ECONOMICS

COST OF PRODUCTION Cost: Expense:

Economics Lecture- 1st Date 10.5.11

Cost may be defined as the summation of all expenses made on particular occasion. It is the outlay of resources in order to receive a benefit or advantage.

Classification of cost: a. Fixed cost

b. Variable cost

c. Total cost

a. Fixed Cost (FC): Cost which does not change with the change in the number of production but remains constant at all levels of activities is known as Fixed Cost. Example House rent remain constant.

400 300

Total Cost

200 100 0 50 150 200 250

FC

Qty n Fig: Shows that fixed cost curve will be parallel to the horizontal axis

Shafiq_Popular Pharma

b. Average fixed cost (AFC) : It is defined as the per unit fixed cost of production to be determine by dividing the total fixed cost with the total number of production.

Total Cost (Tk)

FC

AFC
50 150 200 250

Qty Fig: AFC curve will be moving downward Variable Cost (VC) Cost which changes with the change in the number of production is known as variable cost. Examples are raw material, fuel, electricity etc. Normally variable cost increases with the rise in the number of production, and it decreases with the fall in the number of production and it comes down zero whenever the production shut down.
400 300

VC

Total Cost

200 100 0

50

150

Qty n

200

250

Fig: Normally VC curve will be moving upward from left to right

Shafiq_Popular Pharma

Total Cost (TC) May be define as the summation of all costs incurred on the factors of production. TC= ( R,W,I,P) Where TC= Total Cost, R= Rent , W= wages, I= interest, P = profit, FOP= Factors of production

FOP Land Labour Capital Organization

Cost of FOP Rent Wages Interest Profit

400 300

TC VC

Total Cost

TC= Total Cost VC= Variable Cost FC= Fixed Cost Q= Quantity of production

200 100 0 50 150 200 250

FC

Average Cost (AC) : May be defined as the per unit cost of production to be determined by dividing the total cost with the number of units produced. AC= TC/Q Where TC= Total cost, Q= quantity

Shafiq_Popular Pharma

MARGINAL COST (MC): Marginal Cost may be defined as the additional cost of production incurred in the production of an additional units of production.

Economics Lecture- 2nd Date 24.5.11

In other word, MC represents the rate between a change in total cost and a change in total quantity of production. There fore: MC= TC/ Q
where, TC= Total Cost, Q= Quantity of production

RELATIONSHIP BETWEEN AVERAGE COST (AC) & MARGINAL COST (MC) Each & every production has three stages (i). Primary stage (ii). Optimum stage (iii). Post optimum stage
Q (qty) 1 2 3 4 5 6 7 8 TC (Tk.) 30 40 45 48 50 60 84 120 AC (Tk.) 30 20 15 12 10 10 12 15 MC (Tk.) 30 10 5 3 2 10 24 36

Primary stage of Production

Optimum stage of Production Post Optimum stage of Production

Explanation

Table 1

1. At the primary stage of any production, AC & MC both will be falling as with the increase in the production. But the rate at which AC will be falling is less than the rate at which MC is falling. The relationship between AC & MC at this state will be AC>MC. 2. At the Optimum stage of production, AC & MC both will be equal to each other. But the rate at which AC will be falling is less than the rate at which MC is falling. The relationship between AC & MC at this state will be AC=MC. 3. After Optimum stage of production, we see that AC & MC both will be rising as with the increase in the production. The relationship between AC & MC at this state AC<MC. will be

Shafiq_Popular Pharma

U shaped AC & MC Curve If the table 1 converted to graph then found the following curve.

400

MC
300

Total Cost
200 100 0 50 150 200

AC

250

Explanation

1. At the primary stage of any production, AC & MC both will be falling as with the increase in the production. Therefore AC curve & MC curve will be sloping down words. Since the relation between AC & MC at this stage of production is AC> MC, AC curve will be standing over the MC curve. 2. At the optimum stage of production AC curve & MC curve will be intersecting with each other because of their relationship (AC=MC). 3. After the optimum stage of production AC & MC will be gradually increasing as with the increase in number of production & therefore AC curve & MC curve with moving upward. Since the relationship between AC & MC at this stage of production is AC<MC, AC curve will be standing under the MC curve. 4. The above discussion tells us that AC curve & MC curve both will be appearing as the U shaped curve. Q: What is the relationship between AC & MC? Q: What is the shaped of AC & MC curve? ( Ans must be with table-1 include)

Shafiq_Popular Pharma

MARKET STRUCTURE In a ordinary sense market indicates a particular place where a group of buyers and seller get together in order to exchange goods and services for mutual benefit. For example New Market, Mouchak Market etc. But in Economics market means a particular product or services for which a significant group of buyers of sellers get together in order to exchange goods and services for a price and profit. For example rice market, fish market, share market. But in Marketing a market is define a set of actual & potential buyers of products or services. To organize a market the following conditions needs to be satisfied: 1. There must have a significant group of buyer & sellers who have the intension to exchange some products or services. 2. There must have a particular product or services that will be exchanged between two parties buyers and sellers. 3. There must have a particular price for that product & services at which it will be exchange. 4. There should have a particular place where products & services will be exchange between buyers and sellers.

Shafiq_Popular Pharma

Market Competition
Market competition is mainly two types 1) Perfectly competitive market (Perfect competition market) 2) Imperfect competition market i) Monopoly market ii) Duopoly market iii) Oligopoly market iv) Monopsony market v) Monopolistic market Perfectly competitive marketA market is said to be a perfect competition market which is dominated by the presence of a large number of buyers and sellers to compete for homogenous products in all over the market at only one price. In this market sharp competition prevails between buyers and sellers over the product and price as well and the sellers do not have any control over the supply as well as price of the product. In this market, the sellers do not have any control over the price of the product and they have to be ready to take up the price being set up by the industry and therefore, this market is called a PRICE TAKER MARKET. Characteristics of Perfectly competitive market 1) Presence of unlimited buyers and sellers 2) Here the product is homogenous 3) Presence of large number of substitute products 4) Buyers and sellers are knowledgeable about the product price, feature, availability 5) The product is sold here at only one price 6) The market is free from all type of promotional cost (due to buyers and sellers know everything) 7) Free entry and exit of new entrants are very easy

Monopoly market- A market is said to be a monopoly market which is dominated by the presence of only one seller to operate in all over the market since there is only one supplier, the monopolist is the only supplier of the product he deals and therefore, he enjoys absolute control over the price of the product. In one hand, the monopolist is the sole supplier of the product he deals and on the other hand there is no substitute product in the market, buyers are bound to purchase the product at the price being demanded by the seller. That is the reason this market is known as PRICE MAKER MARKET.

Shafiq_Popular Pharma

Characteristics of Monopoly Market 1. Number of seller is only one in the market 2. Product characteristicsDifferent type of product and there is no substitute product. 3. PriceSeller have full control over price 4. Entrance of new rivals is always restricted 5. DimensionDimension is strongly limited. The market is experience huge promotional expenses. Forms of entry restrictions in monopoly market for new rivals 1. Scarcity of raw materials 2. Scarcity of expert manpower/ personnel 3. Govt. legal restrictions 4. Govt. illegal restrictions 5. Barrier of goodwill Forms of price discriminations in monopoly market 1. Customer price discrimination 2. Time price discrimination 3. Segmented price discrimination (Cities, urban, rural) 4. Service price discrimination (1st class, executive class) 5. Image price discrimination (Specialty products)

DUOPOLY MARKET A true duopoly is a specific type of oligopoly where only two producers exist in one market. In reality, this definition is generally used where only two firms have dominant control over a market. In the field of industrial organization, it is the most commonly studied form of oligopoly due to its simplicity. The most commonly cited duopoly is that between Visa and Mastercard, who between them control a large proportion of the electronic payment processing market. MONOPSONY MARKET It is a type of imperfect competition market which is featured by the presence of only one buyer to operate in the whole market. Therefore, a monopsony is just opposite to what we call a monopoly market.

OLIGOPOLY MARKET

Shafiq_Popular Pharma

It is a type of imperfect competition market which is operated only a few numbers of larger sellers dealing with almost identical products. This market is full of substitute products butt mainly operated under a non-price competition basis among the rival companies. CHARACTERISTICS OF OLIGOPOLY MARKET 1. No. of sellers in this market is limited to more than 2 and less than 15 larger suppliers. Although there is no boundary of numbers to indicate a few sellers. 2. Products selling in this market are almost identical and each of the sellers maintains a separate brand name for its market offers to differentiate one from its competitors. The products are durable as well as high tech base product. 3. In this market every firm maintains a separate production and pricing policy but one firm very closely follows production and pricing policy of other rival firms. 4. In this market sharp competitions are prevailing among the competitors in case of price of the products and therefore, Non-Price Competition becomes inevitable to competing in this market successfully. Tools of non price competition in oligopoly market: 1. Distinctive company and product advertising 2. Distinctive company brand name, sign and symbol logo etc. 3. Attractive packaging contents and material 4. Distinctive color, size, shape of container 5. Different attractive sales promotion tools 6. Different after sales service and warranties 7. Activities of corporate social responsibilities (CSR) COLLUSIVE IN OLIGOPOLY 1. This is a formal agreement among the rival firm in the oligopoly market in order to reduce competition as well as retain profitability in the market. 2. To share production as well as supply of production in the market. 3. To reduce operating cost significantly by taking different measures in terms of distribution outlets, promotion cost and other incidental expenses. 4. To share revenue or profit as agreed upon by the rival companies 5. To have strong comment over production, supply and price of the product they deal. 6. To develop a common strategy to fight against non member firms.

Shafiq_Popular Pharma

Example of Oligopoly market is Organization of Petroleum Exporting Countries (OPEC). OPEC is an international organization which sets production quotas for its members.

Responding to price cuts by competitors and corresponding marketing strategy Actions

Have competitors cut price?

Response
Hold current price Continue to monitor market price

Response
Has price cut negatively affected company sales and profits?

Marketing Strategy
Reduce price in line with rivals prices

Response

Can/ should effective actions Can/Should effective actions be taken

Hold current prices and increase perceived quality Increase quality and raise price

Introduce low price Fighting Brand

Revenue for the firm

Shafiq_Popular Pharma

10

Total revenue (TR) = AR X Q Average revenue (AR) = TR/Q

Where Q = Total unit of sale

TR Marginal revenue (MR) =

Where indicates any change Q

Total revenue in different market situations

1. 2. Perfect competition market Imperfect competition market

Total revenue (TR) in perfect competition market In perfect competition market products are identical and they are sold at only one price in all over the market. Therefore total revenue in this market will be increasing proportionately as with the rise in the sales. The following table shows the fact clearly AR TR Where Q= Quantity in Sale AR = Average Sale TR = Total revenue Q 1 2 3 4 5

10 10 10 10 10

10 20 30 40 50

Since total revenue increases proportionately with the rise in sales, total revenue curve in this market will be moving straight up ward.

Shafiq_Popular Pharma

11

Total revenue in imperfect competition market In an imperfect competition market, products are heterogeneous and they are sold at different prices at different level of sales and to different type of customers. In this market a seller is governed by the law of demand this means, in order to receive more sales, a company has to lower down its prices. Therefore, with the rise in sales Average revenue (AR) gradually trends to be going down and consequently Total revenue (TR) will be increasing at a diminishing rate. At one level Total revenue (TR) will be flatted and after that it will be going down, although with the rise in sales. The fact is presented in the following table

In this market TR curve will be quite different shape over the TR curve available in perfect completion. Total revenue curve will be after U Shape turn. Relationship between AR & MR for perfect competition market In a perfect competition market, products are identical and they are sold at only one price all over the market. Therefore, AR & MR will be same at any level of sales. Therefore, in this market the relationship between AR & MR is AR = MR The following table shows the fact clearly TR AR Where, Q = Quantity of Sales TR = Total Revenue AR = Average Revenue MR = Marginal Revenue Q 1 2 3 4 5 MR

10 20 30 40 50

10 10 10 10 10

10 10 10 10 10

Since in this market, the relationship between AR & MR is AR = MR

Shafiq_Popular Pharma

12

AR curve & MR Curve will be parallel to the horizontal axis and they fall on the same line.

Revenue (Tk.) AR/MR Curve

Qty of Sales Figure: Relationship between AR & MR in perfect competition market Relationship between AR & MR for perfect competition market In the imperfect market products are not identical and they are sold at different prices. In order to receive more sales, a marketer has to lower down its prices. In other words, this means this market experiences a fall in price with the rise in number of sales. With the rise in sales, average revenue (AR) and marginal revenue (MR) will be going down. But AR will be always more than the MR. This is why in this market, the relationship between AR & MR is AR> MR The fact is presented in the following table TR AR Where Q= Quantity in Sale AR = Average Sale MR= Marginal Revenue TR = Total revenue Q 1 2 3 4 5 MR

10 18 24 28 30

10 9 8 7 6

10 8 6 4 2

Shafiq_Popular Pharma

13

Since the relationship between AR & MR in this market is AR> MR and AR & MR will be decreasing with the rise in sales, AR curve & MR curve will be slopping downward & AR curve will always stand over the MR curve.

Revenue (Tk.) MR Curve O Qty of Sales PRICE EQUILIBRIUM OF THE FIRM A firm will be in a position of equilibrium whenever it has be the opportunity to earn maximum profit because profit objective of of output of represents the Short run Normal Profit Super profit Incur loss maximization is the ultimate any sales Long run Normal Profit production unit. Therefore, the level giving the firm the maximum profit equilibrium status of the firm. AR Curve X

In order to reach equilibrium position a firm is required to satisfies the following conditions 1. Marginal Revenue (MR) = Marginal Cost (MC) 2. MC curve must cuts MR curve from below at the equilibrium point

Shafiq_Popular Pharma

14

SHORT-RUN MARKET EQUILIBRIUM: IMPERFECT COMPETITION MARKET Y P1 P2 Revenue (Tk.) MR Curve O (Unit) In order to reach equilibrium position a the following conditions Where TC = Total Cost TR = Total Revenue AC = Average Revenue Q = Quantity X Qty of Production/Sales firm is required to satisfies Q AR Curve Q1 MC Curve AC Curve

1. Marginal Revenue (MR) = Marginal Cost (MC) 2. MC curve must cuts MR curve from below at the equilibrium point According to this figure, Q is the equilibrium point, because at this point MC curve MR curve intersects each other and OM is the equilibrium quantity of production & sales and OP is the equilibrium price. We know that, Profit = TR TC Again TR= AR X Q

Shafiq_Popular Pharma

15

TC= AC X Q According to this figure TR = AR X Q =OP1 X QM =P1OMQ1 TC = AC X Q =OP2 X QM =P1OMQ1

Since, according to this figure, TC > TC The firm is earning super profit & the quantity of which is (P1OMQ1-P2OMQ2 =P1P2Q1Q2 SHORT-RUN MARKET EQUILIBRIUM: IMPERFECT COMPETITION MARKET Y P2 P1 Q AR Curve Revenue (Tk.) MR Curve O Qty of Production/Sales (Unit) In order to reach equilibrium position a firm is required to satisfies the following conditions 1. Marginal Revenue (MR) = Marginal Cost (MC) 2. MC curve must cuts MR curve from below at the equilibrium point We know that Loss = TC-TR TR = AR X Q = OP1 X OM1 = P1OMQ1 = AC X Q = OP X OM = P2OMQ2 X Q2 Q1 AC Curve MC Curve

TC

Shafiq_Popular Pharma

16

The firm is incurring loss & the quantity of which is (P2OMQ2 - P1OMQ1) =P1P2Q1Q2 SHORT-RUN MARKET EQUILIBRIUM: PERFECT COMPETITION MARKET A firm will be in a position of equilibrium whenever it has be the opportunity to earn maximum profit because profit maximization is the ultimate objective of any production unit. Therefore, the level of output of sales giving the firm the maximum profit represents the equilibrium status of the firm. In order to reach equilibrium position a firm is required to satisfies the following conditions 1. Marginal Revenue (MR) = Marginal Cost (MC) 2. MC curve must cuts MR curve from below at the equilibrium point

A firm will be earning normal profit at a point where its total revenue (TR) becomes equal to its total cost (TC) because normal profit of a firm is inherent in the total cost (TC) as a factor cost of the production. MC Curve AC Curve P1 Q1

AC Curve

MR Curve

We know that Loss = TC-TR TR = AR X Q = OP1 X OM1 = P1OMQ1 = AC X Q = OP X OM = P2OMQ2

TC

LONG-RUN MARKET EQUILIBRIUM: PERFECT COMPETITION MARKET

Shafiq_Popular Pharma

17

SHORT-RUN MARKET EQUILIBRIUM: PERFECT COMPETITION MARKET Super profit situation

Shafiq_Popular Pharma

18