain in business?

(b) Should the airline continue with the flight if the price Decreases to $150 Increases to $250



PGDIBS 2012-13

Deriving the Supply Curve

Under what price and cost conditions will the firm be induced to

supply

(i) When P = MC = AC

(ii) When P > MC > AC

(iii) When P < AC or P > AVC



PGDIBS 2012-13

Firm’s Supply Curve

The MC curve above the AVC is the supply curve of a firm, i.e.→ a firm will be induced to supply more only if prices cover at least

average variable cost

The upward sloping MC curve reflects the incremental costs associated with increasing output (Q) beyond cost efficient output (AC minimum)

If market prices rise to match the incremental costs, then firms produce and supply more.

P

Q

S

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Faculty: Prof. Sunitha Raju Cost Analysis-1 Session Date: 27.1.2013 Economics of Pricing Strategies