Module 2
COST ANALYIS
• 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.
Cost Function
• Cost Function is the functional relationship
between Total Cost and the Volume of Output
per unit of time.
TC=f(Q)
Cost Concepts
1. Total Cost:
• Total cost is the sum of fixed costs and variable costs.
TC=TFC+TVC
2. Average Cost:
• AC is the cost per unit of output. It is the Total Cost (TC)
divided by the Total Output(Q).
AC=TC/Q
• AC is the sum of AVC and AFC. (AC=AVC+AFC)
3. Marginal Cost:
• Marginal Cost is the addition to the total cost when one more
unit of the output is produced.
MC=TCn-TCn-1 or MC= ∆TC/∆Q
Types of Cost
1. Private Cost:
• Private cost is the cost incurred by the
producer in the production of a
commodity.
2. External Cost:
• 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.
3. Social Cost:
• Social cost is the sum of Private cost and
External cost.
4. Explicit and Implicit Cost:
• On the basis of payment, costs are two
1. Explicit 2. Implicit
• Explicit Cost is a payment made to outside
parties for hiring the factor services.
Implicit Cost:
• Implicit Cost, are just opposite to the
explicit cost, Implicit Cost is the cost of
self-supplied factors.
• The former is an out of pocket cost,
while the latter is an opportunity cost.
5. Sunk Cost:
• Sunk cost is the cost which has already been incurred and
cannot be recovered. it is totally irretrievable. It is not
used for future decision making
6. Real cost:
• “Real cost is the pain and trouble of
acquiring a product”.
• Real cost is the actual pain and suffering
involved in the production of a commodity.
7. Accounting Cost:
• Also known as “Business costs”
• Accounting Cost is the money cost that can
be recorded in the books of account.
8. Replacement Cost
• Replacement cost is the cost incurred when
an asset depreciates and it is replaced with
the new asset.
9. Money Cost:
• Also known as “Nominal cost.”
• Money cost is the aggregate money
expenditure incurred by a firm on the
various items entering into the production
of a commodity.
10. 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.
11. Opportunity Cost
• Opportunity Cost refers to the value of the next best
alternative that you give up when you make a choice.
• “The value of the next best alternative foregone.”
• Example: You study at home instead of going for a movie.
• Chosen Option: Studying
• Opportunity Cost: Fun time at the movie
• By choosing to study, you miss out on the entertainment
and social time. That missed fun is your opportunity cost.
COST CURVES
Cost curves are generally classified into
two:
1. Short-run Cost Curves
2. Long-run Cost Curves
Short-Run Cost Curves (7)
Total Fixed Cost Curve (TFC)
Total Variable Cost Curve (TVC)
Total Cost Curve (TC)
Average Fixed Cost Curve (AFC)
Average Variable Cost Curve (AVC)
Average Cost Curve (AC)
Marginal Cost Curve (MC)
1. TFC (Total Fixed Cost)
• It is the cost which does not vary with the level of
output.
• Example- Rent of factory building, interest payment
etc.
• TFC Curve is a horizontal straight line parallel to X
2. TVC (Total Variable Cost)
• Variable cost is the cost that vary with the level of
output.
TVC = TC-TFC
• The TVC Curve is an inverse S shaped Curve.
3. TC (Total Cost)
• Total cost is the sum of total fixed cost and total
variable cost.
• TC = TFC+TVC
• TC Curve has the same shape of TVC curve/ Inverse S
shaped Curve
• TC curve is starts from the starting point of TFC curve.
4. AFC (Average Fixed Cost)
• It is the fixed cost per unit of output. AFC is
obtained by dividing TFC by the number of units
of output is (Q) produced.
AFC=TFC/Q
• AFC Curve is a downward sloping, graphically
the Curve is a rectangular hyperbola.
5. AVC (Average Variable Cost)
• It is the variable cost per unit of output.
AVC =TVC/Q
• AVC curve is a U shaped
6. AC (Average Cost)
• AC is the cost per unit of output produced.
AC=TC/Q , AC =AFC+AVC
• AC Curve is U shaped
7. MC (Marginal Cost)
• MC is the addition to total cost when one,
more unit of output is produced. MC is
derived from TC.
MC=TCn-TCn-1
or
MC =∆TC/∆Q
MC is U Shaped
2. Long-Run Cost Curves
(3)
Long-Run Total Cost Curve (LTC)
Long-Run Average Cost Curve (LAC)
Long-Run marginal Cost Curve
(LMC)
1. 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 curve is a inverse S shaped.
2. Long Run Average Cost (LAC)
• LAC is the cost per unit of output in the long run.
• It is also derived from the Short run Average Cost
Curves.
• LAC is U shaped.
3. Long Run Marginal Cost (LMC)
• It is the addition to total cost when one more units of
output is produced in the long run.
• It is derived from the Short run Marginal Cost Curves.
• LMC is also U shaped one.
1. Complete the above table
2. Draw the Diagrams- TFC,TVC,TC,AFC,AVC,AC, MC
REVENUE
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 money income earned by
a firm from the sale of its output.
• It is obtained by Multiplying quantity
(Q) by Price (P).
TR = P X Q
Average Revenue (AR)
• It is the revenue per unit of output sold.
AR = TR/Q or AR is the Price
Marginal Revenue (MR)
• It is the addition to total revenue by selling
one or more unit of output.
MR =TRn-TRn-1
Or
MR =∆ TR/∆Q
1. Find AR, MR
2. Draw the TR,AR &MR Diagram
MARKET
MARKET
•A Market may be defined as
the group of buyers and
sellers dealing in a particular
commodity in the particular
place.
•On the basis of Competition, Markets
are generally classified into two :
1. PERFECT COMPETITION
2. IMPERFECT COMPETITION
1. Perfect Competition
• 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.
• In the 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
1. 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.
2. MC and MR Approach:
• Under this approach profit will be maximum, when two
conditions are satisfied.
1. Marginal Cost equal to Marginal Revenue
(MC =MR)
2. MC curve cut the MR curve from the below
Short run Equilibrium of Perfect Competition
1. TR &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.
The Equilibrium of a
Firm under Perfect
Competition
(MC-MR Approach)
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.
• AC and MC are ‘u’ shaped.
• Under MC and MR Approach a firm is in
equilibrium when satisfy two conditions:
1. MC cuts the MR curve from below
2. MC will be equal to MR
• The process of identifying short run
equilibrium through MC and MR is shown in
the diagram below:
• The above figure satisfies two conditions.
• The output of a firm is optimum at MC=MR.
• They are equal at point E1 .
• OQ is the optimum output of the firm
• At that level of output SATC is MB where AR or
Price is E1 Q.
• The profit per unit is E1 E2
• Total Profit is shown by shaded area P1E1P2E2.
• 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.
2. Imperfect Competition
• Imperfect Competition is a market structure where some
or all conditions of perfect competition are not
fulfilled.
• In other words, A market becomes imperfect when
any of the conditions of perfect competition is
absent.
• Monopoly, Duopoly, Oligopoly, Monopolistic
Competition etc. are the examples of Imperfect
markets.
Features of Imperfect
Competition:
• Many Buyers, Few Sellers
• Product Differentiation
• Limited Entry and Exit
• Price Makers
• Selling Costs
1. MONOPOLY
• 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
[Link] is a single producer or seller of the
product. Entire supply of the product comes
from this single seller.
[Link] is no close substitute for the product.
[Link] is no freedom of entry.
[Link] monopolist is a price maker.
[Link] 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 Less than unitary elastic
demand Curve (Steeper)
• Under MC and MR Approach a firm is in
equilibrium when satisfy two
conditions:
1. MC cuts the MR curve from below
2. MC will be equal to MR
• The process of identifying short run
equilibrium through MC and MR is shown in
the diagram 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.
2. 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
Features of Monopolistic
Competition
• Large number of buyers and sellers
• They are differentiated products
• Freedom of entry and exit
• Non price competition: Selling
cost/Advertisement
• There is absence of perfect knowledge.
• There is no uniform price.
Equilibrium of
Monopolistic Competition
(Price &Output
Determination under
Monopolistic
Competition )
MR and AR Curve (Demand Curve) of a Monopolist
• The demand curve or AR curve under monopoly is
More than Unitary elastic demand Curve
(Flatter sloping)
• Under MC and MR Approach a firm is in
equilibrium when satisfy two
conditions:
1. MC cuts the MR curve from below
2. MC will be equal to MR
• The process of identifying short run
equilibrium through MC and MR is shown in
the diagram below:
• 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.
3. 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 of Oligopoly
• Few Sellers
• Interdependence of Firms
• Barriers to Entry
• Non-Price Competition
• Price Rigidity
• Possibility of Collusion
• Either Homogeneous or Differentiated Products
• Indeterminateness of demand curve facing an
oligopolistic (kinked demand curve)
Equilibrium of Oligopoly
(Price &Output
Determination under
Oligopoly)
Kinked Demand Curve Model
• The Kinked Demand Curve Model is an
economic theory used to explain price
rigidity in an oligopolistic market.
• It was first developed by Paul Sweezy in
1939.
Kinked Demand Curve is based on
two 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.
• 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.
BREAK –EVEN
POINT
• The study of cost-volume-profit
relationship is often referred as BEA.
• BEP is the point at which
total revenue is equal to
total cost. It is the point of
no profit, no loss.
Assumptions
• All costs can be separated into fixed and
variable components,
• Fixed costs will remain constant at all
volumes of output,
• Variable costs will fluctuate in direct
proportion to volume of output,
• Selling price will remain constant,
• TR and TC curves are straight lines.
• TR and TC are measured are
measured along the Y axis and
output along the X axis.
• At point E the TR curve intersects
the TC curve. Hence P is the BEP.
• At this point there is no profit or
loss.
Uses
• It helps in the determination of selling
price
• It helps in the fixation of sales volume
• It helps in forecasting costs and profit
• It helps in determination of costs and
revenue at various levels of output.
Limitations
• Unrealistic Cost Classification
• Constant Selling Price Assumption
• No Inventory Consideration
• Ignores Time Factor
• Linear Cost and Revenue Curves
• No Consideration for Risk and Uncertainty