Managerial Economics:

It is a commonly accepted fact that physical inputs or resources are important for enhancing
production. We, however, tend to miss out on the financial aspect of this rule. Some of the most
important decisions pertaining to business often relate to the cost of production, instead of
physical resources themselves. Hence, it is important for producers to understand cost analysis.
Let’s understand the general concept of costs for that.

Concept of Costs

In order to understand the general concept of costs, it is important to know the following types
of costs:

1. Accounting costs and Economic costs

2. Outlay costs and Opportunity costs

3. Direct/Traceable costs and Indirect/Untraceable costs

4. Incremental costs and Sunk costs

5. Private costs and Social costs

6. Fixed costs and Variable costs

Concept of Costs in terms of Treatment

1. Accounting costs
Accounting costs are those for which the entrepreneur pays direct cash for procuring resources
for production. These include costs of the price paid for raw materials and machines, wages paid
to workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc.
Accounting costs are treated as expenses. Chartered accountants record them in financial
statements.

2. Economic costs
There are certain costs that accounting costs disregard. These include money which the
entrepreneur forgoes but would have earned had he invested his time, efforts and investments in
other ventures. For example, the entrepreneur would have earned an income had he sold his
services to others instead of working on his own business

Similarly, potential returns on the capital he employed in his business instead of giving it to

others, the output generated by his resources which he could have used for others’ benefits, etc.
are other examples of economic costs.

Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn

above the normal profits by investing in ventures other than his.
Concept of Costs in terms of the Nature of Expenses

1. Outlay costs
The actual expenses incurred by the entrepreneur in employing inputs are called outlay costs.
These include costs on payment of wages, rent, electricity or fuel charges, raw materials, etc. We
have to treat them are general expenses for the business.

2. Opportunity costs
Opportunity costs are incomes from the next best alternative that is foregone when the
entrepreneur makes certain choices.

For example, the entrepreneur could have earned a salary had he worked for others instead of
spending time on his own business. These costs calculate the missed opportunity and calculate
income that we can earn by following some other policy.

Concept of Costs in terms of Traceability

1. Direct costs
Direct costs are related to a specific process or product. They are also called traceable costs as
we can directly trace them to a particular activity, product or process.

They can vary with changes in the activity or product. Examples of direct costs include
manufacturing costs relating to production, customer acquisition costs pertaining to sales, etc.

2. Indirect costs
Indirect costs, or untraceable costs, are those which do not directly relate to a specific activity or
component of the business. For example, an increase in charges of electricity or taxes payable on
income. Although we cannot trace indirect costs, they are important because they affect overall
profitability.

Concept of Costs in terms of the Purpose

1. Incremental costs
These costs are incurred when the business makes a policy decision. For example, change of
product line, acquisition of new customers, upgrade of machinery to increase output are
incremental costs.

2. Sunk costs
Suck costs are costs which the entrepreneur has already incurred and he cannot recover them
again now. These include money spent on advertising, conducting research, and acquiring
machinery.
Concept of Costs in terms of Payers

1. Private costs
These costs are incurred by the business in furtherance of its own objectives. Entrepreneurs
spend them for their own private and business interests. For example, costs of manufacturing,
production, sale, advertising, etc.

2. Social costs
As the name suggests, it is the society that bears social costs for private interests and expenses of
the business. These include social resources for which the firm does not incur expenses, like
atmosphere, water resources and environmental pollution.

Concept of Costs in terms of Variability

1. Fixed costs
Fixed costs are those which do not change with the volume of output. The business incurs them
regardless of their level of production. Examples of these include payment of rent, taxes, interest
on a loan, etc.

2. Variable costs
These costs will vary depending upon the output that the business generates. Less production
will cost fewer expenses, and vice versa, the business will pay more when its production is
greater. Expenses on the purchase of raw material and payment of wages are examples of
variable costs.

Other costs:

Explicit costs
Explicit costs, also referred to as actual costs, include those payments that the employer
makes to purchase or own the factors of production. These costs comprise payments for raw
materials, interest paid on loans, rent paid for leased building or machinery and taxes paid to
the government.
An explicit cost is one that has occurred and is clearly reported in accounting books as a
separate cost.

Example: if an organisation borrows a sum of 70,00,000 at an interest rate of 4% per year,

the interest cost of 2,80,000 per year would be an explicit cost for the organisation.

Implicit costs
Unlike explicit costs, there are certain other costs that cannot be reported as cash outlays in
accounting books. These costs are referred to as implicit costs. Opportunity costs are
examples of implicit cost borne by an organisation.
Example: An employee in an organisation takes a vacation to travel to his relative’s place. In
this case, the implicit costs borne by the employee would be the salary that the employee
could

have earned if he/she had not taken the leave. Implicit costs are added to the explicit cost to
establish a true estimate of the cost of production. Implicit costs are also referred to as
imputed costs, implied costs or notional costs.

What is Short Run Cost?

Short Run Cost refers to a certain period of time where at least one input is fixed while
others are variable.
In the short-run period, an organisation cannot change the fixed factors of production, such as
capital, factory buildings, plant and equipment, etc. However, the variable costs, such as raw
material, employee wages, etc., change with the level of output.

Example: If a firm intends to increase its output in the short run, it would need to hire more
workers and purchase more raw materials. The firm cannot expand its plant size or increase
the plant capacity in the short run.
Similarly, when demand falls, the firm would reduce the work hours or output, but cannot
downsize its plant. Therefore, in the short run only variable factors are changed, while the
fixed factors remain unchanged. Let us discuss the cost-output relations in the short run

Type of Short Run Cost- YOU CAN REFER THE TEXT BOOK Y’ALL TOOK
What is Short Run Cost Types? There are basically three types of short run costs:
1. Short Run Total Cost- TFC , TVC & TC
2. Short Run Average Cost- AFC. AVC & AC
3. Short Run Marginal Cost- MC
Short Run Total Cost
The total cost 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

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

rise.
Figure depicts the short run average cost curve of a firm.

The SRAC curve represents the average cost in the short run for producing a given quantity
of output. The downward slope of the SRAC curve indicates that as the output increases,
average costs decrease. However, the SRAC curve begins to slope upwards, indicating that at
output levels above Q1, average costs start to increase.

Average cost is divided into average fixed cost and average variable cost.

1. Average Fixed Costs (AFC):

Refers to the per unit fixed costs of production. In other words, AFC implies fixed cost of
production divided by the quantity of output produced.

It is calculated as:
AFC = TFC/Output

TFC is constant as production increases, thus AFC falls.

AFC curve is shown as a declining curve, which never touches the horizontal axis. This is
because fixed cost can never be zero. The curve is also called rectangular hyperbola, which
represents that total fixed costs remain same at all the levels.
2. Average Variable Costs (AVC):
Refer to the per unit variable cost of production. It implies organization’s variable costs
divided by the quantity of output produced.

It is calculated as:
AVC = TVC/ Output

Initially, AVC decreases as output increases. After a certain point of time, AVC increases
with respect to increase in output.

Thus, it is a U- shaped curve, as shown in Figure-7:

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.

Short-run marginal cost on a graph is the slope of the short-run total cost and depicts the rate
of change in total cost as output changes. The marginal cost of a firm is used to determine
whether additional units need to be produced or not. If a firm could sell the additional unit at
a price greater than the cost incurred to produce the additional unit (marginal cost), the firm
may decide to produce the additional unit.
QUANTITY FIXED TOTAL TOTAL AVERAGE MARGINAL
(Q) COST VARIABLE COST COST(SRAC=TC/Q) COST
(TFC) COST (TVC) (SRTC = (SRMC=
TFC + ΔTC/Δ Q)
TVC)

20 10 15 25 1.25 –

21 10 20 30 1.43 5

22 10 10 20 0.91 10

23 10 12 22 0.96 2
Table shows the estimation of SRTC, SRAC, and SRMC of a firm producing paper bags.
Quantity expressed is in thousands (‘000) and the cost in ` (in lakhs):

Calculation of SRTC, SRAC and SRMC

The figure depicts the Short Run Marginal Cost curve along with all the average cost curves
of a firm:

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.
Unit -4

Meaning of a Market:
A market can be characterised as where a couple of parties can meet, which will expedite the
trading of products and services. The parties involved in the market activities are the sellers
and the buyers. A market is an actual structure like a retail outlet, where the dealers and
purchasers can meet eye to eye, or in a virtual structure like an internet-based market, where
there is the truancy of direct, actual contact between the purchasers and vendors.

Types of the market:

Monopoly:
A monopolistic market is a market formation with the qualities of a pure market. A pure
monopoly can only exist when one provider gives a specific service or a product to numerous
customers. In a monopolistic market, the imposing business organisation, or the controlling
organisation, has the overall control of the entire market, so it sets the supply and price of its
goods and services. For example, the Indian Railway, Google, Microsoft, and Facebook.

Oligopoly:
An oligopoly is a market form with a few firms, none of which can hold the others back from
having a critical impact. The fixation or concentration proportion estimates the piece of the
market share of the biggest firms. For example, commercial air travel, auto industries, cable
television, etc.

Perfect competition:
Perfect competition is an absolute sort of market form wherein all end consumers and
producers have completed and balanced data and no exchange costs. There is an enormous
number of makers and customers rivalling each other in this sort of environment. For
example, agricultural products like carrots, potatoes, and various grain products, the
securities market, foreign exchange markets, and even online shopping websites, etc.

Monopolistic competition:
Monopolistic competition portrays an industry where many firms offer their services and
products that are comparative (however somewhat flawed) substitutes. Obstructions or
barriers to exit and entry in monopolistic competitive industries are low, and the choices
made of any firm don’t explicitly influence those of its rivals. The monopolistic competition
is firmly identified with the business technique of brand separation and differentiation. For
example, hairdressers, restaurant businesses, hotels, and pubs.
Explanation of the above markets in details:
Perfect competition is a unique form of the marketplace that allows multiple companies to
sell the same product or service. Many consumers are looking to purchase those products.
None of these firms can set a price for the product or service they are selling without losing
business to other competitors. There are no barriers to any firm that is looking to enter or exit
the market. The final output from all sellers is so similar that consumers cannot differentiate
the product or service of one company from its competitors.
Features of Perfect Competition
The main features of perfect competition are as follows:

 Many Buyers and Sellers – There will always be a huge number of buyers and
sellers in this form of marketplace. The advantage of having a large number of small-
sized producers is that they cannot combine to influence the market price. If the
quantity offered by an individual seller is very small compared to the total market
produce, they cannot influence the market price independently.
Similarly, if there are many buyers, then an individual will not have the power to
dictate conditions to the market or influence the price by altering demand for a
product. The individual demand will not be large enough to change the price.

 Homogeneity – The product or service produced by the buyers in a perfectly

competitive market should be homogenous in all respects. There should be no
differentiation between them in terms of quantity, size, taste, etc., so that the products
are perfect substitutes for each other. If a seller tries to charge a higher price for
products that are so similar, they will lose their customers immediately.
 Free Entry and Exit – Another condition of a perfectly competitive market is that no
artificial restrictions prevent a firm’s entry or compel an existing firm to stay put
when they want to leave. Their decision to enter, stay or leave the market depends
purely on economic factors.
 Perfect Knowledge – The buyers and sellers have perfect knowledge about the
market conditions. The buyers are aware of the details of the product sold as well as
its price. At the same time, the sellers know about the potential sales of their products
at different price points. Since the buyers are already informed about the product,
there is no need for advertising or sales promotion. So firms don’t have to invest a
single penny in these activities. It also helps sellers save on advertising or other
marketing activities, which keeps the price of their products low.
 Mobility of Factors of Production – The factors of production like labour, raw
materials and capital should have total mobility under perfect competition. The labour
should have the freedom to move from one place (industry, market or production unit)
to another depending on their remuneration. Even the raw materials and capital should
not have any restrictions in movement.
 Transport Cost – In the perfectly competitive market, the costs for transporting
goods, services, or factors of production from one place to another is either zero or
constant for all sellers. The assumption is that all sellers are equally near or farther
away from the market. Thus, the transport cost is uniform for all of them. The result is
that the overall costs for production and the selling price are the same across the
board.
 Absence of Artificial Restrictions – There is no interference from the government or
any other regulatory body to hinder the smooth functioning of the perfect competition.
There are no controls or restrictions over the supply or pricing and the price can
change solely based on the demand and supply conditions.
 Uniform Price – There is a single uniform price for all products and services in a
perfectly competitive market. The forces of demand and supply determine it.
 In a perfectly competitive market, a firm cannot change the price of a product by
modifying the quantity of its output. Further, the input and cost conditions are given.
  Therefore, the firm can alter the quantity of its output without changing the price of the
product. We know that a firm is in equilibrium when its profits are maximum, which
relies on the cost and revenue conditions of the firm.
 These conditions can vary in the long and short-term. Before we take a look at the
equilibrium states, let’s look at the demand curve of a product under perfect competition.

Demand Curve of a Product in a Perfectly Competitive Market

Let’s derive the firm’s demand curve with the help of the market’s demand and supply curve. In
perfect competition, the equilibrium of the market’s demand and supply determines the price.

In the figure above, Price is on the Y-axis and Quantity on the X-axis. The left side of the figure
represents the industry and the right side the case of a firm. The market demand curve is DD and
the market supply curve is SS.

Further, the point at which the market’s demand and supply curves intersect each other is the
equilibrium point. The price at this level is the equilibrium price and the quantity is the
equilibrium quantity.

All firms receive this price in a perfectly competitive market. Also, firms are the price-takers and
the industry is the price-maker. The Average Revenue (AR) Curve is the demand curve of the
firm as it can sell any quantity it wants at the market price.

Short-run Equilibrium of a Competitive Firm

In the short run, there the following assumptions:
  The price of the product is given and the firm can sell any quantity at that price

 The size of the plant of the firm is constant

 The firm faces given short-run cost curves

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.

On the supply side, recall the four cost curves – AFC, AVC, MC, and ATC? Of these,
the supply curve is that portion of the MC curve which lies above the AVC curve and is
upward sloping.

In the short-run, the firm cannot avoid fixed costs. Even if the production is zero, the
firm must incur these costs. Therefore, the firm cannot avoid losses by not producing
 and continues producing as long as its losses do not exceed its fixed costs. In
other words, a firm produces as long as its average price equals or exceeds its AVC.

Three Possibilities in Short-run

In a perfectly competitive market, a firm can earn a normal profit, super-normal profit, or it can
bear a loss. At the equilibrium quantity, if the average cost is equal to the average revenue, then
the firm is earning a normal profit.

On the other hand, if the average cost is greater than the average revenue, then the firm is
bearing a loss. However, if the average cost is less than average revenue, then the firm is earning
super-normal profits.

Normal Profit

In the above figure, you can see that the costs and revenue are on the Y-axis and the Quantity is
on the X-axis. Further, marginal costs cut the marginal revenue curve from below at point A. At
point ‘A’, P is the equilibrium price and ‘Q’ is the equilibrium quantity.

Note that corresponding to the equilibrium quantity, the average cost is equal to the average
revenue. It also means that the firm is earning a normal profit.
Loss

In the figure above, the cost and revenue curves are on the Y-axis and the quantity demanded is
on the X-axis. Further, the marginal cost curve cuts the marginal revenue curve from below at
point ‘A’, the equilibrium point.

Corresponding to point ‘A’, P* and Q* are the equilibrium price and quantity respectively. Also,
corresponding to Q*, the average cost is more than the average revenue.

In this case, the per unit cost of OQ* (average cost) is more than the per unit revenue of OQ*
(average revenue). As per the figure, the per unit revenue is OP and the per unit cost is OP’. this
means that the per unit loss is PP’. Also, the total loss on quantity OQ* is P*P’BA.

Super-normal Profit
In the figure above, the per unit revenue or average revenue is OP* while the per unit cost or
average cost is OP’. Therefore, the per unit receipts are high in comparison with the per unit
cost.

That’s why the average revenue curve lies above the average cost curve corresponding to Q*.
The firm is earning super-normal profits. The per unit profit is P’P* and the total profit is for
quantity OQ* is P’P*BA.

REFER MY NOTES :

PRICING OBJECTIVES
SKIMMING METHOD
PENETRATION METHOD
METHODS OF PRICING
OPPROTUNITY COST – LEARN THE MEANING, TYPES OF OPPORTUNITY COST –
EXPLICIT AND IMPLICIT AND GIVE AN EXAMPLE
Game theory is a Mathematical subject that is commonly used in practical life. It is applied to
various other non-mathematical fields too. Game theory explains how a strategic game is
played. It determines the way or order in which the players should make moves. It considers
the information for the players at each decision point.
In-game theory, the interdependence of actions of players is the essence of the game. The
game has two kinds of strategic interdependence – one is sequential, and the other is
simultaneous. In sequential interdependence, players act in a sequence, aware of other players
actions. While, in simultaneous interdependence, players act at the same time, ignoring other
players’ actions. The game theory is all about such strategies. Let us go ahead and learn more
about game theory.

Game Theory Definition

The game theory is said to be the science of strategies which comes under the probability
distribution. It determines logical as well as mathematical actions that should be taken by the
players in order to obtain the best possible outcomes for themselves in the games. The games
studied in game theory may range from chess to tennis and from child-rearing to takeovers.
But there is one thing common that such an array of games is interdependent, i.e. outcome for
each player depends upon the strategies of all.
In other words, game theory deals with mathematical models of cooperation and conflicts
between rational decision-makers. Game theory can be defined as the study of decision-
making in which the players must make strategies affecting the interests of other players.

Zero-Sum Game Theory

There is a special kind of game studied in game theory, called zero-sum games. They are
constant-sum games. In such games, the available resources can neither be increased nor
decreased. Also, the total benefit in zero-sum games for all combination of strategies, always
adds to zero. We can say that in zero-sum games, one wins and exactly one opponent loses.
The sum of benefits of all the players for any outcome is equal to zero is called a zero-sum
game. Thus, the interest of the two players is opposed.
Several games, game theory are non-zero-sum games, since net result of outcome is less than
or greater than zero. So, when one player’s gain does not correspond to other’s loss, it is
called a non-zero sum game.

Game Theory Applications

The game theory is widely applied to study human as well as animal behaviours. It is utilized
in economics to understand the economic behaviours, such as behaviours of consumers,
markets and firms. Game theory has been commonly used in social sciences as well. It is
applied in the study of sociological, political and psychological behaviours. The use of
analysis based on game theory is seen in biology too. In addition to behavioural prediction,
game theory utilized in the development of theories of normative or ethical behaviour.

Game Theory Example

The best example of game theory is a classical hypothesis called “Prisoners Dilemma”.
According to this situation, two people are supposed to be arrested for stealing a car. They
have to serve 2-year imprisonment for this. But, the police also suspects that these two people
have also committed a bank robbery. The police placed each prisoner in a separate cell. Both
of them are told that they are suspects of being bank robbers. They are inquired separately
and are not able to communicate with each other.
The prisoners are given two situations:

 If they both confess to being bank robbers, then each will serve 2-year imprisonment
for both car theft and robbery.
 If only one of them confesses to being a bank robber and the other does not, then the
person who confesses will serve 1-year and others will serve 20-year imprisonment.
 According to game theory, the prisoners will either confess or deny the bank robbery.
So, there are four possible outcomes :

2-Confess 2-Deny

1-Confess Both punished 5 years Prisoner 1 punished 1 year

Prisoner 2 punished 20 years

1-Deny Prisoner 1 punished 20 year Both punished 2 years

Prisoner 2 punished 1 year
 Here, the best option is to deny. In this case, both will have to serve 2 years sentence.
But it cannot be guaranteed that others would not confess, therefore most likely both
would confess and serve the 3-year sentence.
Dominant strategy – my notes
Nash Equilibrium – my notes