faculty: prof. sunitha raju cost analysis-1 session date: 27.1.2013 economics of pricing strategies
TRANSCRIPT
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?
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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.
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6
Gopal Banerjee & Co.
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
Gopal Banerjee & Co.
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?
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6
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
.
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
Boom conditions and AC curveAC
AC
QQx
→ only if P > MC
(ii) Profit maximizing output
MR = MC
Cost Efficient vs Profit Maximizing Output
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
Decisions on how much to Supply
Depends on incremental cost and the market price
P > MC increase supply
P < MC decrease supply
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
PGDIBS 2012-13
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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
EPGDIB(VSAT) 2012-13
Business Economics/Session:6Economics of Pricing Strategies
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