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Faculty: Prof. Sunitha Raju Cost Analysis-1 Session Date: 27.1.2013 Economics of Pricing Strategies.

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Presentation on theme: "Faculty: Prof. Sunitha Raju Cost Analysis-1 Session Date: 27.1.2013 Economics of Pricing Strategies."— Presentation transcript:

1 Faculty: Prof. Sunitha Raju Cost Analysis-1 Session Date: 27.1.2013 Economics of Pricing Strategies

2 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Cost Related Decision at Firm Level (i)What are the cost implications of production/supply decisions? (ii)Should a profit maximizing firm always supply at cost minimizing level of output? (iii)How do costs influence the size and location of production plants/units?

3 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Economic Definition of Cost (i)Cost Components  Factor inputs (Land, Labour, Capital, Entrepreneurship) (ii)Relevant Cost  Historical vs. Current Cost  Incremental vs. Sunk Cost  Explicit and Implicit Costs.

4 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Defining Total Cost (i)Economic cost of inputs  Explicit + Implicit costs (ii)Why Implicit costs?  Resources being scarce, any input used (whether purchased or owned) for production activity should reflect its true cost  Owned resources have alternate uses (iii)How to value implicit costs?  Opportunity cost principle wherein costs are imputed based on alternate uses of the ‘owned’ resource

5 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Defining Profits  ‘Entrepreneurship’ is a factor input.  As such, factor costs or production costs will include the returns to ‘Entrepreneurship’ i.e. normal profits.  If a production activity results in only normal profits then TR - TC = 0  If a production activity results in supernormal profits, then TR > TC positive profits  Profit maximization implies maximize Supernormal profits Normal vs Supernormal Profits

6 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Gopal Banerjee & Co. Business Decision  To continue with the operations or not  Will continue only if profits are earned π = TR – TC

7 EPGDIB(VSAT) 2012-13 Business Economics/Session:6 Gopal Banerjee & Co. ParticularsRs. Net Profit as per Trading Profit & Loss Account 22,000 Less: Implicit costs not accounted: a) Manager’s Salary (600 x 12)7,200* b) Building rent (800x12)9,600** c) Interest on capital (2,00,000@9%) 18,000***34,800 Net loss as per Business Economist(12,800) Profit & Loss Statement * Earning Rs. 600/- per month as manager in a jewellery shop ** Rent of Rs. 800/- per month if the space let out *** Interest of Rs. 1,500/- per month if the amount is invested

8 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Gopal Banerjee & Co. Assume the following (i)interest rate falls to 5% (ii)rent increases to Rs. 1000 (iii) Mr. Banerjee was unemployed before starting the business What would be the implications on profits?

9 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Cost Determinants in the Short Run  Total costs (TC) are determined by output (Q)  As Q increases, TC also increases TC = f (Q)  As Q produced depends on inputs used [i.e. Labour (L) and Capital (K)], TC = P L. L + P K. K → P L. L is Variable costs → P K. K is Fixed costs  Variable costs determine supply decisions

10 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 QTC 1$120 2 138 3 151 4 162 5 175 6 190 7 210 8 234 9 263 10 300 Short Run Cost – Output Relations

11 EPGDIB(VSAT) 2012-13 Business Economics/Session:6 Short Run Cost – Output Relations QTCTFCTVC  TC 1$120$100$20- 2 138 100 3818 3 151 100 5113 4 162 100 6211 5 175 100 757 6 190 100 9015 7 210 100 11020 8 234 100 13424 9 263 100 16329 10 300 100 20037

12 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Output-Cost Decisions in the Short Run  Cost implications of output decisions by firms is based on Average Cost i.e. cost per unit of output AC =  Output (Q) corresponding to minimum AC is cost efficient output/production

13 EPGDIB(VSAT) 2012-13 Business Economics/Session:6 Q/TC  TC ATC 1$120-$120.0 2 13818 69.0 3 15113 50.3 4 16211 40.5 5 1757 35.0 6 19015 31.7 7 21020 30.0 8 23424 29.3 9 26329 29.2 10 30037 30.0 Average Cost Relations

14 EPGDIB(VSAT) 2012-13 Business Economics/Session:6 Q/TFCTVCTCATCAFCAVCMC 1$ 100$20$120$120.0$100.0$20 2 100 38 138 69.0 50.019.0 18 3 100 51 151 50.3 33.317.0 13 4 100 62 162 40.5 25.015.5 11 5 100 75 175 35.0 20.015.0 13 6 100 90 190 31.7 16.715.0 15 7 100 110 210 30.0 14.315.7 20 8 100 134 234 29.3 12.516.8 24 9 100 163 263 29.2 11.118.1 29 10 100 200 300 30.0 10.020.0 37 Average Cost Relations

15 EPGDIB(VSAT) 2012-13 Business Economics/Session:6 Cost Analysis for Efficient Production Decisions (i)TC = TFC + TVC = P K. K + P L. L (ii) AC inversely related to AP L and AP K. (iii)Cost Efficient output = AC minimum  behaviour of average fixed cost (AFC) as output increases  behaviour of average variable cost (AVC) as output increases

16 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 (i) Should a firm produce at cost efficient level of output (min. AC) (ii) Under what market conditions can a firm deviate from this level. Efficient Production Decision at Firm Level

17 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Cost Efficient vs Profit Maximizing Output (i)Is it profitable to always produce cost efficient output?  Recession and Excess Capacity conditions Excess capacity AC Q QxQx

18 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13  Boom conditions and AC curve AC Q QxQx → only if P > MC (ii)Profit maximizing output MR = MC Cost Efficient vs Profit Maximizing Output

19 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Decisions on how much to Supply  Depends on incremental cost and the market price P > MC increase supply P < MC decrease supply

20 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Problem Solving Airway express has an evening flight from Los Angeles to New York with an average of 80 passengers and a return flight the next afternoon with an average of 50 passengers. The one-way ticket for the flight is $200. The operating cost of the plane for each flight is $11,000. The fixed costs for the plane are $3,000 per day whether it flies or not. (a)Should the airline remain in business? (b)Should the airline continue with the flight if the price  Decreases to $150  Increases to $250

21 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Deriving the Supply Curve Under what price and cost conditions will the firm be induced to supply (i)When P = MC = AC (ii)When P > MC > AC (iii)When P AVC

22 EPGDIB(VSAT) 2012-13 Business Economics/Session:6Economics of Pricing Strategies PGDIBS 2012-13 Firm’s Supply Curve  The MC curve above the AVC is the supply curve of a firm, i.e. → a firm will be induced to supply more only if prices cover at least average variable cost  The upward sloping MC curve reflects the incremental costs associated with increasing output (Q) beyond cost efficient output (AC minimum)  If market prices rise to match the incremental costs, then firms produce and supply more. P Q S

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