Microeconomics

Session 9, 10

Cost Analysis

Dr. Pallavi Mody

Email: pallavimody@spjimr.org

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 What is aim of business?
Profit.
Profit = Total Revenue (Q x P) - Total Cost

For Maximum Profit: Maximize Revenue and Minimize Cost

Maximizing revenue is constrained by ability of the firm to raise price and

sell large quantities by consumer demand on the one hand and competition
on the other.

Cost management and improvement in productivity of resources is equally

important to raise the profitability of business. E.g. Local Bakery, Aviation,
Telecom, Automobiles, Steel

This simple principle has universal applicability

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 Total Revenue, Total Cost and Profit

• Profit = Total Revenue (TR) –Total Cost (TC)

• TR = Q X P, Calculating TR is simpler in most businesses

Calculating TC is more complex

• TC includes all the expenses incurred by the producers in buying variety of inputs
• Inputs include; premises, machines, power, raw material, logistics, managers,
labour
• Classifying the inputs for single use/multiple uses, short term/long term and
managing them efficiently is a challenge.
• Using an input with awareness of its opportunity cost is an important decision
making tool

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 What is Opportunity Cost?

• All inputs are scarce and have alternative uses

• When you choose an input for one use, you give
up the alternative use
• Opportunity Cost of an input is what you give up
or what you forgo
• It involves weighing in terms of costs and
benefits
• The concept of opportunity cost is useful for the
most efficient use of a resources
• A business can apply it for its entrepreneurial
activity, capital employed, premises used

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 Two Types of Cost
Explicit Costs Implicit Costs

• Expenses that are incurred for buying
Inputs
• They enter in the books of accounts and
give clear picture of the profitability of the
business
• Accounting Profit=Revenue-Explicit Cost
• There may not be direct expenses on
inputs as they may be owned by the
entrepreneur
• They do not enter into the books of
account but the opportunity cost of
these inputs guides the decision making
• Economic Profit=Revenue-(Explicit cost +
Implicit cost)

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 What are costs?
Costs are expenses incurred by the producer for buying all inputs

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 Costs: Numerical Example
Output (units ) Total cost (Rs.) Variable cost (Rs.) Fixed Cost (Rs.) Marginal Cost
(Rs.)
0 50 0 50
1 100 50 50 50
2 128 78 50 28
3 148 98 50 20
4 162 112 50 14
5 180 130 50 18
6 200 150 50 20
7 232 182 50 32
8 268 218 50 36
9 360 310 50 92
10 480 430 50 120
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 What are total costs? How do they behave with
expansion in output over short run?
Costs are defined as the expenses incurred
on inputs in the process of production.

• Total Costs = Total Fixed Cost (TFC) and

Total Variable Cost (TVC).

• TFC, overheads, remain fixed at all levels

of output.

• TVC, cost of variable factors, increases

with increase in output at differential
rate

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 How do average and marginal cost behave with
expansion in output

• Average Fixed Cost (AFC) =TFC/Q , falls

continuously with increase in output
• Average Variable Cost (AVC) = TVC/Q, U-
shaped curve
• Average Total Cost (ATC) = AFC + AVC, U-
shaped curve
• Marginal Cost (MC) = Change in
TC/Change in output

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 Relationship between AC and MC

The U-shaped AC emerges in the short run from

economies and diseconomies of scale on
firm’s expansion path.

• When AC is falling, MC<AC

• When AC is minimum, MC=AC
• When AC is rising, MC>AC

The marginal cost is the rate at which TC

changes and therefore helps in finding optimal
solution.

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 How do the costs behave with expansion in
output over a long run?
The long run Average Cost curve envelopes the
short run ACs and therefore is a flat U-shaped.

Over the long run, when all inputs are variable,

the economies of scale emerge from
• Technical economies
• Labour Economies
• Managerial
• Financial
• Marketing
• Risk-bearing economies

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 Ultimately Diminishing Returns Operate

• The long-run AC is also U-shaped which becomes the basis of the

predictions of the economic theory of ultimate diminishing returns.

• % increase in output< % increase in inputs as the firm suffers the

diseconomies of scale.

• Diminishing returns are visible in Agriculture, small businesses etc.

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 Are diminishing returns the ultimate reality?

• How should the firms keep the diminishing returns away?

• Technology- Innovation
• Management- Innovation

Successful global firms have managed to keep diminishing returns away.

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