Economics for Engineers – MODULE 2 STC CHENGANNUR,

Module 2 - Syllabus
Cost concepts – Social cost, private cost – Explicit and implicit cost – Sunk cost - Opportunity cost - short run
cost curves - Revenue concepts Firms and their objectives – Types of firms – Markets - Perfect Competition –
Monopoly - Monopolistic Competition - Oligopoly (features and equilibrium of a firm) Cost concepts – Social
cost, private cost – Explicit and implicit cost – Sunk cost - Opportunity cost - short run cost curves - Revenue
concepts Firms and their objectives – Types of firms – Markets - Perfect Competition – Monopoly - Monopolistic
Competition - Oligopoly (features and equilibrium of a firm)

COST ANALYSIS

A production function tells us how much output a firm can produce with its existing plant and
equipment. The level of output depends on prices and costs. The most desirable rate of output
is the one that maximizes total profit that is the difference between total revenue and total
cost. Entrepreneurs pay for the input factors- Wages for labor, price for raw material, rent for
building hired, interest for borrowed money. All these costs are included in the cost of
production. The economist’s concept of cost of production is different from accounting.

Cost Concepts

There are various classifications of costs based on the nature and the purpose of
calculation. But in economics and for accounting purpose the following are the important
cost concepts.
 Opportunity cost: The revenue which could have been earned by employing that good
or service in some other alternative uses. (Eg. A land owned by the firm does not pay
rent. Thus a rent is an income forgone by not letting it out)

Explicit cost: Cost actually paid by the firm. If the factors of production are hired or
rented, then it is an explicit cost.
 Implicit cost: If the factors of production are owned by a firm then its cost is implicit
cost.

Difference between Explicit Cost and Implicit Cost

Basis Explicit Cost Implicit Cost

Explicit Cost is a payment made

Implicit Cost is the cost of self-supplied
Meaning to outside parties for hiring the
factors.
factor services.

It consists of the firm's imputed value

Money It includes paying with actual money
of factors. There is no monetary
Payment to purchase and hire inputs.
payment involved.

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Basis Explicit Cost Implicit Cost

Payment of salaries, Rent, Insurance Interest on capital, Rent of self-owned

Example premiums, etc. land, etc.

 Economic costs are related to future. They play a vital role in business decisions as the
costs considered in decision - making are usually future costs. They are similar in
nature to that of incremental, imputed explicit and opportunity costs
 Social Cost: social cost is the sum of private cost and external cost. Private cost is the
cost incurred by the producer in the production of a commodity. These are the expense
of producer in buying or hiring factor services.
When a commodity is produced it may cause damages to the environment in the form
of air pollution, water pollution etc. These are the external cost and it is met by the
society.
 Sunk Cost
Sunk cost is the cost which has already been incurred and cannot be recovered. In other
words, it is totally irretrievable.
Determinants of Short –Run Cost
Short-run cost is the price of a product that has short-term implications in the production process, i.e.,
it is used across a limited number of end products. These are the costs that are made only once and
cannot be recovered, such as wages, raw material costs, electricity bills and so on.

For example- Let’s say a firm notice a sudden rise in demand for caps and it realises that the only way
to meet the additional demand in the short run is to change the temporary elements, like, the firm can
hire more labours or buy raw materials in bulk, but the plant size or machinery cannot be changed to
increase the firm’s production capacity of caps. As a result, the short-run cost includes all costs
expended on variable components such as labour and raw materials.

The short-run cost varies with the change in total output from an analytical standpoint, while the firm’s
size remains constant. As a result, the short-run cost is always considered a variable cost.

Fixed cost: Some inputs are used over a period of time for producing more than one batch of goods.
The costs incurred in these are called fixed cost. For example, amount spent on purchase of equipment,
machinery, land and building.

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Variable cost: When output has increased the firm spends more on these items. For example, the money
spent on labor wages, raw material and electricity usage. Variable costs vary according to the output. In
the long run all costs become variable.

Total cost: The market value of all resources used to produce a good or service.

Total Fixed cost (TFC or FC): Cost of production remains constant whatever the level of output.
Eg: salary, rent

Total Variable cost (TVC or VC): Cost of production varies with output. Eg: Raw materials
Average cost (AC): Total cost divided by the level of output.
AC = TC / Q or TFC + TVC /Q or AFC + AVC
Average variable cost: Variable cost divided by the level of output.
AVC = TVC / Q

Average fixed cost: Total fixed cost divided by the level of output.

AFC = TFC / Q

Marginal cost: Cost of producing an extra unit of output.

MC = TC n – TCn– 1
∆ 𝑻𝑪
MC =
∆𝑸

Short Run Cost Output Relationship

Fixed cost curve is a horizontal line which is parallel to the ‘X’ axis. This costis constant with respect
to output in the short run. Fixed cost does not change with output. It must be paid even if ‘0’ units of
output are produced. For example: if you have purchased a building for the business you have invested
capital on building even if there is no production.
Total fixed cost (TFC) consists of various costs incurred on the building, machinery, land, etc. For
example, if you have spent Rs. 2 Lakhs and bought machinery and building which is used to produce
more than one batch of commodity, then the same cost of Rs. 2 Lakhs is fixed cost for all batches.
The total variable costs vary according to the output. Whenever the output increases the firm has to
buy raw materials, use more electricity, labor and other sources therefore the TVC curve is upward
sloping. The total cost consists of fixed (TFC) and variable costs (TVC). The TFC of Rs. 2 Lakhs is
included with the variable cost throughout the production schedule so the total cost (TC) is above the
TVC [Link] table and graphs shown below indicates the total costs curves and average cost curves
at various output level.

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Output TC TFC (FC) TVC (VC) AFC ATC AVC MC

(AC)
0 300 300 - - - - -

1 1800 300 1500 300 1800 1500 600

2 2000 300 1700 150 1000 850 200

3 2100 300 1800 100 700 600 100
4 2250 300 1950 75 562.5 487.5 150
5 2600 300 2300 60 520 460 350

6 3300 300 3000 50 550 500 700

GRAPH-Average Cost Curves

GRAPH-Average Cost Curves

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From the above table and set of graphs we can understand that capital is the fixed factor of production and
the
total fixed cost will be the same Rs. 300,000.
The total variable cost will increase as more and more goods are produced. So the total variable cost TVC
of producing 1 unit is Rs.1500 000, for 2 units 1700 000 and so on.
Total cost = TFC + TVC for 1-unit TC = 300 + 1500 = 1800.

The marginal cost of producing an extra unit is calculated based on the difference in total cost.
MCn = TCn – TCn-1

MC2 = TC2 – TC 2-1 = 2000 – 1800 = 200

MC for 5th unit = TC of 5th unit minus TC of 4th unit, In our example
2600 – 2250 = 350.
AVC also is calculated in the same manner TVC / output = 2600 / 5 = 460 AFC =
TFC / output = 300 / 5 = 60.
Long Run Cost

The long-run cost is a cost in the production process that has long-term repercussions, i.e.; it is spread over
a wide range of output. These costs are incurred on fixed factors of production, such as plant, building, and
machinery.

As the firm’s size of production grows, even fixed costs become variable costs in the long run.
Entrepreneurship, land, labour, capital goods, and other factors all change over time to achieve the desired
level of profits, and the cost of each item contributes to the long-run costs

 In long run all costs varies

 There is no fixed cost in long run
Long Run Average Cost (LAC)

In economics, marginal cost is the change in the total cost that arises when the quantity produced changes
by one unit. So in the short run, some inputs are fixed so that the marginal cost will reflect the cost of the
variable inputs. And in the long run, all inputs are variable, so the long run marginal cost (LRMC) includes
the cost of any one additional unit of labour.

Marginal cost can be considered the cost of producing one additional unit of a good or service. The concept
of marginal cost is important in microeconomics because it is used to make decisions about how much of a
good or service to produce.

• LAC is derived from short run AC

• LAC is termed as the collection of SAC

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Long Run Total Cost Curves

A Long Run Total Cost Curve (LRTC) is a graphical representation of the relationship between a firm's
long-run average cost (LRAC) and output levels. The LRTC is usually downward sloping, indicating that
long-run average cost decreases as output increases. The LRTC can be used to analyse economies of scale,
economies of scope, and the optimal scale of production.

Long Run Average Cost (LAC)

It is also known as Envelope Curve or Planning curve

Long-run average cost curves (LAC) show how much it costs a firm to produce a given output level as the
number of units of input increases. The LAC curve is U-shaped, which means that as the number of units
of input increases, the average cost falls and then rises. The fall in average cost is due to economies of scale,
while the rise is due to diminishing returns. Diminishing returns occur when the marginal product of an
input (e.g. labour) starts to fall as the level of that input increases. This happens because, at some point, the
extra workers are not as productive as the earlier workers.

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REVENUE

Revenue means receipts from sale of output by a firm in a given period

Total Revenue (TR)

• It is the total amount of money received by a firm from the sale of
goods and services during a certain period
TR = Q x P
i.e PQ
Q = Quantity/Output P = Price
Average Revenue (AR)
• AR = TR/Q
• PxQ/Q=P

i.e. AR = P
Marginal Revenue (MR)

It is the addition to total revenue from the sale of an additional unit of output
MR = TR n - TR n-1
MR = d(TR) / d(Q)

BREAK EVEN ANALYSIS

Break-Even analysis in economics or a business refers to the point where a company's revenue
equals the costs incurred, resulting in neither profit nor loss. The break-even analysis is the state
or point where the company's total revenue and expenses, including fixed and variable costs, are
equal.

The break-even analysis chart depicts the number of units of a product a company has to sell or
the total revenue required to cover all the expenses. If the company cannot reach the unit sales,
it will be in a loss-making position. Break-Even analysis is also called the Cost-Volume-Profit
analysis.
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That's why every company must employ break-even analysis tools to understand more about the
relationship between its expenses and revenue. This analysis helps companies determine the
minimum amount of products or services they need to sell to cover costs and achieve profitability.

Components of Break-Even Analysis

Fixed costs: These costs are also known as overhead costs. These costs materialise once the
financial activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation
cost, labour cost, interests, energy cost, etc.
Variable costs: These costs fluctuate and will decrease or increase according to the volume of
the production. These costs include packaging cost, cost of raw material, fuel, and other materials
related to production. Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Importance of Break-Even Analysis

 Manages the size of units to be sold: With the help of break-even analysis, the company or the
owner comes to know how many units need to be sold to cover the cost. The variable cost and
the selling price of an individual product and the total cost are required to evaluate the break-
even analysis. 

 Budgeting and setting targets: Since the company or the owner knows at which point a
company can break-even, it is easy for them to fix a goal and set a budget for the firm accordingly.
This analysis can also be practised in establishing a realistic target for a company. 

 Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease.
The break-even analysis helps the company to decide the least number of sales required to make
profits. With the margin of safety reports, the management can execute a high business decision.

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 Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable
cost. Therefore, with break-even analysis, the management can detect if any effects are changing
the cost.

 Helps to design pricing strategy: The break-even point can be affected if there is any change in
the pricing of a product. For example, if the selling price is raised, then the quantity of the product
to be sold to break-even will be reduced. Similarly, if the selling price is reduced, then a company
needs to sell extra to break-even.

Uses of Break-Even Analysis

 New business: For a new venture, a break-even analysis is essential. It guides the management with
pricing strategy and is practical about the cost. This analysis also gives an idea if the new business
is productive. 

 Manufacture new products: If an existing company is going to launch a new product, then they still
have to focus on a break-even analysis before starting and see if the product adds necessary
expenditure to the company. 

 Change in business model: The break-even analysis works even if there is a change in any business
model like shifting from retail business to wholesale business. This analysis will help the company
to determine if the selling price of a product needs to change. 

MARKET

Market is a term which is commonly used for a particular place or locality where goods are bought
and sold. According to Prof. Samuelson, “A market is a mechanism by which buyers and sellers
interact to determine the price and quantity of a good or service.” Based on competition, the market
structure has been classified into two broad categories:

1. Perfectly competitive. (Perfect Competition)

2. Imperfectly competitive. (Monopoly, Monopolistic competition and Oligopoly)

Perfect Competition
Perfect competition is defined as a market structure in which an individual firm producing homogenous
commodities cannot influence the prevailing market price of the product on its own.

Perfect competition is a market structure characterized by complete absence of rivalry among individual
firms

Features of Perfect Competition

1. Very Large Number of Buyers and Sellers

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There are so many buyers and sellers that no individual buyer or seller can influence the price of the commodity
in the market. He is a price-taker having no bargaining power in the market

The demand curve facing a firm is derived from the market equilibrium. In a perfectly competitive
market, price of the commodity is determined by the intersection of the market demand and
supply curves of the commodity. This occurs at point E where DD = SS.
2. Homogeneous Product
Firms in the market produce a homogeneous product. Homogeneity of a product implies that one unit of
the product is a perfect substitute for another.

3. Free Entry or Exit of Firms

The industry is characterized by freedom of entry and exit of firms. In a perfectly competitive market, there
are no barriers to entry or exit of firms. Entry or exit may take time, but firms have freedom of movement
in and out of an industry.

4. Perfect Knowledge
Firms have all the knowledge about the product market and the factor market. Buyers also have perfect
knowledge about the product market.

5. Perfect Mobility of Factors of Production

The factors of production can move easily from one firm to another. Workers can move between jobs and
between places.

6. Absence of Transportation Cost

All goods are produced locally. Transportation costs are zero.

Equilibrium of a Competitive Firm

We know that the necessary and sufficient conditions for the equilibrium of a firm are:
MC = MR
MC curve cuts the MR curve from below
In other words, the MC curve must intersect the MR curve from below and after the intersection lie above the
MR curve. In simpler terms, the firm must keep adding to its output as long as MR>MC. This is because
additional output adds more revenue than costs and increases its profits. Further, if MC=MR, but the firm
finds that by adding to its output, MC becomes smaller than MR, then it must keep increasing its output

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Since it is a perfectly competitive market, the demand for the product of the firm is perfectly elastic.
Further, it can sell all its output at the market price. Therefore, its demand curve runs parallel to the
X-axis throughout its length and its MR curve coincides with the AR curve.

MONOPOLY
• The word monopoly is derived from two Greek words ‘mono’ means single and ‘polo’
means to sell
• Monopoly is a market in which a single seller sells a product which has no substitutes
• E.g. RBI, Rail transport

Features of Monopoly
1. High barriers of entry: Competitors are unable to break into the market due to a single
company's control of it.
2. Price maker: The Company that operates the monopoly can determine the price of its
product without the risk of a competitor undercutting its price. A monopoly can raise
prices at will.
3. Profit maximizer: a monopoly maximizes profits. Due to the lack of competition a firm can
charge a set price above what would be charged in a competitive market, thereby
maximizing its revenue.
4. No Close Substitutes. There are no close substitutes for the commodity. The product sold
by monopolist has no close substitute.
5. High barriers to entry: other sellers are unable to enter the market of the monopoly.

6. Single seller: in a monopoly one seller produces all of the output for a good or service. The
entire market is served by a single firm. For practical purposes the firm is the same as the
industry.
7. Price discrimination: in a monopoly the firm can change the price and quantity of the good
or service. It is the act of charging different prices for the same product from different
consumers.

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Demand Curve under Monopoly

The monopolist produces all the output in a particular market. The

monopolist is a ‘price-maker’. It does not mean that monopolist can
fix both price and the quantity demanded. If he fixes a high price, less
commodity will be demanded. The result is a downward sloping
demand curve. The demand curve is a constraint facing a monopoly
firm. Demand curve is also the price line and the AR curve. Since AR
is downward sloping, MR lies below AR curve and is twice as steep
as the AR curve

Equilibrium under Monopoly

Under monopoly, for the equilibrium and price determination there are two different conditions
which are:

1. Marginal revenue must be equal to marginal cost.

2. MC must cut MR from below.

If the price determined by the monopolist in more than AC, he will get super normal profits. The
monopolist will produce up to the level where MC=MR. This limit will indicate equilibrium output.
In Fig. output is measured on X-axis and price on Y- axis. SAC and SMC are the short run average
cost and marginal cost curves respectively while AR and MR are the average revenue and marginal
revenue curves respectively.
The monopolist is in equilibrium at point E because at point E both the conditions of equilibrium
are fulfilled i.e., MR = MC and MC intersects the MR curve from below. At this level of equilibrium,
the monopolist will produce OQ1 level of output and sells it at CQ1 price which is more than average
cost DQ1 by CD per unit. Therefore, in this case total profits of the monopolist will be equal to
shaded area ABDC.

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Dumping
It means a monopolist sells his product at a higher price in the home market and lower price in the
international market.

Regulation of Monopoly
1. Promote competition. In some industries, it is possible to encourage competition, and
therefore there will be less need for government regulation.
2. Quality of service. If a firm has a monopoly over the provision of a particular service, it
may have little incentive to offer a good quality service. Government regulation can ensure
the firm meets minimum standards of service.
3. Prevent excess prices. Without government regulation, monopolies could put prices
above the competitive equilibrium. This would lead to allocative inefficiency and a decline
in consumer welfare.

Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another. It is a market structure at which large number
of sellers dealing with differentiated commodities. The main feature of monopolistic competition
is Product Differentiation
Product Differentiation means commodities marketed by each seller can be distinguished from
the products marketed by other seller in the form of size, shape, brand, color etc..
The term Monopolistic comp was given y Prof. Edward H Chamberlin.

Features of Monopolistic Competition

 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the good is highly
differentiated
 Large number of sellers
 Product Differentiation
 Freedom for entry and exit
 Advertisement and selling cost
 Lack of Perfect Knowledge

Price – Output determination under monopolistic competition.

In the short run, the diagram for monopolistic competition is the same as for a monopoly.

The firm maximizes profit where MR=MC. This is at output Q1 and price P1, leading to supernormal
profit. (Refer Monopoly)

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OLIGOPOLY

An oligopoly is a market characterized by a small number of firms who realize they are
interdependent in their pricing and output policies. The number of firms is small enough to give
each firm some market power. The word oligopoly is derived from two Greek words ‘Oligo’ means
few and ‘Polo 'means to sell. It is a market with few sellers dealing with homogenous and
differentiated commodities. In oligopoly one firm’s action will cause its competitors to react. This
shows that firms have interdependence under oligopoly.

Features of Oligopoly

a) Few Firms with Large Market Share

A market may have thousands of sellers, but if the top 5 firms have a combined market share
of over 50 percent, it can be classified as an oligopolistic market. This is because the power
is concentrated between a few sellers who are able to exercise power over the market.
b) High Barriers to Entry
Oligopolistic firms maintain their position through a number of barriers to entry. For
instance, brand loyalty, patents, and high start-up costs are but to name a few. These make
it difficult for new entrants to build a presence in the market and attract customers.
c) Interdependence
Any action a firm takes in an oligopolistic market will strongly affect the actions of its
competitors.
d) Nature of the Product
The firms under oligopoly may produce homogeneous or differentiated product.
e) Indeterminate Demand Curve
Under oligopoly, the exact behavior pattern of a producer cannot be determined with
certainty. So, demand curve faced by an oligopolistic is indeterminate (uncertain).

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Price – Output determination under oligopoly

The Kinked demand curve model was developed by Paul M Sweezy in 1939. The kinked demand
curve is distinctive of an oligopolistic market. It shows how, at higher and lower prices, the elasticity
of demand changes. As a result, prices remain relatively rigid. As competitors keep their prices
stable, the firm that increases prices will lose customers to cheaper rivals. At the same time,
reducing prices won’t increase demand. This is because price decreases will be met with fierce
competition. In an oligopoly, when one firm reduces its prices, the others follow. In turn, any real
gains in demand will be negligible.

Diagram of kinked demand curve

Collusive Oligopoly
Collusive Oligopoly Sometimes, firms may try to remove uncertainty related to acting
independently and enter into price agreements with each other. This is collusion. Collusion is either
formal or informal. It can take the form of cartel or price leadership. A cartel is an association of
independent firms within the same industry which follow the common policies relating to price,
output, sale, profit maximization, and the distribution of products. Price leadership is based on
informed collusion. Under price leadership, one firm is a large or dominant firm and acts as the
price leader who fixes the price for the products while the other firms allow it.
According to Samuelson “Collusion denotes a situation where two or more firms jointly set their
prices or output, divide the market among them, or make the business decisions”

Non – Price Competition

Non-price competition involves ways that firms seek to increase sales and attract custom through
methods other than price. Non-price competition can include quality of the product, unique selling
point, superior location and after-sales service

Forms of non-price competition

Loyalty card – Some big business has invested considerably in loyalty cards which give ‘rewards’ or
money back to customers who build up points/spending.

Subsidized delivery - Amazon has been successful at pushing Prime Delivery accounts. This promises
free next day delivery. Amazon is offering this delivery service as a loss leader. The cost of delivery is

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often higher than what a customer is actually paying.

Advertising/brand loyalty - Firms spend billions on advertising because repeated exposure to famous
brands can make consumers more likely to buy ‘trusted’ brands.
After-sales service - For some goods, like TVs and car, offering free after-sales service can be a factor in
encouraging customer trust. It can also be a profitable aspect of the business. For example, Apple Care
offers a three-year warranty, but it is priced at a good margin.
Coupons and free gifts- Some sellers provide coupons and free gifts along with product.

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