COST ANALYSIS

DR. SK LAROIYA
UNIVERSITY OF DELHI
AND
AMITY BUSINESS SCHOOL

WHY COST ANALYSIS?

THE NATURE OF CONTEMPORARY MARKET IN
INDIA
NO LONGER SELLERS MARKET
IT IS BUYER MARKET

COST CONCEPTS :

ECONOMIC COSTS

EXPLICIT AND IMPLICIT COSTS

OPPORTUNITY COSTS
NORMAL PROFIT

HISTORICAL AND REPLACEMENT COSTS

FIXED AND VARIABLE COSTS
INCREMENTAL AND SUNK COSTS

INCREMENTAL COST IS BROADER CONCEPT AND REFERS TO CHANGE IN TOTAL
COSTS FROM IMPLEMENTING A PARTICULAR MANAGEMENT DECISION SUCH AS
INTRODUCTION OF A NEW PRODUCT LINE OR UNDERTAKING A NEW ADVERTIZING
CAMPAIGN
WHERE AS MARGINAL COST REFERS TO CHANGE IN TOTAL COST DUE TO CHANGE
IN OUTPUT BY ONE UNIT

SUNK COSTS ARE EXPENDITURES THAT HAVE BEEN MADE IN THE PAST OR THAT
MUST BE MADE IN FUTURE AS A PART OF CONTRACTUAL AGREEMENT
IN GENERAL SUNK COSTS ARE IRRELEVANT IN MAKING MANAGERIAL DECISIONS


EXAMPLE : SUNK COSTS

IF A FIRM HAS HIRED A WARE HOUSE FOR Rs.10,000 PER
MONTH ON A LONG TERM LEASE AND FIND IT NOW
REDUNDANT AS IT HAS NO USE FOR IT
THE FIRM HAS AN OFFER FOR ITS SUBLEASE FOR RS. 20,000
PER MONTH
THE FIRM MUST ACCEPT THE SUBLEASE AS IT MAKES A
PROFIT
THE Rs.10,000 PER MONTH PAYMENT IS IRRELEVANT
BECAUSE IT MUST BE PAID BY THE FIRM REGARDLESS OF ITS
DECISION TO RENT THE WARE HOUSE SPACE
SEPARABLE AND COMMON COSTS

PRIVATE AND SOCIAL COSTS

TOTAL, AVERAGE AND MARGINAL COSTS

LONG RUN AND SHORT RUN COSTS
COST FUNCTION:

COSTS WHICH A FIRM INCURS IN THE
PRODUCTION OF GOODS AND SERVICES
DEPENDS ON

1. FIRMS PRODUCTION FUNCTION
2. MARKETS INPUT SUPPLY FUNCTIONS

C= f ( Q, E
1
, P
1
)

WHERE

C = TOTAL PRODUCTION COST
Q= TOTAL OUTPUT
E
1
= EFFICIENCIES OF INPUTS
P
1
= PRICES OF INPUTS

f
1
= dC / dQ > 0
f
2
= dC / dE
1
< 0
f
3
= dC / dP
1
> 0

THE TOTAL COST IS AN INCREASING FUNCTION OF OUT PUT

INCREASING PRODUCTION, CETERIS PARIBUS, REQUIRES
INCREASING UNITS OF INPUTS AND ALL INPUTS DO CARRY
PRICE TAGS

IMPROVEMENTS IN FACTOR PRODUCTIVITIES-
E
1
, CETERIS PARIBUS,
HAVE A DEPRESSIVE EFFECT
ON INPUT REQUIREMENTS PER UNIT OF OUTPUT


LEADING TO DECREASE IN TOTAL COST

FACTOR PRODUCTIVITIES DEPEND ON
INCLUDING

1. LEVEL OF TECHNOLOGY
2. QUALITY OF WORK FORCE
3. MANAGEMENT

INCREASE IN INPUT PRICES, CETERIS PARIBUS,
HAS A DIRECT IMPACT ON TOTAL COST OF
PRODUCTION

OF THE THREE SET OF DETERMINANTS OF COST
FUNCTION,

OUTPUT ASSUMES A SPECIAL ROLE FOR A FIRM
FOR TWO REASONS

1. OUTPUT IS THE ONLY VARIABLE WHICH IS UNDER
THE DIRECT CONTROL OF A FIRM




2. THE RELATIONSHIP BETWEEN TOTAL COST AND THE
OUTPUT , THOUGH UNIQUE IN DIRECTION, IS VARYING
IN TERMS OF OUTPUT.

THAT IS TC INCREASES AS OUTPUT EXPANDS,

BUT THE RATE OF INCREASE VARIES FROM ONE SET OF
OUTPUT LEVELS TO ANOTHER FOR THE SAME FIRM

AND FOR THE SAME SET OF OUTPUT LEVEL FROM ONE
FIRM TO ANOTHER FIRM
COST OUTPUT RELATION:

SHORT RUN
LONG RUN
IN SHORT RUN AT LEAST ONE FACTOR IS FIXED
AND DUE TO THIS CONSTRAINT, THE FIRM MAY
NOT BE ABLE TO ACHIEVE THE BEST
COMBINATION OF INPUTS FOR ITS DESIRED
LEVEL OF OUTPUT


CONSEQUENTLY, THE SHORT RUN COST COULD
EXCEED LONG RUN COST FOR A GIVEN OUTPUT
LEVEL
THE SHORT RUN COST CURVES ARE DERIVED
FROM THE SHORT RUN PRODUCTION CURVES,
GIVEN THE FACTOR PRICES
SEVEN COST CONCEPTS IN THE SHORT RUN
1. TC
2. TFC
3. TVC
4. ATC
5. AFC
6. AVC
7. MC



RELATIONSHIP AMONG THE SHORT RUN COST
CURVES AND OUTPUT


LONG RUN COST CURVES
1. LTC
2. LAC
3. LMC
ECONOMIES OF SCALE

A FIRM IS SAID TO BE REAPING ECONOMIES
OF SCALE WHEN ITS LONG RUN TOTAL COST-
LTC- INCREASES LESS THAN
PROPORTIONATELY WITH INCREASE IN ITS
SCALE OF OPERATION (OUTPUT) OR WHEN
LAC FALLS AS OUTPUT EXPANDS
ALTERNATIVELY, IT COULD BE DEFINED IN
TERMS OF OUTPUT ELASTICITY OF TOTAL
COST (
e
TC, q):


e
TC,q = ( TC / q) x ( q / TC)
IF
e
TC , q, < 1,
THERE ARE ECONOMIES OF SCALE
DUE TO LARGE PLANT:

1. SPECIALIZATION
2. INDIVISIBILITY
3. PRODUCTIVITY/ PRICE
4. EQUIPMENT MAINTENANCE

DUE TO LARGE FIRM:

1. QUANTITY DISCOUNTS
2. FUND RAISING
3. SALES PROMOTION
4. INNOVATION
5. MANAGEMENT

DISECONOMIES OF SCALE
THERE ARE CERTAIN COST DISADVANTAGES IN
MASS PRODUCTION VIS A VIS SMALL
PRODUCTION

DUE TO LARGE PLANT:

1. TRANSPORTATION COST
2. IMPERFECTION IN LABOR MARKET
DUE TO LARGE FIRM:

1. COORDINATION AND CONTROL
ECONOMIES OF SCOPE:

REFER TO THE LOWERING OF COSTS THAT A
FIRM OFTEN EXPERIENCES WHEN IT
PRODUCES TWO OR MORE PRODUCTS
TOGETHER RATHER THAN EACH PRODUCT
ALONE




- A SMALLER COMMUTER AIRLINE LIKE INDIGO,
CAN PROFITABLY EXTEND INTO CARGO
SERVICES, THEREBY LOWERING THE COST OF
EACH OPERATION ALONE


- A FIRM THAT PRODUCES A SECOND PRODUCT
IN ORDER TO USE THE BY - PRODUCTS
(WHICH OTHERWISE THE FIRM HAS TO
DISPOSE OFF ATA COST) ARISING OUT OF
FIRST PRODUCT


THE MANAGEMENT MUST BE ALERT TO THE
POSSIBILITY OF PROFITABLY EXTENDING ITS
PRODUCT LINE TO EXPLOIT SUCH
ECONOMIES OF SCOPE
ESTIMATION OF COST FUNCTION

AS DECISION MAKING REQUIRES FORWARD
PLANNING, ANY FIRM EITHER A NEW ONE OR
EXISTING ONE, WOULD LIKE TO ESTIMATE THE
COST FUNCTION

THE EXACT FUNCTION MAY NOT BE AVAILABLE
UNTIL THE FIRM REALLY GOES IN FOR
EXPANSION OF ITS OUTPUT

METHODS ARE AVAILABLE THROUGH WHICH A
FIRM COULD GET APPROXIMATE INFORMATION
OF ITS FUTURE COST-OUTPUT RELATIONSHIP

1. ENGINEERING METHOD
2. SURVIVORSHIP METHOD
3. STATISTICAL METHOD
ENGINEERING METHOD:

IS BASED DIRECTLY ON PHYSICAL
RELATIONSHIP EXPRESSED IN PRODUCTION
FUNCTION FOR A PARTICULAR PRODUCT

ON THE BASIS OF THE PRODUCTION
FUNCTION, AND INPUT PRICES,
THE OPTIMUM INPUT COMBINATION
FOR
PRODUCING GIVEN QUANTITY OF A GIVEN
PRODUCT IS DETERMINED (THE LEAST COST
COMBINATION)

THE COST CURVE IS
THEN FORMULATED BY
MULTIPLYING EACH INPUT IN THE SO
OBTAINED LEAST COST COMBINATION
BY ITS PRICE AND SUMMING, TO DEVELOP
THE COST FUNCTION

SINCE THE ESTIMATES ON THE LEAST COST
ESTIMATES
ARE
PROVIDED BY THE ENGINEERS,
IT IS CALLED AS ENGINEERING METHOD
AS THE METHOD IS BASED ON

1. CURRENTLY AVAILABLE TECHNOLOGY
2. AND EXISTING FACTOR PRICES

IT IS NECESSARY FOR A FIRM TO HAVE
THOROUGH KNOWLEDGE OF THE PRODUCTION
TECHNOLOGY AS WELL AS FACTOR PRICES


CAUTION:

SINCE THE TECHNOLOGY AND FACTOR
PRICES ARE HIGHLY VOLATILE OVER A PERIOD
OF TIME, THE ENGINEERING METHOD MAY
NOT ALWAYS YIELD ACCURATE ESTIMATES
SURVIVORSHIP METHOD:

DEVELOPED BY GEORGE STIGLER

THE VARIOUS FIRMS OF AN INDUSTRY ARE
FIRST CLASSIFIED INTO CERTAIN SIZE
GROUPS, THEN THE GROWTH OF FIRMS OVER
TIME IN EACH GROUP IS EXAMINED


THE SIZE GROUP WHOSE SHARE IN THE
INDUSTRY GROWS MOST
IS THEN
CONSIDERED AS THE MOST EFFICIENT (THE
LEAST AVERAGE COST) SIZE GROUP,
AND VICE VERSA
EXAMPLE:
LET THE FIRMS BE DIVIDED INTO THREE CLASSES ON THE BASIS OF THEIR
CURRENT OUTPUTS
LET THE SHARE OF EACH GROUPS IN THE INDUSTRY IN THE BASE YEAR AND THE
CURRENT YEAR BE AS FOLLOWS:


SIZE GROUP INDUSTRY SHARE
BASE YEAR CURRENT YEAR
SMALL 10 12
MEDIUM 30 50
LARGE 60 38

ON THE BASIS OF THE DATA IN THE TABLE,
THE METHOD
WOULD CONCLUDE
THAT MEDIUM SIZE CLASS IS THE MOST
EFFICIENT ONE
AND THE LARGE SIZE CLASS IS THE MOST
INEFFICIENT
RATIONALE:

COMPETITION WILL TEND TO
ELIMINATE
THOSE FIRMS WHOSE SIZE
IS RELATIVELY INEFFICIENT,

LEAVING ONLY THOSE SIZE FIRMS WITH LOWER
AVERAGE COSTS TO SURVIVE OVER TIME
THOUGH THE METHOD IS SIMPLE, IT SUFFERS
FROM A MAJOR LIMITATION

IT GIVES THE OPTIMUM SIZE OF A FIRM ONLY
THAT TOO IN TERMS OF OUTPUT RANGE OR
THE SIZE CLASS

IT DOES NOT YIELD COST FUNCTION

STATISTICAL METHOD:

COST FUNCTION IS ESTIMATED THROUGH THE
APPLICATION OF STATISTICAL TECHNIQUE-
GENERALLY MULTIPLE REGRESSION
TO HISTORICAL DATA ON THE COST AND ITS
DETERMINANTS

THE DATA COULD BE

1. TIME SERIES DATA OF A FIRM IN THE
INDUSTRY OR ALL THE FIRMS IN THE
INDUSTRY
2. OR A CROSS SECTION DATA FOR A
PARTICULAR YEAR FROM VARIOUS FIRMS IN
THE INDUSTRY


THE COST FUNCTION COULD BE
HYPOTHESIZED AS:

C= F (Q , Z)
C= TOTAL COST
Q= OUTPUT
Z= OTHER DETERMINANTS OF COST
THE FUNCTION COULD BE SPECIFIED IN ONE
OF THE FOUR FORMS :

LINEAR: C= a
0
+ a
1
Q + a
i
Z
i
QUADRATIC : C= A
0
+ A
1
Q + A
2
Q
2
+
CUBIC : C= b
0
+b
1
Q+b
2
Q
2
+b
3
Q
3
+.
DOUBLE LOG: log C= B
0
+B
1
logQ+ B
i
log Z
i
GUIDELINES FOR THE USE OF COST ESTIMATION METHODS:

- THERE IS NO HISTORICAL DATA ON COST AND OUTPUT
FOR NEW PRODUCTS. STATISTICAL METHOD AND
SURVIVOR METHODS CAN NOT BE USED FOR COST
ESTIMATION


- FURTHER, IF THE PRODUCT IS OLD BUT HAS BEEN IN
EXISTENCE FOR A FEW YEARS ONLY, DATA MAY BE
INADEQUATE FOR APPLYING EITHER OF THE TWO
METHODS i.e., STATISTICAL METHOD AND SURVIVOR
METHOD



- ENGINEERING METHOD MAY BE GOOD CHOICE

- SINCE NO METHOD IS PERFECT, MORE THAN
ONE METHOD SHOULD BE USED ( IF
PERMITTED BY RESOURCES) AS IT WOULD
IMPROVE THE CREDIBILITY OF THE ESTIMATES
AND THEIR USEFULNESS

LEARNING CURVE

AS FIRMS GAIN EXPERIENCE IN THE
PRODUCTION OF A COMMODITY OR SERVICE,
THEIR AVERAGE COST OF PRODUCTION
USUALLY DECLINES

THAT IS , FOR A GIVEN LEVEL OF OUTPUT PER PERIOD OF
TIME,

THE INCREASING CUMULATIVE TOTAL OUTPUT OVER MANY
PERIODS OFTEN PROVIDES THE MANUFACTURING
EXPERIENCE

THAT ENABLES

THE FIRMS TO LOWER THEIR AVERAGE COST OF
PRODUCTION

THE LEARNING CURVE
SHOWS
THE DECLINE IN THE AVERAGE INPUT COST OF
PRODUCTION WITH RISING CUMULATIVE
TOTAL OUTPUTS OVER TIME
EXAMPLE:
IT MIGHT TAKE 1000 HOURS TO ASSEMBLE THE
100
th
AIRCRAFT BUT ONLY 700 HOURS TO
ASSEMBLE 200
th
AIRCRAFT

WHY?

MANAGERS AND WORKERS BECOME MORE
EFFICIENT AS THEY GAIN MORE EXPERIENCE


WHERE AS ECONOMIES OF SCALE REFER TO
DECLINING AVERAGE COST AS THE FIRMS
OUTPUT PER TIME PERIOD INCREASES
LEARNING CURVE-
AVERAGE
COST (Rs)
CUMULATIVE TOTAL OUTPUT
LEARNING CURVE

THE FIRMS USUALLY ACHIEVES THE LARGEST
DECLINE IN AVERAGE COSTS WHEN THE
PRODUCTION PROCESS IS
RELATIVELY NEW

AND FIRMS MATURE, THE DECLINE IS LESS
LEARNING CURVES HAVE BEEN DOCUMENTED IN A WIDE
SPECTRUM OF MANUFACTURING AND SERVICE
INDUSTRIES SUCH AS:


MANUFACTURING OF

AIRCRAFTS
APPLIANCES
SHIPBUILDING
REFINED PETROLEUM PRODUCTS
ETC.

USED TO FORECAST
THE NEEDS FOR

PERSONNEL,
MACHINERY,
RAW MATERIAL,

FOR SCHEDULING PRODUCTION,
DETERMINE THE PRICE AT WHICH TO SELL THE OUTPUT
AND EVEN FOR EVALUATING SUPPLIERS PRICE QUOTATIONS

TEXAS INSTRUMENTS:

ADOPTED AN AGGRESSIVE PRICE STRATEGY BASED

ON

LEARNING CURVE
BELIEVING THAT LEARNING CURVE IN CHIP PRODUCTION WAS STEEP,
IT KEPT UNIT PRICES LOW IN ORDER TO INCREASE ITS CUMULATIVE
TOTAL OUTPUT RAPIDLY AND THEREBY BENEFIT FROM LEARNING
BY DOING


THE STRATEGY WAS SUCCESSFUL AND TEXAS
INSTRUMENTS
BECAME
ONE OF WORLDS MAJOR PLAYERS IN THIS
MARKET


HOW RAPIDLY THE LEARNING
CURVE(AVERAGE INPUT COSTS) DECLINES
CAN DIFFER WIDELY AMONG THE FIRMS


RAPID DECLINE IS CAUSED, AMONG OTHER
FACTORS, BY

- SMALLER IS THE EMPLOYEE TURNOVER
- THE FEWER THE PRODUCTION INTERRUPTIONS (
WHICH OTHERWISE LEAD TO FORGETTING)
- GREATER IS THE ABILITY OF FIRM TO TRANSFER
KNOWLEDGE FROM THE PRODUCTION OF THE
OTHER PRODUCT


FIRMS HOWEVER DO NOT ONLY RELY ON
THEIR PRODUCTION EXPERIENCE TO LOWER
THE COSTS
AND DO LOOK

FARTHER AND FARTHER AFIELD FROM THEIR
INDUSTRY TO GAIN INSIGHTS ON HOW TO
INCREASE PRODUCTIVITY
COST-VOLUME-PROFIT ANALYSIS


EXAMINES THE RELATIONSHIP AMONG THE
TOTAL REVENUE, TOTAL COST AND TOTAL
PROFITS OF THE FIRM AT VARIOUS LEVELS OF
OUTPUT

ALSO KNOWN AS BREAKEVEN ANALYSIS

USED BY THE EXECUTIVES TO
DETERMINE

THE SALES VOLUME REQUIRED FOR THE FIRM TO
BREAK EVEN AND

TOTAL PROFIT AND LOSSES AT OTHER SALES LEVELS
100
200
300
400
500
600
700
10 20 30 50 40 60 70
TFC
TC
TR
Rs.
QUANTITY
B
-THE SLOPE OF THE TR CURVE REFERS TO THE PRODUCT PRICE OF
Rs. 10 PER UNIT

- THE VERTICAL INTERCEPT OF THE TC CURVE REFERS TO THE TFC
OF Rs. 200

- AND THE SLOPE OF TC CURVE REFERS TO AVERAGE VARIABLE
COST OF Rs. 5

- THE FIRM BREAKS EVEN WITH TR=TC=Rs. 400 AT OUTPUT OF 40
UNITS PER PERIOD OF TIME (POINT B)

- THE FIRM INCURS LOSSES AT SMALLER LEVELS OF OUTPUT AND
EARNS PROFIT AT LARGER LEVELS OF OUTPUT
COST VOLUME PROFIT ANALYSIS:
AN ALGEBRAIC FORMULATION

TR= (P)(Q) .1
TC= TFC+AVC(Q) .2

SETTING TR EQUAL TC AND SUBSTITUTING Q
B
(THE BREAK EVEN OUTPUT) FOR Q,
WE HAVE

TR=TC . 3
(P) (Q
B
) = TFC+ AVC(Q
B
) .. .. 4
SOLVING FOR (4) ABOVE FOR THE BREAKEVEN OUTPUT QB, WE GET
(P)(Q
B
) (AVC)(Q
B
) = TFC
(Q
B
) (P-AVC) = TFC
Q
B
= TFC / P AVC .. .. 5


FOR EXAMPLE,

WITH TFC =200, P=10 AND AVC=5,

Q
B
= 200 / 10 - 5
= 40
THIS IS THE BREAK EVEN OUTPUT ON THE COST-VOLUME-PROFIT FIGURE
EARLIER
THE DENOMINATOR IN THE EQUATION -5- IS CALLED
CONTRIBUTION MARGIN PER UNIT
BECAUSE IT REPRESENTS THE PORTION OF THE SELLING PRICE THAT CAN BE
APPLIED TO COVER THE FIXED COSTS OF THE FIRM AND TO PROVIDE THE
PROFIT
SUPPOSE THE FIRM WISHES TO EARN A SPECIFIC PROFIT AND WANTS TO
ESTIMATE THE QUANTITY THAT IT MUST SELL TO EARN THAT PROFIT

THE COST-VOLUME-PROFIT ANALYSIS CAN BE USED IN DETERMINING THE
TARGET OUTPUT (Q
T
) AT WHICH THE TARGET PROFIT (
T
) CAN BE ACHIEVED
TO DO SO , WE SIMPLY ADD
T
TO THE NUMERATOR OF THE EQUATION -5, AND
WE HAVE

Q
T
= TFC +
T
/ P AVC ..6
IF A FIRM WANTS TO EARN A TARGET PROFIT OF RS. 100, THE TARGET
OUTPUT WOULD BE

Q
T
= 200 +100/10 5
=300/5
=60
TO SEE THAT Q=60 DOES INDEED LEAD TO THE TARGET
PROFIT (
T
) OF 100

NOTE THAT

TR= P.Q
= (10) (60) = 600
TC= TFC+ AVC(Q)
= 200+ (5)(60)
=500

T
= TR TC
= 600 500
= 100
COST-VOLUME PROFIT ANALYSIS ASSUMES

- CONSTANT PRICES
- CONSTANT AVC
- FIRM PRODUCES A SINGLE PRODUCT OR
CONSTANT MIX OF PRODUCTS
OVER A PERIOD OF TIME, THE PRODUCT MIX
CHANGES AND IT MAY BE DIFFICULT TO ALLOCATE
THE FIXED COSTS AMONG VARIOUS PRODUCTS


DESPITE THESE SHORTCOMINGS, IT IS A
USEFUL TOOL IN MANAGERIAL DECISION
MAKING
OPERATING LEVERAGE

REFERS TO THE RATIO OF THE FIRMS TFC TO TVC

THE HIGHER THIS RATIO, MORE LEVERAGED THE FIRM
IS SAID TO BE

AS THE FIRM BECOMES MORE AUTOMATED OR MORE
LEVERAGED (i.e., SUBSTITUTES FIXED FOR VARIABLE
COSTS), ITS TOTAL FIXED COSTS RISE BUT ITS
AVERAGE VARIABLE COSTS FALL
BECAUSE OF HIGHER OVERHEAD COSTS, THE BREAKEVEN OUTPUT OF
THE FIRM INCREASES

IN THE FIGURE ON THE NEXT SLIDE, THE INTERSECTION OF TR AND TC
DEFINES BREAK EVEN OUTPUT OF Q
B
=40

IF THE FIRMS TFC RISES FROM 200 TO 300, WHILE AVC DECLINES FROM 5
TO 3.33 (SLOPE OF TC),
THE BREAKEVEN OUT PUT WILL RISE TO

Q
B
= 45 ( GIVEN BY THE INTERSECTION OF TR AND TC )

100
200
300
400
500
600
700
10 20 30 50 40 60 70
TFC
TC
TR
Rs.
QUANTITY
B
TC
B
TFC

THE FIGURE ALSO SHOWS THAT THE HIGHER
THE RATIO OF TFC TO TVC (i.e., THE MORE
LEVERAGED THE FIRM IS), THE MORE
SENSITIVE ARE FIRMS PROFITS TO CHANGE
IN OUTPUT OR SALES
FOR EXAMPLE, THE INCREASE IN OUTPUT OR SALES FROM 60 TO 70
UNITS INCREASES THE PROFIT FROM 100 TO 150 WITH TC AND
166.67 WITH TC

THE RESPONSIVENESS OR SENSITIVITY OF FIRMS TOTAL PROFIT ,
TO A CHANGE IN ITS OUTPUT OR SALES, Q, CAN BE MEASURED BY
THE DEGREE OF OPERATING LEVERAGE (DOL)
THIS IS SALES ELASTICITY OF PROFIT AND IS DEFINED AS
DOL = % / % Q 1
= / Q x Q/
OR USING CALCULUS / Q x Q/
BUT
= Q(P- AVC) -TFC
AND
= Q(P - AVC). SUBSTITUTING THESE VALUES INTO EQUATION 1 , WE GET

DOL = Q (P-AVC)Q / Q[Q (P-AVC) AFC]
= Q (P-AVC)/ Q (P-AVC) TFC 2

THE NUMERATOR IN EQUATION (2) ABOVE IS TOTAL CONTRIBUTION TO
FIXED COST PROFIT OF ALL UNITS SOLD BY THE FIRM AND THE
DENOMINATOR IS THE TOTAL (ECONOMIC ) PROFIT




FOR EXAMPLE

FOR INCREASE IN OUTPUT FROM 60 TO 70 UNITS, THE DEGREE OF
OPERATING LEVERAGE WITH TC IS

DOL= 60(10-5) / 60(10-5) 200
= 300/100
=3
WITH TC (i.e., WHEN THE FIRM BECOMES MORE LEVERAGED), THE
DEGREE OF LEVERAGE BECOMES

DOL = 60(10-3.33) / 60(10-3.33) 300
= 400/100
= 4

THUS , DOL INCREASES AS THE FIRM
BECOMES MORE LEVERAGED OR CAPITAL
INTENSIVE
DOL IS ALSO HIGHER, CLOSER WE ARE TO THE BREAK EVEN POINT
BECAUSE THE BASE IN MEASURING THE % CHANGE IN PROFITS( THE
DENOMINATOR IN EQUATION 1 EARLIER) IS CLOSE TO ZERO NEAR
THE BREAK EVEN POINT
(NOTE THAT WHEN FIRMS SALES AND OUTPUT ARE HIGH GREATER THAN
60 UNITS IN THE FIGURE EARLIER, THE FIRM MAKES LARGER PROFITS
WHEN IT IS MORE LEVERAGED- i.e., WITH TC)

BUT IT ALSO INCURS LOSSES SOONER, AND
THESE LOSSES RISE MORE RAPIDLY THAN WHEN
FIRM IS LESS HIGHLY LEVERAGED (i.e., WITH TC)

THE LARGER PROFITS OF MORE HIGHLY
LEVERAGED FIRM IS HIGH (GREATER THAN 60
UNITS IN THE EARLIER FIGURE) AND CAN THUS
BE REGARDED AS THE RETURN FOR ITS
GREATER RISK
GIVEN THE TOTAL COST FUNCTION

TC = 1000 + 10Q 0.9Q
2
+ 0.04Q
3


FIND THE RATE OF OUTPUT THAT RESULTS IN
MINIMUM AVERAGE VARIABLE COST

MC IS THE FIRST DERIVATIVE OF THE TOTAL
COST FUNCTION
=MC = 10 1.8Q + 0.12Q
2

NOW FIND THE TVC FUNCTION BY SUBTRACTING THE FIXED
COST COMPONENT
( 1000) FROM THE TOTAL COST FUNCTION THAT IS
TVC = 10 Q 0.9 Q
2
+ 0.04 Q
3

dQ
TC d ) (

THEN FIND THE AVERAGE VARIABLE COST- AVC- BY
DIVIDING TVC BY OUTPUT- Q
THAT IS
AVC =

AVC = 10 0.09 Q + 0.04 Q
2


















Q
Q Q Q
Q
TVC 3 2 04 . 0 9 . 0 10

BECAUSE MINIMUM POINT OF AVC OCCURS AT ITS INTERSECTION WITH

MARGINAL COST,
EQUATE THE AVC AND MC FUNCTIONS AND SOLVE FOR Q , THAT IS

AVC = MC
10 0.9Q + 0.04 Q
2
= 10 -1.8 Q + 0.12 Q
2

REARRANGING THE TERMS YIELDS A QUADRATIC EQUATION

- 0.08 Q2 + 0.9 Q = 0
OR Q( - 0.08 Q + 0.9) = 0
WHICH HAS ROOTS
Q
1
= 0 AND Q
2
= 11.25



DISREGARDING THE ROOT ASSOCIATED WITH ZERO OUTPUT RATE, IT IS
SEEN THAT THE MINIMUM AVC IS ACHIEVED AT AN OUTPUT RATE OF
11.25 UNITS

ALTERNATIVELY , THE MINIMUM POINT OF AVC COULD BE FOUND BY
SETTING THE FIRST DERIVATIVE OF AVC EQUAL TO ZERO AND SOLVING FOR
Q.
THAT IS


25 11
9 0 08 0
0 08 0 09
.
. .
. .
) (

Q
Q
Q
DQ
AVC d
PRICE DISCRIMINATING MONOPOLIST

PROBLEM:
A MONOPOLIST IS SELLING PRODUCT X IN
TWO MARKETS 1 & 2 SUCH THAT PRICE
BEING CHARGED IN MARKET 1 DIFFERS FROM
THAT OF MARKET 2.
IF THE TOTAL DEMAND FUNCTION IS GIVEN AS

X= 50 0.5 P

AND THE DEMAND FUNCTION OF
SEGMENTED MARKETS 1 & 2 ARE
X
1
= 32 0.4 P
1

X
2
= 18 0.1 P
2
AND THE TOTAL COST FUNCTION IS ALSO
GIVEN AS

TC = 50 + 40 (X
1
+X
2
)
FIND OUT THE AS TO HOW MUCH THIS FIRM
MUST SELL IN MARKETS 1 AND 2 SUCH THAT
ITS PROFIT IS MAXIMIZED
THE CONDITION FOR PROFIT MAXIMIZATION IS

= TR
1
+ TR
2
TC
GIVEN
X
1
= 32 0.4P
1

OR P
1
= 80 2.5 X
1

AND
X
2
= 18 0.1P
2
OR P
2
= 180 10X
2

X = 50 -0.5P
OR
P = 100 2X

( X
1
+ X
2
= X)
TR IN MARKET 1

TR
1
= X
1
P
1

= X
1
( 80 2.5X
1
)
= 80X
1
2.5 X
1
2


MR
1
=

1 5 80
1
1
X
dX
dTR

TR IN MARKET 2

TR
2
= X
2
P
2

= X
2
( 180 10 X2 )
= 180 X
2
10 X
2
2

MR
2
=
2 20 180
2
2
X
dX
dTR


MC =
40
2 1

dX
dTC
dX
dTC
dX
dTC
SETTING THE MR IN EACH MARKET EQUAL TO
COMMON MC
WE OBTAIN

80 5X
1
= 40
180 20X
2
= 40
X
1
= 8
X
2
= 7
X = 15
THE PRICES ARE
P
1
= 80 -2.5X
1
= 80 2.5(8) = 60
P
2
= 180 10X
2
= 180 -10(7) =110

THUS
TR
1
= 60 x 8 = 480
TR
2
= 110x 7= 770

TOTAL COST
TC =50 + 40(X)
= 50 + 40(15)
= 650

= TR
1
+ TR
2
TC
=480 + 770 650
= 600
THE ELASTICITIES ARE

e
1
=
3
8
60
) 4 . 0 (
1
1
1
1

X
P
x
dP
dX


e
2
=
57 . 1
7
110
) 1 . 0 (
2
2
2
2

X
P
x
dP
dX
THUS

e
1
> e
2

AND
P
1
< P
2