Module 2
Cost Analysis
Cost
Cost is the expenditure incurred by a firm in the production of a commodity. To
produce a commodity a firm needs raw materials, labour, buildings etc. the
expenses of these items are termed as Cost. Today there are two main approaches
in Cost analysis:
1. Traditional theory of Cost-Marshall
2. Modern theory of cost- PWS Andrews
Cost Function
Cost Function is the functional relationship between Total Cost and the Volume of
Output per unit of time.
TC=f(Q)
Types of Costs
1. Explicit and Implicit cost
Explicit cost is the expenses actually met by the producer while producing a
commodity. In other words, these are the payments incurred by the producer for
outsiders who supply labour, raw materials, electricity etc. Therefore, an explicit
cost is the monitory payment made by a firm for use of an input owned or
controlled by others. Explicit costs are also referred to as accounting costs.
Implicit cost is the opportunity cost of the factor services supplied by the
organization itself. Implicit costs represent the value of foregone opportunities but
do not involve an actual cash payment. Implicit costs are just as important as
explicit costs but are sometimes neglected because they are not as obvious.
2. Real cost
This is the actual pain and suffering involved in the production of a commodity.
Real cost is the pain and trouble of acquiring a product”.
3. 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. However, 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.
4. Accounting Cost
Accounting Cost is the money cost that can be recorded in the books of account.
This is same as explicit cost.
5. Replacement Cost
Replacement cost is the cost incurred when an asset depreciates and it is replaced
with the new asset.
6. Sunk Cost
Sunk cost is the cost which has already been incurred and cannot be recovered. In
other words, it is totally irretrievable. It is not used for future decision making.
7. Fixed and Variable Costs:
In a short run, costs of a firm may be split up into two Fixed and Variable Costs.
The costs which remain constant and do not vary with the output are called Fixed
costs or Supplementary Costs. Variable costs are those expenses in production,
which vary more or less proportionately with the output.
8. Private Cost
Private cost is the monetary expense that a firm or individual directly incurs while
producing or using a product.
9. External Cost
External Cost (also called Externality or Spillover Cost) is the cost of producing or
consuming a good or service that is borne by a third party who is not directly
involved in the transaction.
10. Social Cost
Social Cost is the total cost to society from producing or consuming a good or
service. It includes:
The Private Cost (borne by the producer/consumer)
Plus the External Cost (borne by others in society)
Social Cost=Private Cost + External Cost
[Link] Cost
Opportunity Cost is the value of the next best alternative that is given up when a
choice is made.
Opportunity Cost = Value of Best Alternative Foregone
Concepts of Cost
Total Cost:
Total cost is the sum of fixed costs and variable costs.
TC=TFC+TVC
Average Cost:
AC is the cost per unit of output. It is the Total Cost (TC) divided by the Total
Output(Q). AC is the sum of AVC and AFC. (AC=AVC+AFC).
TC
AC=
Q
Marginal Cost
Marginal cost is the addition to the total cost when one more unit of the output is
produced.
∆ TC
MC=TCn-TCn-1 or MC= ∆Q
Short run and Long run
Short run is a period in which a firm can increase its output only by employing
more of the variables factors such as labour and raw materials. In the short run
fixed factors such as building, machinery etc. remains the same.
On the other hand, in the long run all factors are variable. Hence, size of plant and
building can be increased. Thus output can be increased by increasing the
quantities of all the factors.
Short run Cost Curves
Since in the short run certain factors are fixed and certain other factors are variable,
a firm incur fixed and variable cost.
Total Fixed Cost (TFC) - It is the cost which does not vary with the level of
output. In other words, it has to be met even at zero level of output. Rent of
factory, interest payment, salary of permanent employees etc. are examples of
fixed cost. TFC curve is a horizontal straight line parallel to the X axis.
Total Variable Cost (TVC) – Variable cost is the cost that vary with the level of
output. The TVC curve is an inverse S shaped curve.
Total Cost (TC) - Total cost is the sum of total fixed cost and total variable cost.
TC = TFC+TVC
TC curve has the same shape of the TVC curve. But its starts from the starting
point of the TFC curve. The TC and TVC curves are parallel.
Average Fixed Cost (AFC) – It is the fixed cost per unit of account. AFC is
obtained by dividing TFC by the number of units of output (Q) produced. AFC
curve is a rectangular hyperbola.
TFC
AFC=
Q
Average Variable Cost (AVC) – It is the variable cost per unit of output. It is
TVC
obtained by dividing TVC by the number of units of output (Q). AVC= Q .
Therefore, AVC curve is ‘U’ shaped.
Average Cost (AC) – AC is the cost per unit of output produced. It is obtained by
dividing TC by the number of units of output (Q) produced.
TC
AC= ∨ AC = AFC + AVC . Thus AC is the sum of AFC and AVC.
Q
Marginal Cost (MC) – MC is the addition to total cost when one or more unit of
output (Q) is produced.
∆ TC
MC= ∨MC=T C n-TCn-1
∆Q
MC is derived from TC. But TC is the sum of TFC and TVC. Therefore, MC is U
shaped.
Long Run Cost Curves
Long run is a period which is sufficient to increase the quantities of all the factors
such as building, machinery, labour etc. Hence all factors are variable in the long
run.
Long Run Total Cost (LTC)
It is the minimum cost at which a given level of output can be produced in the
long run. LTC curve is derived from the short run total cost curves. LTC is also
inverse S shape.
Long Run Average Cost (LAC)
LAC is the cost per unit of output in the long run. It is also derived from short run
average cost curves (SAC’s). LAC curve is a U shaped.
Long Run Marginal Cost (LMC)
It is the addition to total cost when one or more unit of output is produced in the
long run. It is derived from the short run marginal cost curves. LMC is also U
shaped.
Example:
Units TFC TVC TC AFC AVC AC
(TFC/Q) (TVC/
Q)
0 40 0 40 0 0 0
1 40 20 60 40 20 60
2 40 30 70 20 15 35
3 40 32 72 13.3 10.7 24
4 40 34 74 10.0 8.5 18.5
5 40 36 76 8 7.2 15.2
6 40 38 78 6.6 6.3 13
7 40 40 80 5.7 5.7 11.4
8 40 46 86 5.0 5.7 10.7
9 40 48 88 4.4 5.4 9.8
Revenue
Revenue is the income from the sale of output. Revenue is explained on the basis
of three concepts:
1. Total Revenue
2. Average Revenue
3. Marginal Revenue
Total Revenue (TR) – It is the total receipts from the sale of a given quantity of
output. It is obtained by multiplying quantity sold (Q) by price per unit (P).
TR=P × Q
Average Revenue (AR) - It is the revenue per unit of output sold. AR is the
Price.
TR
AR=
Q
Marginal Revenue (MR)- It is the addition to total revenue by selling one or more
unit of output.
∆ TR
MR =TRn-TRn-1 or MR= ∆Q
The following table explains the relationship between TR, AR and MR
Units of TR AR MR
the
product
1 12 12 12
2 20 10 8
3 26 8.7 6
4 30 7.5 4
5 30 6 0
6 28 4.7 -2
7 24 3.4 -4
The above table relations can be observed between MR and TR
1. When MR is positive TR increases
2. When MR is zero TR is maximum
3. When MR is negative TR decreases
MARKET
The word ‘Market’ is generally understood to mean a particular place or locality
where goods are sold and purchased. A Market may be defined as the group of
buyers and sellers dealing in a particular commodity in the particular place.
There are different types of market structures in an economy. On the basis of
competition, markets are generally classified into two categories:
1. Perfect Competition
2. Imperfect Competition
In an Economy markets classified into three forms:
1. Monopoly
2. Monopolistic Competition
3. Oligopoly
1. Perfect Competition Market
Perfect competition may be defined as a market situation in which there are large
number of buyers and sellers with perfect knowledge and close contact, dealing in
identical commodity without price discrimination.
Features or Characteristics
1. Large No of buyers and sellers: The number of buyers and sellers is so
large that the act of a single seller or buyer cannot influence the price or
output in the market.
2. Homogenous Product: under perfect competition all sellers selling an
identical product which is same appearance, colour, quality etc.
3. Uniform market price: under perfect competition all products charge the
same prices.
4. Freedom of entry and exit: there are no restrictions on the entry and exit of
firms. Thus there is open competition. It ensures normal profit in the market.
5. Perfect Knowledge: buyers and sellers have perfect knowledge about
market conditions. Buyers know about price and product.
6. No Transport cost: it is assumed that transport cost is absent in perfect
competition.
Under Perfect Competition all firms are “Price Takers”.
Equilibrium of a firm
Under any market situation a firm is in equilibrium when it gets maximum profit.
There are two approaches to find the profit maximizing level of output.
1. TC and TR approach
2. MC and MR approach
TC and TR Approach
Under this approach a firm will be in equilibrium when it produces the level of
output where the difference between TR and TC (Profit) is the maximum.
MC and MR Approach
Under this approach profit will be maximum when the following two conditions
are satisfied:
1. Marginal Cost is equal to Marginal Revenue
2. MC curve cut the MR curve from below
Equilibrium or Profit maximization of a firm under Perfect
Competition
1. TR and TC Approach
Under this approach a firm will be in equilibrium when it produces the level of
output where the difference between TR and TC (Profit) is the maximum. Even if
one more unit of output is produced, then the profit falls. In other words, the
marginal cost becomes higher than the marginal revenue if one more unit is
produced.
In the figure above, the X-axis shows the levels of output and Y-axis shows total
costs and total revenues. TC is the Total Cost Curve and TR is the Total Revenue
Curve. Also, P is the equilibrium point where the distance between TR and TC is
maximum. Further, you can see that before the point P’ and after the point P”,
TC>TR. Therefore, the producer must produce between P’P” or M’M”. At the
point P, a tangent drawn to TC is parallel to TR. In other words, at point P, the
slope of TC is equal to the slope of TR. This equality is not achieved at any other
point.
AR, MR Curve under Perfect competition
The demand curve for the product of a firm under perfect competition is perfectly
elastic. Average revenue curve (AR) and marginal revenue (MR) curves are
horizontal straight lines like the demand curves (DD) of firms under perfect
competition. Under P.C Both average cost (AC) and Marginal Cost (MC), are ‘u’
shaped.
2. MC and MR Approach under Perfect Competition
The MR-MC approach is derived from the TR-TC approach. The two conditions
of equilibrium under the MR-MC approach are:
1. MR = MC
2. MC cuts the MR curve from below
Profit is defined as the difference between Total Revenue and Total cost. A firm is
in equilibrium when it gets maximum profit.
The process of identifying equilibrium through MC and MR is shown in the
diagram below:
In the above figure X axis represents output and Y axis is cost and revenue. The
above figure satisfies two conditions. The output of a firm is optimum at
MC=MR. They are equal at point A. OM is the optimum output of the firm at
that level of output SATC is MB where AR or Price is MA. The profit per unit
is AB. Total Profit is shown by shaded area ABCD. So this is the Super
Normal profit.
Loss making situation Under Perfect Competition
In the next diagram, the firm is making a loss at its equilibrium, profit maximising
or loss minimising output, where MC=MR.
The price charged per unit of output P2 is lower than average total cost, P1 and
hence the firm makes a loss of P1P2CD.
Normal Profit situation Under Perfect Competition
2. Monopoly
It is the Imperfect market situation. The term “Monopoly” is derived from the
syllables “mono” and “poly”. “Mono” means Single and “poly” means selling.
Monopoly may be defined as a market situation in which there is only one seller of
a particular commodity, and he has sufficient control over the supply of
commodity so as to influence price. Under monopoly, all the firms are price maker
and not a price taker.
Features or Characteristics
1. There is a single producer or seller of the product. Entire supply of the
product comes from this single seller.
2. There is no close substitute for the product.
3. There is no freedom of entry.
4. The monopolist is a price maker.
5. Monopolist may follow a discriminating price policy for product.
Equilibrium of Monopoly (Price &Output Determination under
Monopoly)
MR and AR Curve (Demand Curve) of a Monopolist.
The demand curve or AR curve under monopoly is Steeper/negatively sloped. The
demand curve is drawn on the assumption that the monopolist is charging the same
price for all buyers.
Two conditions are to be satisfied to identify equilibrium..
a. MC should be equal to MR
b. MC curve should cut MR curve from below.
The monopolist aims at profit maximisation. He will maximize his profit when his
MC is equal to the MR and MC must be rising at the point of intersection. In other
words, the slope of MC must be greater than slope of MR at the point of
intersection This is shown below.
In the diagram at point E, MC =MR, and MC cuts the MR curve from below.
Hence E is the equilibrium point and OQ is the equilibrium level of output. When
the firm produce OQ level of output QA is the AR or Price. But the AC is less
than this and it is QB. AB is the profit per unit. The rectangle PABC shows the
total profit earned by monopolist.
Loss Making situation under Monopoly
Normal Profit Situation under Monopoly
3. Monopolistic Competition
Monopolistic Competition may be defined as the market situation in which there
are a large number of buyers and sellers dealing in differentiated products with
different prices.
Features of Monopolistic Competition
1. Large number of buyers and sellers
2. They are differentiated products
3. Freedom of entry and exit
4. Non price competition: Selling cost/Advertisement
5. There is absence of perfect knowledge.
6. There is no uniform price
Equilibrium of Monopolistic Competition (Price &Output
Determination under Monopolistic Competition)
AR Curve (Demand Curve)and MR Curve of a firm:
• AR curve or demand curve of a firm is Flatter downward sloping
• MR curve lies below the AR curve
Price and output determination
A firm in Monopolistic competition is in equilibrium when it maximizes profit.
Two conditions are to be satisfied to identify equilibrium.
a. MC should be equal to MR
b. MC curve should cut MR curve from below.
A firm earn supernormal profit in the short run. This situation is explained with the
help of the following diagram.
In the above diagram at point E, MC =MR and at this point firm is producing OM
level of output. When production is OM, average cost is MR but AR is greater than
AC which is MQ. QR shows profit per unit of output. The rectangle PSRQ is the
total profit of firm.
4. Oligopoly:
Oligopoly simply means ‘competitions among the few”. It may be defined as that
form of imperfect competition in which there are a few firms selling either an
identical products or differentiated products. Oligopoly is also known as
Incomplete Monopoly, multiple monopoly etc.
Features or Characterises
1. Few sellers:
Under oligopoly a few sellers dominate the entire industry. The sellers influence
the price of each other.
2. Homogenous or differentiated product:
In certain cases, product may be homogenous like product in perfect competition.
3. Barriers to Entry
Even though there are no legal barriers, various economic barriers prevent the
entry of new firms.
4. Mutual Interdependence
It implies that firms are influenced by each other’s decision.
5. Existence of price rigidity
6. Kinked Demand Curve
Equilibrium of Oligopoly (Price &Output Determination under Oligopoly)
Kinked Demand Curve:
The kinked demand curve model was developed by Paul M Sweezy in 1939.
Kinked demand curve explains price rigidity under Oligopoly on the basis of
following assumptions:
1. If firm increases its price others will not follow
2. If firm decreases its price others will also do the same.
Usually in oligopoly firms will not enter into a price war and price remains rigid. If
firm decreases the price others will also reduce the price and If firm increases its
price others will not follow. The lower part of the demand curve is less elastic
because a cannot gain from a price cut. The upper part of the demand curve is more
elastic because there will be a fall in demand if price hike. The kink at point P in
the demand curve.
If marginal revenue and marginal costs are added it is possible to show that profits
will also be maximised at price P. Profits will always be maximised when MC =
MR, and so long as MC cuts MR in its vertical portion, then profit maximisation is
still at P. Furthermore, if MC changes in the vertical portion of the MR curve, price
still sticks at P. Even when MC moves out of the vertical portion, the effect on
price is minimal, and consumers will not gain the benefit of any cost reduction.
MC curve passes through the discontinuity range of MR curve. So the equilibrium
quantity and price will be corresponding to the kink. Here OQ is the output and OP
is the price. Even when there is a large rise in marginal cost, price tends to stick
close to its original, given the high price elasticity of demand for any price rise.
…………………………………………..
Questions
1. Suppose a chemical factory is functioning in a residential area. What are the
external costs?
2. What are the advantages of large-scale production?
3. Distinguish between explicit and implicit costs?
4. What do you mean by non-price competition under oligopoly?
5. What are the features of monopolistic competition?
6. Explain the equilibrium of a firm earning supernormal profit under
monopolistic competition.
7. Make a comparison between perfect competition and monopoly?
8. Explain price rigidity under oligopoly with the help of diagram?
9. Explain the equilibrium of a firm under monopolistic competition.
[Link] is a monopolist called price maker?