E-LESSON-5

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MBA 2 All right are reserved with CU-IDOL MANAGERIAL ECONOMICS Course Code: MBA601 Semester: First SLM UNIT : E-Lesson: 6 5 www.cuidol.in Unit-6 (MBA601)

THEORY OF COST AND REVENUE 33 ANALYSIS OBJECTIVES INTRODUCTION Student will be able to : Cost analysis has a key role to play in business Discuss the reasons for entering international economics as every business decision virtually markets. involves a comparison between costs and returns. Explain different modes of entering international markets. The cost of production of a good depends on the number of factor units necessary to produce a Analysis of pros and cons of each mode and given level of output and the prevailing prices of decide the appropriate mode for MNC. the factor units. Analyse the functional alliances. The cost of production is jointly determined by the technique of production adopted, the www.cuidol.in Unit-6 (MBA601) organizational efficiency of entrepreneurs and the productive efficiency of factors and their prices, along with the rate of output and the size of plant. INSATlIlTUriTgEhOt FarDeISrTeAsNerCvEedANwDithONCLUIN-IDE OLELARNING

TOPICS TO BE COVERED 4 > Cost Structure > Fixed and Variable Costs (or Prime and supplementary Costs) > Short-run Total Cost Schedule of a Firm > The Behaviour of Short-run Average Cost Curves > Relationship between Marginal Cost and Average Cost > Characteristic of Long-run Costs and Revenue Concepts. > Relationship between Price and Revenues under Perfect Competition and Monopoly Demand > Relationship between Price and Revenues under Monopoly www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

COST STRUCTURE 5 All right are reserved with CU-IDOL There are different view points on the cost concepts. We shall review some of them as follows:  Outlay Cost and Opportunity Cost Outlay cost refers to the actual financial expenditure of the firm. It is recorded in the firm’s books of account. For instance payment of wages, interest, cost of raw materials, cost of machineries, etc., are the actual or outlay costs. Opportunity cost, on the other hand, is a notional idea. It is not the actual expenditure incurred by the firm. It is measured in terms of the opportunity cost. It represents sacrificed alternatives. Opportunity cost may be measured in terms of profits from the next best alternative venture that are foregone by the firm by using the available resources for a particular business. www.cuidol.in Unit-6 (MBA601)

COST STRUCTURE  Explicit and Implicit Money Costs 6 Cost of production measured in terms of money is called the money cost. “Money cost” is the monetary expenditure on inputs of various kinds - materials, labour, etc., required for the output, i.e., the money spent on purchasing the different units of factors of production needed for producing a commodity. Money cost is, therefore, the payment made for the factors in terms of money. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

COST STRUCTURE While analysing total money costs, economists speak of explicit and implicit money costs. To 7 determine total costs, they include both explicit as well as implicit money costs.  Explicit or Out-of-Pocket Costs Explicit cost refer to the actual money outlay or out-of-pocket expenditure of the firm to buy or hire the productive resources it needs in the process of production.  Implicit or Book Costs Implicit costs are the opportunity costs of the use of factors which a firm does not buy or hire but already owns. Unlike out-of-pocket costs they do not require current cash expenditures. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Fixed and Variable Costs (or Prime and 8 Supplementary Costs) Fixed factors are unalterable. These factors are, for instance machineries, factory building, managerial staff etc., which remain unchanged over a period of time. Variable factors are labour, raw materials, power, etc., the inputs of which are varied to vary the output in the short run. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Fixed Costs (or Supplementary Costs) 9 Fixed costs are those costs that are incurred as a result of the use of fixed factor inputs. They remain fixed at any level of output in the short-run. These costs remain unchanged even if the output of the firm is nil. Fixed costs, therefore, are known as “supplementary costs” or “overhead costs”. Fixed or supplementary costs usually include:  Payments of rent for building  Interest paid on capital  Insurance premiums  Depreciation and maintenance allowances  Administrative expenses-salaries of managerial and office staff, etc  Property and business taxes, license fees etc. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Fixed Costs (or Supplementary Costs) 10 Fixed costs may be classified into two categories: I. Recurrent and II. Allocable.  Recurrent fixed costs are those which give rise to cash output as certain explicit payments like rent, interest on capital, general insurance premiums, salaries of permanent irreducible staff, etc., are to be made at regular time-interval by the firm.  The allocable fixed costs refer to implicit money costs like depreciation charges which involve no direct cash outlays but are to be reckoned on the basis of time rather than usage. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Variable Costs (or Prime Costs)  Variable costs are those costs that are incurred by the firm as1a1 result of the use of variable factor inputs. They are dependent upon the level of output. Variable costs are frequently referred to as direct costs or prime costs. Briefly, variable costs or prime costs represent all those costs which can be altered in the short-run as the output alters. The short-run variable costs include:  Prices of raw materials  Wages of labour  Fuel and power charges  Excise duties, sales tax  Transport expenditure etc. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Variable Costs (or Prime Costs) 12 Variable costs may be classified into: (i) fully variable costs and (ii) semi-variable costs.  The former vary more or less at the same rate of output, e.g. cost of raw materials, power etc.  Semi variable costs are, however, those costs which do not change with output, but they will be completely eliminated when output is nil. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Behavioural Costs and their Measurement 13 In economic analysis the following types of costs are considered in studying behavioural cost data of firm: (A) Total Cost (TC) TC = f (Q) (B) Total Fixed Cost (TFQ) (C) Total Variable Cost (TVC) (D) Average Fixed Cost (AFC), AFC = TFC/Q (E) Average Variable Cost (AVC), AVC = TVC/Q (F) Average Total Cost (ATC), ATC or AC = T C/Q and (G) Marginal Cost (MC), MCn = TCn - TCn - 1, www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Short-run Total Cost Schedule of a Firm A cost-schedule is a statement of variations in cost resulting from variations in the level of output. It shows 14 the response of costs to changes in output. Cost schedules depend upon the length of the time interval. So they vary from short period to long period.  Short-Run Total Costs: To examine the cost behaviour in the short-run, we may begin our analysis with the consideration of the following three total cost concepts:  Total Fixed Cost (TFC)  Total Variable Cost (TVC)  Total Cost (TC) TC = TFC+TVC www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

The Short-run Total Costs Schedule of a Firm 15 (Hypothetical Data) The data are based on the following assumptions: 1. Labour and capital are the two factor inputs. 2. Labour is the variable factor. 3. Capital is the fixed factor. 4. Price of labour is Rs.10 per unit. Price of capital is 25 per unit. 5. Since 4 units of capital are used as fixed factors, the total fixed cost (TFC) Rs.100 remains constant throughout (see column 4 in Table). 6. The total variable cost (TVC) varies with the variation in labour units (see column 5). 7. Column 6 measures the total cost. It is derived by the summation of TFC and TVC at all levels of output. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Behaviour of Total Costs 16  TFC remains constant at all levels of output. It is the same even when the output is nil. Fixed costs are thus independent of output.  TVC varies with the output. It is nil when there is no output. Variable costs are, thus, direct costs of the output.  TVC does not change in the same proportion. Initially, it is increasing at a decreasing rate, but after a point, it increases at an increasing rate. This is due to the operation of the law or variable proportions or non- proportional output.  TC varies in the same proportion as the TVC. Thus, in the short period, the changes in total cost are entirely due to changes in the total variable costs as fixed costs, the other component of total costs remaining constant. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

TFC, TVC and TC Curves 1. The curve TFC is the curve of total fixed costs. It is a straight horizont1a7l line, parallel to the X-axis, denoting a constant characteristic of fixed costs at all levels of output. 2. The curve TVC represents total variable costs. It reflects the typical behaviour of total variable costs, as it initially rises gradually, but eventually becomes steeper, denoting a sharp rise in total variable costs. The upward rising total variable costs are related to the size of the output 3. The curve TC represents total costs. It is derived by vertically adding up TVC and TFC curves. It is easy to see that the shape of TC is largely influenced by the shape of TVC. When the TVC curve becomes steeper. TC also becomes steeper. Further, the vertical distance between TVC curve and TC curve is equal to TFC and is constant throughout because TFC is constant. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Short-run Per Unit Cost  Per unit cost is the average cost. It refers to the cost per unit of output. Following are the four important per unit 18 costs in which a firm is always interested in the short period. 1. Average Fixed Cost = Total Fixed Cost + Output AFC = TFC/Q 2. Average Variable Cost = Total Variable Cost + Output. AVC = TVC/Q 3. Average Total Cost = Average Fixed Cost + Average Variable Cost (ATC = AFC + AVC). 4. Marginal Cost = (Total Cost associated with the quantity of output). Alternatively (Total cost associated with the quantity of output one less). Marginal Cost = Change in total Cost + One unit change in output. MC = TC/Q www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Output, Total Costs and Average or Unit Costs of a Firm (Hypothetical Data) 19 1. AFC decreases as the output increases. Since the total fixed costs remain the same, average fixed costs decline continuously. It is the outcome of “spreading the overhead over more units”. 2. AVC first decreases and then increases as the output increases. 3. ATC also decreases initially. It remains constant at a point for a while, but then goes on increasing as output increases. 4. Marginal Cost (MC) also decreases initially but then increases as the output is increased. 5. The MC is determined by the rate of increase in the total variable cost (TVC). In the beginning, for the very first unit, thus average variable cost and marginal cost are the same (because AVC = TVC for the first unit). 6. When the average cost is minimum, MC = AC. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

The Behaviour of Short-run Average Cost Curves 20  The behaviour patterns and relations of short-run unit costs become more explicit when we plot the cost data on a graph and draw the respective cost curves. There are four short-period cost curves: (1) AFC curve, (2) AVC curve, (3) ATC curve, and (4) MC curve. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

The Behaviour of Short-run Average Cost Curves 21 Average Fixed Cost Curve (AFC Curve): As the output increases, the total fixed costs get spread over a large and larger output, and therefore, the average fixed cost goes on progressively declining. Consequently, the average fixed curve slopes downwards from the left to the right throughout its entire stretch. In mathematical terms, AFC curve approaches both the axes asymptotically, i.e., it gets very close but never touches either axis. Average Variable Cost Curve (AVC Curve): The average variable cost generally declines in the initial stages as the firm expands and approaches the optimum level of output. After the plant capacity output is reached, the average variable cost begins to rise sharply. Thus, usually the average variable cost curve declines initially, reaches the minimum and then goes on rising. The AVC curve is , thus, slightly U-shaped. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

The Behaviour of Short-run Average Cost Curves 22 Average Total Cost Curve (ATC Curve): Since the average total cost is the sum of fixed average variable costs, the ATC curve is also a vertical summation of the AFC and AVC curves. Hence, the curve ATC is derived by the superimposition of the AVC curve over the AFC curve. As such, the ATC curve is U-shaped, indicating that if the output of the firm is increased, initially the average total cost curve decreases up to a point, then it remains constant for a while and, thereafter, it starts rising. Marginal Cost Curve (MC Curve): The marginal cost curve also assumes U-shape indicating that in the beginning, the marginal cost declines as output expands, thereafter, it remains constant for a while and then starts rising upward. Marginal cost is the rate of change in total costs when output is increased by one unit. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Relationship Between Marginal Cost and Average Cost 23 1. When AC is minimum, the MC is equal to AC. Thus, MC curve must intersect at the minimum point of ATC curve. 2. When AC is falling, MC is also falling initially, after a point MC may start rising but AC continues to fall. However, AC is greater than MC, (AC >MC). Hence, ultimately at a point both costs will be equal. Thus, when MC and AC are falling, MC curve lies below the AC curve. 3. Once MC is equal to AC, then as the output increases AC will start rising and MC continues to rise further but now MC will be greater than AC. Therefore, when both the costs are rising, MC curve will always lie above the AC curve. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Relationship Between Marginal Cost and Average Cost 24 1.1. Initially, both MC and AC curves are sloping downward. When AC curve is falling, MC curve lies below it. 2. When AC curve is rising, after the point of intersection, MC curve lies above it. 3. It follows thus that when MC is less than AC, it exerts a downward pull on the AC curve. When MC is more than AC it exerts an upward pull on the AC curve. Consequently, MC must equal AC, while AC is at the minimum. Hence, MC curve intersects at the lowest point of AC curve. It may be recalled that MC curve also intersects the lowest-point of AVC curve. Thus, it is a significant mathematical property of MC curve that it always cuts both the AVC and ATC curves at their minimum points. In this Fig. thus MC curve crosses the AC curve at point E. At this point P, for OQ level of output the average cost is EQ which is the minimum. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Characteristics of Long-run Costs 25  The long-run period is long enough to enable a firm to vary all its factor inputs. In the long-run, a firm is not tied to a particular plant capacity. It can move from one plant capacity to another whenever it is obliged to do so in the light of changes in demand for its products.  In the long-run, there are only the variable costs or direct costs as total cost.  In the long run, when we examine the unit cost of a firm, we come across only the average marginal costs. Hence, we have only to study the shape and relationships of the long-run average cost curve and the long-run marginal cost curve.  The long-run is a ‘planning horizon.’ All economic activity actually operates in the short-run, the long is only a perspective view for the future course of action.  The long-run consists of perspective planning for the expansion of the firm; hence, it involves various short-run adjustments visualised over a period of time. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Derivation of the LAC Curve 26  The long-run average cost curve (LAC) is the envelope of the various short run average cost curves. It is drawn as a tangent to the short-run average cost curve (SACs) as depicted in Figure.  In this figure the LAC is derived as tangent to SAC1 . SAC2 and SAC3 . The LAC is, thus, a flatter U-shaped curve. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Features of the LAC Curve 27  Tangent Curve  Envelope Curve  Planning Curve  Minimum Cost Combinations  Flatter U-Shaped www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Revenue Concepts 28 All right are reserved with CU-IDOL  Revenue means sales receipts. These are the receipts obtained by a firm by selling various quantities of its products.  Revenue depends on the price at which the quantities of output are sold by the firm.  A firm revenue can be categorized as: (i) Total revenue(P*Q) (ii) Average revenue(TR/Q) and (iii) Marginal revenue(TRn-TRn-1) Unit-6 (MBA601) www.cuidol.in

Relationship between Price and Revenues under Perfect 29 Competition  A firm under perfect competition is a price-taker. It sells its output at the prevailing market prices over a period of time. Thus, price is constant in a competitive firm’s model.  Under conditions of perfect competition, a firm’s average revenue will be identical and constant. Therefore, in the case of a firm operating under conditions of perfect competition, its average and marginal revenue curves will form one identical curve parallel to the X-axis or the quantity-axis. In such a case, where average revenue, i.e., price, remains constant, the average revenue curve will be a horizontal straight line parallel to the X-axis. The slopes of AR and MR curves are zero. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Relationship between Price and Revenues under Perfect 30 Competition www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Relationship between Price and Revenues 31 under Perfect Competition  Following points may be noted in this context: 1. Price is constant. 2. Since price is constant, the average revenue is also constant. AR is the same as P. 3. Since price is unchanged, for each additional unit sold, the same addition is made to the total revenue; therefore, the marginal revenue (MR) also remains constant. MR is, thus, the same thing as P or AR. 4. Total revenue (TR) increases at a constant rate (since MR is constant) as the units of output sold increase. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Monopoly Demand 32 The demand condition under monopoly is crucially different from that of a competitive firm. The demand curve faced by a monopolist is identical with the industry demand curve for the product, which is downward-sloping. Further, in the absence of competing substitutes for the monopolist’s product, its demand usually tends to be highly inelastic; but it cannot be perfectly inelastic due to the influence of the elasticity with determinants like income, taste, habit, preference, remote substitutes, etc. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Monopoly Demand 33 The inelastic demand curve (with a negative slope) of a monopolist has the following major implications: 1. The downward-sloping market demand curve suggests that less quantity is demanded at a higher price and more is demanded at a low price. This means that the monopolist can increase the sale of his product only by lowering the price and, if he wishes to charge a high price, he has to remain satisfied with lower sales. 2. Due to the absence of competition and inelasticity of demand for the product, a monopolist acts as a ‘price-maker’ in the market. As the market supply of the product is under his control, by restricting output he can charge a high price. It follows that depending on the demand, monopolist can either dictate a high price and sell less or can produce more and allow the price to take its own course in relation to the given demand position. Thus, a monopolist can either control quantity or price but not both at the same time. 3. On account of inelasticity of the demand curve, the relationships of monopoly output are of a distinct nature. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Relationship between Price and Revenues under Monopoly34  A monopolist has a complete control over the market supply. So, he is in a position to determine the price for his product. The demand curve for the monopoly product is not perfectly elastic. Thus, a monopolist can sell more only by lowering the prices.  Price is the average revenue. Thus, the average revenue tends to decline as price declines at each level of increase in output.  The total revenue increases at diminishing rate as price (= AR) tends to decline.  Marginal revenue is the addition to total revenue by selling an extra unit. Thus, marginal revenue also decreases and it will be less than average revenue or price at all output levels. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

Relationship between Price and Revenues under Monopoly 35 www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

SUMMARY 36  Money cost refers the cost of production measured in terms of money.  Implicit costs are not directly on actually paid-out costs.  Fixed cost remain fixed in the short run: costs of machinery, factory plant.  Variable cost or prime cost, varies with the level of output - for example labout cost, raw material cost.  In long-run, all cost tend to become variable costs.  Total cost = Total fixed cost + Total variable cost.  Marginal cost is the cost of producing an extra unit of output. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

MULTIPLE CHOICE QUESTIONS 1. The concept of opportunity cost is useful in explaining 37 (a) Determination of cost structure (b) Relative price of different goods (c) Determination of economic significance (d) Trend of business behaviour 2. Entrepreneurial Remuneration signifies (a) Implicit cost (b) Explicit cost (c) Out of pocket cost (d) All of the above 3. Office rent is regarded as (a) Prime cost (b) Supplementary cost (c) Property cost (d) None of the above 4. Raw-material cost are (a) Fully variables (b) Semi-variable (c) Fixed (d) Out of total cost 5. Revenue means (a) sales receipts (b) post office revenue (c) government revenue (d) total revenue Answers 1. (b), 2. (a), 3. (b), 4. (a), 5. (a) www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

FREQUENTLY ASKED QUESTIONS 38 Q1. Define Fixed Costs. Ans: Fixed costs are those costs that are incurred as a result of the use of fixed factor inputs. They remain fixed at any level of output in the short-run. These costs remain unchanged even if the output of the firm is nil. Fixed costs, therefore, are known as “supplementary costs” or “overhead costs”. For further detail please Refer to SLM. Q2. What is Marginal Revenue? Ans: Marginal revenue is the addition made to the total revenue by selling one more unit of the item. Or simply, it is the revenue or sales receipt of the marginal unit of the firm’s output. Algebraically, the marginal revenue of nth unit per period of time of a given product is the difference between the total revenue earned by selling n units and the total revenue earned by selling n - 1 units per period of time For further detail please Refer to SLM. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

REFERENCES 39 1. Salvatore, D. (2012).Managerial Economics: Principles and Worldwide Applications. Oxford: Oxford Press. 2. Ahuja, H. L.(2017).Managerial Economics, New Delhi: S. Chand. 3. Dwivedi, D.N.(2018).Managerial Economics, New Delhi: Vikas Publications. 4. Peterson, L., Jain.(2005). Managerial Economic. New Delhi: Prentice Hall of India. 5. Mote, V.L., Gupta G..S.(2017).Managerial Economics. New Delhi: McGraw Hill Education. www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL

40 THANK YOU For queries Email: [email protected] www.cuidol.in Unit-6 (MBA601) All right are reserved with CU-IDOL