• Equilibrium of firm• Cost and revenue• Break-even analysis.• Shut down point.

BySaikiran.y

Sarath.Santosh.h

Sandeep.s

Equilibrium of a firm

The firm is said to be in equilibrium if it has no inclination to expand or to

contract its output.

• The firm will reach such a state when it maximises its residual profits.

• Residual profits are the difference between total revenue and total costs.

• Thus the firm will reach the equilibrium when it maximises the difference between its total revenue and total costs.

• The behavioural rule of profit maximisation or the equilibrium output of the firm is explaned by the Marginal Revenue-Marginal Cost equality approach(MR:MC approach).

• An informative and useful method of determining a firm’s equilibrium output is the comparison of Marginal Cost(MC) with Marginal Revenue(MR) at each successive unit of output, Instead of Total Revenue(TR) and Total Cost(TC).

• The marginal cost-marginal revenue(MR:MC) approach clearly shows the behavioural role of profit maximisation by using price as an explicit variable.

• The profit maximising condition may be stated as the rate of output at which the difference between TR and TC is the greatest, or the point at which MR=MC.( or nearly equal )

• Let us consider a much simplified case study of a hypothetical firm under perfect competion.

• Assuming the prevailing market price to be Rs 10 per unit, its revenue, and cost data are presented in following table .

MarketPrice.Rs per Unit(p)

Units ofOutputSold(q)

Total revenue(Rs)(TR=PQ)

Total cost(+)(Rs)(TC)

Profit or loss (-)=(TR – TC)

Marginal revenue(Rs)(MR)

Marginal cost.(Rs)(MC)

1010101010101010101010

012345678910

0102030405060708090100

1016202122253037476181

- 10- 60+ 9+ 18+ 25+ 30+ 33+ 33+ 29+ 19

010101010101010101010

0> 6> 4> 1> 1> 3> 5> 7= 10< 14< 20

• The equality between the marginal cost(MC) and marginal revenue(MR) of the firm is the condition of profit maximising output as well as the eqilibrium of the firm.

• This suggests the firm will go on expanding its output as long as every additional unit produced adds more to it total revenue than what it adds to the total costs.

• The firm will not produce a unit which will add more to its total cost than what it adds to its total revenue, obviously because it would put the firm to a loss.

• In other words, the firm will be increasing its profits by expanding its output to the level at which the marginal revenue just equals the marginal cost.

• It will be disadvantageous for the firm to produce an output of less than this level or more than this level, because then its total residual profits will be less than maximum.

P

O

A

B

F

G

Q1 Q

E

T

S

MRBreak even point

Cos

t

reve

nue

output

MC

Cost Analysis

Definition of Cost :

The aggregate of prices paid for the factors of production used in producing a commodity is known as the cost of production of that commodity

Types of Production Cost

• Total Fixed Costs• Total Variable Costs• Total Costs• Marginal Costs• Average Fixed Costs• Average Variable Costs• Average Total Costs

Total Fixed Costs

• Those costs that are incurred by the firm on fixed factor inputs.

• They remain fixed on all levels of output.• Also known as ‘supplementary costs’ or

‘overhead costs’.

Total Variable Costs

• Costs incurred by the firm on the use of variable factor inputs.

• Variable costs are directly proportional to the output of the firm.

• Also known as ‘direct costs’ or ‘prime costs’.

Total Cost

• It is the overall expenses incurred by the firm in producing a given level of output.

• It varies with the level of output.

Average Fixed Costs

• It is the total fixed cost divided by total number of units produced.

• AFC = TFC/Q.

Average Variable Costs

• It is the total variable cost divided by the number of units produced.

• AVC = TVC/Q

Average Total Cost

• It is the total cost divided by the total number of units produced.

• ATC = TC/Q or = AFC + AVC

Marginal Cost

• It is the addition made to the total cost by producing one more unit of output.

Short run average cost schedule of a firm

No. of units

TFC TVC TC AFC AVC ATC MC

0 100 0 100 - - - -

1 100 25 125 100 25 125 25

2 100 40 140 50 20 70 15

3 100 50 150 33.3 16.6 50 10

4 100 60 160 25 15 40 10

5 100 80 180 20 16 36 20

6 100 110 210 16.3 18.3 35 30

7 100 150 250 14.2 21.4 35.7 40

8 100 300 400 12.5 37.5 50 150

9 100 500 600 11.1 55.6 66.7 200

10 100 900 1000 10 90 100 400

Revenue Analysis

Revenue Analysis

• Revenue means sales receipts.• It depends upon the price at which the

quantities of output are sold by the firm.• Revenue can be categorised in three

categories :1.Total Revenue2.Average Revenue3.Marginal Revenue

Total Revenue

• It is the total sales receipts of a firm over a given period of time.

• TR = PxQ

Average Revenue

• It is the revenue obtained per unit of output sold.

• AR = TR/Q

Marginal Revenue

• It is the addition made to the total revenue by selling one more

• It is defined as the ratio of change in total revenue to unit change in output sold.

Break Even Analysis.(BEA)

• The break-even analysis has considerable significance for economic research, business decision making, company management, investment analysis and public policy.

• The BEA is an important technique to trace the relationship between costs, revenue at varying levels of output or sales.

• Here a break-even point is located at that level of output or sales at which the net income or profit is ZERO.

Break-even chart.

• Break even chart is the essence of break-even analysis.

• The break-even chart (BEC) is basically a graph which shows the relation of total cost and total revenue to the rate of output or sales.

• Thus it also shows the profit output relationship for the firm.

(TR)

(TC)

Total costTotal revenue

Assumptions of break-even analysis.

1) Cost function and revenue function are linear.2) Total cost is divided into fixed cost and

variable cost.

Assumptions of break-even analysis.

1) Cost function and revenue function are linear.2) Total cost is divided into fixed cost and

variable cost.3) The selling price is constant.4) The volume of sales and volume of production

are identical.5) The product mix is stable in case of a multi-

product firm.

Assumptions of break-even analysis.5 )The product mix is stable in case of a multi-

product firm.

In practice all these assumptions are unlikely to be fulfilled.

Limitations of BEA• It is static: in BEA, everything is assumed to be

constant. But the real world conditions are dynamic. Like market and prices may change, technology and policies may change.

• The scope is limited to short run only.• It assumes horizontal demand curve with the

given price of the product.• The traditional BEA is very simple and does not

take into account factors like income tax etc.

Usefulness of BEA

• BEA can be used to determine the safety margin regarding the extent to which the firm can permit decline in sales.

• It gives a prediction of profits and hence a company can decide on future course of action.

• It gives a microscopic view of the profit structure of the firm.

• The cost function used in BEA is a great help for cost control in a business.

To conclude BEA is a highly significant in business decision

making pertaining to every aspect like pricing policy, sales

projection, capital budgeting etc.

SHUT DOWN POINTDEFINITION

A point of operations where a firm is indifferent between continuing operations and shutting down temporarily. The shutdown point is the combination of output and price where a firm earns just enough revenue to cover its total variable costs.

EXPLANATION

• If a firm is operating at its shutdown point, it is usually operating at a loss. The concept is that if a firm can produce revenue greater or equal to its total variable costs, it can use the additional revenue to pay down its fixed costs. This assumes that fixed costs will still be incurred when a firm shuts down, such as lease contracts or other lengthy obligations.

GRAPHICAL REPRESENTATION

• This diagram shows the profits from operating when P < AVC. If a firm were to operate, the profit maximizing output would be where P = MC, which is Q. Profits at Q are (P - AC) Q which is negative because P < AC. Losses (negative profits) are the two boxes, -FC and X Loss added together. Since the firm would only incur the loss of FC if it shutdown and it incurs the loss of FC and X (for extra) Loss by operating, it is better off to shutdown.