Managerial Economics

Cost Analysis I
Prof. Sunitha Raju
 IFM 2010-12

Learning Objectives
Managerial Economics/ Module 3

(i) To define and examine economic cost of inputs

(ii) To develop cost-output relationship framework for

business decisions

(iii) To derive firm’s supply curve in the short run

 IFM 2010-12

Cost Related Decision at Firm Level

Managerial Economics/ Module 3

(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?
 IFM 2010-12

Gopal Banerjee & Co.

Managerial Economics/ Module 3

Business Decision

 To continue with the operations or not

 Will continue only if profits are earned
π = TR – TC
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Gopal Banerjee & Co.

Managerial Economics/ Module 3
Profit & Loss Statement
Particulars Rs. Rs.
Net Profit as per Trading Profit & Loss 22,000
Account
Less: Implicit costs not accounted:
a) Manager’s Salary (600 x 12) 7,200*
b) Building rent (800x12) 9,600**
c) Interest on capital 18,000*** 34,800
(2,00,000@9%)
Net loss as per Business Economist (12,800)
* 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
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Defining Total Cost

Managerial Economics/ Module 3

(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
 IFM 2010-12
Gopal Banerjee & Co.

Managerial Economics/ Module 3

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?

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Defining Profits
Managerial Economics/ Module 3
Normal vs Supernormal 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
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Cost Determinants in the Short

Run
• Total costs (TC) are determined byEconomics/
Managerial output (Q)Module 3

• As Q increases, TC also increases

TC = f (Q)

• As Q produced depends on inputs used [i.e.

Labour (L) and Capital (K)], TC = PL . L +
PK . K

→ PL . L is Variable costs
→ PK . K is Fixed costs
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Cost Determinants in the Short
Run
Managerial Economics/ Module 3

 Fixed costs are Sunk Costs

 Variable costs: determine supply decisions
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Short Run Cost – Output Relations

Managerial Economics/ Module 3

Q TC TFC TVC
1 $120 $100 $20
2 138 100 38
3 151 100 51
4 162 100 62
5 175 100 75
6 190 100 90
7 210 100 110
8 234 100 134
9 263 100 163
10 300 100 200
TFC : unchanged as Q ↑ es
TVC : vary as Q ↑ es
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Short Run Cost – Output
Relations
Managerial Economics/ Module 3

Q TC TFC TVC TC

1 $120 $100 $20 -
2 138 100 38 18
3 151 100 51 13
4 162 100 62 11
5 175 100 75 7
6 190 100 90 15
7 210 100 110 20
8 234 100 134 24
9 263 100 163 29
10 300 100 200 37
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Managerial Economics/ Module 3

Behaviour of TC,TVC nad TFC

350
300
250
200
Cost

150
100
50
0
1 2 3 4 5 6 7 8 9 10
Quantity

TFC TVC TC
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Output-Cost Decisions in the Short

Run
Managerial Economics/ Module 3

 Cost implications of output decisions by firms is based on

Average Cost i.e. cost per unit of output
AC = TCQ

 Output (Q) corresponding to minimum AC is cost efficient

output / production
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Average Cost Relations

Managerial Economics/ Module 3
Q/ TC ATC
1 $120 $120.0
2 138 69.0
3 151 50.3
4 162 40.5
5 175 35.0
6 190 31.7
7 210 30.0
8 234 29.3
9 263 29.2
10 300 30.0
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Cost Analysis for Efficient

Production Decisions
Managerial Economics/ Module 3
(i) TC = TFC + TVC
= PK . K + P L . L
TC TFC TVC
AC     AFC  AVC
(ii) Q Q Q
K L
 PK .  PL .
Q Q
1 1
 P .
AC inversely
 P .
APK related AP
K L to AP and AP .
L K
L

(iii) Cost efficient output=AC minimum

• behaviour of average fixed cost (AFC) as output increases
• behaviour of average variable cost (AVC) as output increases
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Average Cost Relations

Managerial Economics/ Module 3

Q/ TFC TVC TC ATC AFC AVC MC

1 $ 100 $20 $120 $120.0 $100.0 $20
2 100 38 138 69.0 50.0 19.0 18
3 100 51 151 50.3 33.3 17.0 13
4 100 62 162 40.5 25.0 15.5 11
5 100 75 175 35.0 20.0 15.0 13
6 100 90 190 31.7 16.7 15.0 15
7 100 110 210 30.0 14.3 15.7 20
8 100 134 234 29.3 12.5 16.8 24
9 100 163 263 29.2 11.1 18.1 29

10 100 200 300 30.0 10.0 20.0 37

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Managerial Economics/ Module 3

Behaviour of AC, AVC,AFC,MC

140

120

100

80

60

40

20

ATC AFC AVC MC

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Efficient Production Decision at
Firm Level
Managerial Economics/ Module 3

(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.
 IFM 2010-12

Cost Efficient vs Profit

Maximizing Output
Managerial Economics/ Module 3
(i) Is it profitable to always produce cost efficient
output?

 Recession and Excess Capacity conditions

AC
AC

Ex
ces
sc
apa
c it
y

Qx Q
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Managerial Economics/ Module 3

 Boom conditions and AC curve
AC
AC

Qx Q

→ only if P > MC

(ii) Profit maximizing output

MR = MC
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Decisions on how much to supply

Managerial Economics/ Module 3

 Depends on incremental cost and the market

price

P > MC increase supply

P < MC decrease supply

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Problem Solving
Managerial Economics/ Module 3
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
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Deriving the Supply Curve

Managerial Economics/ Module 3

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 < AC or P > AVC
 IFM 2010-12

Firm’s Supply Curve

Managerial Economics/ Module 3
• 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
S