Course Module

Managerial Economics
 Unit One:
An Overview of Nature and Scope of Managerial Economics

• WHAT IS ECONOMICS?
Economics is the study of how individuals and societies
make choices subject to constraints.
• The need to make choices arises from scarcity. From the
perspective of society as a whole, scarcity refers to the
limitations placed on the production of goods and services
because factors of production are finite.
• From the perspective of the individual, scarcity refers to
the limitations on the consumption of goods and services
because of limited of personal income and wealth.
• Definition: Economics is the study of how individuals and
societies choose to utilize scarce resources to satisfy
virtually unlimited wants.
• Definition: Scarcity describes the condition in which the
availability of resources is insufficient to satisfy the wants
and needs of individuals and society.
• The concepts of scarcity and choice are central to the
discipline of economics. Because of scarcity, whenever the
decision is made to follow one course of action, a
simultaneous decision is made to forgo some other course
of action. Thus, any action requires a sacrifice.
• The concept of scarcity is summarized in the economic
admonition that there is no “free lunch.”
• Goods, services, and productive resources that are scarce
have a positive price.
• Positive prices reflect the competitive interplay between the
supply of and demand for scarce resources and commodities.
• A commodity with a positive price is referred to as an
economic good.
• Commodities that have a zero price because they are
relatively unlimited in supply are called free goods.
• What are these scarce productive resources? Productive resources, sometimes called
factors of production or productive inputs, are classified into one of four broad
categories: land, labor, capital, and entrepreneurial ability.
 WHAT IS MANAGERIAL
ECONOMICS?
•Managerial economics is the application of economic theory and quantitative
methods
(mathematics and statistics) to the managerial decision-making process. Simply
stated, managerial
economics is applied microeconomics with special emphasis on those topics
Definition: Managerial economics is the synthesis of microeconomic theory and quantitative
methods to find optimal solutions to managerial decision-making problems.
The role of managerial economics in the decision-making process is
•Managerial economics refers to the application of economic theory and decision
science tools to find the optimal solution to managerial decision problems.
• Managerial economics * refers to the application of economic theory and the tools
of analysis of decision science to examine how an organization can achieve its aims
or objectives most efficiently.
• Management decisions need to be made in any organization—be it a firm, a not-for-
profit organization (such as a hospital or a university), or a government agency—
when it seeks to achieve some goal or objective subject to some constraints. For
example, a firm may seek to maximize profits subject to limitations on the
availability of essential inputs and in the face of legal constraints. A hospital may
seek to treat as many patients as possible at an “adequate” medical standard with its
limited physical resources (physicians, technicians, nurses, equipment, beds) and
budget.
 Scope of Managerial Economics

•Managerial economics is concerned with the application of economic concepts and analysis to the problem of
formulating rational managerial decisions. There are four groups of problem in both decision making and
forward planning.
1. Resource allocation: Scarce resources have to be used with utmost efficiency to get optimal results. These
include production programming, problem of transportation, etc.
2. Inventory and queuing problem: Inventory problems involve decisions about holding of optimal levels of
stocks of raw materials and finished goods over a period. These decisions are taken by considering demand
and supply conditions. Queuing problems involve decisions about installation of additional machines or
hiring of extra labour in order to balance the business lost by not undertaking these activities.
3. Pricing problems: Fixing prices for the products of the firm is an important part of the decision making
process. Pricing problems involve decisions regarding various methods of pricing to be adopted.
4. Investment problems: Forward planning involves investment problems. These are problems of allocating
scarce resources over time. For example, investing in new plants, how much to invest, sources of funds, etc
•Study of managerial economics essentially involves the analysis of certain major
subjects like:
•Notes
1. Demand analysis and methods of forecasting
2. Cost analysis
3. Pricing theory and policies
4. Profit analysis with special reference to break-even point
5. Capital budgeting for investment decisions
6. The business firm and objectives
7. Competition.
•An analysis of scarcity of resources and choice making poses three basic questions:
1. What to produce and how much to produce?
2. How to produce?
3. For whom to produce?

•A firm applies principles of economics to answer these questions. The first question relates to what
goods and services should be produced and in what quantities. Demand theory guides the manager
in the selection of goods and services for production. It analyses consumer behavior with regard to:
1. Type of goods and services they are likely to purchase in the current period and in the future,
Goods and services which they may stop consuming,
2. Factors influencing the consumption of a particular good or service, and
3. The effect of a change in these factors on the demand of that particular good or service.
•
Relationship to Economic Theory

• The organization can solve its management decision problems by the application
of economic theory and the tools of decision science.
• Economic theory refers to microeconomics and macroeconomics.
• Microeconomics is the study of the economic behavior of individual decision-
making units, such as individual consumers, resource owners, and business firms,
in a free-enterprise system.
• Macroeconomics , on the other hand, is the study of the total or aggregate level of
output, income, employment, consumption, investment, and prices for the
economy viewed as a whole. Although the (microeconomic) theory of the firm is
the single most important element in managerial economics, the general
macroeconomic conditions of the economy (such as the level of aggregate
demand, rate of inflation, and interest rates) within which the firm operates are
also very important.
•Economic theories seek to predict and explain economic behavior. Economic theories usually
begin with a model. This abstracts from the many details surrounding an event and seeks to
identify a few of the most important determinants of the event. For example, the theory of the firm
assumes that the firm seeks to maximize profits, and on the basis of that it predicts how much of a
particular commodity the firm should produce under different forms of market structure or
organization. While the firm may have other (multiple) aims, the profit maximization model
accurately predicts the behavior of firms, and, therefore, we accept it.
•Thus, the methodology of economics (and science in general) is to accept a theory or model if it
predicts accurately and if the predictions follow logically from the assumptions.
•Like an economy, the manager of a firm also faces five basic issues:

1) Choice of product, i.e., the products a firm has to produce-A manager has to allocate the available
resources, so as to maximize the profit of the firm.
2) Choice of inputs- After determining the profit maximizing level of output, the manager has to identify
the input-mix which would produce the profit maximizing level of output at minimum cost
3) Distribution of the firms’ revenue- The revenue received by the firm through sales has to be distributed
in a just and fair manner by the manager. Workers, over of factory building, bankers, and all those who
have contributed their materials and services in the process of production, storage and transportation,
have to be paid remunerations, according to the terms and conditions already agreed upon. The residual
after such payments constitutes the firm’s profit which has to be distributed among the owners of the
firm after tax payment.
4. Rationing- This constitutes an important function of a manager. He/she should utilize the
scarce resources optimally, which involves expenditure. As the manager has to often look after
several plans simultaneously, he/she must prioritize not only the allocation of resources but also
the time.
5. Maintenance and expansion-In addition, the manager has to plan strategies to ensure that the
level of output is maintained, the efficiency of the firm is retained over time, and also to plan the
future expansion of the firm. Expansion of the firm involves making adequate provisions for
mobilizing additional capital from the market and/or borrowing money from banks. A dynamic
manager always aspires to expand the firm’s scale of operation, so as to increase the profits.
Relationship to the Decision Sciences

•Managerial economics is also closely related to the decision sciences. These use
the tools of mathematical economics and econometrics to construct and estimate
decision models aimed at determining the optimal behavior of the firm (i.e., how
the firm can achieve its goals most efficiently). Specifically, mathematical
economics is used to formalize (i.e., to express in equational form) the economic
models postulated by economic theory. Econometrics
applies statistical tools (particularly regression analysis) to real-world data to
estimate the models postulated by economic theory and for forecasting.
 Relationship to the Functional Areas of Business Administration Studies

•Having defined the subject matter of managerial economics and its function, we can now examine the
relationship between managerial economics and the functional areas of business administration
studies.

•The latter include accounting, finance, marketing, personnel or human resource management, and
production. These disciplines study the business environment in which the firm operates and, as such,
they provide the background for managerial decision making.

•Thus, managerial economics can be regarded as an overview course that integrates economic theory,
decision sciences, and the functional areas of business administration studies; and it examines how
they interact with one another as the firm attempts to achieve its goal most efficiently.
 Relationship with decision sciences

•The decision sciences provide the tools and techniques of analysis used in
managerial economics.

•The most important aspects are as follows:

[Link] and algebraic analysis
[Link]
[Link] estimation and forecasting
[Link] of risk and uncertainty
[Link] and time-value-of-money techniques
THE BASIC PROCESS OF DECISION MAKING

• Regardless of the type, all decision-making processes involve or can be

subdivided into five basic steps
1. Define the Problem
2. Determine the Objective
3. Identify Possible Solutions
4. Select the Best Possible Solution
5. Implement the Decision
 THE THEORY OF THE FIRM

•Business firms are a combination of manpower, financial, and physical resources which help in
making managerial decisions. The performances of firms get analyzed in the framework of an
economic model.
•The economic model of a firm is called the theory of the firm.
•Business decisions include many vital decisions like whether a firm should undertake research and
development program, should a company launch a new product, etc.
•Business decisions made by the managers are very important for the success and failure of a firm.
Complexity in the business world continuously grows making the role of a manager or a decision
maker of an organization more challenging! The impact of goods production, marketing, and
technological changes highly contribute to the complexity of the business environment.
•Reasons for the Existence of Firms and Their Functions

•A firm is an organization that combines and organizes resources for the purpose of producing goods
and/or services for sale.
•Firms exist because it would be very inefficient and costly for entrepreneurs to enter into and
enforce contracts with workers and owners of capital, land, and other resources for each separate step
of the production and distribution process.
•The firm exists in order to save on such transaction costs. By internalizing many transactions (i.e.,
by performing many functions within the firm), the firm also saves on transfer pricing, taxation on
multiple transactions, and reduces volatility in business by reducing dependence on outside agencies.
•The Objective and Value of the Firm

•Managerial economics begins by postulating a theory of the firm, which it then uses to analyze
managerial decision making. Originally, the theory of the firm was based on the assumption that
the goal or objective of the firm was to maximize current or short-term profits.
•Since both short-term as well as long-term profits are clearly important, the theory of the firm
now postulates that the primary goal or objective of the firm is to maximize the wealth or value of
the firm. This is given by the present value of all expected future profits of the firm. Future profits
must be discounted to the present because a rupee of profit in the future is worth less than a rupee
of profit today.
CHAPTER 2: ANALYSIS OF DEMAND

• The success or failure of a business depends primarily on its ability to generate revenues by
satisfying the demands of consumers. By identifying and analyzing the basic determinants of
consumer needs and wants, demand theory and analysis provides many useful insights for
business decisions. These decisions include pricing decisions, forecast sales and formulating
marketing strategies.
• Demand analysis is concerned with understanding consumer behavior, measuring and
characterizing the market response to a change in price or incomes or other economic variables.
It also derives the demand side information necessary to make sound business decisions.
• The term demand, of course, refers a desire for goods and services but this desire should be
backed by ability and willingness to buy. For example if a man wants to buy a car but he does
not have sufficient money to buy it, his want is not his demand for the car. And if a rich
miserly person wants to buy a car but is not willing to pay for his desire, too his want is not his
demand for a car.
• Therefore, the term demand is always defined in combination with desire with adequate
purchasing power and willingness to pay.
Individual versus Market Demand

•The expenditure decisions made by each individual determine his or her

demand for a given good. The quantity of a commodity which an
individual is willing to buy at a particular price during a specific time
period, given his money income, his taste and price of other commodities
(particularly substitutes and complements), is called “individual’s
demand for a commodity”.
• Although choices by individuals are the basis of the theory of
demand, it is the total or market demand that is of primary
interest to managers. The total quantity which all the
consumers of a commodity are willing to buy at a given price
per time Chapter, given their money income, taste and prices of
other commodities (mainly substitutes) is known as “market
demand for the commodity”. In other words, the market
demand for a commodity is the sum of individual demands by
all the consumers (buyers) of the commodity, over a time
period and at a given price, other factors remaining the same.
 DETERMINANTS OF MARKET DEMAND

•Quantity demanded is a function of a number of different factors (i.e. independent variable) Demand function describes the relationship
that exists during some period of time between the number of Chapters of a good or service that consumers are willing to buy and a given
set of conditions that influence the willingness to purchase.
• Algebraically, the demand function can be expressed as
• QD= f (P, Ps, Pc, Y, A, Ac, N, Cp, PE ...)
• Where QD = quantity demand of the product
• P= Price of the product
• Ps= Price of substitute product (S)
• Pc= price of complementary product (c)
• Y= income of consumers
• A= Advertising expenditures
• Ac= competitors advertising expenditures on the product
• N= population and other demographic factors
• Cp= consumer tastes and preferences for the product
 The demand factor Expected Effect
 Increase (decrease) in price of substitute good (Ps) Increase (decrease) in quantity demand (QD)
 Increase (decrease) in price of complementary goods. Decrease (increase) in QD
 Increase (decrease) in consumer Income levels (Y) Increase (decrease) QD
 Increase (decrease) the amount of advertising and marketing Increase (decrease) QD
expenditures (A)
 Increase (decrease) the amount of advertising and marketing by Decrease (Increase) QD
competitors (Ac)
 Increase (decrease) in population (N) Increase (decrease) QD
 Increase (decrease) in consumer preference for the good or Increase (decrease) QD
services. (Cp)
 Expected future price increase (decrease) for the good (P E) Increase (decrease) QD

 Increase (decrease) consumer tastes and preferences for Increase (decrease) QD

the product Cp
ELASTICITY

• The concept of elasticity of demand plays a crucial role in business

decision. For managerial decisions the relationship between demand
and its determinants is not sufficient. What is more important is the
degree of responsiveness of demand to the change in its determinants.
Elasticity is a measure of the responsiveness of quantity demanded to
a change in one of the factors influencing demand, such as price,
income levels, advertising etc.
•There are two approaches to computing elasticity. The choice between the two depends on the available data and the
intended use. The arc elasticity of demand is a technique to measure elasticity of demand between any two finite
points (determinants). Thus taking price as an example of determinant arc elasticity is defined as:
• ED= Q2-Q1 . P2 +P1

P2-P1 Q2-Q1
Where,
ED=Elasticity of demand
Q1= Quantity sold before price change

Q2= Quantity sold after price change

P1= Original price

P2= price after price change

•The concept of point elasticity whereas is used for measuring elasticity where change in
determinants is very small thus change in price (p) approach to zero, the term Q/p can be written
as dQ/dP, recall our previous discussion dQ/dp is the partial derivative of Q with respect to P.
•Hence the equation for point elasticity can be written as ED= Q/P. P/QD
• Where,
•ED=Elasticity of demand
•Q/P= derivative of Q with respect to P
•Q = Quantity sold
•P = price
PRICE ELASTICITY OF DEMAND

•Price elasticity of demand is defined as the responsiveness or sensitiveness of demand

for a commodity to change in its price. More precisely price elasticity of demand is the
percentage change in demand as a result of one percent change in the price of the
commodity and it is represented by the following formula:
• EP= %Q/%P
•Where;
• EP = price elasticity of demand
• Q= change in Quantity demand
• P= change in price.
•Price elasticity of demand will always have a negative value because either P or
Q will carry a negative sign due to inverse relationship between price and quantity
demand. Price elasticity of demand can be calculated using arc or point elasticity
techniques:-
•The arc price elasticity of demand calculates price elasticity between two prices
and indicates the effect on the demand.
•And recall the formula Ep = Q2-Q1 . P2 + P1

P2-P1 Q2+ Q1
 The Price Elasticity and Total Revenue

•Look at the following example: A new movie was opened to the public. At the first day, the entry fee for this movie
was $12 per person. In the second day hoping of increasing revenue the fee was raised to $20 per person, but there
were compliant that the fee was too high for that kind of movies. After words the organizer learned that at the first
day the movie attracted 1600 person in the second day the movie attracted only 900 people.
•The price elasticity can be estimated as
•EP = Q2-Q1 x P2 + P1

P2-P1 Q2+ Q1
•EP = 900-1600 x 20+12___
12.900+1600
•EP = -700 x 32 = 22400 = 1.12
2500 20000
•A one percent increase in price brought 1.12 percent decrease in demand. The first
price attracted 1600 person and thus generated income of $19,200 (1600 x 12) the
newly increased price attracted only 900 people and thus generated income of only
$18,000 (900*2). Because of an increase in price the movies organizers loss a total
of $1,200 (19,200 – 18,000). The above example demonstrates the business
application of price elasticity specifically in revenue maximization. Depending on
the nature of the demand function a price change can either increase or decrease the
total revenue.
•The uncertainties involved in price decision could be reduced if managers had a method of measuring the
probable effect of price change on total revenue.
•A firm aiming of enhancing its total revenue would like to know whether increasing or decreasing the price
would achieve its goal. The price elasticity coefficient of demand for its product at different levels of price
provides the answer to this question. The price elasticity of demand indicates the effect a change in price
will have on the total revenue to be generated. Bear in mind total revenue (TR) is equal to price times the
number of Chapters sold. QD we may determine, from our knowledge of demand elasticity, the effect on TR
when price changes. The following table illustrates this relationship.
Price Elasticity and change in Total Revenue

Elasticity coefficient Description Change in Price Change in Total Revenue

ED=0 Perfectly inelastic Increase/decrease Increase/decrease

0<Ed<1 Inelastic Increase/decrease Increase/decrease

ED=1 Chapter elastic Increase/decrease no change/ no change

1<ED<  Elastic Increase/decrease Decrease/increase

ED =  perfectly elastic decrease to zero infinite

increase
•When demand is Chapter elastic, a percentage change in price P is matched by an equal percentage change in quantity
demand QD, the net result being a constant TR. When demand is elastic, a percentage change in P is exceeded by the

percentage change in QD as a result an increase in price brings a reduction in total revenue and to the reveres. In

contrast for inelastic demand, a percentage change in P results in a smaller percentage change in Q D and it brings an
increase in TR.
•Decision makers must be aware of the relationship among price, elasticity and total revenue. Price increment strategy
will only be successful if the current estimation of demand is inelastic. As a number of empirical studies shows, for
example, the demand for durable goods like furniture is extremely price elastic (3.04) in such a case any further
increase in price will be self-defeating, leading to a reduction in total revenues whereas the demand for regular goods
like coffee (0.16) is extremely price inelastic in this case increase in price may bring additional revenue.
 Factor Affecting the Price Elasticity of Demand

•We have noted that price elasticity vary greatly among different products and service. Referring the above example, price elasticities of
furniture and coffee, some of the factors that account for the differing responsiveness of consumers to price change are Substitutes may be
different products like coffee and tea that give relatively the same satisfaction or the same products; like Ford and Toyota. The greater the
number of substitute goods, the more price elastic is the demand for a product because a customer can easily shift to substitute goods if the
price of a product in question increases.
1. Durable goods
•The demand for durable goods like car, refrigerator or furniture tends to be more price elastic than the demand for non-durable goods like
food items. Because when the price of the former increases customers either get the old one repaired or replacing a ‘Second hand’ instead
of buying new. On the other hand, consumption of necessary goods like food, clothes cannot be postponed and hence their demand is
inelastic, where as demand for luxury goods is more elastic than the demand for necessities.
1. Time factor in adjustment of consumption pattern
•Through time, the demand for many products tends to become more elastic because of the increase in the number of substitutes that
became available. For example, when the price of electricity increases, in the short term people may have few options or may not reduce
electricity consumption. But over a longer time they may switch to gas or improve the energy efficiency of their home.
 INCOME ELASTICITY OF DEMAND

•Income is among the variables that strongly affect demand. Income elasticity of demand measures the
responsiveness of a change in quantity demanded of some commodity to a change in income.
It can be expressed as EY= % QD
% Y
Where QD = change in quantity demand
Y = Change in income
•As price elasticity, income elasticity can be expressed and calculated either by arc or point method.

•Arc income elasticity is used when relatively large changes in income are being considered and is defined as
EY= Q2 - Q1 x Y2 +Y1

Y2 + Y1 Q2 + Q1
•Example 1: what is the income elasticity of automobiles as per capital income increases from, $10,000 to $11,000? The demand for automobiles as a function of
income per capital is given by the equation. Q= 50,000 +5(y)
•Solution: First find Q1 and Q2 by substituting Y1= $10,000 and Y2= 11,000 in to the demand equation respectively.

• Q1 = 50,000+5(10,000)
50,000 + 50,000
Q1 = 100,000 cars

Q2 = 50,000+5(11,000)
50,000 +55,000
Q2 = 105,000 car
•Thus EY = 105,000-100,000 x 11,000+10,000
11,000-10,000 105,000+100,000

EY= 0.512
•The result can be interpreted as over the income range $10,000 to 11,000 each 1 percent increase in income causes about 0.51 increase in quantity demanded.
 1. Income Elastic and Nature of Goods
•Income elastic ties can be either negative or positive. When they are negative, an increase in income is associated with a decrease in the
quantity demanded of the good or service. “Shiro wot” or bean might be an example. Those living on tight budgets may be unable to
afford any kind of meat. But as their incomes increase, they give up “Shiro wot” or bean and switch to other types of food which may be
meat or vegetable. Thus the increase in income causes a decrease in demand for “Shiro wot”. Goods with negative income elasticties like
“Shiro wot” or bean are defined as inferior goods.
•Normal goods and services have positive income elasticties of demand. They can be further classified by the magnitude of E I. If 0 < EI <
1, the percentage change in demand is positive but less than or equal to the percentage change in income. Such goods and services
are referred to as necessities or normal good. That is, demand is relatively unaffected by changes in income. Finally, luxuries are goods and
services for which EI >1. This means that the change in demand is proportionately greater than the change in income. For example, if E I =
4,a one percent increase in income would cause a 4 percent increase in demand. Jewelry is an example of a luxury good. As individuals
become richer, they have more disposable income, thus, purchases of necklaces, rings and fine watches tend to represent a larger share of
their incomes.
Income elasticity and Decision Making

• Income elasticity for a firm's product is an important determinant of the firm's

success at different stages of the business cycle. During periods of expansion,
incomes are rising, and firms have a chance to sell luxury items. Demand for their
products will increase at a rate that is faster than the rate of income growth.
However, during a recession, demand may decrease rapidly. Conversely, sellers
of necessities such as fuel and basic food items will not benefit as much during
periods of economic prosperity. This will also prove that their markets are some
what recession-proof. That is, the change in demand will be less than that in the
economy in general. Knowledge of income elastic ties can be useful in targeting
marketing efforts. Consider a firm specializing in expensive men’s colognes.
Because such goods are luxuries, those in high-income groups would be expected
to be the prime customers. Thus the firm should concentrate its marketing efforts
on media that reach the wealthier segments of the population.
 CROSS ELASTICITY OF DEMAND

•Another variable that often affects the demand for a product is the price of a related product (Substitute or complementary). Cross Elasticity denoted as Ex
and it is a measure of the responsiveness of change in the quantity demanded (Q DA) of product A to price changes for Product B (P B).

Ex= %QDA, ceteris paribus

% PB

•Where % QDA= change in quantity demanded of Product A

% PB = change in price of Product B

•As we did previously Arc cross Elasticity uses to compute cross elasticity between two price levels. It is calculated as
EX= QA2 - Qal x PB2+PB1

PB2-PB1 QA2+QA1

•Where QA2= quantity demanded of A after a price change in B

QA1= original quantity demanded of A

PB2= new price for Product B

PB1= original price for Product B

•Example 1: Suppose at a local grocery store the price of butter increase from, $1 to $1.50 per pound. As a result, the
quantity demanded of margarine QA increase from 500 pounds to 600 pounds Per a month. Compute the arc cross
elasticity of demand.
•Solution: Substituting the relevant data into the above equation
• Ex = 600 – 500 x $1.50 + $1.00
$1.50 - $1.00 600 + 500
• Ex = 0.45
•The result can be interpreted as follow a 1 percent increase in the price of butter will lead to a 0.45 percent increase in
the quantity demanded of margarine, which is, of course, a butter substitute, ceteris paribus.
 Cross Elasticity and Decision Making

•Like that of income elasticity, cross elasticity can be either negative or positive. If the cross elasticity measured between
items A and B is positive (as might be expected in our pork/beef meat example the two products are referred to as
substitutes for each other. The higher the cross elasticity, the closer is the substitute relationship. A negative cross
elasticity, on the other hand, indicates that two products are complementary. For example, an increase in the price of fuel
would probably result in a decrease in the demand for personal automobile.
•The number of close substitutes that a product has may be an important determinant of market structure. The fewer and
poorer the number of close substitutes that exist for a product, the greater the amount of monopoly power that is
possessed by the producing or selling firm. The importance of the definition of the relevant product market and the
determination of the cross elasticity of demand among close substitute products is emphasized in this and many other
cases.
CHAPTER 4: ANALYSIS OF COST

•Analysis of cost lays the ground work for major business decisions.
Supply decisions of firms and the price output determination in markets
are the basic that can be mentioned. Mangers seeking to make the most
efficient use of the enterprise’s resources and to maximize the value of the
enterprise must be concerned with cost –output relationships. This
Chapter first discusses the different cost concepts and later on devotes on
cost output relationships in the short run and the long run.
 COST CONCEPTS

•The word cost refers to the sacrifice incurred whenever an exchange or transformation of
resources take place however, problem arises when one attempts to measure this sacrifice.
The appropriate manner to measure or define costs is a function of the purpose for which
the information is to be used. Thus the term “Cost” has different meaning under different
settings and is subject to various interpretations.
•
•The cost concepts, which are relevant to business operations and decisions can be
grouped under two categories.
1. Concepts used for accounting purposes
2. Concepts used in economic analysis for business activities
•It is important to note here that this classification of cost concepts is only
a matter of analytical convenience. Accountants have been primarily
concerned with measuring costs for financial reporting purpose. As a
result, they define and measure cost by the historical outlay of fund that
take place in the exchange or transformation of a resources. However,
economists have been mainly concerned with measuring costs for
decision making purposes.
•Opportunity Cost and Actual cost
•Recall our discussion in Chapter one, resources available to any person, firm or society is scarce.
But these scarce resources have alternative uses with different returns. Owners seek to maximize
their income, can put these scarce resources to their most productive use and thus, they foregone
the income expected from the second best use of the resources. This basic fact introduces the idea
of opportunity cost. The opportunity cost may be defined as the expected returns form the second
best use of the resources which are foregone due to the scarcity of resources. Bear in mind had the
resource available to person, a firm or a society been unlimited there would be no opportunity cost.
The opportunity cost is also called alternative cost.
\
•Associated with the concept of opportunity cost the concept of Economic rent or
Economic profit is introduced. In our example of expected earnings firm taxi economic
rent can be calculated as follow. Economic rent of the taxi is the excess of its earning
from the taxi over the income expected from the bank. That is, economic rent equals to
birr 5,000 (20,000 birr- 15,000 birr). The implication of this concept for a business
decision is that investing on the taxi is preferable so long as its economic rent is greater
than zero. From this we can conclude that, if firms know the economic rent of the
various alternative uses of their resources, it will be simple to choice the best investment
avenue.
•In contrast to the concept of opportunity cost, actual costs are those
which are actually incurred by the firm. It includes payment for labor,
material, plant, building, machinery, equipment, traveling and transport,
advertisement, etc. Or actual costs refer the total money expenses
recorded in the books of accounts for all practical purposes. In our
example, the cost of the taxi, i.e., 100,000 birr is the actual cost.
Explicit and Implicit or Imputed costs
• Explicit costs are those which fall under actual costs entered in the books of accounts.
The payments for wages and salaries, material, license fee, insurance premium,
depreciation charges are the examples of explicit costs. These costs involve cash
payment and are recorded in normal accounting practices. In contrast to explicit costs,
there are certainly other costs which do not take the form of cash outlays, nor do they
appear in the accounting system. Such costs are known as implicit or imputed costs.
• Opportunity cost is an important example of implicit cost. For example, suppose an
entrepreneur does not utilize his services in his own business and works as a manager
in some other firm on a salary basis. If he sets up his won business later on he
foregoes his salary as manager. This loss of salary is the opportunity cost of income
from his own business. Thus, implicit wages, and rent are the wages, rents which an
owner’s labor and building, respectively, can earn from their second best use.
•Implicit costs are not taken into account while calculating the losses or gains of the business, but they form an
important consideration in whether or not a factor would remain its present occupation. The explicit and implicit
costs together make the economic cost.
Some Analytical Cost Concepts
Fixed and Variable Costs
•Fixed costs are those, which are fixed in volume for a certain given output. In other words, costs that do not
vary for a certain level of output are known as fixed costs. Plant, building, machinery are the best examples of
fixed costs.
•Variable costs are those which vary with the variation in the total output. Variable costs include cost of raw
material, running cost of fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labor charges
associated with the level of output, and the costs of all other inputs that vary with output.
• Total, Average and Marginal Costs
• Total cost (TC) is the total expenditure incurred on the production of goods and services. It refers to
the total outlays of money expenditure, used to produce a given level of output. It includes both
fixed and variable costs. The total cost for a given output is given by the cost function.
• Average cost (AC) is of statistical nature – it is not actual cost. It is obtained by dividing the total
cost (TC) by the total output (Q) i.e., AC = TC/Q. AC simply tells us the cost used to produce a
Chapter output.
• Marginal cost (MC) is the addition to the total cost on account of producing one additional Chapter
of the product. Or, marginal cost is the cost of the marginal Chapter produced. Marginal cost is
calculated as TC n _TCn-1 where n is the number of Chapters produced. Alternatively, given the
cost function, MC can be defined as MC = TC/ Q which is the first derivate of the total cost
function in respect to Q. These cost concepts are discussed throughout the Chapter. Total, Average
and Marginal cost concepts are used in the economic analysis of firm’s production activities.
Short-Run and long -Run costs
• Short run and long-run cost concepts are related to variable and fixed costs,
respectively, and often figure in economic analysis interchangeably.
• Short-run costs are the costs, which vary with the variation in output, the size of the
firm remaining the same. In other words, short run costs are the same as variable
costs.
• Long run costs on the other hand, are the costs, which are incurred of the fixed assets
like plant, building, machinery, etc. It is important to note that the running cost and
depreciation of the capital assets are included in the short-run or variable costs.
• Long run costs are by implication the same as fixed costs. In the long-run, however,
even the fixed costs become variable costs as the size of the firm or scale of
production increases. Broadly speaking, the short run costs are those associated with
variables in the utilization of fixed plant or other facilities whereas long-run costs are
associated with the changes in the size and kind of plant.
 Incremental Costs and Sunk Costs
• Conceptually, incremental costs are closely related to the concept of marginal cost but
with a relatively wider connotation. While marginal cost refers to the cost of the
marginal Chapter of output, incremental cost refers to the total additional cost
associated with the decisions to expand the output or to add a new variety of product,
etc. Incremental costs arise also owing to the change in product lines, addition or
introduction of a new product , replacement of worn out plant and machinery,
replacement of old technique of production with a new one, etc.
• Sunk costs are those, which cannot be altered, increased or decreased, by varying the
rate of output. For example, once it is decided to make incremental investment
expenditure and the funds are allocated and spent, all the preceding costs are
considered to be the sunk costs since they accord to the prior commitment and cannot
be revised or reversed or recovered when there is a change in market conditions or
change in business decisions.
 THE COST-OUTPUT RELATIONS

•The relationship between cost and output serves as an important building block in the theories of resource allocation and pricing
with in the firm. The theory of cost deals with the behavior of cost in relation to change in output. The basic principle of the cost
behavior is that the total cost increase with increase in output. However what is important from a theoretical and managerial point
of view is not the absolute increase in the total cost but the direction of change in the average cost (AC) and the marginal cost
(MC). The direction of change in AC and MC – whether AC and MC decrease or increase or remain constant – depends of the
nature of the cost function. The behavior of cost is expressed in terms of cost function. A cost function is a symbolic statement of
the technological relationship between the cost and output. The general form of the cost function is written as
• TC = f (Q) TC/Q>0
•The specific form of the cost function depends on whether the time framework chosen for cost analysis is short-run or long-run. It
is important to recall here that some costs remain constant in the short run while all costs are variable in the long run. Thus,
depending on whether cost analysis pertains to short-run or to long run , there are two kinds of cost functions, Accordingly, the
cost output relations are analyzed is short-run and long-run framework.
•1 Short -Run Cost- Output Relation
•Short- run cost output relationship help managers to plan for the most profitable level of output given the capital resources
that are immediately available. Total, Average and Marginal costs functions are basic analytical cost concepts used in the
analysis of cost behavior in the short run. The short-run TC is composed of two major elements:
i. Total fixed cost (TFC)
ii. Total variable cost (TVC). That is, in the short-run,
• TC=TFC+TVC
•As mentioned earlier, TFC (i.e., the cost of plant, building, etc.) remains fixed in the short-run, regardless of whether a
small or large quantity of output is produced during the period. TVC varies with the variation in the output though the
variation is not proportional.
•Mathematically for a given quantity of output (Q), the average total cost, (AC) average fixed cost (AFC) and average variable cost (AVC) can
be defined as follow
• AC = TC/Q = TFC+TVC/Q
• AFC = TFC/Q
• AVC = TVC/Q
• AC = AFC +AVC
•As we discuss previously Marginal cost (MC) is defined as the change in the total cost divided by the change in the total output, i.e.,
• MC = TC/Q
• = VC/Q since FC is zero in the short run
•or as first derivative of cost function i.e ., TC/ Q
•Since TC = TFC + TVC and, in the short-run, TFC=0, Therefore, TC = TVC. Furthermore, under the marginality concept, where
Q= 1 MC =TVC. The concepts AC, AVC, AFC, and MC give only a static relationship between cost and output. These concepts do not tell
us anything about cost behavior, i.e. how AC, AVC, MC and AFC behave when output changes. This can be understood better with a cost
function of empirical nature.
 Q VC FC TC = FC + VC AFC = FC/Q AVC= VC/Q ATC = TC/Q MC = TC/Q

0 $0 $150 $150 - - - -

6 50 150 200 $25 $8.33 33.33 $8.33

16 100 150 250 9.38 6.25 15.63 5.00

29 150 150 300 5.17 5.17 10.34 3.85

44 200 150 350 3.14 4.55 7.95 3.33

55 250 150 400 2.73 4.55 7.27 4.55

60 300 150 450 2.5 5.00 7.5 10.00

62 350 150 500 2.42 5.65 8.06 25.00

•Short run Average and Marginal cost function
•The AC and MC functions calculated from the table and are plotted in the figure4:2. From the graph we can observe the following important
relationships:
 Over the rage of output AFC and AVC fall, AC also falls because AC= AFC+AVC. When AFC falls, AVC increases, so change in AC depends on
the rate of change in AFC and AVC.
 When MC falls, AC follows, over a certain rage of initial output. When MC is falling, the rate of fall in MC is greater than that of AC, because
in the case of MC the decreasing marginal cost is attributed to a single marginal Chapter while, in case of AC, the decreasing marginal cost is
distributed over the entire output. Therefore, AC decreases at a lower rate than MC.
 Similarly, when MC increases, AC also increases but at a lower rate for the reason given above. Compare the behavior of MC and AC over the
range of output from 44 to 55from table 3.1 over this range of output, MC begins to increase while AC continues to decrease.
 MC intersects both AC and AVC cost functions at their minimum point. AC reaches its minimum when output increases to 55 Chapters. Beyond
this level of output AC stars increasing which shows that the law of diminishing returns comes into operation. The level of output that minimizes
the AC of production 55 in the above case is an optimum level of output that makes the firm efficient. Bear in mind this optimum level of output
may not result in maximum profit for the firm. The level of output that introduces the maximum profit will be discussed in Chapter six.
•Optimum level of output can be calculated using optimization technique. Optimization technique is a technique of maximizing or minimizing a function. It helps to find the best way to allocate
resources given an objective function, for example to find the level of output that would minimize the average cost. Mathematically, let the short run cost function is given as follow. To find the rate
of output that result in minimum AC.
T C = 200 + 5Q + 2Q2
•We have noted above that an optimum level of output is one that equalizes AC and MC. Given the cost function
AC = 200+5Q+2Q2
Q
= 200 + 5 + 2Q
Qand MC = TC = 5 + 4Q
Q
•Now you can solve for Q by equating AC an MC equations equal
200 +5 + 2Q = 5 + 4Q
Q
•Rearranging terms yields a quadratic equation
2Q2 = 200
Q = 10
•The result shows that Q = 10 minimizes the average cost. In other words, the optimum size of the output is 10 Chapters. Any other output level will increase the average cost of production.
•Long -Run Cost Output Relations
•Long run cost output relationships are important inputs into the decision to expand or contract the size of the firm. As we
define at the beginning of the Chapter, long-run is a period in which all the inputs become variable. Firms are, therefore,
in a position to expand the scale of their production by hiring a larger quantity of all the inputs. Thus the firm can choose
the combination of inputs that minimizes the cost of producing a desired level of output. The long-run cost-output
relations, therefore, imply the relationship between the changing scale of the firm and the total output, where as in the
short-run this relationship is essentially one between the total output and the variable input basically that of labor.
•To understand the long-run-cost-output relations and to derive long-run cost curves it will be helpful to imagine that (as
we observed in fig 4.3) a long-run cost curve is composed of a series of short-run cost curves. We may now derive the
long-run cost curves and study their relationship with output using the following figure.
•Long-Run and Short-Run Average and Marginal Cost Curves
•Long-run cost curves can be used to show how a firm can decide on the optimum size of the firm. Conceptually, the optimum size of a
firm is one which ensures the most efficient utilization of resources. Practically, the optimum size of the firm is one, which minimizes the
LAC.
•The long-run average cost curve (LAC) is derived by combining the short-run average cost curves (SACs). In Fig.4.3 there are three
corresponding SAC curves as given by SAC1, SAC2, and SAC3. Thus, the firm has a series of SAC curves, each having a bottom, point

showing the minimum SAC. The LAC curve can be drawn through the SAC 1, SAC2, and SAC3 as shown in Fig. 4.3. The LAC curve is
also known as the “Envelope curve” or “Planning Curve.” as it serves as a guide to the manager in his plans to expand production.
•LAC initially decreased until the optimum utilization of the second plant and then it begins to increase. These cost-output relations
follow the “low of return to scale.” When the scale of the firm expands, Chapter cost of production initially decreases, but ultimately
increases as shown in Fig 4.4. The decrease in Chapter cost is attributed to the internal and external economies and the eventual increase in
cost, to the internal and external diseconomies. The economies and diseconomies of scale are discussed in the following section.
•Given the state of technology over time, there is technically a unique size of the firm and level of output as socialite with the least-
cost concept. In Fig 4.3 the optimum size consist of two plants, which produce 0Q2 Chapters of a product at minimum long run
average cost (LAC) of BQ2. The downtrend in the LAC indicates that until output reaches the level of 0Q2”, the firm is of less than

optimal size. Similarly, expansion of the firm beyond production capacity 0Q2, causes a rise in SMC. The long run marginal cost

curve (LMC) is derived from the short-run marginal cost curves (SMCS). The derivation of LMC considers the points of tangency
between SACs and the LAC, i.e., point A, B and C. In the long-run production planning, these points determine the output levels at
the different level of production. For example, if we draw perpendiculars from points A, B and C to the X-axis, the corresponding
output levels will be 0Q1, 0Q2 and 0Q3. Another important point to notice is that LMC intersects LAC when the latter is at its

minimum SAC coincides with the minimum LAC. This point is B where SAC2=SMC2=LAC=LMC
•It follows that given technology, a firm aiming to minimize its average cost over time must choose a plant which gives minimum
LAC where SAC=SMC=LAC=LMC: This size of plant assures the most efficient utilization of the resource. Any change in output
level, increase or decrease, will make the firm enter the area of in optimality.
 ECONOMIC AND DISECONOMIES OF SCALE

•LAC decreases with the expansion of production scale up to 0Q 2 (relatively lower range of output) and then it begins to
rise over higher rang of out put. This behavior of LAC is caused by the economies and diseconomies of scale. Declining
LAC over the lower part of the range of possible output is usually attributed to economic of scale. Rising LAC at higher
level of output is usually attributed to dis-economic of scale. The sources of economic or dis-economic of scale may be
internal or external factors.
•Uses of advanced technology, specialization in production and marketing practice have a potential to reduce per Chapter
cost of an output. These factors considered as internal factors and arise from the expansion of the plant-size of the firm and
attributed to economic of scale. Ability of large scale purchase of raw material and acquisition of external finance on the
other hand considered as external factors. These factors are available to all the firms of an industry and they have a
contribution to reduce per Chapter cost of the product. Expansion of the scale of production leads to managerial
inefficiencies as a result close control and supervision reduced, consequently dis- economic of scale begins to appear
•On the other hand increase on the number of labor union encourages labor union activities,
which simply mean the loss of output per Chapter of time and hence, rise in the cost of
production. Externally when all the firms of the industry are expanding, the discounts and
concessions that are available on bulk purchases of inputs and concessions finances come to
an end. This situation creates higher demand for input market and input prices began to rise
causing a rise in the cost of production.
 CHAPTER 5
ANALYSIS OF REVENUE

•One indication of a firm’s success is the amount of total revenue (TR) generated by
the scale of its product. Ranking of firm’s size are usually made on the basis of total
revenue. Similarly growth is often expressed in term of increase in total revenue. In
this respect it reflects the ability of the firm to satisfy consumer demands, so the use of
total revenue as a measurement of success has some merit. As a result some
economists suggested maximization of TR as an alternative objective of the firm. This
Chapter is therefore devoted to the discussion of the analysis of revenue focusing of its
relation on elasticity of demand and marginal cost of the firm.
CONCEPTS OF TOTAL, MARGINAL AND AVERAGE REVENUE

•To achieve the maximum profit the firm should raise the following two important questions. These are what price
should it charge? And what output level should it produce and sell? To answer these questions of course we need to
compare the costs of production with revenues from production. More precisely, we need to calculate the change in
profits that occurs when production increases. We will see that by comparing the marginal cost of additional output
with the Marginal revenue of addition sale.
•As far as analysis of costs is concerned, we have developed all the relevant cost concepts (TC, MC, and AC) in the
previous Chapter. We now let develop analysis of the major revenue concepts.
•Total Revenue defined as quantity sold by the firm times price. From the firm’s demand curve, we know the
relationship between Price (P) and quantity sold (Q).
 (1) (2) (3) (4) (5)
Quantity q Price P TOTAL REVENUE MARGINAL REVENUE MR: TR/Q AVERAGE REVENUE AR=TR/Q
TR=p*q

0 $200 0 -- 200
1 $180 180 +180 180
2 160 320 +140 160
3 140 420 +100 140
4 120 480 +60 120
5 100 500 +20 100
6 80 480 -20 80
7 60 420 -60 60
8 40 320 -100 40
9 20 180 -140 20
10 0 0 -180 0
•As an example Table 5:1 shows the relationship for a hypothetical monopolistic firm of price (p) and quantity (q). Then
let us extend that analysis to estimate the impact of quantity sold on TR. By multiplying price times quantity (p*q) the
total revenue associated with each price quantity pair is determined at column [Link] illustrate 0 Chapter of product or
sale brings in TR of 0, 1 Chapter brings in TR= $180, 2 Chapters bring in $ 160* 2=320; and so forth.
•In this example of a straight-line or linear demand curve, total revenue at first rises with output, since the reduction in p
needed to sell the extra Q is moderate in this first elastic rage of the demand curve. But when we reach the midpoint of
the straight-line demand curve, TR reaches its maximum. This comes at q=5, P=$100, with TR=$500. Thus when we
put this graphically TR will be dome-shaped, rising from zero to a maximum of $500 and falling back to zero when P
has become ravishingly small.
•Already table 5:1 illustrates an important fallacy: “A firm wants to maximize its profits will always charge
what the traffic will bear”. That means charging the highest possible price. This statement is incorrect. As we
understand from the above situation higher price does not bring higher revenue at all. Even if we reinterpret this
doctrine to mean charging the highest price at which anything at all can be sold, it is obvious that selling but 1
Chapter even at a high price is not the way to maximize profit. If we neglect for a moment all costs, the correct
interpretation of charging what the traffic will bear must mean that we find the best compromise between a high
P and a high q.
•Before proceeding to introduce the important concept of marginal revenue, let us discuss Average Revenue.
Average revenue (AR) is by definition equal to dividing TR by q. Thus, we get P=AR (just as we earlier got
AC by dividing TC by q). We can note the fact that the price per Chapter can be called as average revenue,
column (5) verifies AR. It has the same characteristic to that of price.
•Marginal revenue (MR) defined as the increment in total revenue (plus or minus) that results from a one-
Chapter change in quantity demanded. Marginal revenue is shown in column (4) of Table 5.1. Here is how they
are calculated. Subtract the TR we get by selling q Chapters from the TR we get by selling Q+1 Chapters. The
difference will be our extra revenue or MR. Thus, from q=0 to q=1, we get MR=$180-0. From q=1 to q=2, MR
is $320 -$180=$140. Algebraically MR is defined as the first order derivative of the total revenue function in
respect to output. Marginal revenue is the convenient concept to find the highest-profit equilibrium of the firm;
we need to measure the impact of selling an extra Chapter of output on total revenue.
•MR is positive until we arrive at q=5, and negative from then on. That does not mean you are giving goods
away at a negative price. Actually, average revenue which is another name for P continues to be positive. It is
merely that in order to sell the sixth Chapter of q, you must reduce the price so much on the first 5 Chapters as to
end up getting less TR than before which is what the negative MR is telling us.
ELASTICITY AND MARGINAL REVENUE

•As we noted in Chapter three understanding the relationship between the price elasticity of demand and marginal
revenue is essential for decision making. Marginal revenue is positive when demand is elastic, zero when demand
is Chapter-elastic and negative when demand is inelastic
•This result is really a different way of restating the definition of elasticity we used in Chapter 3. Recall that
demand is elastic when a price decrease leads to a revenue increase. In such a situation, a price decrease raises
output demanded so much that revenues rise, so that marginal revenue is positive. For example, in 5.1 as price falls
in the elastic region from P= $180 to P=$160, output demanded rises sufficiently to raise total revenue, so marginal
revenue is positive. When demand is Chapter-elastic, a price cut is then just matched by an increase in output so
marginal revenue is zero. As a result total revenue remains unaffected. In case of an inelastic demand quantity
demanded increases by less than the proportionate decrease in price and hence the TR falls when price falls.
 MARGINAL ANALYSIS

• Marginal analysis is one of the useful concepts of economic decision making. Resource allocation decisions typically are
expressed in terms of marginal condition that must be satisfied to attain an optimal solution. The familiar profit
maximization rule for the firm of setting marginal cost equal to marginal revenue is one such a example. This analysis of
marginal revenue equips us for the task of finding the maximum profit equilibrium of the firm, of course which is the
focus point of the next Chapter. Until that to maximize profits, the firm must find the equilibrium price and quantity,
which gives the largest profit or the largest difference between TR and TC. Some reflections will tells us that this
maximum profit will occur when output has expanded to just the point where the firm’s MR is equal to MC,
 (1) (2) (3) (4) (5) (6) (7)
Quantity Price TR=p*q TC T profit MR MC
q P

0 $200 0 145 - 145 - MR>MC

1 $180 180 175 +5 +180 30

2 160 320 200 +120 +140 25

3 140 420 220 +200 + 100 20

4 120 480 250 +230 + 40 40 MR=MC

5 100 500 300 +200 +20 40

6 80 480 370 +110 - 20 70

7 60 - 460 -40 - 60 90

8 40 320 570 -250 - 100 110 MR<MC

• shows the optimal quantity and price that will maximize total profit. Column (5)
tells us that the optimal quantity, which is 4 Chapters, requires a price of $ 120 per
Chapter. This produces TR of $ 480 and after subtracting TC of $ 250 we calculate
total profit to be $230. At this level of maximum profit MR equals to MC.
Moreover as we understand from the table as long as MR is greater than MC the
firm's profit is increasing. So the firm would continue to increase output. By
contrast, suppose that at a give level of output MR is less than MC which means
that increasing output would lead to lower profit, so the profit maximizing firm
should at that point get back on cutting output.
THE RULE OF TR MAXIMIZATION

• The rule of maximization of total revenue is that, the total revenue is maximized at
the level of sales (Q) at which MR=0, that is, the marginal revenue (MR), i.e. the
revenue from the sale of the marginal Chapter of the product must be equal to zero.
MR is given by the first derivative of the TR function. Some to find the value Q that
maximizes TR, we need to find the derivative of the TR function with respect to Q,
set it equal to zero and solve it for Q, as shown below.
•Given the TR function the first derivative of the TR function can be obtained as follows.
•The total revenue (TR) of a firm is defined as TR=P.Q
Where P= price and Q= quantity sold.
•Suppose a price function is given as
P= 500-5Q
•By substituting the price function into the TR function, we get TR as follows.
TR = (500-5Q) Q
= 500Q-5Q2
•Now the problem is to find the value of Q that maximizes total revenue.
dTR = 500 - 10Q
dQ
•By setting dTR/Q equal to zero and solving for Q, we get
500 - 10Q = 0
-10Q =-500
Q = 50
•The above equation shows that Q=50 maximizes the total revenue. The maximum TR can be obtained by substituting 50 for Q in the TR function. Thus,
TR = 500(50) -5(50)2
= 25,000-12,500
= 12500
•Let us now check the result whether TR= $ 12,500 is maximum. This can be checked by increasing and decreasing Q by one Chapter and then comparing TR at
Q =51 and at Q = 49 with TR at Q = 50
TR (at Q=51) = 500(51) -5(51) 2
= 25,500-13,005
= 12,495

TR (at Q=51) 500(49) -5(49) 2

= 24,500 -12,005
= 12,495
.
•The calculation made above show that if sales are increased above 50 Chapters or reduced below 50 Chapters, TR decreases in both the cases. Thus, it is proved
that Q=50 maximizes TR.
 CHAPTER 6
ANALYSIS OF PROFIT

•In a free market system, economic profit (excess of revenues over cost) play an important role in guiding the
decisions made by the thousands of competing, independent economic Chapters, firms.
1. It acts as a signal to producers to increase or decrease the rate of output or to enter or leave an industry.
2. It is a reward for entrepreneurial activity like that of risk taking, and innovative practice of the manager.
3. It helps to determine the type and quantity of goods and services that are produced and sold and also to decide
the demand for various factors of production- labor, capital, and natural resources.
•In the previous Chapters we have developed the theories and techniques useful in analyzing cost and function.
Techniques are developed to determine where the total revenue is maximized and total costs are minimized.
However, profit will not be maximized by operating at the revenue maximizing or the cost minimizing levels of
output.
• Profit maximizing managers seek a pricing and output strategy that will maximize the present value of the future
profit stream of the firm.
•The determination of this maximizing price – output strategy mainly depends on:
 The production capacity and technology available to the firm
 The potential for future changes in this production capacity and technology available
 The cost of producing various levels of output
 The nature of the demand and
 The potential for immediate and longer term competition
 MARKET STRUCTURE AND PRICE – OUTPUT DECISION

•Profit maximization assumption depends on the price and output decision with respect to different market structure. In
an economic sense, a market is a system by which buyers and sellers bargain for the price of a product, settle the price
and transact their business to buy and sell a product. In some cases forward sale and purchase, even immediate transfer
of ownership of goods is not necessary, and market does not necessarily mean a place. The market for a commodity
may be local, regional, national or international. What makes a market is a set of buyers, a set of sellers and
commodity. While buyers are willing to buy and there is a price for the commodity.
•We are concerned in this Chapter with the question: How is the price and level of output of a commodity determined in
the market? The determination of price-output of a commodity depends on the number of sellers and the number of
buyers. The number of sellers of a product in a market determines the nature and degree of competition in the market.
The nature and degree of competition make the structure of the market.
• The market structure influences firms price – output decisions ay grate deal. Later
on price and output decision affects the level of profit since the degree of
competition determines a firm’s degree of freedom in determining the price of its
product. The degree of freedom implies the extent to which a firm is free or
independent of the rival firms in taking its own price output decisions. As a matter
of rule, the higher the degree of competition, the lower the firm’s degree of
freedom in pricing decision and control over the price of its own product and vice
versa. Let us now see how the degree of competition affects price – output
decisions in two different kinds of market structures, under pure competition
market structure and monopolistic market structure.
PROFIT ANALYSIS: PURE COMPETITION MARKET STRUCTURE

•The pure competition market structure has the following characteristics:

1. A very large number of buyers and sellers where a single buyer’s or seller’s actions
cannot have a perceptible impact on the market price.
2. A homogeneous product produced by each firm, which is no product differentiation.
3. Free entry and exit from the market, that is, minimal barriers to entry and exit.
4. No collusion among firms in the industry.
5. Complete knowledge of all relevant market information by each firm.
•The single firm in a purely competitive industry is, in essence, a price taker. Because the products of each producer
are perfect substitutes for the products of every other producer, the single firm in pure competition can do nothing but
offer its entire output at the going market price. As a result, the individual firm’s demand curve approaches perfect
elasticity at the market price. It can sell nothing at a higher price because all buyers (assuming rationality) will shift
to other sellers. If the firm sells at a price slightly below the long-run market price, its quantity demanded
approaches infinity. In the long run, at a price below the market price the firm will lose money. In addition, the firm
has no motivation to sell below the market price because each firm may sell its entire output at the market price
without having any perceptible influence on that price.
•In a perfectly competitive market, therefore the main problem for a profit maximizing firm is not determining the
price of its product but to adjust its output to the market price so that profit is maximized. Price determination under
perfect competition can be analyzed under two line periods, in the short run and the long run
 Price and Out Determination in the Short-Run

•A short run is, by definition, a period in which firms can neither change their size nor quit, nor can new firms enter
the industry. As noted earlier, however, in the short-run, it is possible to increase (or decrease) the output (supply) by
increase (or decrease) the variable inputs. In the short run, therefore, supply curve is elastic.
•The following example algebraically illustrates the profit –maximization conditions for a firm operating in purely
competitive market structure in the short –run.
•Assume ABC trading faces the following TR and TC functions
•TR=8Q
•TC= Q2+4Q+2
•Find the output level that maximizes the profit of the firm
•Solution- When profit is maximized MR=MC. Recall- MR and MC are defined as the first derivative of TR and TC functions respectively. Thus
•MR= dTR/ dQ = 8
•MC = dTC/ dQ = 2Q+4
•Profit to be maximized MR=MC 8=2Q+4
8-4=2Q
4/2=2Q/2 Q=2
•Total profit () is maximized when Q sets 2 (it is also necessary to check the second derivative of the profit function to be certain that we have found a
maximum not a minimum value. (See the appendix)
• = TR-TC = PQ - TC
8Q-(Q2+4Q+2)
= -Q2+4Q-2
d = -2Q1+4=0
dQ
d  = -2
2

dQ2
•Because the second derivative is negative, we know that we have found a maximum value for the profit function.
Price - Output Determination in the Long Run

• In the long run new firms can enter the industry and all inputs are free to vary.
Hence no differentiation exists between fixed and variable costs. Under long run
conditions, average cost will tend to be just equal to price and all excessive profits
will be eliminated. If P exceeds AC, more firms will enter the industry, supply
will increase, and price will be driven down towards the equilibrium, zero profit
level. In addition as more firms bid for available factors of production labor,
capital managerial talent, the cost of these factors will tend to rise. As a result in
the long-run equilibrium all firms will tend to have identical costs, and prices will
tend to equal AC. Thus we may say that the long run profit maximization level of
output under pure competition, equilibrium will be achieved at a point where
P=MR=MC=AC. At this point the firm is producing at its most efficient level of
output.
 PROFIT ANALYSIS UNDER MONOPOLISTIC MARKET STRUCTURE

•The term monopoly is defined as a market structure characterized by one firm producing a highly differentiated product in a market with
significant barriers to entry. In other words, a monopoly market is one in which there is only one seller of a product having no close substitute.
The cross elasticity of demand for a monopoly product is either zero or negative.
•
•A monopolized industry is a single firm industry thus firm and industry are identical in a monopoly setting. The following points considered as
the major sources for emergence and survival of monopoly power.
1. Legal constriction or barriers to entry of new firms: Entry may be prevented by law because of different reasons. For example in most
countries the public sectors basically controlled by the government or the state may create private monopolies through patent.
2. Control over key raw material: Some firms acquire monopoly power because of their traditional control over scarce and key raw materials.
3. Efficiency or Economic of scale:- If a firm’s long run minimum cost of production or its most efficient scale of production almost
coincides with the size of the market, then the large-size firm finds it profitable in the long-run to eliminate competition through price
cutting in the short-run. Once its monopoly is established, it become almost impossible for the new firms to enter the industry.
•Profit maximization level of price and output in monopolistic market can be examined in different time period just like that of competitive
market structure.
 Price and Output Determination in the Short Run

•The criterion for maximizing profits is the same for monopolists as for firms in perfect competition; pricing and output decision are based on revenue
and cost conditions. Although cost conditions, i.e. AC and MC curves, in a competitive and monopoly market are generally identical, revenue
conditions are different. Revenue conditions, i.e., AR and MR curves, are different under monopoly. Because, unlike a competitive firm, a monopoly
firm faces a downward sloping demand curve. For a monopolist it is possible to reduce the price and sell more and at the same time it can raise the
price and still retain some customers. Precisely, since monopoly firm and monopolized industry are one and the same, the demand curve of the industry,
a typically sloping downward curve, becomes the demand curve for the firm. When a demand curve is sloping downward, marginal revenue (MR),
curve lies below the AR curve and the slope of the Marginal revenue (MR), curve lies below the AR curve and the slope of the MR is twice that of AR.
•The short-run revenue and cost conditions faced by a monopoly firm are presented in Fig. 6.3. Firm’s average and marginal revenue curves are shown
by the AR and MR curves respectively and its short run average and marginal cost curves are shown by SAC and SMC curves, respectively. The price
and output decision rule for profit maximizing monopoly is the same as for a firm in the competitive industry. A profit maximizing monopoly firm
chooses a price-output combination at which MR= SMC. While the competitive firm, the price is unaffected by output, so the decision criterion is to
produce until price equals marginal cost.
•The following example illustrates algebraically price and output determination by a monopoly firm in the short run.
•Suppose demand and total cost functions for a monopoly firm are given as follows.
•Demand function : Q=100-0.2P
•Price function : P=500-5Q
•Cost function : TC=50+20Q+Q2
•We know that profit is maximized at an output which equalizes MR and MC. So the first step is to find MR and MC
from the demand and cost function, respectively. We have noted earlier that MR and MC are the first derivation of TR
and TC functions, respectively. TC function is given, but TR function is not. So, let us find TR function first,
•TR=P.Q since P= (500-5Q) Q Total Revenue (TR) equals TR=500Q-5Q 2
•Now MR can be obtained by differentiating the TR-function
MR = dTR = 500 - 10Q
dQ
•Likewise, MC can be obtained by differentiating the TC function
MC = dTR = 20 + 2Q
dQ
•Now that MR and MC are known, profit maximizing output can be easily obtained. Recall that profit is maximum where MR=MC. As given above,
MR=500-10Q
MC=20+2Q
•and by substitution, we get profit maximizing output as
500-10Q=20+2Q
480=12Q
Q=40
•The output Q =40 is the profit maximizing level of output
•Now profit maximizing price can be obtained by substituting 40 for Q in the price function
Thus, P=500-5(40)
=300
•Profit maximizing price is $300 and Total profit () can be obtained as follows
 =TR -TC
•By substitution, we get
 = 500Q-5Q2 - (50+20Q+Q2)
=500Q-5Q2-50-20Q-Q2
•By substituting profit maximizing output (40) for Q, we get
 = 500(40)-5(40) (40) – 50 - 20(40) – (40*40)
= 20,000-8,000-50-800-1600
= $ 9,550
•Total maximum profit is $ 9,550.
•Price and Output Determination in the Long Run
•In the long run a monopolist gets an opportunity to expand the size of its firm with a view to enhance its long-run profits. The expansion
of the plant size may, however, be subject to such conditions like;
o size of the market
o expected economic profit
o risk of inviting legal restrictions.
•Let us assume, for the time being, that none of these conditions limits the expansion of a monopoly firm and discuss the price and output
determination in the long run. In the long run, a monopolist can end up operating an optimum scale plant. An optimum scale plant is the
plant size that will lead to a maximum level of profits for the firm. The monopolist seeking to restrain entry of new competitors into the
industry may install excess capacity that can be used to flood the market with supply and lower prices, thus making entry less attractive to
potential competitors. On the other hand, by keeping prices high and earning monopoly profits, the monopolist firm encourages potential
competitors to commit resource in an effort to obtain a share of these profits. For example, if a monopoly is based on a patented product
(or production process), potential competitors may invest funds in research and development in order to design an alternative to the
monopolist firm’s product (production process).
• We have already examined that the monopolistic firm’s short-run profits are
maximized by setting marginal revenue equal to marginal cost. This yields an optimal
out put and an optimal price. Such a solution, however, may not necessarily
maximize the long-run profits (or shareholder wealth) of the firm. In the long run
instead of charging the short-run profit-maximizing price, the monopolist firm may
decide to engage in limit pricing strategy, where it charges a lower price, such as P L in
figure 6.4, in order to discourage entry into the industry by potential rivals. With a
limit pricing strategy, the firm forgoes some of its short-run profit. The limit price,
such as PL in figure 6.4 was set below the minimum point on a potential competitor’s
average total cost curve, (ATCc). The appropriate limit price is a function of many
different factors.
 MONOMOLY VERSUS PURE COMPETITION

• The monopolist produces at a level of output which is smaller than the industry output would be
under pure competition because equilibrium is reached in pure competition at a point where the ATC
curve is minimized. The profit-maximizing monopolist, faced with a negative- sloping demand
curve, will always produce at an output short of that output at which average costs are minimized.
When one concludes that a monopoly will produce less than a purely competitive industry, all other
things being equal. Both demand and cost may change when a monopolist takes over a
competitive industry. For instance, the monopolistic cost function may reflect economies of scale
that were not possible for the smaller firms in pure competition. Such economies might relate to
more efficient plant sizes, the centralizing of inventories, and the centralizing of such functions as
financing, purchasing, and legal service. Because of the possibility of making large profits, the
monopolist may find it advantageous to advertise, possibly increasing aggregate market demand.
However, a large monopolist might require a huge administrative structure where coordination and
effective communication become increasingly difficult, and diseconomies results. On balance a
simple comparison between monopoly and pure competition can furnish little more than a possible
clue about the levels of output that might be expected under each market structure.
• Even if pure competition does result in a large output than results from a monopoly, it cannot be
concluded, especially under conditions of full employment that breaking up a monopoly (which would
lead to an increase in that industry’s output) will be in society’s best interest. Under full employment,
an increase in output in the liquor industry, for example, would require that resources be drawn away
from other industries and prices in those industries would possibly rise. To take an extreme example,
assume that the liquor industry is a monopoly, the economy is operating under conditions of full
employment, and the government seeks to break the liquor monopolist into a large number of smaller
competitive firms. As a result, output in the industry increases. The new small liquor companies bid for
the services of chemists to work on product development. Some chemists are attracted from drug firms,
and those who remain work at a higher wage. May we conclude that society is better off because more
liquor is produced? Prices of liquor perhaps are lower, but the cost of drugs may have risen. Under
conditions of full employment, we must be very careful to analyze the impact of reallocating resources
from one industry to another before concluding that greater output in any one industry necessarily
makes society better off.
 Chapter 3
Optimization techniques

•Economics is a science of choice. If we want to undertake an economic project, say

producing a certain product, there may be several possible ways of doing it. However,
one or more of them will be more important than others from the point of view of some
criteria. Thus, the main duty of optimization problem is choosing the best alternative
according to the specified criteria.
•In economics we usually use the objective of profit maximization or cost
minimization as the most common criteria to select the best alternative to carry out the
project. In economics, optimization problem is a general heading which represents both
minimization and maximization problem. Optimization means ' the quest for the best".
• Optimization techniques are very crucial activities in managerial decision making process.
• According to the objective of the firm, the manager tries to make the most effective decision
out of all the alternatives available.
• Though the optimal decisions differ from company to company, the objective of optimization
technique is to obtain a condition under which the marginal revenue is equal to the marginal
cost.
•The first step in presenting optimization techniques is to examine the methods to express
economic relationship.
•Expressing relationships through equations is very useful in economics as it allows the
usage of powerful differential technique, in order to determine the optimal solution of the
problem.
•Many problems in economics involve the determination of “optimal” solutions.
For example, a decision maker might wish to determine the level of output that
would result in maximum profit. The process of economic optimization
essentially involve three steps:
1. Defining the goals and objectives of the firm
2. Identifying the firm’s constraints
3. Analyzing and evaluating all possible alternatives available to the decision maker
•In essence, economic optimization involves maximizing or minimizing some
objective function, which may or may not be subject to one or more constraints.
•To solve optimization problem, first we should formulate the objective function which
will be maximized or minimized. This function includes dependent and independent
variables. The independent variables are referred to as choice variables because the
economic unit chooses their magnitude to optimize the objective function.
• In general, the nature of optimization process is to get the values of the choice variables
that will optimize the objective function. This unit is emphasized on unconstrained
optimization, i.e. minimization or maximization of objective function without constraint .
 Functions of One Independent Variable

•What is unconstrained function?

•Some objective functions involve constraints and others do not. Functions which do not involve
constraints are referred to as unconstrained functions and the process of optimization is said to be
unconstrained or free optimization.
•Given the function y = f(x) which is continuous and differentiable, it is said to have a maximum value
at a point where it changes from an increasing to decreasing function where as it is said to have a
minimum value at the point where it changes from decreasing to increasing functions.
•The values of x at which the function is at its minimum or maximum point are known as critical
values. The given function should satisfy two conditions in order to decide about maximum and
minimum value at a particular point. These conditions are called order conditions.
a) Conditions for minimum value
1. First order condition (Necessary condition) f ( x) 0
2. Second order condition (Sufficient condition) f ( x)  0
b) Conditions for Maximum value
1. First order condition (Necessary condition) f ( x) 0
2. Second order condition (Sufficient Condition) f ( x)  0
However, the second derivative of the function may be equal to zero in some cases. When f ( x) 0 ,
Example
Find the minimum and maximum values of the function f ( x ) 3 x 4  10 x 3  6 x 2  5
Solution
The first order condition is f ( x ) 0 .We can determine the critical values using this condition.

Thus, f ( x ) 12 x 3  30 x 2  12 x 0

3 x( 4 x 2  10 x  4) 0

or

or

Therefore, are critical values

We should test the second order condition at these points to know whether the function is at its relative
maximum or minimum point.
f ( x) 36 x 2  60 x  12
 At x 0 ,
f ( x) 36(0) 2  60(0)  12 12  0 . Thus, the function is at its relative minimum point at x = 0.
 At x = 2, f ( x) 36( 2) 2  60( 2)  12 =144-120 +12
f ( x) 36  0 . Thus, the function is at its relative minimum point at x 2 .
1 1 1
 At x = ½, f ( x ) 36( )  60( )  12 = 36( )  30  12
2 2 4
= 9  30  12  9  0
1
Therefore, the function is at its relative maximum point when x  .
2
Economic Applications

Revenue functions
Revenue represents the amount of money that the firm generates either from the sale of the products or
providing services. Therefore,

Total Revenue = Price x Quantity Sold

It can be written as TR = P x Q; Where P is price and Q is quantity.

The firm can maximize its total revenue when
dTR
0 or MR 0 (First order condition) and
dQ

d 2TR d ( MR )
2
0 or  0 ( Second order condition
dQ dQ
Profit functions
Do you remember the conditions that should be satisfied for profit maximization? What are they? As
we know that the main objective of every firm is profit maximization; therefore, it wants to know the
level of output which maximizes profit.
Total profit = Total revenue - Total cost
 = TR – TC
Where  represents total profit, TR is total revenue and TC is total cost.
We have discussed above that there are first orders and second order conditions for maximizing
profit. The first order condition that must be fulfilled for maximizing profit is that the slope of total
revenue (marginal revenue) has to be equal to the slope of total cost (marginal cost). That is
d dTR dTC
0   0
dQ dQ dQ

MR - MC = 0 MR = MC
The second condition that has to be satisfied is that the slope of marginal revenue must be less than
the slope of marginal cost. In other words, the marginal cost curve has to cross the marginal revenue
curve from below. That is

d 2 d 2TR d 2TC
<0   <0
dQ 2 dQ 2 dQ 2
d ( MR ) d ( MC )

dQ dQ

Slope of < Slope of

MR MC
Example
1. Suppose a monopolist has a demand curve Q = 106 - 2 P and average cost curve.
Q
AC = 5+ , where P is price per unit and Q is the number of units of output. Determine the profit
50
maximizing level of output and price of this monopolist.

Solution
Total profit (  ) = Total Revenue (TR) - Total Cost (TC) but TR = PQ. Thus we should rewrite the
demand function in the form of price expressed in terms of quantity. That is
2P = 106 - Q
1
P = 53  Q
2
1
Thus, TR = (53 - Q) Q
2
1
TR = 53Q - Q2  MR = 53 - Q
2
And
TC = AC (Q)
Q
= (5+ )Q
50
1 1
TC = 5Q + Q2  MC = 5 +
50 25 Q

Profit is maximized when

MR = MC
1
53 - Q = 5 + Q
25
1
53 - 5 = Q + Q
25
26
48 = Q
25
48( 25)
Q =
26
Q = 46.15
However, this information is not sufficient enough to conclude that it is the profit maximizing level of
output. Thus it must fulfill the following condition at this point.
d 2TR d 2TC 1
When Q = 46.15, - = -1 -
dQ 2 dQ 2 25
 26
= < 0
25
Now we are confident enough to conclude that Q = 46.15 is the profile maximizing level of output of
the monopolist as this level of output satisfies both of the above conditions.
The profit maximizing level of price is
1
P = 53 - (46.15)
2
= 53 - 23.075
P = 29.93
Cost Functions
Do you remember the analysis of cost in your Microeconomics I study? As you remember costs
represent the amount of expenditures that firm’s incurred in the production process. It includes both
implicit and explicit cost. Thus, firms want to minimize these costs. Given Total Cost;
(TC) = f (Q), where Q is output, Firms can minimize total cost if and only if
dTC
i) 0  MC 0
dQ
2
d TC d ( MC )
ii) 2
0 >0
dQ dQ
Example
1. Suppose the total cost of producing Q units of a certain product is described by the function TC =
100,000 + 1, 500Q + 0.4 Q2 where TC is the total cost stated in Birr. Determine the amount of
output which minimizes average cost.
Solution
TC
Average cost (AC) =
Q
100,000
AC = + 1, 500+ 0.4 Q
Q
AC is minimized when
2
dAC d ( AC )
0 And 0
dQ dQ 2
dAC  100,000
  0.4 0
dQ Q2
100,000
- = - 0 .4
Q2
100,000
Q 2
0.4
Q 2 = 250,000
Q =  500 but output should be positive.
Therefore, Q = 500. But we should check the second order condition at this point to reach to our
conclusion.
 d 2 AC  2(  100,000)
When Q= 500, =
dQ 2 Q3
200,00 200,000
= = >0
Q3 (500) 3
Thus, the level of output which minimizes average cost is Q = 500 units.

1. Find the minimum point of the average cost function

AC = 25 Q  1 + 0.1Q
Solution
Applying the same conditions
dAC
= - 25 Q  2 + 0.2Q = 0
dQ
-25Q  2 + 0.2Q = 0
-25Q  2 = - 0.2Q
25
= 0.2Q
Q2
Q3 = 125
Functions of Several Independent Variables

• Now let us turn our attention to develop away of finding the extreme values of an objective function which
includes two or more choice variables. Then we will have the ability to solve problems such as determining
the profit maximizing level of outputs for several commodities and the optimal combinations of several
different inputs.
Given the function z = f(x, y), the objective function z to be maximum or minimum, it must satisfy
both of the order conditions.
The first order conditions are
z z
=0 and =0
x y
This means, the first order total differential of the function is zero ( dz  f x dx  f y dy 0 ).

However, there are two sets of second order conditions

2 z 2 z
a) To be maximum  0 , and < 0 ----------------------------------- (1)
x 2 y 2

2 z 2 z
b) To be minimum >0, and 2 > 0
x 2 y
The other second order condition for both to be at maximum and minimum value is
2 z 2 z 2 z 2
( )( ) > ( )
x 2 y 2 xy
Example
1. Given the function Z= 160x – 3x2 - 2xy - 2 y2 + 120 y - 18, find the maximum value of the function.
Solution
The first order conditions that should be satisfied for maximum are
Z Z
Zx  0 And Zy  0
x y
z
Zx = = 160 - 6x - 2y = 0
x
6x + 2y = 160 -------------------------------- (1)

Z
Zy  = -2x - 4y + 120 = 0
y
2x + 4y = 120 -------------------------------------- (2)

Taking equation (1) and (2) simultaneously, multiplying (1) by 2 and subtracting equation (2) from
this gives us
 6x +2y = 160
2 x  4 y 120
12x +4y = 320
2 x  4 y 120

10 x + 0 =200
10 x = 200
x= 20

Substituting 20 in place of x in either of the two equation we will get y = 20

Taking the second partial derivatives,
Z xx = - 6 < 0, Z yy = - 4 < 0
And
( Z xx ) ( Z yy ) > ( Z xy ) 2

(-6) (- 4) > (-2)2

24 > 4