Module – 2

Cost of Production (Concepts)

• Cost is the expenditure incurred y a firm in the production of a commodity.

Cost Concepts
1. Explicit Cost: It is the expenses actually met y the producer while producing a
commodity. (Raw materials)
2. Implicit Cost: It is the opportunity cost of the factor services supplied by the firm itself.
(Rent)
3. Accounting Costs: This is the monetary outlay for producing a certain good. Accounting
costs will include your variable and fixed costs you have to pay.
4. Sunk Costs: These are costs that have been incurred and cannot be recouped. (Adv cost)
5. Social Costs: This is the total cost to society. It includes private costs plus any external
costs.
6. Private cost: It is the cost incurred by the producer in the production of a good.
7. External Cost: When a commodity is produced it may cause damages to the environment
in the form o fair pollution, water pollution etc.
8. Replacement cost: It is the amount of money required to replace an existing asset with an
equally valued or similar asset at the current market price.

Types of Cost
• Short run cost: Cost refers to a certain period of time where at least one input is fixed
while others are variable. It refers to a certain period of time where at least one input is
fixed while others are variable.
• Long run cost: The long run is a period of time in which all factors of production and
costs are variable.

Short Run Cost

The total cost/Short run total cost (SRTC) refers to the actual cost that is incurred by an
organisation to produce a given level of output. The Short-Run Total Cost (SRTC) of an
organisation consists of two main elements:

Total Fixed Cost (TFC): These costs do not change with the change in output. TFC remains
constant even when the output is zero. TFC is represented by a straight line horizontal to the x-
axis (output).
Total Variable Cost (TVC): These costs are directly proportional to the output of a firm. This
implies that when the output increases, TVC also increases and when the output decreases, TVC
decreases as well.

SRTC is obtained by adding the total fixed cost and the total variable cost.

SRTC = TFC + TVC

As the TFC remains constant, the changes in SRTC are entirely due to variations in TVC.
Figure depicts the short run cost curve of a firm:

Short Run Average Cost

The average cost is calculated by dividing total cost by the number of units a firm has produced.
The short-run average cost (SRAC) of a firm refers to per unit cost of output at different levels of
production. To calculate SRAC, short-run total cost is divided by the output.

SRAC = SRTC/Q = TFC + TVC/Q

Where, TFC/Q =Average Fixed Cost (AFC) and

TVC/Q =Average Variable Cost (AVC)

Therefore, SRAC = AFC + AVC

SRAC of a firm is U-shaped. It declines in the beginning, reaches to a minimum and starts to
rise.

Short Run Marginal Cost

Marginal cost (MC) can be defined as the change in the total cost of a firm divided by the
change in the total output. Short-run marginal cost refers to the change in short-run total cost due
to a change in the firm’s output.
Position of short run average and marginal cost curves
The short-run marginal cost (SRMC), short-run average cost (SRAC) and average
variable cost (AVC) are U-shaped due to increasing returns in the beginning followed by
diminishing returns. SRMC curve intersects SRAC curve and the AVC curve at their lowest
points.

Long Run Cost

The long run is a period of time in which all factors of production and costs arevariable.
According to the long run, all inputs are variable. There is no fixed cost.

Long Run Total Costs

Long run total cost refers to the minimum cost of production. It is the least cost of producing a
given level of output.

Long Run Average Cost Curve

Long run average cost (LAC) can be defined as the average of the LTC curve or the cost per unit
of output in the long run. It is derived from the short run average cost curves.

Long Run Marginal Cost

Long run marginal cost is defined at the additional cost of producing an extra unit of the output
in the long-run
Revenue
Revenue is the money payment received from the sale of a commodity.

Concepts

Total Revenue (TR)

TR is defined as the total or aggregate of proceeds to the firm from the sale of a

commodity.

TR = P.Q where

P = Price

Q = Quantity sold

Average Revenue (AR)

AR is revenue per unit of output sold. It is obtained by dividing total revenue by the

number of units sold.

AR = Total Revenue / Number of units sold

 Marginal Revenue (MR)
MR is addition made to total revenue when one more unit of output is sold.

MR = TR n - TR n-1

MR = d(TR) / d(Q)

Shutdown Point
A shutdown point is a level of operations at which a company experiences no benefit for
continuing operations and therefore decides to shut down temporarily—or in some cases
permanently. At the shutdown point, there is no economic benefit to continuing production.

A shutdown arises when price or average revenue (AR) falls below average variable cost
(AVC) at the profit-maximizing output level. Continued production will incur additional variable
costs but will not generate enough revenue to cover them. At the same time, the firm will still
have fixed costs to pay, further increasing the losses.

Shutdown point is defined as that point where the market price of the product is equal to
the AVC in the short run.
 In summary, the shutdown point has the following characteristics:

1. It is the output and price point where a firm is able to just cover its total variable
cost.
2. The average variable cost (AVC) is at its minimum point.
3. It is where the marginal cost (MC) curve intercepts the average variable cost
(AVC) curve.
4. The firm is indifferent between shutting down and continuing production where
losses equal to the total fixed costs are incurred regardless of either decision.

Break Even Point

• It is method used to study the relationship between TC and TR . The break-even point is
the point at which total cost and total revenue are equal, meaning there is no loss or gain
for your small business.

• Breakeven point (BEP) is used to understand this relationship

• BEP is the point where TC equals to TR. No profit , no loss (zero profit)

BEP: TC = TR

Profit / Loss = TR – TC

Profit / Loss = (P x Q) – (TFC + TVC)

BEP = TFC / P – AVC

NOTE:

1.) At BEP, it is zero profit

2.) When no of units sold is lesser than BEP, it is loss

3.) When no of units sold is greater than BEP, it is profit

Observations:

TC > TR, it is Loss

TC < TR, it is Profit

TC = TR, No Profit , No Loss ( BEP )

PV Ratio
PV Ratio (Profit Volume Ratio) is the ratio of contribution to sales.

P/V Ratio = Sales – Variable cost/Sales i.e. S – V/S

or, P/V Ratio = Fixed Cost + Profit/Sales

 arket Structures

Market is a term which is commonly used for a particular place or locality where goods are
bought and sold. According to Prof. Samuelson, “A market is a mechanism by which buyers and
sellers interact to determine the price and quantity of a good or service.” Based on competition,
the market structure has been classified into two broad categories:

1. Perfectly competitive. (Perfect Competition)

2. Imperfectly competitive. (Monopoly, Monopolistic competition and Oligopoly)

Perfect Competition
• Perfect competition is defined as a market structure in which an individual firm
producing homogenous commodities cannot influence the prevailing market price of the
product on its own.

• Perfect competition is a market structure characterized by complete absence of rivalry

among individual firms.

Features of Perfect Competition

1. Very Large Number of Buyers and Sellers

There are so many buyers and sellers that no individual buyer or seller can influence the price of
the commodity in the market. He is a price-taker having no bargaining power in the market.

The demand curve facing a firm is derived from the market equilibrium. In a perfectly
competitive market, price of the commodity is determined by the intersection of the market
demand and supply curves of the commodity. This occurs at point E where DD = SS.
 2. Homogeneous Product

Firms in the market produce a homogeneous product. Homogeneity of a product implies

that one unit of the product is a perfect substitute for another.

3. Free Entry or Exit of Firms

The industry is characterized by freedom of entry and exit of firms. In a perfectly

competitive market, there are no barriers to entry or exit of firms. Entry or exit may take time,
but firms have freedom of movement in and out of an industry.

4. Perfect Knowledge

Firms have all the knowledge about the product market and the factor market. Buyers
also have perfect knowledge about the product market.

5. Perfect Mobility of Factors of Production

The factors of production can move easily from one firm to another. Workers can move
between jobs and between places.

6. Absence of Transportation Cost

All goods are produced locally. Transportation costs are zero.

Equilibrium of a Competitive Firm

We know that the necessary and sufficient conditions for the equilibrium of a firm are:

1. MC = MR

2. MC curve cuts the MR curve from below

In other words, the MC curve must intersect the MR curve from below and after the intersection lie
above the MR curve. In simpler terms, the firm must keep adding to its output as long as MR>MC.
This is because additional output adds more revenue than costs and increases its profits. Further, if
MC=MR, but the firm finds that by adding to its output, MC becomes smaller than MR, then it must
keep increasing its output.
Since it is a perfectly competitive market, the demand for the product of the firm is perfectly elastic.
Further, it can sell all its output at the market price. Therefore, its demand curve runs parallel to the
X-axis throughout its length and its MR curve coincides with the AR curve.

Monopoly
• The word monopoly is derived from two Greek words ‘mono’ means single and ‘polo’
means to sell

• Monopoly is a market in which a single seller sells a product which has no substitutes

• E.g. RBI , Rail transport

Features of Monopoly

1. High barriers of entry: Competitors are unable to break into the market due to a single
company's control of it.
2. Price maker: The Company that operates the monopoly can determine the price of its
product without the risk of a competitor undercutting its price. A monopoly can raise
prices at will.
3. Profit maximizer: a monopoly maximizes profits. Due to the lack of competition a firm
can charge a set price above what would be charged in a competitive market, thereby
maximizing its revenue.
4. No Close Substitutes. There are no close substitutes for the commodity. The product sold
by monopolist has no close substitute.
5. High barriers to entry: other sellers are unable to enter the market of the monopoly.
 6. Single seller: in a monopoly one seller produces all of the output for a good or service.
The entire market is served by a single firm. For practical purposes the firm is the same
as the industry.
7. Price discrimination: in a monopoly the firm can change the price and quantity of the
good or service. It is the act of charging different prices for the same product from
different consumers.

Demand Curve under Monopoly

The monopolist produces all the output in a particular market. The monopolist is a ‘price-maker’.
It does not mean that monopolist can fix both price and the quantity demanded. If he fixes a high
price, less commodity will be demanded. The result is a downward sloping demand curve. The
demand curve is a constraint facing a monopoly firm. Demand curve is also the price line and the
AR curve. Since AR is downward sloping, MR lies below AR curve and is twice as steep as the
AR curve.

Equilibrium under Monopoly

Under monopoly, for the equilibrium and price determination there are two different conditions
which are:

1. Marginal revenue must be equal to marginal cost.

2. MC must cut MR from below.
 If the price determined by the monopolist in more than AC, he will get super normal
profits. The monopolist will produce up to the level where MC=MR. This limit will
indicate equilibrium output. In Fig. 10.6 output is measured on X-axis and price on Y-
axis. SAC and SMC are the short run average cost and marginal cost curves respectively
while AR and MR are the average revenue and marginal revenue curves respectively. The
monopolist is in equilibrium at point E because at point E both the conditions of
equilibrium are fulfilled i.e., MR = MC and MC intersects the MR curve from below. At
this level of equilibrium the monopolist will produce OQ1 level of output and sells it at
CQ1 price which is more than average cost DQ1 by CD per unit. Therefore, in this case
total profits of the monopolist will be equal to shaded area ABDC.

Dumping

• It means a monopolist sells his product at a higher price in the home market and lower
price in the international market.

Regulation of Monopoly
1. Promote competition. In some industries, it is possible to encourage competition, and
therefore there will be less need for government regulation.

2. Quality of service. If a firm has a monopoly over the provision of a particular service, it
may have little incentive to offer a good quality service. Government regulation can
ensure the firm meets minimum standards of service.
3. Prevent excess prices. Without government regulation, monopolies could put prices
above the competitive equilibrium. This would lead to allocative inefficiency and a
decline in consumer welfare.
Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another. It is a market structure at which large number
of sellers dealing with differentiated commodities. The main feature of monopolistic competition
is Product Differentiation

Product Differentiation means commodities marketed by each seller can be distinguished from
the products marketed by other seller in the form of size, shape, brand, color etc..

The term Monopolistic comp was given y Prof. Edward H Chamberlin.

Features of Monopolistic Competition

✓ Freedom of entry and exit.
✓ Firms produce differentiated products.
✓ Firms have price inelastic demand; they are price makers because the good is highly
differentiated
✓ Large number of sellers
✓ Product Differentiation
✓ Freedom for entry and exit
✓ Advertisement and selling cost
✓ Lack of Perfect Knowledge

Price – Output determination under monopolistic competition.

In the short run, the diagram for monopolistic competition is the same as for a monopoly.

The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit. (Refer Monopoly)
Oligopoly

An oligopoly is a market characterized by a small number of firms who realize they are
interdependent in their pricing and output policies. The number of firms is small enough
to give each firm some market power. The word oligopoly is derived from two Greek
words ‘Oligo’ means few and ‘Polo 'means to sell. It is a market with few sellers dealing
with homogenous and differentiated commodities. In oligopoly one firm’s action will
cause its competitors to react. This shows that firms has interdependence under oligopoly.

Features of Oligopoly

1. Few Firms with Large Market Share

A market may have thousands of sellers, but if the top 5 firms have a combined market
share of over 50 percent, it can be classified as an oligopolistic market. This is because
the power is concentrated between a few sellers who are able to exercise power over the
market.

2. High Barriers to Entry

Oligopolistic firms maintain their position through a number of barriers to entry. For
instance, brand loyalty, patents, and high start-up costs are but to name a few. These
make it difficult for new entrants to build a presence in the market and attract customers.

3. Interdependence
Any action a firm takes in an oligopolistic market will strongly affect the actions of its
competitors.

4. Nature of the Product

The firms under oligopoly may produce homogeneous or differentiated product.

5. Indeterminate Demand Curve

Under oligopoly, the exact behaviour pattern of a producer cannot be determined with
certainty. So, demand curve faced by an oligopolistic is indeterminate (uncertain).

Price – Output determination under oligopoly

The Kinked demand curve model was developed by Paul M Sweezy in 1939. The kinked
demand curve is distinctive of an oligopolistic market. It shows how, at higher and lower
prices, the elasticity of demand changes. As a result, prices remain relatively rigid.
As competitors keep their prices stable, the firm that increases prices will lose customers
to cheaper rivals. At the same time, reducing prices won’t increase demand. This is
because price decreases will be met with fierce competition. In an oligopoly, when one
firm reduces its prices, the others follow. In turn, any real gains in demand will be
negligible.

Diagram of kinked demand curve

Collusive Oligopoly
Collusive Oligopoly Sometimes, firms may try to remove uncertainty related to acting
independently and enter into price agreements with each other. This is collusion.
Collusion is either formal or informal. It can take the form of cartel or price leadership. A
cartel is an association of independent firms within the same industry which follow the
common policies relating to price, output, sale, profit maximization, and the distribution
of products. Price leadership is based on informed collusion. Under price leadership, one
firm is a large or dominant firm and acts as the price leader who fixes the price for the
products while the other firms allow it.
According to Samuelson “Collusion denotes a situation where two or more firms jointly
set their prices or output, divide the market among them, or make the business decisions”

Non – Price Competition

Non-price competition involves ways that firms seek to increase sales and attract custom
through methods other than price. Non-price competition can include quality of the
product, unique selling point, superior location and after-sales service.
Forms of non-price competition

Loyalty card – Some big business have invested considerably in loyalty cards which give
‘rewards’ or money back to customers who build up points/spending.

Subsidized delivery - Amazon has been successful at pushing Prime Delivery accounts.
This promises free next day delivery. Amazon is offering this delivery service as a loss
leader. The cost of delivery is often higher than what a customer is actually paying.

Advertising/brand loyalty - Firms spend billions on advertising because repeated

exposure to famous brands can make consumers more likely to buy ‘trusted’ brands.

After-sales service - For some goods, like TVs and car, offering free after-sales service
can be a factor in encouraging customer trust. It can also be a profitable aspect of the
business. For example, Apple Care offers a three-year warranty, but it is priced at a good
margin.

Coupons and free gifts- Some sellers provide coupons and free gifts along with product.