Faculty: Prof. Sunitha Raju

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

2. 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. Economic Definition of Cost • Cost Components • Factor inputs (Land, Labour, Capital, Entrepreneurship) • Relevant Cost • Historical vs. Current Cost • Incremental vs. Sunk Cost • Explicit and Implicit Costs.

4. Defining Total Cost • Economic cost of inputs • Explicit + Implicit costs • 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 • How to value implicit costs? • Opportunity cost principle wherein costs are imputed based on alternate uses of the ‘owned’ resource

5. Defining Profits 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

6. Gopal Banerjee & Co. Business Decision • To continue with the operations or not • Will continue only if profits are earned π = TR – TC

7. Gopal Banerjee & Co. 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. 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. 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 = PL . L + PK . K → PL . L is Variable costs → PK . K is Fixed costs • Variable costs determine supply decisions

10. Short Run Cost – Output Relations

11. Short Run Cost – Output Relations

12. 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. Average Cost Relations

14. Average Cost Relations

15. Cost Analysis for Efficient Production Decisions (i) TC = TFC + TVC = PK . K + PL . L (ii) AC inversely related to APL and APK. • Cost Efficient output = AC minimum • behaviour of average fixed cost (AFC) as output increases • behaviour of average variable cost (AVC) as output increases

16. Efficient Production Decision at Firm Level (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.

17. Cost Efficient vs Profit Maximizing Output • Is it profitable to always produce cost efficient output? • Recession and Excess Capacity conditions AC AC Excess capacity Qx Q

18. Cost Efficient vs Profit Maximizing Output • Boom conditions and AC curve AC AC Q Qx → only if P > MC (ii) Profit maximizing output MR = MC

19. Decisions on how much to Supply • Depends on incremental cost and the market price P > MC increase supply P < MC decrease supply

20. 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? • Should the airline continue with the flight if the price • Decreases to $150 • Increases to $250

21. Deriving the Supply Curve Under what price and cost conditions will the firm be induced to supply • When P = MC = AC • When P > MC > AC • When P < AC or P > AVC

22. 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 S Q