lesson_4-me

8/3/2019 Lesson_4-ME

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Lesson 4-MECOST FUNCTION AND COST CURVES;

REVENUE FUNCTION AND REVENUE

CURVES; FIRMS EQUILIBRIUM


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IMPLICIT AND EXPLICIT COSTS

Activity

After completing his management education,your friend, Deepak, was offered a job for a

monthly salary of Rs. 40,000 in an IT consultingfirm.

Deepak declined the offer. He set up his ownconsulting firm. He opened his office in a room in

his home. This room had separate entrance.Such rooms in his locality could easily be rentedout for Rs. 3,000 per month.


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Activity continued

Deepak used his personal computer, faxmachine and printer etc. which he hadrecently purchased for Rs. 50,000.This

money was gifted to him by his father. Thedeposit rate on a one-year deposit was 9%per annum

He employed a few assistants and othersupport staff. His monthly salary bill for thewhole staff was Rs. 50,000.


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Cont.

His monthly office expenditure on

miscellaneous items such as electricity,

stationary, entertainment etc. was Rs.30,000.

In his first year of operations, Deepak

received Rs. 14,00,000 (fourteen lakh) as

consultancy charges.


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He calculated that after deducting his

costs- staff salary and miscellaneous

expenses- he made a profit of Rs.4,40,000 as per the following balance

sheet ( assume that there is no direct or

indirect tax)


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Balance sheet of Deepaks firm-

accountants version

Receipts

Consultancy

charges= 14,00,000

Expenses

Salary= 50,000 X 12=

6,00,000

Misc. expenses=

30,000 X 12 =

3,60,000

Total cost = 9,60,000 Surplus (profit) =

4,40,000


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Deepak is obviously very happy that he

made a profit of Rs. 4,40,000 in his first

years operation.He invites you to dinner for celebrating his

success. He explains the entire sequence

of events as reported to you earlier.

WHATWILL BE YOUR RESPONSE AS

A STUDENT OF ECONOMICS?


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Economists version

Receipts = 14,00,000 Costs

Explicit costs= 9,60,000

Implicit costs=

1. Salary foregone=40,000 X 12 = 4,80,000

2. Potential rent income of

room =3,000 X 12 =

36,0003. Interest lost =4,500


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Income = 14,00,000

Loss = 80,500

Expenditure

1. Explicit costs =

9,60,000

2. Implicit costs =

5,20,500

Total cost =

14,80,500


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Point to remember

In economics, total cost includes both

explicit and implicit cost

An economists calculation of costs is,therefore, different from an accountants

calculation.


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ACCOUNTING COST AND ECONOMIC

COST

Besides opportunity cost, an accountant

and an economist differ in their treatment

of Depreciation.

Accountants calculate depreciation as per

tax laws and governments permissible

limits.

Economists calculate according to the life

time of the plant-capital budgeting


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SUNK COSTS

Costs which cannot be recovered, once

these have been incurred, are sunk costs.

The opportunity cost of sunk cost is zero.

Difference between sunk cost and fixed

cost


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Fixed and variable costs

Costs which do not vary (change) with

output are fixed (supplementary) costs.

Costs which change with output arevariable (prime) costs


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SUNK COST, FIXED COST, VARIABLE

COST

Computer hardware firm- most costs arevariable- the cost of components likemicroprocessor, memory chips, hard disk

drives, staff salary, packaging andshipping

Computer software firm- most costs are

sunk costs; a large part of spending ondeveloping a new program. Duplicationcosts (variable) are negligible.


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Fixed costs- costs incurred by a

restaurant-ovens, chairs, tables, dishes

etc are fixed costs, as these can be resold

if the restaurant goes out of business.

Variable costs (mainly food ingredients)

are low.


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Social costs?

Air pollution

Water pollution

Noise pollutionEnvironmental degradation.


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Costs in short run

In short run, firms inputs are dividedbetween fixed and variable;

Accordingly, in short run, a firms costs aredivided between fixed and variable costs.

In short run, existing firms can not exit(leave) the industry; new firms can not

enter the industryDifference between shut down and wind

up.


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Costs in short run (SR)

1. Total Fixed Cost (TFC)- remains the

same at all output levels

2. Total Variable Cost (TVC)- changes withoutput

3. Total Cost (TC) = TFC + TVC


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SR costs- complete the table

Output

(units of x)

TFC

( Rs.)

TVC

(Rs.)

TC

0 10

1 10

2 18

3 24

4 32

5 42

6 54

7 68


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SR costs

Average Fixed Cost (AFC) = TFC / Q; (Q

is output)

Average Variable Cost (AVC) = TVC/ QAverage Cost (AC) or Average Total Cost

(ATC) = TC/Q; or AC= AFC + AVC

Marginal Cost (MC) = dTC/dQ


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Complete the table

Q TFC TVC TC AFC AVC AC MC

0 10

1 10

2 18

3 24

4 32

5 42

6 54

7 68


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Costs in long run (LR)

In long run, all inputs are variable, so all

costs are variable costs. NO FIXED COST

Freedom of entry and exit

LR AC and MC are much more flatter than

SR AC and MC


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REVENUE FUNCTION

Activity

Pick any one of the following firms and

list all sources of its income/revenue:1. Infosys Technologies Ltd.

2. Maruti Udyog Ltd.

3. ICICI Bank4. Hindustan Unilever ltd.


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Simplifying Assumptions

Producer himself is seller- no intermediary

One product firm

Only source of revenue is by selling thecommodity/product; no other source ofrevenue

No commodity taxes

No unplanned unsold stocks/inventories-production equals sales volume

Implication Sales Revenue= total revenue


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Total Revenue (TR), Average Revenue

(AR) and Marginal Revenue (MR)

TR = Price X Quantity (P X Q)

AR = TR/Q = P

MR = dTR/dQ


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Given demand function,

Q = 100- 5P, calculate and plot TR, AR and MR curves

P Q TR AR MR

20

18

16

14

12

10

8

6

4

2

0


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Calculate and plot TR,AR and MR

Q = 40- 4P

Q = 10

P = 20Q = 100/P


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FIRMS EQUILIBRIUM

Points to remember

Ignore ownership pattern

One product firmNo inventory; output produced = output

sold

Profit is the sole objective.Profit = TR - TC


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ECONOMIC PROFIT AND

ACCOUNTING PROFIT

Abnormal or Supernormal Profit

( TR > TC)

Normal profit ( TR = TC)

Loss ( TR < TC)


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Firms Equilibrium

Maximize Profit i.e produce that output

where the difference between TR and TC

is maximum

However in reality, it is impractical; firms

do not measure TR and TC at different

levels of output

Firms adopt marginal equivalency rule.


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Marginal Equivalency Rule

If MR > MC; increase output/sales

If MR < MC; decrease output/sales

If MR = MC; continue status quo- nochange; firms equilibrium


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Marginal change and incremental change

In reality, due to indivisibility of factors ortechnological constraints, it may not bepossible to make small (marginal)

changes. In that case, firms are guided by

incremental changes.

In that case firm shall maximize profitwhere Incremental revenue (roughly)equals incremental cost.

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