Managerial Economics

Cost Analysis

 Profit Maximization Main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features. 1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. 2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern. 3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. 4. Profit maximization objectives help to reduce the risk of the business.

 Favourable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also.

 Unfavourable Arguments for Profit Maximization The following important points are against the objectives of profit maximization: (i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the sake holders such as customers, suppliers, public shareholders, etc.

 Drawbacks of Profit Maximization Profit maximization objective consists of certain drawback also: (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. (ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. (iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern.

 Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business.

 Favourable Arguments for Wealth Maximization (i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. (iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society.

 Unfavourable Arguments for Wealth Maximization (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. (ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. (iii) Wealth maximization creates ownershipmanagement controversy. (iv) Management alone enjoy certain benefits. (v) The ultimate aim of the wealth maximization objectives is to maximize the profit. (vi) Wealth maximization can be activated only with the help of the profitable position of the business concern.

Profit Maximisation vs Wealth Maximization

Profit maximisation is different from wealth maximisation. While the former is concerned with profits, that is, the excess of revenues over cost, the latter aims at maximising the net present value of future cash flows that are derived from costs and benefits. Whatever may be the firms objectives, the analysis of costs and benefits is the central concern of all managerial decisions

We will study a number of cost concepts and then develop a relationship between cost and output, both in short-run and long-run.

While on one hand, cost is the charge on revenue from which profits are found out, on the other, it also forms the basis of price, which is a component of revenue. Thus, cost plays a pivotal role in determining the profits of the firm.

Cost concepts
There are various prevalent cost concepts. Cost is understood differently for different purposes. The definition of cost thus varies from decision to decision. Cost may include price to be paid for a good, its transportation, storage and handling expenses besides other miscellaneous outflows. Since different decisions are affected by different types of costs, it is essential for a manager to understand which decision should consider which cost, that is, he must identify the relevant cost.

Actual Cost & Opportunity Costs

Costs that are actually incurred in acquiring or producing a good or service are known as actual costs. Since these costs are real cash outflows and are generally recorded in the account books, they are also called acquisition or accounting costs. Any process of production requires input factors to be used for producing an output. Each factor of production has its price. For land, it is rent, for labour it is wages, for capital it is interest and so on.

All these costs form the actual costs. Cash outflows in the form of the expenditure / payments made by the firm to the suppliers of factors of production are only recorded by the accountant in the account books of the firm.

Resources seldom have a single use. Normally they can be put to use in a number of alternative ways. A firm selects the best alternative and implements it. In doing so, it rejects all the other uses of the resource. Had the resources not been put to use in the best alternative, they would have gone to the second best alternative. Thus the price of the resource (cost to the firm) must be atleast equal to the

Value of the resource in the next best alternative use. The opportunity cost is the notional cost of sacrificing the alternatives.

In other words, it is the value of a resource in its best alternative use i.e the value that must be forgone in putting a resource to one particular use.

Example
Consider a firm that has Rs.100. With this amount it can either make a fixed deposit with a bank and earn interest of 10% per annum (p.a) or can purchase the factors of production for Producing t-shirts

Let the cost of land, labour, capital and management be Rs.20, 35, and 10 respectively. Thus, the actual cost of the production activity be Rs.95.

The opportunity cost will however be Rs.10.

Producing T-Shirts Lost out opportunity Rs.95 Rs.10

Since opportunity cost is a notional concept, it is not recorded in the books of accounts. However, it should be considered in decisionmaking. It should be used as a break-even cost.

A firm should continue to be in business only till the time it is able to generate more profits than what it would have made in an alternative

Business, in case of two alternatives, or the next best alternative, in case of many alternatives.

Fixed Costs & Variable Costs

In economics, fixed costs are business expenses that are not dependent on the activities of the business. They tend to be timerelated, such as salaries or rents being paid per month. This is in contrast to variable costs, which are volume-related (and are paid per quantity.)

Fixed cost remain constant. They might exist even if no output is produced. On other hand, costs that vary with changes in output are known as variable costs.

The rent of building and factory, interest on borrowed capital, cost of plant and machinery etc. are all fixed costs,

while the costs of raw material , wages etc are all variable costs. In other words, costs of fixed assets are all fixed costs and those of current assets are variable costs. Explicit and Implicit Costs

In economics, an implicit cost occurs when one foregoes an alternative action but does not make an actual payment.

(For instance, the explicit cost of a night at the movies includes the moviegoer's ticket and soda, but the implicit cost includes the pay he would have earned if he had chosen to work instead.) Implicit costs are related to forgone benefits of any single transaction.

An Explicit cost is an easy accounted cost, such as wage, rent and materials. It can be transacted in the form of money payment and is lost directly, as opposed to monetary implicit costs. Explicit cost are those which the entrepreneur has to pay from his own pocket

Today
- Understand Explicit and Implicit cost through examples - Cost analysis continued with Average cost, Marginal Cost, Total Cost, Short-run costs and long-run costs (example: hockey sticks mfg) - Discussion on Class activity of Opportunity cost of joining an MBA course - Discussion on class activity of CSR - Once again, MC, TC, FC, TVC, AVC, AFC, - Case Study Bogus Manufacturing Company - Short notes - Production Process and Production Function

- Understanding the graphs of costs

 Implicit Costs, Explicit Costs, and Total Costs Implicit Cost + Explicit Cost is a component of Total Cost

 A simple example: Thomas builds a cabinet. He spends 2 hours building the cabinet. He could have been working instead and normally makes Rs.25/hour at his job. Since he was building a cabinet he wasn't paid for this time. The materials to make the cabinet cost him Rs.20. His Explicit Costs are: Rs.20 in materials His Implicit Costs are: Rs.25/hr x 2 hrs= Rs.50 of foregone pay His Total Costs are: Rs.20 in materials + Rs.50 of foregone pay = Rs.70 Total Costs

Implicit costs are intangible costs that are not easily accounted for or defined clearly at all times.

For example, the time and effort that an owner puts into the maintenance of the company rather than working on expansion.

More examples include the value of an entrepreneurs labor and the interest that could be earned were the owners assets (including the values of stock in corporations) not tied up in the business.

In entering the software business and creating Windows, and subsequently Microsoft, Bill Gates dropped out of college and made a conscious decision to surrender what wages he could have made as a college graduate if his endeavor failed.

Though it paid off for him, similar decisions are made on a daily basis by people all over the world and it doesnt always end favorably for everyone.

Firms must all bear both implicit and explicit costs into consideration to make rational business decisions.

Total costs, Average Costs and Marginal costs

The sum total of all the costs : fixed, variable, explicit and implicit for the entire output, is known as total cost.

Average cost is the cost per unit of output and is computed by dividing the total cost by the number of units produced.
Marginal cost is the change in total cost due to the production of one additional unit of output.

Short-run costs & Long-run costs

Short-run is a period during which one or more inputs of the firm are fixed. In the long-run all the factors inputs are variable. Case study : Hockey sticks manufacturing

Raw materials such as lumber Labor Machinery A factory Suppose the demand for hockey sticks has greatly increased, prompting our company to produce more sticks. We should be able to order more raw materials with little delay, so we consider raw materials to be a variable input. We'll need extra labor, but we can likely increase our labor supply by running an extra shift and getting existing workers to work overtime, so this is also a variable input.

 The equipment on the other hand, may not be a variable input. It may be time consuming to implement the use of additional equipment. It depends how long it would take us to buy and install the equipment and how long it would take us to train the workers to use it. Adding an extra factory is certainly not something we could do in a short period of time, so this would be the fixed input.

 Using the definitions given at the beginning , we see that the short run is the period in which we can increase production by adding more raw materials and more labor. In the short run we cannot add another factory, but in the long run all of our inputs are variable, including our factory space.

 The increase in demand for hockey sticks will have different implications in the short run and the long run at the industry level. In the short run each of the firms will increase their labor supply and raw materials to meet the added demand for hockey sticks.

At first only existing firms will be likely to capitalize on the increased demand as they will be the only ones who will have access to the four inputs needed to make the sticks.
However we know that in the long run the factor input is variable as well.

 This means that existing firms can change the size and number of factories they own and new firms can build or buy factories to produce hockey sticks. In the long run we will see new firms enter the hockey stick market, while we will not in the short run because firms will not be able to acquire all of the inputs they need.

Fixed

Rent Depreciation of Plant Depreciation of equipment

Costs
Wages Insurance Travel Training Fuel Maintenance Supplies

Variable

Class Activity
Opportunity cost is not just monetary. Discuss your opportunity cost of attending college and opting for MBA as the course.

Also, calculate, using the best estimates.

Should I go to work today? Should I go to college after high school? Should the government spend money on a new weapon system?

These are decisions that are made everyday;

however, what is the cost of our decisions?

What is the cost of going to work, or the decision not to go to work? What is the cost of college, or not to go to college? Finally what is the cost of buying that weapon system, or the cost of not buying that weapon? In economics it is called opportunity cost.

Opportunity cost is the cost we pay when we give up something to get something else.

There can be many alternatives that we give up to get something else, but the opportunity cost of a decision is the most desirable alternative we give up to get what we want

 Lets look at the college example. We are all told to go to college so you can get a good education and that will translate into a good job. How do we know that college is such a good thing? How much college do we need?

 There are distinct benefits of a college education.

Higher Earnings - Earning a MBA degree provides the average student with over Rs.3,00000 p.a in future earnings. (on an average)
Increased level of education. That is, a Masters degree

For the society : People with higher education contribute time and money to charitable causes at a higher rate than those with less education.
Increased levels of education are associated with the increased likelihood of voting or registering to vote.

A better all-rounder individual. Benefits include increased self-awareness, the ability to think critically, and an opportunity to meet many different people. Overall, the entire college experience will provide you with a lifetime of benefits. As we can see there are many benefits to a college education.

 So what are the costs? There are monetary costs for sure. I am currently in a job which pays Rs.1,80,000 a year. Also, we will spend two or more years going to classes. We could be working and earning money instead of going to college. (Rs.1,80,000x 2) = 3,60,000 Finally we will be giving up free time for study time that could be used to do other things.

Cost_concepts.doc

Production Analysis
Production is a process of converting an input into a more valuable output. The analysis of demand is mainly used for planning the production processes and determining the level of production.
For equilibrium , supply should be equal to demand. Production is an aspect of the supply side of the market.

 A firm must purchase all the necessary inputs and then transform them into the product (outputs) that it wishes to sell.

For example a football shirt manufacturer must buy the fabric, pay someone for a design, invest in machinery, rent a factory and employ workers in order for the football shirts to be made and then sold.

 How well-organised a firm is at undertaking this transformation process will determine its success. This is known as the productive efficiency of a firm and it will want to be as efficient as possible in transforming its inputs into outputs (i.e. using the minimum number of inputs as possible to achieve a set amount of output). This will reduce the cost per unit of production and allow the firm to sell at a lower price.

 Ultimately, the objective of the production process is to create goods and services that meet the needs and wants of customers. The needs and wants of customers will be met if a business can produce the correct number of products, in the shortest possible time, to the best quality and all at a competitive price.

Introduction to Production Function

what is the production function of a economy? The concept of the production function is one of the most important and elegant contributions of economics to human thought. It is the recipe of inputs (factors of production) for the output of a firm or nation and is defined by a given state of technical knowledge (Samuelson 1961, 570).

In symbolic form, a production function may be stated as: Y = f (K, L, N) t where: Y = output f = some function of K = capital L = labour N = natural resources t = time This reads: Output (Y) is some function (f) of capital (K), labour (L) and natural resources (N) in a given time period (t). In effect, the state of technical knowledge, or technology, is implicit in the f of the equation. It is the recipe. How much of each input, in what combinations and under what conditions can ingredients be mixed to produce maximum output and minimize cost? It is also time specific, i.e., it has vintage.

An increase in any of these factors of production, when the other factors are constant, will lead to an increase in output. Before moving ahead with the discussion, it will be worthwhile to understand the basic nature of the factors of production. Their meaning is not limited to what is ordinarily understood. They have a much wider connotation in economic theory.

For example in economics, land does not only mean soil. It comprises of all the natural resources that have exchange value and can be used for producing goods. Such resources include air, light, heat

And water besides soil surface. These resources can be renewable or non-renewable. Similarly, in economic theory, capital goes beyond money. It is that part of mans wealth, other than land, which yields income. It is not an original factor of production, but a man made instrument of production. It includes a whole stock of wealth consisting of machines, tools, raw material, fuel and consumables. Capital can be fixed or working. While the former capital can be used for production more than once till it finally wears out, the latter capital is a single use producers good.

Labour denotes all kinds of work done by man for monetary reward. Management consists of bringing of all these three factors of production together, putting them to work and seeking returns while bearing the associated risks. Generally , the output of any commodity is related to its inputs. Though the determinants may be almost the same, their relative importance varies from commodity to commodity. Consider two commodities, a ball point pen and a mobile phone. Production of mobile phone requires larger capital and technology plays more

Crucial role in it than compared to a ball point pen. Similarly, a diamond polishing process may require larger capital but smaller land as compared to a marble polishing process. The concept of production function can be better understood by considering two inputs for an output. Although any two inputs can be considered, we take labour and capital since they are the most important variables of all. Thus Q = f (L, K)

Different combinations of the two inputs will produce different quantities of output. More inputs should logically produce more output. Say one unit of labor and one unit of capital produce one unit of output. The following table illustrates this reasoning for say, a garment exporting company. The table gives the output matrix for cotton t-shirts for different combinations of inputs.

L 1
2 3

2
3 7

3
4 8

5
7 10

8
10 13

12
14 17

The production function is basically a tool to analyse the input-output relationship.

Revision
Total Variable Cost

What it is: Variable costs are corporate expenses that vary in direct proportion to the quantity of output. Unlike fixed costs, which remain constant regardless of output, variable costs are a direct function of production volume, rising whenever production expands and falling whenever it contracts. Examples of common variable costs include raw materials, packaging, and labor directly involved in a company's manufacturing process.

The formula for calculating total variable cost is: Total Variable Cost = Total Quantity of Output * Variable Cost Per Unit of Output

Class activity

Let's assume XYZ Company has received an order for 5,000 units for a total sales price of Rs.5,000 and wants to determine the gross profit that will be generated by completing the order.

First, the variable costs per commodity must be determined.

Let's assume the following: Annual units Produced - 100,000 Raw Materials Costs - Rs.10,000 Direct Labor Costs - Rs.50,000 Determine Variable cost & Gross Profit

From this information, we can conclude that each unit costs 10 paise (Rs.10,000/100,000 units) in raw materials and 50 paise (Rs.50,000/100,000 units) in direct labor costs. Using the formula above, we can calculate that XYZ Company's total variable cost on the order is: 5,000 * (Rs.0.10 + Rs.0.50) = Rs.3,000 Therefore, the company can reasonably expect to earn a Rs.2,000 gross profit (Rs.5,000 - Rs.3,000) from the order.

Short Run Total Cost Curve

Y TC

Cost

TVC

TFC

O Output

In figure , output is measured on the X axis. Since Total fixed cost remains constant whatever the level of output, the total fixed cost curve (TFC) is parallel to the X-axis. The curve starts from a point on the Y-axis meaning thereby that the total fixed cost will be incurred even if the output is zero.

On the other hand, the total variable cost curve (TVC) rises upward showing thereby that as the output is increased, the total variable costs also increase.

The total variable cost (TVC) starts from the origin which shows that when output is zero the variable costs are also nil.

It should be noted that total cost is a function of the total output, the greater the output , the greater will be the total cost. In symbols, we can write TC = f(q)

Total cost curve (TC) has been obtained by adding up vertically , the total fixed cost curve and total variable cost curve because the total cost is the sum of total fixed cost and total variable cost. The shape of the total cost curve (TC) is exactly the same as that of total variable cost curve (TVC) because the same vertical distance always separates the two curves.

There are difficulties in classifying fixed and marginal costs. Nevertheless, the distinction made is very useful in decision making.

It is essential for forecasting the effect of shortrun changes in volume upon costs and profits.
In the short-run , a profit maximising firm will continue its operation so long as its viable cost is covered but in the long run, both fixed as well as variable costs must be covered.

Cost Function

Definition of The Cost Function: The cost function is a function of input prices and output quantity. Its value is the cost of making that output given those input prices. A common form: c(w1, w2, y) is the cost of making output quantity y using inputs that cost w1 and w2 per unit.

Marginal Cost

 Marginal Cost (MC) The marginal cost of an additional unit of output is the cost of the additional inputs needed to produce that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output. Marginal cost and average cost can differ greatly. For example, suppose it costs Rs.1000 to produce 100 units and Rs.1020 to produce 101 units. The average cost per unit is Rs.10, but the marginal cost of the 101st unit is Rs.20

Law of diminishing marginal utility

 What Does Law of Diminishing Marginal Utility Mean? A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product.

 explains Law of Diminishing Marginal Utility This is the premise on which buffet-style restaurants operate. They entice you with "all you can eat," all the while knowing each additional plate of food provides less utility than the one before. And despite their enticement, most people will eat only until the utility they derive from additional food is slightly lower than the original.

For example, say you go to a buffet and the first plate of food you eat is very good. On a scale of ten you would give it a ten. Now your hunger has been somewhat tamed, but you get another full plate of food. Since you're not as hungry, your enjoyment rates at a seven at best. Most people would stop before their utility drops even more, but say you go back to eat a third full plate of food and your utility drops even more to a three. If you kept eating, you would eventually reach a point at which your eating makes you sick, providing dissatisfaction, or 'dis-utility'.

Isoquant Curve

 Isoquant Curve What Does Isoquant Curve Mean? A graph of all possible combinations of inputs that result in the production of a given level of output. Used in the study of microeconomics to measure the influence of inputs on the level of production or output that can be achieved. explains Isoquant Curve In Latin, "iso" means equal and "quant" refers to quantity. This translates to "equal quantity". The isoquant curve helps firms to adjust their inputs to maximize output and profits. At some point, the returns of adding another worker or piece of equipment will start to hurt output.

Total Cost, Average Cost & Marginal Cost

Total Cost includes all cash payment made to hired factors of production and all cash charges imputed for the use of the owners factors of production in acquiring or producing a good or service.

Thus, the total cost of a firm is the sum total of the explicit plus implicit expenditure incurred for producing a given level of output.

For example , a shoe makers example cost will include the amount he spends on leather, thread, rent for his workshop , wages, interest on borrowed capital, salaries of employees etc. and the amount he charges for his services and his own funds invested in the business.

Marginal cost is the extra cost of producing one additional unit. At a given level of output, one examines the additional costs of being incurred in producing one extra unit and this yields the marginal cost.

For example, if the total cost of a firm is Rs.5000 when it produces 10 units of a good but when 11 units of the good are produced , it increases to Rs.5,300 then the marginal cost of the 11th unit is Rs.5300-5000 = Rs.300.

 In other words, marginal cost of nth units (MCn) is the difference between total cost of nth unit (TCn) and total cost of n-1th unit (TCn).

MCn = TCn TCn-1

The relationship between MC, AC and TC is shown in the following table

Units of goods produced 1

Total Cost (TC)

Average Cost 3 = 2/1 3

Marginal Cost (TCn- TCn-1) 4

10 11 12 13 14 15

5000 5300 5550 5700 5950 6350

500 481.82 462.5 438.46 425 423.33

300 250 150 250 400

The total cost concept is useful in break-even analysis and in finding out whether a firm is making profits or not.

The average cost concept is significant for calculating the per unit profit of a business concern.
The marginal and incremental cost concepts are needed in deciding whether a firm needs to expand its production or not.

 In fact , the relevant costs to be considered will differ from one situation to the other depending on the problem faced by the manager.

TC = FC + VC ATC = TC/Q AFC = FC/Q

AVC = VC/Q ATC = AFC + AVC

Output 1 4

Fixed Cost (TFC) 2 50

Variable Costs (TVC) 3 50

Total Costs

Average Fixed Costs

Average Variable Costs

Average Costs

5
10 11 17 18

50
50 50 50 50

60
100 106 150 157

21

50

182

Output 1 4

Fixed Cost (TFC) 2 50

Variable Costs (TVC) 3 50

Total Costs 100

Average Fixed Costs 12.50

Average Variable Costs 12.50

Average Costs 25

5
10 11 17 18

50
50 50 50 50

60
100 106 150 157

110
150 156 200 207

10
5 4.54 2.94 2.78

12
10 9.64 8.82 8.72

22
15 14.18 11.76 11.50

21

50

182

232

2.38

8.67

11.05

Managerial Economics devotes a great deal of attention to the behavior of costs. Total Cost varies directly with output. The more output a firm produces , the higher will be its production costs and vice versa, This is because increased production requires use of raw materials, labour, etc and if the increase is substantial even fixed inputs like plant and equipments and managerial staff may have to be increased.

The relationship between cost and output is rather important.

Revisiting 1st Chapter

Conventional theory of firm assumes profit maximization is the sole objective of business firms. But recent researches on this issue reveal that the objectives the firms pursue are more than one.

Some important objectives, other than profit maximization are: (a) Maximization of the sales revenue (b) Maximization of firms growth rate (c) Making satisfactory rate of Profit (d) Long run Survival of the firm (e) Risk-avoidance

 Accounting versus Economic Profit Everyone strives to acquire as much profit as possible. Profit is the positive gain from an investment or business operation after subtracting all the expenses. Yet despite the evident importance given to such concept, profit remains to be one of the most misunderstood features of finance.

 Profit was taken from the Latin word "to make progress" which then denotes two thingseconomic and accounting progress.

There is the economic profit which is the increase in wealth that an investor gains from the investment activities he/she has engaged into, taking into considerations all cost associated in the investment.

 These costs may include opportunity cost of capital. Accounting profit, on the other hand, pertains to the difference between the price and the costs of setting up in the market whatever enterprise you have. These costs include the component cost of delivered services and goods, as well as, operating costs.

 An economic profit is acquired whenever the revenue exceeds the total opportunity cost of its inputs.

The opportunity cost here is the value of opportunity given up. In calculating economic profit, the opportunity cost is opportunity cost is deducted from the revenues earned.
These opportunity costs are the alternative returns forgone by using the selected inputs.

 Accountants measure profit differently. They do it in terms of the sales of firms less costs like wages, rent, fuel, raw materials, interest on loans and depreciation. Profit is synonymous to income. Accounting profits is mainly the companys total earnings, calculated based on the Generally Accepted Accounting Principles (GAAP).

 To distinguish between economic and accounting profit, we can look at this little scenario.

Dana imports clothes from Thailand and sells them from her home.
She collects around Rs.500,000 annual revenue. Around Rs.200,000 of that money is spent on clothes and shipping costs and Rs.30,000 on accounting services and utilities.

 Before she was engaged in this business, Dana was making Rs.100,000 yearly by working in a publication agency.

Now she is working on her garage. Danas accounting profit is Rs.270,000.

 Accounting profit is equals annual revenue (Rs.500,000) decreased with expenses [(Rs.200,000) + (Rs.30,000)].

In finding the economic profit, we will have to subtract the opportunity cost (the job Dana left to invest in her current endeavor) to the accounting profit gained. That is Rs.270,000 - Rs.100,000, which then results to Rs.170,000.

 Well, fairly easy right. It didnt take much calculation to find the economic and accounting profit.

It is important the traders and investors carefully analyze the economic and accounting profit because these enables them to evaluate their personal investment strategy, prospective markets, as well as, performances.

Veblon effect

A commodity is a Veblen good if people's preference for buying it increases as a direct function of its price. The definition does not require that any Veblen goods actually exist. However, it is claimed that some types of highstatus goods, such as expensive wines or perfumes are Veblen goods, in that decreasing their prices decreases people's preference for buying them because they are no longer perceived as exclusive or high status products.

The Veblen effect is named after the economist Thorstein Veblen, who invented the concepts of conspicuous consumption and status-seeking .

A giffen good is a type of inferior good (a good that people buy more of when their income goes down). Giffen goods are goods that are substitutes for a more expensive good, that people buy more of when they cannot afford a superior good. The classic example of a giffen good is bread for the very poor. If their income falls, they will stop buying luxuries such as meat, and will buy more bread instead to fill themselves up.

A veblen good is a good that people buy because it is expensive, as a show of wealth. Therefore it is a superior good with respect to income, but if the price falls, less of the good will be demanded

 Advertisement elasticity or Promotional elasticity The expenditure in advertisement and other sales promotion activities does help in promoting sales, but not in the same degree at all levels of the total sales. The concept of advertisement elasticity is useful in determining the optimum level of advertisement expenditure. It may be defined as, the responsiveness of demand to changes in advertising or other promotional expenses. EA = Proportionate change in sales ------------------------------------------------------------ Proportionate change in advertising and other promotional expenditure

Back to Cost Analysis

 MARGINAL RETURNS: The change in the quantity of total product resulting from a unit change in a variable input, holding all other inputs fixed. Marginal returns is an older and more generic term for marginal product. While marginal product has largely replaced marginal returns in most discussions of shortrun production, the phrase does persist in a few terms like the law of diminishing marginal returns.

 Two Returns Marginal returns can either increase or decrease. Increasing Marginal Returns: Increasing marginal returns occurs during the course of short-run production by a firm if an increase in the variable input results in an increase in the marginal product of the variable input.

Increasing marginal returns typically surface when the first few quantities of a variable input are added to a fixed input.

 Decreasing Marginal Returns: Decreasing marginal returns results with short-run production if an increase in the variable input results in a decrease in the marginal product of the variable input. Decreasing marginal returns usually emerge only after the first few quantities of a variable input are added to a fixed input and persist throughout production.

 A Big, Empty Factory How about an example to illustrate marginal returns?.

Suppose that a car factory is producing the wildly popular Sports Coupe in its two-million square foot assembly plant located on the outskirts of a town. This assembly plant is filled with the machinery, tools, and equipment needed to produce Sports Coupes.

In the short run, this capital, the assembly plant and related equipment, is fixed. To produce cars, the factory needs workers. The vast size of this plant, means that car company can easily provide separate productive tasks (installing engines, painting the exterior, checking the horn) for several thousand workers

 First, Increasing Marginal Returns What happens when workers are added?

The first few hundred workers hired by car company are bound to make increasingly more effective use of this enormous plant. If car company employs only a dozen or so workers, each performs a wide range of unrelated tasks using a wide range of capital equipment.

 On a given day, one worker might spend time at the engine installation work-station to install an engine, then move off to the painting room to paint the exterior, then amble over to the hoodornament polishing position to polish the hood ornament, then dash off to horn-testing area to honk the horn.

A relatively small contingent of labor is not able to effectively use the fixed capital. This means that each additional worker employed can use the capital more effectively. Each worker can concentrate on a specific task. This gives rise to increasing marginal returns, increasing marginal product, and the upwardsloping segment of the marginal product curve.

 Next, Decreasing Marginal Returns However, as the workforce continues to expand, the capacity of the fixed capital is approached. Workers have to share the equipment and substitute for each other on lunch and coffee breaks. Some workers might do nothing but assist other workers.

 While the efforts of these extra workers does increase total production, the incremental increase declines for each one. This gives rise to decreasing marginal returns, decreasing marginal product, and the downward-sloping segment of the marginal product curve. Most important, decreasing marginal returns is a reflection of the key principle underlying the study of short-run production--the law of diminishing marginal returns.

 AVC Average variable cost is the total variable cost divided by the number of units of output produced. TVC Therefore AVC = ----- Q

Thus, average variable cost is the variable cost per unit of output.

Due to the first increasing and then decreasing marginal returns to variable input, average product initially rises, reaches maximum and then declines.

Case Study Output of Funky Trousers

Now we get into the most interesting and important cost curve, the Marginal Cost Curve. It is the additional cost of producing one more unit and later on will allow us to maximize profits.

Yeahoo! I love profits $$$! As the production of trousers increase, determining the additional cost of producing one more pant is crucial since that information will help us decide whether to produce or not that particular pair. In order to calculate the Marginal Cost we calculate Total Cost between the previous unit and the current unit. The table below calculates the Marginal Cost for Funky Trousers:

Output (Funky Trousers)

Short-Run /Total Cost

Short Run /Marginal Cost

 The calculations start with the first unit, as the cost went from $36 to $44, the marginal cost of producing the first unit is $8 ($44-$36), for the second unit the cost is $4, and so on. The arrows illustrate that the marginal cost is the additional cost of producing one more unit. Suppose someone offers you $25 for the eight pair of trousers, would you sell it at $25? How much did it cost you to sew that particular pair? ($17, so sell!) The graph below shows why the Marginal Cost is more challenging to understand, notice that the coordinates are not exactly at 1,2,3..units, they are graphed at 0.5,1.5,2.5, etc. This is because the MC starts increasing as you start producing the units. In this case imagine you got your cloth and you add a zipper, costs have increased yet you are not finished with the pair of trousers. In order to reflect that graphically economists graph the MC at mid point to account for the transition. This is a bit confusing yet useful in drawing accurate graphs and arriving at accurate conclusions!

Marginal cost generally falls as the quantity increases because people learn to do their jobs better as they produce more, and the equipment is more fully utilized. However, the increase in Marginal Cost continues only up to a point. At a certain point, marginal cost -- the additional cost to produce one more unit -- begins to increase because inefficiencies develop as production increases.

The staff is trying to do more with the same amount of equipment, perhaps, and the equipment may be inadequate to handle the volume.

The result is that inventory stacks up at a machine that is the "bottleneck" for the operation, or perhaps the machines keep breaking down because they are being operated too intensively without adequate maintenance.
Or there are simply not enough machines to keep all of the people busy, so people are standing around waiting to get onto a machine. So marginal cost begins to increase. This is called the "law of diminishing returns."

The law of diminishing returns states that as additional units of a variable resource such as labor are added to a fixed resource such as equipment, beyond some point the extra (marginal) product attributed to each additional unit of the variable resource will decline.

This is not saying that the later units of the resource are of lower quality than the early ones. With labor, for example, each successive worker added is assumed to have the same ability, education, training and work experience. The reason that marginal product diminishes is not because successive workers do not do as good a job as the other workers. It is because more workers are being used relative to the amount of plant and equipment available, and this leads to inefficiencies.

Marginal cost decreases and then begins to rise after its lowest point because of the relationship between marginal product and marginal costs.

The marginal cost of each additional unit will fall as long as the marginal product of each added variable resource is rising.

But when the marginal product of each added variable resource begins to decline, marginal cost begins to increase.

One worker can be hired for $20 per hour, and during one hour's time, that one worker can produce 10 units of product.

Marginal product is 10 (10 - 0). The average marginal cost of labor is $______ per unit

One worker can be hired for $20 per hour, and during one hour's time, that one worker can produce 10 units of product.

Marginal product is 10 (10 - 0). The average marginal cost of labor is $__2____ per unit ($20/ 10)

A second worker is hired, also for $20 per hour, so the total hourly labor cost is now $_____, and the marginal cost is $____ per hour.

The second worker and the first worker together can produce 25 units per hour, so marginal product is _______ units per hour .
The average marginal labor cost of those additional 15 units is $20 / 15, or $1.33 per unit.

A second worker is hired, also for $20 per hour, so the total hourly labor cost is now $40, and the marginal cost is $20 per hour ($40 - $20).

The second worker and the first worker together can produce 25 units per hour, so marginal product is 15 units per hour (25 units - 10 units).
The average marginal cost of those additional 15 units is $20 / 15, or $1.33 per unit.

A third worker is hired, and the hourly cost goes up by another $20. The three workers together can produce 45 units per hour, so marginal product is _____ units per hour.

The average marginal cost of the additional 20 units is $20 / 20, or $1.00 per unit. The marginal product in terms of hourly output is rising, so the average marginal cost per unit of labor is falling.

A third worker is hired, and the hourly cost goes up by another $20. The three workers together can produce 45 units per hour, so marginal product is 20 units per hour (45 - 25 units).

The average marginal cost of the additional 20 units is $20 / 20, or $1.00 per unit. The marginal product in terms of hourly output is rising, so the marginal cost per unit is falling.

A fourth worker is added, and labor cost per hour increases by another $20. In one hour, the four workers can produce 60 units. Marginal product per hour is now ______(60 - 45 units). Marginal product is now falling, because of the law of diminishing returns.

The marginal labor cost of these additional 15 units is $20 / 15, or $1.33 per unit. Now, the marginal cost of labor is rising, because the marginal product is falling.

This will continue until the diminishing marginal returns turn into negtive marginal returns. Because of increasing inefficiencies, the marginal product will finally become negative because total product will actually decrease when additional workers are hired.

A fourth worker is added, and labor cost per hour increases by another $20. In one hour, the four workers can produce 60 units. Marginal product per hour is now 15 (60 - 45 units). Marginal product is now falling, because of the law of diminishing returns. The marginal labor cost of these additional 15 units is $20 / 15, or $1.33 per unit.

Now, the marginal cost of labor is rising, because the marginal product is falling. This will continue until the diminishing marginal returns turn into negtive marginal returns.

Because of increasing inefficiencies, the marginal product will finally become negative because total product will actually decrease when additional workers are hired.

Indifference Curve Analysis

 An theory of consumer demand was put forward by J.R Hicks and R.G.D. Allen. This approach considers utility to be ordinal i.e it cannot be measured but can only be ranked or compared. Thus, while under the utility analysis it could be said that a person got 10 utils from ice cream and 6 utils from rasgulla, under this approach it can only be said that ice cream gives more utility to the person than rasgulla.

Assumptions
The assumptions of the indifference curve analysis are 1. Utility is ordinal 2. Utility being subjective is rank able but not measurable 3. The consumer is a rational 4. The income of the consumer is limited and constant.

The tastes and preferences of the consumer remain unchanged

Consumers generally consume products as part of a group of goods and services rather than as individual products.

As a large number of goods and services are available, a wide array of combinations exist. And it is very possible that a number of these combinations will give the same level of satisfaction to the consumer.

Indifference Curve The locus of points, each representing a different combination of two goods, which provide the same level of utility to the consumer is known as the indifference curve. The curve derives its name from the fact that a consumer is indifferent to any of these combinations when it comes to making a choice between them.

For the sake of simplicity we assume that there is continuous and not incremental variation in consumption. What results then is a smoothened curve.

Combination A

Apple Mango Y X 1 30

Total Utility (TU) U

B
C D E F G

2
3 4 5 6 7

24
19 15 12 10 9

U
U U U U U

Thus, the consumer is indifferent to choose between any combination of apples and mangoes as all combinations provide the same level of utility U to him. This data can be represented in a graph

Indifference Curve

Quantity of Mangoes

x
Quantity of Apples

We can now enumerate certain essential characteristics of indifference curves 1 Indifference curves are downward sloping This is because for the same level of utility if the demand of one commodity increases, the demand for the second commodity has to decrease

2 Indifference curves are convex to origin. This is because two goods cannot be perfect substitutes for each other. As the consumer gets larger quantities of one commodity X at the cost of another commodity Y, marginal utility of X decreases. Due to reduced availability of Y, the marginal utility of Y (i.e ) MUy increases. Thus, the consumer will be ready to sacrifice lesser quantity of Y for each additional quantity of X.