Course: BBASubject: Business Economics

Unit: 4

Cost Analysis & Price Output Decisions

Syllabus content

• Market: Meaning of Market, Types of Market and their important features: Perfect Competition, Monopoly, Monopolistic Competition and Oligopoly.

• Cost: Concept of Cost, Cost Function, Short Run Cost, Long Run Cost, Economies and Diseconomies of Scale, Explicit Cost and Implicit Cost, Private and Social Cost.

• Pricing: Under Perfect Competition, Pricing Under Monopoly, Control of Monopoly, Price Discrimination, Pricing Under Monopolistic Competition, Pricing Under Oligopoly.

What is market?

• Market is a place, where the buyers and the sellers of a good are in contact with each other.

• This contact may be direct or indirect.

Check Your Understanding

COST ANALYSIS

What is cost???

• Cost means the amount of money that a company spends on the creation or production of goods or services

"short run” and "long run"

• The difference between the short run and the long run is the flexibility decision makers have

• Short run: period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.

• Long run: period of time in which the quantities of all inputs can be varied.

"short run cost” and "long run cost"

• short run cost: The costs which incurred over the short run

• long run cost: The costs which incurred over the long run

Explicit Cost and Implicit Cost

• Explicit Cost: Business expense that is easily identified and accounted for.

• For Example: wage expense, rent or lease costs, and the cost of materials

• Implicit costs can also be thought of as intangible costs that are not easily accounted for.

• For example, the time and effort that an owner puts into the maintenance of the company, rather than working on expansion, can be viewed as an implicit cost of running the business.

Economies of Scale

• Economics of Scale exist when the production cost of a single product decreases with the number of unit produced

• Economies of scale is about the benefits gained by the production of large volume of a product

• In business, economies of scale are usually considered in relation to specific areas of the production process, which may be technical, managerial, marketing, finance, and risk bearing .

Diseconomies of scale

• Diseconomies of Scale exist when the production cost of a single product increases with the number of unit produced

• Diseconomies of scale is about the disadvantages faced by the production of large volume of a product

• In business, diseconomies of scale are usually due to Decision making, Managerial problems, Communication problems, Co-ordination/control problems, Staffing problems

Private cost and social cost

• Private cost: Monetary cost, which a firm incurs in the production of a good.

• Social Cost: Real cost, which the society incurs in the production of a good. For example- Pollution from a factory

Cost Function

• Cost is dependent on some factors. These factors make cost function.

• Short Run Cost function C=f (X, Pf ,T,K)

• Long Run Cost function C=f (X, Pf ,T)

Here C=CostX=OutputPf =Price of Factor

T= TechnologyK=Capital

EXAMPLE 1

11,000

9,000

7,000

5,000

3,000

1,000

Total Cost(Rs.)

30005

28004

24003

18002

10001

10,000

8,000

6,000

4,000

2,000

0

1,000

1,000

1,000

1,000

1,000

1,00000

Cost of labor(Rs.)

Fixed Cost(Rs)

Q(Quantity of Pens)

L(no. of

workers)

Total Cost Curve

0 1000 2000 30000

2000

4000

6000

8000

10000

12000

Quantity of Pen

To

tal c

os

t(R

s.)

Marginal Cost• Marginal Cost (MC)

is the increase in Total Cost from producing one more unit:

∆TC∆Q

MC =

Total and Marginal Cost

10.00

5.00

3.33

2.50

2.00

Marginal Cost (MC)

11,000

9,000

7,000

5,000

3,000

1,000

Total Cost

3000

2800

2400

1800

1000

0

Q

∆Q = 1000 ∆TC = 2000

∆Q = 800 ∆TC = 2000

∆Q = 600 ∆TC = 2000

∆Q = 400 ∆TC = 2000

∆Q = 200 ∆TC = 2000

Marginal Cost Curve

0 500 1,000 1,500 2,000 2,500 3,000 $0

$2

$4

$6

$8

$10

$12

Q

Mar

gin

al C

ost

($)

Costs

7

6

5

4

3

2

1

620

480

380

310

260

220

170

$100

520

380

280

210

160

120

70

$0

100

100

100

100

100

100

100

$1000

TCVCFCQ

$0

$100

$200

$300

$400

$500

$600

$700

$800

0 1 2 3 4 5 6 7

Q

Cost

s

FC

VCTC

Average Variable Cost

5207

3806

2805

2104

1603

1202

701

74.29

63.33

56.00

52.50

53.33

60

$70

n/a$00

AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:

AVC = VC/Q

As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7Q

Co

sts

Usually, as in this example, the ATC curve is U-shaped.

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Cost

s

Average Total Cost

88.57

80

76

77.50

86.67

110

$170

n/a

ATC

6207

4806

3805

3104

2603

2202

1701

$1000

TCQ

The Various Cost Curves Together

AVCATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Cost

s

Total, Average, Marginal Revenue for competitive firm

Pricing under Perfect Competition

Diagrammatic representation

Cost/Revenue

Output/Sales

P = MR = AR

MC

AC

Q1

Total, Average, Marginal Revenue for Monopoly

%Pricing under Monopoly

QuantityQ Q0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost

Monopolyprice

QMAX

B

1. The intersection of themarginal-revenue curveand the marginal-costcurve determines theprofit-maximizingquantity . . .

A

2. . . . and then the demandcurve shows the priceconsistent with this quantity.

Controlling Monopoly

• Government may regulate the prices that the monopoly charges(Examples: CNG, PNG prices)

• Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (Example: Railway)

• Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.

PRICE DISCRIMINATION

• Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same

• Price discrimination is not possible when a good is sold in a perfect competitive market because there are many firms all selling at the market price.

• For price discrimination, the firm must have some market power.

• Perfect Price Discrimination– Perfect price discrimination refers to the situation when the

monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

PRICE DISCRIMINATION

• Examples of Price Discrimination– Movie tickets– Airline prices– Discount coupons– Financial aid– Quantity discounts

Total Revenue for Oligopoly

GAME THEORY AND THE ECONOMICS OF COOPERATION

• Game theory is the study of how people behave in strategic situations.

The Prisoners’ Dilemma

Bonnie’ s Decision

Confess

Confess

Bonnie gets 8 years

Clyde gets 8 years

Bonnie gets 20 years

Clyde goes free

Bonnie goes free

Clyde gets 20 years

gets 1 yearBonnie

Clyde gets 1 year

Remain Silent

RemainSilent

Clyde’sDecision

Jack and Jill Oligopoly Game

Copyright©2003 Southwestern/Thomson Learning

Jack’s Decision

Sell 40Gallons

Sell 40 Gallons

Jack gets$1,600 profit

Jill gets$1,600 profit

Jill gets$2,000 profit

Jack gets$1,500 profit

Jill gets$1,500 profit

Jack gets$2,000 profit

Jill gets$1,800 profit

Jack gets$1,800 profit

Sell 30 Gallons

Sell 30Gallons

Jill’sDecision

42

Pricing in A Monopolistically Competitive Firm in the Short Run

MR1

$70

30

250

d1

A MCATC

Dollars

Homes Serviced per Month

2. and charges $70 per home.

4. Kafka's monthly profit–$10,000–is the area of the shaded rectangle.

1. Kafka services 250 homes per month, where MC and MR intersect . . .

3. ATC at 250 units is less than price, so profit per unit is positive.

43

Pricing in A Monopolistically Competitive Firm in the Long Run

d2MR2

E

MC

$40

100 250

Dollars

Homes Serviced per Month

ATC

MR1

In the long run, profit attracts entry, which shifts the firm's demand curve leftward.

The typical firm produces where its new MR crosses MC.

d1

Entry continues until P = ATC at the best output level, and economic profit is zero.