Business Management Programme for

Defense Officers

SESSION 5 & 6
Managerial Economics

Topic: Theory of Cost and Estimation

 Measuring Cost: Which Costs Matter?
➢ Accounting costs
➢ Economic costs
Accounting costs are the actual monetary costs recorded on the books while economic costs
include those costs plus opportunity costs. Both consider explicit costs, but economic cost
methods also consider implicit costs.
Opportunity Cost

Opportunity cost Cost associated with opportunities forgone

when a firm’s resources are not put to their best alternative use.
The concept of opportunity cost is particularly useful in
situations where alternatives that are forgone do not reflect
monetary outlays.

Formula and Calculation

Opportunity Cost=FO−CO
where: FO=Return on best foregone option;
CO=Return on chosen option

● sunk cost Expenditure that has been made and cannot be

recovered.
 • Fixed Costs and Variable Costs

● total cost (TC or C) Total economic cost of production, consisting of fixed

and variable costs.
● fixed cost (FC) Cost that does not vary with the level of output and that can
be eliminated only by shutting down.
● variable cost (VC) Cost that varies as output varies.
 • Marginal and Average Cost
TABLE A FIRM’S COSTS
AVERAGE
RATE OF VARIABLE MARGINAL AVERAGE AVERAGE
FIXED COST TOTAL COST VARIABLE
OUTPUT COST COST FIXED COST TOTAL COST
(DOLLARS (DOLLARS COST
(UNITS PER (DOLLARS (DOLLARS (DOLLARS (DOLLARS
PER YEAR) PER YEAR) (DOLLARS PER
YEAR) PER YEAR) PER UNIT) PER UNIT) PER UNIT)
UNIT)
(FC) (1) (VC) (2) (TC) (3) (MC) (4) (AFC) (5) (AVC) (6) (ATC) (7)
0 50 0 50 — — — —
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
The total cost (TC) of producing computer software diskettes (Q) is given as:

What is the variable cost?

A) 200
B) 5Q
C) 5
D) 5 + (200/Q)
E) none of the above
Answer: B
A firm's total cost function is given by the equation:
TC = 4000 + 5Q + 10Q^2.
(1) Write an expression for each of the following cost
concepts:
a. Total Fixed Cost
b. Average Fixed Cost
c.Total Variable Cost
d. Average Variable Cost
e. Average Total Cost
MARGINAL COST (MC)
● marginal cost (MC) Increase in cost resulting from the production of one
extra unit of output.

MC = ∆VCΤ∆𝑞 = ∆TCΤ∆𝑞

AVERAGE TOTAL COST (ATC)

● average total cost (ATC) Firm’s total cost divided by its level of output.

● average fixed cost (AFC) Fixed cost divided by the level of output.

● average variable cost (AVC) Variable cost divided by the level of output.
 • The Shapes of the Cost Curves

COST CURVES FOR A FIRM

In (a) total cost TC is the vertical sum
of fixed cost FC and variable cost
VC.
In (b) average total cost ATC is the
sum of average variable cost AVC
and average fixed cost AFC.
Marginal cost MC crosses the
average variable cost and average
total cost curves at their minimum
points.
 ● economies of scale Situation in which output can be doubled for
less than a doubling of cost.

● diseconomies of scale Situation in which a doubling of output requires

more than a doubling of cost.

Economies of scale are often measured in terms of a cost-output elasticity, EC. EC is the
percentage change in the cost of production resulting from a 1-percent increase in output:

𝐸𝐶 = ∆CΤC Τ ∆𝑞Τ𝑞
 • The Isocost Line

● isocost line Graph showing all possible combinations of labor and

capital that can be purchased for a given total cost.

To see what an isocost line looks like, recall that the total cost C of producing
any particular output is given by the sum of the firm’s labor cost wL and its
capital cost rK:

𝐶 = 𝑤𝐿 + 𝑟𝐾

Isoquant: Shows combinations of two inputs that the firm can use to
produce a specific level of output.
Case I
Maximization of output subject to cost constraint

A
Capital

C x3
K1
x2
X1
0 L1 B
Labour

13
Case II
Minimization of cost for given level of output

K1 e
X

0 L1 L

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CASE STUDY ON AVIATION INDUSTRY

15
Why do airlines in India go bankrupt?

16
19-10-2022 17
19-10-2022 18
19
20
Topic: Market Structure: Perfect
Competition, Monopoly, Monopolistic
Competition and Oligopoly
The Four Types of Market Structure

Number of Firms?

Many
firms

Type of Products?

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition

• • • •
• • • •

Copyright © 2004 South-Western

 Characteristics of Perfect
Competition

• The concept of perfect

competition however is useful
because it functions as standard
to measure the efficiency and
effectiveness of real-world
markets.

23
Examples of perfect competition
In the real world, it is hard to find examples of industries which fit all the criteria
of ‘perfect knowledge’ and ‘perfect information’. However, some industries are
close.
1.Foreign exchange markets.
2.Agricultural markets.
3.Internet related industries.
➢ The consumer surplus refers to the the difference between what a
consumer is willing to pay for a good and what the consumer
actually pays when buying it.

➢ The producer surplus is the difference between the market price

and the lowest price a producer is willing to accept to produce a
good.
 CONSUMER AND PRODUCER SURPLUS

Aggregate Surplus =
Consumer surplus +
producer surplus
Together, consumer and producer surplus
measure the welfare benefit of a
competitive market.
1. If the market is in equilibrium, total consumer 2. If the market is in equilibrium, total producer surplus is:
surplus is: A) $30.
A) $30. B) $70.
B) $70. C) $400.
C) $400. D) $800.
D) $800. E) $1200.
E) $1200.
Answer: C
Answer: D
Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and producers.

● deadweight loss Net loss of total (consumer plus producer) surplus.

CHANGE IN CONSUMER
AND PRODUCER SURPLUS
FROM PRICE CONTROLS
The price of a good has been
regulated to be no higher than Pmax,
which is below the market-clearing
price P0.
The gain to consumers is the
difference between rectangle A and
triangle B.
The loss to producers is the sum of
rectangle A and triangle C.
Triangles B and C together
measure the deadweight loss from
price controls.
 Minimum Prices

PRICE MINIMUM
Price is regulated to be no lower than
Pmin.
Producers would like to supply Q2,
but consumers will buy only Q3.
If producers indeed produce Q2, the
amount Q2 − Q3 will go unsold and
the change in producer surplus will
be A − C − D. In this case, producers
as a group may be worse off.

Supply curve is the aggregate marginal cost

curve for the industry

The total change in consumer surplus is: CS = −A − B

The total change in producer surplus is: PS = A − C − D
 Reasons for Monopoly Forming
Monopolies or near monopolies typically develop because of one of more of the following:
1. Intellectual Property Protection 2. Patents and Licenses

3. Distribution Network
 4. Exclusive Rights 5. Economies of Scale

DeBeers diamond company, own most of the

resources to supply the product. This serves as a
barrier to entering the industry.
6. Proprietary Technology

According to a StockApps.com data

presentation, Windows has lost 17% of
its market share in the last decade. The
site has presented data showing that the
OS's market share has plunged from
90.96% in 2013 to the current 73.72%

7. Trade restrictions :
Governments impose tariffs, quotas, and other import restrictions to
protect domestic producers.
Examples of Monopoly in India
1) Majority of electricity companies
2) Railways
3) Oil marketing companies - IOCL, BPCL, HPCL all of
them government companies.
4) Coal India, largest market share in production and
marketing of coal
5) Hindustan Aeronautics Limited, India's only manufacturer
or jets and helicopters
 Sources of Monopoly Power

Three factors determine a firm’s elasticity of demand.

1. The elasticity of market demand.

2. The number of firms in the market.
3. The interaction among firms.

Monopolies and Restrictive Trade Practices Act 1969 (MRTP Act).

The Competition Act, 2002, was fully constituted on March 1, 2009 – replacing the
Monopolistic and Restrictive Trade Practices Act of 1969.
Company A has a monopoly in the edible nuts industry. The demand
curve, marginal revenue and marginal cost curve for edible nuts are
given as follows:
P = 360 - 4Q MR = 360 - 8Q MC = 4Q

What is the profit maximizing level of output?

A) 0
B) 30
C) 45
D) 60
E) none of the above
Answer: B
 Monopolistic Competition

The Makings of Monopolistic Competition

A monopolistically competitive market has two key characteristics:

1. Firms compete by selling differentiated products that are highly

substitutable for one another but not perfect substitutes. In other words,
the cross-price elasticities of demand are large but not infinite.

2. There is free entry and exit

Ram is a producer in a monopoly industry. His demand curve, total revenue
curve, marginal revenue curve and total cost curve are given as follows:

Q = 160 - 4P MR = 40 - 0.5Q TR = 40Q - 0.25 TC = 4Q MC = 4

Refer to Scenario. How much output will Ram produce?

A) 0
B) 22
C) 56
D) 72
E) none of the above
Answer: D
Refer to Scenario. The price of his product will be:
A) $4.
B) $22.
C) $32.
D) $42.
E) $72.
Answer: B

Refer to Scenario. How much profit will he make?

A) $-996
B) $0
C) $1,296
D) $1,568
Answer: C
 Oligopoly:Markets with only a few sellers
• Characteristics of an Oligopoly Market
• Few sellers offering similar or identical products
• Interdependent firms
• Best off cooperating and acting like a monopolist by producing a small
quantity of output and charging a price above marginal cost
Competition Versus Collusion: The Prisoners’ Dilemma

● prisoners’ dilemma Game theory example in which two prisoners must

decide separately whether to confess to a crime; if a prisoner confesses, he will
receive a lighter sentence and his accomplice will receive a heavier one, but if
neither confesses, sentences will be lighter than if both confess.

TABLE PAYOFF MATRIX FOR PRISONERS’ DILEMMA

PRISONER B

CONFESS DON’T CONFESS

Confess –5, –5 –1, –10

Prisoner A
Don’t confess –10, –1 –2, –2
 An Oligopoly Game

Iraq’s Decision

High Production Low Production

Iraq gets $40 billion Iraq gets $30 billion

High
Production

Iran gets $40 billion Iran gets $60 billion

Iran’s
Decision Iraq gets $60 billion Iraq gets $50 billion

Low
Production

Iran gets $30 billion Iran gets $50 billion

Copyright©2003 Southwestern/Thomson Learning

 Dominant Strategies
● dominant strategy Strategy that is optimal no matter what an
opponent does.
TABLE PAYOFF MATRIX FOR ADVERTISING GAME
Firm B

Advertise Don’t advertise

Advertise 10, 5 15, 0

Firm A
Don’t advertise 6, 8 10, 2

Advertising is a dominant strategy for Firm A.

The same is true for Firm B: No matter what firm A does, Firm B does best by
advertising. The outcome for this game is that both firms will advertise.

● equilibrium in dominant strategies Outcome of a game in which

each firm is doing the best it can regardless of what its competitors are
doing.
What value needs to be placed in ‘A’ for Player 1 to have a dominant strategy?

Player 2

Advertise Don’t advertise

Advertise 3,4 0, 5
Player 1
Don’t A, 0 1, 1
advertise
MOVIE: A BEAUTIFUL MIND
 The Nash Equilibrium

Dominant Strategies: I’m doing the best I can no matter what you do.
You’re doing the best you can no matter what I do.
Nash Equilibrium: I’m doing the best I can given what you are doing.
You’re doing the best you can given what I am doing.

THE PRODUCT CHOICE PROBLEM

Two new variations of cereal can be successfully introduced—provided that
each variation is introduced by only one firm.
TABLE PRODUCT CHOICE PROBLEM
Firm 2
Crispy Sweet
Crispy –5, –5 10, 10
Firm 1
Sweet 10, 10 –5, –5

In this game, each firm is indifferent about which product it produces—so long as it does not
introduce the same product as its competitor. The strategy set given by the bottom left-hand
corner of the payoff matrix is stable and constitutes a Nash equilibrium: Given the strategy of its
opponent, each firm is doing the best it can and has no incentive to deviate.
TABLE Investment Game

Ford
Maintain Expand

4, 3 2, 4
Maintain
GM
Expand 2, 4 3, 5
Ex: Two firms are in the chocolate market. Each can choose to go for the high end of the market (high quality) or
the low end (low quality). Resulting profits are given by the following payoff matrix:

What outcomes, if any, are Nash equilibria?

Ans: A Nash equilibrium exists when neither party has an incentive to alter its strategy, taking the other’s strategy as
given. If Firm 2 chooses Low and Firm 1 chooses High, neither will have an incentive to change (100 > -20 for Firm 1
and 800 > 50 for Firm 2). If Firm 2 chooses High and Firm 1 chooses Low, neither will have an incentive to change
(900 > 50 for Firm 1 and 600 > -30 for Firm 2). Both outcomes are Nash equilibria. Both firms choosing low is not a
Nash equilibrium because, for example, if Firm 1 chooses low then firm 2 is better off by switching to high since 600
is greater than -30.