cost analysis i

8/8/2019 Cost Analysis I

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Managerial Economics

Prof. Sunitha Raju

Cost Analysis I


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IFM 2010-12

Managerial Economics/ Module 3

Learning Objectives

(i) To define and examine economic cost of inputs

(ii) To develop cost-output relationship framework for

business decisions

(iii) To derive firms supply curve in the short run


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IFM 2010-12


Co stCo st Related Decisi o n at Firm LevelDecisi o n 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?


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IFM 2010-12


Gop al Banerjee & Co.

Business Decisi o n

To continue with the operations or not

Will continue only if profits are earned

= TR TC


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IFM 2010-12



P articulars Rs. Rs.Net P rofit as per Trading P rofit & Loss

Account22,000

Less: Implicit costs not accounted:

a) Managers 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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IFM 2010-12


Defining T o tal Co st

(i) Ec o n o mic c o st o f in p utsExplicit + Implicit costs

(ii) Why Im p licit c o sts?Resources being scarce, any input used (whether purchased or owned) for production activity shouldreflect its true costOwned resources have alternate uses

(iii) H ow to value im p licit c o sts?Opportunity cost principle wherein costs are imputedbased on alternate uses of the owned resource


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IFM 2010-12



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?


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IFM 2010-12


Defining Pr o fits

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 norm al pro f itsthen

TR - TC = 0

If a production activity results in supernorm al pro f its ,then

TR > TC positive profits

P rofit maximization implies maximize Supernormalprofits

Normal vs Supernormal Profits


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Co st Determinants in the Sh o rtRun

Total costs (TC) are determined by output (Q) As Q increases, TC also increases

TC = f (Q)

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

P L . L is Variable costsP K . K is Fixed costs


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IFM 2010-12


Fixed costs are Sunk Costs

Variable costs: determine supply decisions

Co st Determinants in the Sh o rtRun


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IFM 2010-12


Short Run Cost Short Run Cost Output RelationsOutput Relations

Q TC TF C TVC1 $120 $100 $202 138 100 38

3 151 100 514 162 100 625 175 100 756 190 100 907 210 100 1108 234 100 1349 263 100 163

10 300 100 200TF C : unchanged as Q esTV C : vary as Q es


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IFM 2010-12


Sh o rt Run Co st Out p utRelati o ns

Q TC TF C TVC ( TC1 $120 $100 $20 -2 138 100 38 18

3 151 100 51 134 162 100 62 115 175 100 75 76 190 100 90 157 210 100 110 208 234 100 134 249 263 100 163 29

10 300 100 200 37


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Managerial Economics/ Module 3Behaviour of TC,TVC nad TFC

0

50

100

150

200

250

300

350

1 2 3 4 5 6 7 8 9 10

Q uantity

C o s t

TFC TVC TC


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Out p ut- Co st Decisi o ns in the Sh o rtRun

Cost implications of output decisions by firms is based on Av er ag e Cost i.e. cost per unit of output

AC =

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

Q

TC


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Managerial Economics/ Module 3Q/ TC ATC

1 $120 $120.02 138 69.03 151 50.34 162 40.55 175 35.06 190 31.77 210 30.08 234 29.39 263 29.2

10 300 30.0

Average Co st Relati o ns


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Co st Analysis f o r EfficientPr o ducti o n Decisi o ns

(i) TC = TFC + TVC= P K . K + P L . L

(ii)

AC inversely related to A P L and A P K.

(iii) Co st efficient o ut p ut= AC minimumbehaviour of average fixed cost (AFC) as outputincreasesbehaviour of average variable cost (AVC) as outputincreases

AV C AF C Q

T V C Q

T F C Q

TC A C !!!

Q L P

Q K P L K ..!

L

L

K

K AP

P AP

P 1

.1

.!


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IFM 2010-12

Managerial Economics/ Module 3Q/ TF C TVC TC ATC AFC AVC MC

1 $ 100 $20 $120 $120.0 $100.0 $202 100 38 138 69.0 50.0 19.0 18

3 100 51 151 50.3 33.3 17.0 134 100 62 162 40.5 25.0 15.5 115 100 75 175 35.0 20.0 15.0 136 100 90 190 31.7 16.7 15.0 157 100 110 210 30.0 14.3 15.7 208 100 134 234 29.3 12.5 16.8 249 100 163 263 29.2 11.1 18.1 29

10 100 200 300 30.0 10.0 20.0 37

Average Co st Relati o ns


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Managerial Economics/ Module 3Behaviour of AC, AVC,AFC,MC

0

20

40

60

80

100

120

140

ATC AFC AVC MC


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

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

Efficient Pr o ducti o n Decisi o n atFirm Level


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Co st Efficient vs Pr o fitMaximizing Out p ut

(i) Is it profitable to always produce cost efficientoutput?

Recession and Excess Capacity conditionsACAC

QQ x


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Managerial Economics/ Module 3Boom conditions and AC curveAC

AC

QQ x

only if P > MC

(ii) Profit maximizing output

MR = MC


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Decisi o ns o n h ow much t o su pp ly

D epends on incremental cost and the marketprice

P > MC increase supply

P < MC decrease supply


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IFM 2010-12


Deriving the Su pp ly Curve

Under what price and cost conditions will the firm be inducedto supply

(i) When P = MC = AC

(ii) When P > MC > AC

(iii) When P < AC or P > AVC


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IFM 2010-12


Firms Su pp ly 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

averagevariable cost

The upward sloping MC curve reflects the increment al costsa ssoci a ted with incre a sin g output (Q) beyond cost efficient output (ACminimum)

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

P

Q

S

cost analysis i

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