Tag: University of Mumbai BMS Notes

Cost analysis is all about the study of the behavior of cost with respect to various production criteria like the scale of operations, prices of the factors of production, size of output, etc. It is all about the financial aspects of production.

Accounting and Economic Costs

When a firm starts producing goods, it has to pay the price for the factors employed for the production. These factors include wages to workers employed, prices for the raw materials, fuel and power used, rent for the building he hires, and interest on the money borrowed for doing business, etc.

Accounting Costs are these costs which are included in the cost of production. Hence, accounting costs take care of all payments and charges that the firm makes to suppliers of different productive factors.

Usually, a businessman invests some capital in his firm. If he would have invested the amount in some other firm, then he could have earned a certain interest/dividend. Further, he invests time for his business and also contributes his entrepreneurial and managerial ability to the business.

If not involved in the business, he could have offered his services to other firms for an amount of money. Accounting costs do not involve these costs. They form a part of the Economic Costs. Hence, Economic costs include:

• The normal return on the money that the businessman invests in his own business
• The salary not paid to the entrepreneur but could have been earned if the services would have been sold elsewhere.
• A reward for all factors owned by the businessman and used in his own business.

Therefore, the accounting costs involve cash payments that the firm makes. Economic costs, on the other hand, include the accounting costs and also take into account the amount of money the businessman could have earned with his resources if he would not have started the business.

Another name for accounting costs is Explicit Costs. Whereas, the alternate name for the costs of factors that the businessman owns is Implicit Costs. A businessman earns profits when his revenues exceed both explicit and implicit costs.

Implicit and explicit cost

Implicit cost

An implicit cost is any cost that has already occurred but not necessarily shown or reported as a separate expense. It represents an opportunity cost that arises when a company uses internal resources toward a project without any explicit compensation for the utilization of resources. This means when a company allocates its resources, it always forgoes the ability to earn money off the use of the resources elsewhere, so there’s no exchange of cash. Put simply, an implicit cost comes from the use of an asset, rather than renting or buying it.

Implicit costs are also referred to as imputed, implied, or notional costs. These costs aren’t easy to quantify. That’s because businesses don’t necessarily record implicit costs for accounting purposes as money does not change hands.

These costs represent a loss of potential income, but not of profits. A company may choose to include these costs as the cost of doing business since they represent possible sources of income.

Explicit Cost

Explicit costs are normal business costs that appear in the general ledger and directly affect a company’s profitability. Explicit costs have clearly defined dollar amounts, which flow through to the income statement. Examples of explicit costs include wages, lease payments, utilities, raw materials, and other direct costs.

Explicit costs—also known as accounting costs—are easy to identify and link to a company’s business activities to which the expenses are attributed. They are recorded in a company’s general ledger and flow through to the expenses listed on the income statement. The net income (NI) of a business reflects the residual income that remains after all explicit costs have been paid. Explicit costs are the only accounting costs that are necessary to calculate a profit, as they have a clear impact on a company’s bottom line. The explicit-cost metric is especially helpful for companies’ long-term strategic planning.

Fixed and Variable Costs

Fixed costs or Constant costs are not a function of the output. That is, they do not vary with the output up to a certain extent. They require a fixed expenditure of funds regardless of the output.

For example, rent, property taxes, interest on loans, etc. However, note that fixed costs can vary with the size of the plant and are usually a function of capacity. Therefore, we can conclude that fixed costs do not vary with the output volume within a capacity level.

Businesses cannot avoid fixed costs and are applicable as long as the business is operating. Alternate names for fixed costs are inescapable or uncontrollable costs.

It is important to note here, that some fixed costs continue even after the suspension of business. For example, costs associated with storing of machines that the business cannot sell in the market, etc.

Variable costs are cost concepts which are a function of the output in the production period. Variable costs vary directly with the output. Some examples of variable costs are the cost of raw materials, wages, etc. Sometimes, they vary proportionally with the output too. However, these variations depend on the utilization of fixed facilities and resources during the production process.

Total Cost

In economics, the total cost (TC) is the total economic cost of production. It consists of variable costs and fixed costs. Total cost is the total opportunity cost of each factor of production as part of its fixed or variable costs.

Marginal Cost

In economics, marginal cost is the change in the total cost when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost is not related to fixed costs. An example of calculating marginal cost is: the production of one pair of shoes is $30. The total cost for making two pairs of shoes is $40. The marginal cost of producing the second pair of shoes is $10.

Average Cost

The average cost is the total cost divided by the number of goods produced. It is also equal to the sum of average variable costs and average fixed costs. Average cost can be influenced by the time period for production (increasing production may be expensive or impossible in the short run). Average costs are the driving factor of supply and demand within a market. Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.

Relationship between Average and Marginal Cost

Average cost and marginal cost impact one another as production fluctuate:

Time element plays an important role in price determination of a firm. During short period two types of factors are employed. One is fixed factor while others are variable factors of production. Fixed factor of production remains constant while with the increase in production, we can change variable inputs only because time is short in which all the factors cannot be varied.

Raw material, semi-finished material, unskilled labour, energy, etc., are variable inputs which can be changed during short run. Machines, capital, infrastructure, salaries of managers and technical experts are included in fixed inputs. During short period an individual firm can change variable factors of production according to requirements of production while fixed factors of production cannot be changed.

Cost-Output Relationship in the Short Run

(i) Average Fixed Cost Output

The greater the output, the lesser the fixed cost per unit, i.e., the average fixed cost. The reason is that total fixed costs remain the same and do not change with a change in output.

The relationship between output and fixed cost is a universal one for all types of business.

Thus, average fixed cost falls continuously as output rises. The reason why total fixed costs remain the same and the average fixed cost falls is that certain factors are indivisible. Indivisibility means that if a smaller output is to be produced, the factor cannot be used in a smaller quantity. It is to be used as a whole.

(ii) Average Variable Cost and Output

The average variable costs will first fall and then rise as more and more units are produced in a given plant. This is so because as we add more units of variable factors in a fixed plant, the efficiency of the inputs first increases and then decreases. In fact, the variable factors tend to produce somewhat more efficiently near a firm’s optimum output than at very low levels of output.

But once the optimum capacity is reached, any further increase in output will undoubtedly increase average variable cost quite sharply. Greater output can be obtained but at much greater average variable cost. For example, if more and more workers are appointed. It may ultimately lead to overcrowding and bad organization. Moreover, workers may have to be paid higher wages for overtime work.

(iii) Average Total Cost and Output

Average total costs, more commonly known as average costs, will decline first and then rise upward. The significant point to note here is that the turning point in the case of average cost comes a little later in the case of average variable cost.

Average cost consists of average fixed cost plus average variable cost. As we have seen, average fixed cost continues to fall with an increase in output while average variable cost first declines and then rises. So long as average variable cost declines the average total cost will also decline. But after a point, the average variable cost will rise. Here, if the rise in variable cost is less than the drop in fixed cost, the average total cost will still continue to decline.

It is only when the rise in average variable cost is more than the drop in average fixed cost that the average total cost will show a rise. Thus, there will be a stage where the average variable cost may have started rising yet the average total cost is still declining because the rise in average variable cost is less than the drop in average fixed cost. The net effect being a decline in average cost.

The least cost-output level is the level where the average total cost is the minimum and not the average variable cost. In fact, at the least cost-output level, the average variable cost will be more than its minimum (average variable cost). The least cost- output level is also the optimum output level. It may not be the maximum output level. A firm may decide to produce more than the least cost-output level.

(iv) Short-Run Output Cost Curves

The cost-output relationships can also be shown through the use of graphs. It will be seen that the average fixed cost curve (AFC curve) falls as output rises from lower levels to higher levels. The shape of the average fixed cost curve, therefore, is a rectangular hyperbola.

However, the average variable cost curve (AVC curve) starts rising earlier than the ATC curve. Further, the least cost level of output corresponds to the point LT on the ATC curve and not to the point LV which lies on the AVC curve.

Another important point to be noted is that in Fig. the marginal cost curve (MC curve) intersects both the AVC curve and ATC curve at their minimum points. This is very simple to explain. If marginal cost (MC) is less than the average cost (AC), it will pull AC down. If the MC is greater than AC, it will pull AC up. If the MC is equal to AC, it will neither pull AC up nor down. Hence, MC curve tends to intersect the AC curve at its lowest point.

Similar is the position about the average variable cost curve. It will not make any difference whether MC is going up or down. LT is the lowest point of total cost and LV is the lowest point of variable cost.

The inter-relationships among AVC, ATC, and AFC can be summed up as follows:

• If both AFC and AVC fall, ATC will also fall.
• If AFC falls but AVC rises

(a) ATC will fall where the drop in AFC is more than the rise in AVC.

(b) ATC will not fall where the drop in AFC is equal to the rise in AVC.

(c) ATC will rise where the drop in AFC is less than the rise in AVC.

Cost Output Relationship in Long Run

The long run is a period long enough to make all costs variable including such costs as are fixed in the short run. In the short run, variations in output are possible only within the range permitted by the existing fixed plant and equipment. But in the long run, the entrepreneur has before him a number of alternatives which includes the construction of various kinds and sizes of plants.

Thus, there are no fixed costs since the firm has sufficient time to fully adapt its plant. And all costs become variable. In view of this, the long-run costs will refer to the costs of producing different levels of output by changes in the size of plant or scale of production. The long-run cost-output relationship is shown graphically by the long- run cost curve—a curve showing how costs will change when the scale of production is changed.

The concept of long-run costs can be further explained with the help of an illustration. Suppose that at a particular time, a firm operates under average total cost curve U2 and produces OM. Now it is desired to produce ON. If the firm continues under the old scale, its average cost curve will be NT. If the scale of firm is altered, the new cost curve will be U3. The average cost of producing ON will then be NA.

NA is less than NT. So the new scale is preferable to the old one and should be adopted. In the long run, the average cost of producing ON output is NA. This may be called as the long-run cost of producing ON output. It may be noted here that we shall call NA as the long-run cost only so long as the U3 scale is in the planning stage and has not actually been adopted. The moment the scale is installed, the NA cost will be the short-run cost of producing ON output.

To draw a long-run cost curve, we have to start with a number of short-run average cost curves (SAC curves), each such curve representing a particular scale or size of the plant, including the optimum scale. One can now draw the long-run cost curve which tangential to the entire family of SAC curves, that is, it touches each SAC curve at one point.

Long run is that time period when a firm can change all its inputs. In fact, there are no fixed inputs in the long run; all inputs are variable. Thus, in the long run, there is no fixed cost; all costs are variable. That is why, in the long run, a firm can change its scale of production according to its needs.

In the short run, size of a plant or the scale remains fixed while, in the long run, changes in plant size can be made. In the long run, a firm can move from one plant to another plant thereby giving rise to different cost relationships. If the situation demands, it can build up a large- sized plant or a smaller one.

It is to be mentioned here that long run is a “planning horizon” in the sense that it acts as a guide to the firm relating to the future output decision. We know that production takes place in the short run. In brief, short run is the ‘operating period’ of a firm. Every firm aims at production for a future date and chooses many aspects of the short run situations among which the firm may choose.

LAC is, thus, derived from the SAC curves. LAC depicts the lowest possible average cost for producing various possible levels of output. To derive the LAC curve, we assume that there are three different sizes of plants in an industry— small, medium and large. Small-sized, medium-sized, and large- sized plants are represented by the three SAC curves—SAC₁, SAC₂ and SAC₃, respectively, as shown in Fig. 1.

These SAC curves are also called plant curves. Since we are considering the long run situation, the firm can choose any plant size in which it will operate in the future to produce a given output level at the lowest possible cost.

If the firm decides to produce OQ₁, it will choose plant size denoted by SAC₁. A lower output (say OQ’₁) can also be produced on SAC₁ but at a higher cost. But the same plant size, i.e., SAC₁ enables a firm to produce large output at a lower cost. If OQ₂ is considered to be most profitable level output, the firm will select SAC₂ —the medium-sized plant.

It will select the large-sized plant, SAC₃, to produce OQ₃ level of output. But taking such decision is not an easy job as it appears at first sight. Suppose, the firm operates at SAC₁ and demand for its product gradually rises. Of course, it can produce OQ₁ at the lowest cost even operating on SAC₁. Production beyond OQ₁ will entail a larger cost.

If the firm expects to produce OQ”₁, (as in Fig. 2) its choice of plant size becomes a difficult one since costs are the same for both the plant-sizes—SAC₁ and SAC₂. Now the choice of the optimal plant size depends on the firm’s anticipation or expectation regarding its demand for product in the coming years. At this level of output, cost cannot be the determinant of the choice of a plant size.

It is quite natural that the firm expects its demand for the product to increase in future. So, the firm, quite likely, will install the plant number SAC₂ rather than SAC₁. Larger outputs can now be produced with lower cost. Similarly, though output OQ”2 can be produced by both the plant sizes, SAC₂ and SAC₃, it is better to use the plant size represented by SAC₃ since larger output (OQ₃) can be produced at a lower cost (OQ₃).

However, let us assume that the industry faces a large number of plant sizes represented by, say, five SAC curves, as shown in Fig.2. These curves will generate a smooth and continuous curve called the ‘planning curve’ or the LAC curve.

Each point on this curve shows the least possible cost for producing the corresponding level of output. The LAC curve is a planning curve because it is the curve which helps a firm to decide which plant is to be established in order to produce an output level consistent with the optimal cost.

The firm selects that short run plant which yields the minimum cost of producing the anticipated output level. To produce a particular output in the long run, the firm must select a point on the LAC curve corresponding to that output, and it will then build a relevant short run plant and operate on the corresponding SAC curve.

Suppose, the firm thinks that for producing output OQ₁ point A on SAC₁ becomes the most profitable one. It will then build up a plant at the lower cost represented by the curve SAC₁. [At point A, the SAC₁ curve is tangent to the LAC curve.] However, the firm could reduce its cost by expanding output to the amount associated with point B, the minimum point on the SAC₁ curve.

But the firm anticipates that demand for its product in future would be rising. So, it would construct a new plant, represented by the SAC₂ curve and will operate at point D on the SAC₂ curve, thereby lowering its unit cost and not on the lowest point on the SAC₂ curve [Corresponding to the output level OQ₂, SAC₂ is tangent to the curve LAC].

Similarly, for output OQ₃, the firm would construct SAC₃ plant and operate at E where unit costs become the lowest. [Again, SAC₃ is tangent to the LAC curve] Same would be the case for all other outputs in the long run. For output OQ₄, the firm would construct plant size SAC₄ and would operate at point F.

However, the minimum point of SAC now lies to the left of the operational point, F. Similarly, OQ₅ output could be produced by the plant size SAC₅.

The firm should operate at point G on the curve SAC₅. Each point of the LAC curve is, thus, the point of tangency with the corresponding SAC curves. The LAC curve is the locus of all the tangency points. As a consequence of this, the LAC curve is called the ‘envelope curve’ as it envelops or supports a family of SAC curves.

It is to be remembered here that the LAC curve, throughout its length, is not tangential to the minimum points of all the SAC curves. When LAC is falling, it is tangential to the falling portion of the SAC curves, not to the minimum point of the SAC curves.

For instance, the firm operates at point A on the curve SAC, the falling portion, rather than B where costs are the lowest. In other words, since the slope of the LAC curve up to point E is negative, the slope of the SAC curves must also be negative. This is because, at the tangency points, both the SAC and LAC curves have the same slopes. Only at point E, the minimum point of LAC is tangent to the minimum point of the SAC.

To the right of this point, as LAC is rising, it is tangent to the rising portion of SAC curves. Note that, at the points of tangency, SAC = LAC, but to the right or left of the tangency point SAC > LAC. However, the minimum points of SAC curves below OQ₃ output lie to the right of the operational point. Beyond OQ₃ output, SAC’s minimum points lie to the left of the operational point.

Thus, we can say that the LAC curve is U-shaped—it first falls, reaches minimum, and rises afterwards as output expands. But the U-shape of the LAC curve is less pronounced than the U-shape of SAC curve.

Business economics is a field of applied economics that studies the financial, organizational, market-related, and environmental issues faced by corporations. Economic theory and quantitative methods form the basis of assessments on factors affecting corporations such as business organization, management, expansion, and strategy. Studies might include how and why corporations expand, the impact of entrepreneurs, the interactions among corporations, and the role of governments in regulation.

Business economics is, thus, an applied economics. Economics is the study of human beings (e.g., consumers, firms) in producing and consuming goods and services in the midst of scarcity of resources. Managerial or business economics is an applied branch of organizing and allocating a firm’s scarce resources to achieve its desired goals.

Managerial economics or business economics is economics applied in decision-making. Business economics, thus, interweaves economic principles and business. Business managers apply economic laws and principles while presenting business problems and their ways of solutions. Thus, business economics can be defined as the application of economic analysis to business problems faced by an enterprise. It provides a link between economic theory and the decision sciences in the analysis of managerial decision-­making. It relies heavily on traditional economics and decision sciences.

On the basis of past knowledge and experience, business managers take business decisions and make future plans. But decision-makers are constrained by the ‘uncertainty’ of the real world where changes occur either in a hidden way or in an open way. In this changing but uncertain world, an accurate decision-making is impossible even if talents of top quality business economists are employed.

It is due to this uncertainty, prediction or estimation relating to the volume of sales of a product, cost of production, profit, etc., is more likely to be imperfect. In other words, against the backdrop of uncertainty and a changing world, business managers will have to anticipate changes so that the impact of unfavorable situations becomes insignificant. Thus, business decision-making is an art.

Example of Business Economics

There are various organizations associated with the field of business economics. In the United States, the National Association for Business Economics (NABE) is the professional association for business economists. The organization’s mission is “to provide leadership in the use and understanding of economics.” In the United Kingdom, the equivalent organization is the Society of Business Economists.

Scope of Business Economics

Business economics is applied microeconomics employed for the purpose of decision making and planning for an organization. The scope of business economics is wider since it uses the logic of different disciplines such as mathematics, statistics, marketing and finance to solve problems relating to decision making.

1. Analysis, estimation and forecasting of demand

Analysis of demand is all about studying consumer behaviour. It includes the understanding of changing the behaviour of consumers and their preferences with the effect of change in other determinants of demand such as the price of goods, tastes and preferences and income etc. Every business concern decides its level of production based on this demand analysis. They make research and conduct market surveys to know the preferences of consumers. Business economics estimates consumer behaviour in the market and forecasts the quantity demanded by consumers to the production department. It also includes the allocation of resources in an effective manner to meet consumer demands.

For example

 Suppose sales of ‘X’ product in ABC Ltd. in April, May and June is 500,600 and 700 units respectively. So, we can easily estimate the demand for ‘X’ product for month July approximately 600 units, provided market conditions remain the same.

2. Cost and output analysis

Business economics deals with various types of costs associated with the operations of an enterprise and the optimum level of output to achieve the organizational goals. The costs analysis enables the firm to identify the behaviour of all costs incurred in the organization which leads to minimization of costs whereas output analysis enables the firm to increase the output by securing economies of scale. Thus, business economics is concerned with the minimization of costs and maximization of output.

Some of the defined costs under business economics are:

• Opportunity costs
• Implicit and explicit costs
• Historical and replacement costs
• Short run and long run costs
• Fixed and variable costs
• Controllable and uncontrollable costs
• Incremental costs and sunk costs
• Total, Average and Marginal costs etc.

3. Capital budgeting and capital management

Business economics assists long-run decisions of the firm such as capital budgeting and management of funds. Among the other decisions, managers have to take care of investment decisions that where to invest and how much to be invested. Various theories of business economics give an idea to evaluate these decisions and to allocate the capital. These theories also help the firm to assess the capital structure and its efficiency. Thus, when a firm has to take decisions regarding funds or finance, business economics serves the decision-making process.

Some of the methods used in capital budgeting are:

• Discounted payback period
• Net present value
• Profitability index
• Internal rate of return etc.

4. Market structure and pricing policies

Business economics helps to know the extent of competition in the market through the analysis of the market structure. It also enables the firm to draft market strategies for market management under different competitive situations. On the other hand, this market analysis helps the firms to create pricing policies. It provides guidelines to determine price levels under different market conditions.

For example:

Adoption of price skimming strategy includes the high price at the initial stage of the product to maximize profits before competition brings out and prices start to begin whereas penetration pricing includes low prices at the initial stage of the product to undercut the competition and gain market.

5. Inventory management

Business economics helps firms while making inventory policies. The profitability of the firm depends on proper inventory management. The business theories provide rules to minimize the costs associated with the inventory such as raw material, work-in-progress and finished goods. Hence, business economics gives different methods such as ABC Analysis and economic order quantity models to maintain optimum stock of inventories.

For example:

For the business dealing in perishable goods for which demand is time sensitive e.g. fashion items, calendar etc. keeping inventory in stock can be costly.

6. Profit analysis

Profit maximization is the main aim of every business entity. But at the same time, it faces risks and uncertainty against it. It has to be innovative in its production and marketing of goods to attain the objectives. Business economics deals with all the matters relating to the profitability analysis such as break-even point. The profit theories enable the firm to measure and manage profits under different conditions. Also, it helps in planning profits in future.

7. Risk and uncertainty analysis

As we know the business environment is uncertain and risky. Uncertainty exists when the outcomes of decisions can’t be predicted accurately and risk is the chance of loss when all possible outcomes and probability of happenings are not known. Business economics provide experience, insight and prudence to allow managers to make strategies to minimize the chances of failing to meet the organizational goals.

For example:

The investment in government bonds and securities are less risky as returns are certain whereas investment in new business or expansion are riskier as returns are uncertain.

8. Allocation of resources

Allocation of resources in business economics means scientific management of resources in line of production, distribution, exchange and consumption. The different methods of resource allocation are explained in economic theories under different conditions.

 For example:

In the capitalist economy, it is based on market mechanism whereas, in a free economy, it depends on the forces of demand and supply. Also, business economics uses advanced tools like linear programming and solver to create the best allocation for the optimum utilization of resources.

Thus, there is very wast Scope of Business Economics, which covers all those problems which a manager has to face. As these problems can be internal or external, business economics gives different theories to tackle them.

Business economics is generally applied microeconomics. It normally bridges up the business gap that exists between business practices and pure economic theory. It encompasses logical science, mathematics, decision science, and economics. These concepts usually help in taking rational and optimal business decisions. Business economics integrates theories of economics with business practice. In short, business economics is a decision making science.

I am going to provide copious details on the importance of business economics. They are not limited to the following benefits.

1. It covers demand analysis and forecasting

Demand analysis is always crucial in identifying the different factors that often influence the demand for the product of the firm. It offers clear guidelines on how to manipulate demand. Normally, the core area of business decision making relies on demand accurate estimate.

Forecasting is a critical topic that is studied in business economics. Each business enterprise initiates and progresses in its process of production based on the demand anticipation for its products in the future. It conducts a market survey and enables research with a view to understanding the fashions, tastes, and preferences of consumers. Business economics usually analyzes the behavior of the demand and predicts the quantity that is demanded by the consumers.

2. Plays a key role in cost analysis

Business economics often handles the analysis of various costs that business firms incur. Every business always desires to minimize their costs and maximize its profits by embracing different economies of scale. Nonetheless, the firms fail to determine exact costs that are involved in the production process. Business economics often deals with the cost estimates and offers knowledge to the business people concerning cost analysis of their enterprise.

3. Profit analysis

Most firms desire to gain maximum profits, however, they often experience risk and uncertainty in getting the maximum profits. The business has to come up with new innovations in marketing and production of its products. Business economics handles issues regarding profit analysis such as profit policies, techniques and even break down the analysis.

4. Capital management

Business economics covers capital management where it further denotes control and planning of expenditure of capital in a business firm. It normally covers areas such as rate of return, selection of best project, cost of capital and evaluation among other topics.

5. It covers and determines production analysis

One feature of factors of production is that are normally scarce and usually have alternative uses. In most cases, producers conjoin these factors of production in a certain way in the production process to accomplish maximum output. Business economics sheds more light concerning factor productivity, production function, least cost inputs combination among others.

6. Price determination and its techniques

Appropriate pricing decisions normally influence on how a firm can maximize its profits. Business economics deals with different techniques of price determination under various categories of market structures. Other topics related to price determination and their methods that are covered by business economics are not limited to pricing objectives, price discrimination, pricing methods, pricing of a joint product among others.

7. Has an influence on objectives of a business firm

It is important to appreciate the fact that, each and every business enterprise has an objective to achieve. A firm should ensure that its objectives should work with the way business wants to accomplish its goals. The objectives of a business entire often offer a clear guideline to the owner of the business while he/she focuses on making informed decisions concerning its output and price. The objective of the firm might revolve around sales maximization, profit maximization, satisfaction maximization, utility maximization among other objectives. Business economics normally covers theories concerning the objectives of a business organization propounded by various economics.

8. Business environment

It goes without saying that the business environment always has a significant effect on business organizations. Note that, business economics usually studies about several categories of business environment inclusive of business phase cycle, capital market and situation of money, market structure among other crucial topics. Business environment and business economics are complementary to each other.

Of late, there has been a new trend regarding integration of operation research and business economics, where methods like inventory models, linear programming, the theory of games are regarded as part of important areas to study in business economics. Therefore, business economics is a very important element that allows most organizations and individuals to accomplish their goals.

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision.

Following are the basic economic tools for decision making:

• Opportunity cost
• Incremental principle
• Principle of the time perspective
• Discounting principle
• Equi-marginal principle

1. Opportunity cost principle

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision.

For e.g.

• The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds if they have been employed in other ventures.
• The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.
• The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs.

2. Incremental principle

It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are

• Incremental cost
• Incremental Revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if:

• It increases revenue more than costs
• It decreases some costs to a greater extent than it increases others
• It increases some revenues more than it decreases others and
• It reduces cost more than revenues”

3. Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations.

For example

Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)

Analysis

From the above example the following long run repercussion of the order is to be taken into account:

• If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution.
• If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against.

In the above example it is therefore important to give due consideration to the time perspectives. “a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective”.

4. Discounting Principle

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two reasons:

• The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of
• Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108

5. Equi marginal Principle

This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities.

Tables are the simplest and most direct form for presenting economic data. When these data are displayed electronically in the format of an accounting income statement or balance sheet, the tables are referred to as spreadsheets. When the underlying relation between economic data is simple, tables and spreadsheets may be sufficient for analytical purposes. In such instances, a simple graph or visual representation of the data can provide valuable insight.

Complex economic relations require more sophisticated methods of expression. An equation is an expression of the functional relationship or connection among economic variables. When the underlying relation among economic variables is uncomplicated, equations offer a compact means for data description; when underlying relations are complex, equations are helpful because they permit the powerful tools of mathematical and statistical analysis to be used.

Functional Relations: Equations

The easiest way to examine basic economic concepts is to consider the functional relations incorporated in the basic valuation model. Consider the relation between output, Q, and total revenue, TR. Using functional notation, total revenue is

TR = f(Q)

Equation is read, “Total revenue is a function of output.” The value of the dependent variable (total revenue) is determined by the independent variable (output). The variable to the left of the equal sign is called the dependent variable. Its value depends on the size of the variable or variables to the right of the equal sign. Variables on the right-hand side of the equal sign are called independent variables. Their values are determined independently of the functional relation expressed by the equation.

Equation does not indicate the specific relation between output and total revenue; it merely states that some relation exists. Equation provides a more precise expression of this functional relation:

TR = P×Q

where P represents the price at which each unit of Q is sold. Total revenue is equal to price times the quantity sold. If price is constant at $1.50 regardless of the quantity sold, the relation between quantity sold and total revenue is

TR = f(Q)

Data in Table are specified by Equation and graphically illustrated in Figure.

Total, Average, and Marginal Relations

Total, average, and marginal relations are very useful in optimization analysis. Whereas the definitions of totals and averages are well known, the meaning of marginals needs further explanation. A marginal relation is the change in the dependent variable caused by a one-unit change in an independent variable. For example, marginal revenue is the change in total revenue associated with a one-unit change in output; marginal cost is the change in total cost following a one-unit change in output; and marginal profit is the change in total profit due to a one-unit change in output.

Relation Between Total Revenue and Output; Total Revenue = $1.50

Marginal cost

The marginal cost is the increase in total cost as a consequence of an increase in a production unit, or in mathematical terms, it is the first differential quotient of the total cost function. This can be expressed as a partial derivative of change of total costs and variation in one unit of production.

It is useful using marginal cost to check the convenience of velocity of production of a firm into multiple levels of production:

The law of increasing returns implies that production is increasing more with impact of one additional unit of production, therefore the marginal cost gradient, as the second derivate of marginal cost is below 0 and firm is reducing marginal costs as result of production.

The second scenario is law of constant returns, where the total cost curve is regular and smooth and change in productions maintain the same marginal cost and marginal cost gradient is equal to 0.

The law of diminishing returns applies where total cost curve is convex and marginal cost increases monotonically, being marginal cost gradient positive when production increase.

Firm´s decision to maximize profit depend greatly if marginal cost are lower than price of product, expanding production until marginal cost is equal to price.

Average cost

Average costs represent the quotient of the ordinate and abscissa of a point on the total cost curve. Also it is named as cost of velocity of production, where it measures the cost per unit, taking in consideration fixed cost and variable costs, divided on total production.

The average cost can be explained in two components:

• Variable cost: where it is included only costs related to velocity of production.
• Fixed cost: related with investment required to produce the firm but it does not depend on velocity of production.

The average cost start declining as result of average fixed cost falls with velocity of production. However, it will rise, as impact of fixed factors constrains production, limiting the benefits of increase production and impact in total cost per unit. To move from a lower average cost, firm requires increase the fixed factors of production to move to a new lower point, developing scale economics. As result of behavior of fixed and variable cost, average cost shape is U form.

The usage of average cost is useful to know about total costs incurred by firm based on units of productions. Every velocity of production has a cost covering price and depending the amount of production with lowest cost covering prices is where enterprise can sell without generating losses. However, if firm is looking return investment, the respective price must be equal to average cost to recover fixed cost and variable costs.

Average Cost vs. Marginal Cost Comparison Table

 Average Cost vs. Marginal Cost

1. Average cost is nothing but the Total cost divided by the number of units manufactured which shows the result as per unit cost of the product, whereas Marginal cost is extra cost generated while producing one or some extra unit of products and it is calculated by dividing the change in total cost with Chang in total manufactured unit.
2. Marginal cost considered all cost which fluctuates during the level of production and fixed cost remain constant up to a certain level of production, whereas Average cost considered Fixed cost and Variable cost. In Average cost, both Fixed and Variable cost is product cost whereas in margin cost Fixed cost is considered as period costs and Variable cost is product cost.
3. Average cost calculates the effect on total unit due to change in output level whereas marginal cost is calculated to find out if producing one extra unit of product is profitable or not.
4. Average cost method also called a weighted average method and Marginal cost method is also called as variable costing.
5. Both average cost vs marginal cost is measured under the same units and obtain the result from Total cost.
6. If an objective is to increase profit during production level than the marginal cost technique is useful and when an objective is to reduce cost during production level, in that case, the Average cost technique is used.

Marginal cost vs. Average cost both are costing technique used to calculate the cost of the product which incurred while manufacturing. It helps an organization to set the final price of the product and cover all its expenses through it. Marginal cost method helps an organization to increase profitability at the production level and the Average cost method helps an organization to reduce cost at the production level. Average cost helps to understand how much expenses incurred while producing a single of product and Marginal cost helps to understand how much extra cost will incur while producing one extra unit of product.

Marginal cost does not depend on fixed cost because it does not change with output, or it remains constant up to a certain level of production whereas variable cost change with the output, so in short marginal cost is due to change in variable cost. The average cost considers both fixed cost and variable cost of the product which is called Total cost. The average cost and Marginal cost effect each other as the production varies. When average cost decreases in that case marginal cost is less than the average cost and vice versa and when the average cost is the same or constant in that case both are equals to each other. Marginal cost plays an important role in economics as it shows the costs at a very definite point in time. Even though the average and marginal cost is an important concept for an organization but some time pricing of products with this method leads to a significantly different result.

Marginal analysis plays a crucial role in managerial economics, the study and application of economic concepts, to guide in making managerial decisions. The idea is to predict and measure the impact of per unit changes of an organization’s goals, ultimately identifying the optimal resource allocation given the constraints of the business.

The Value of Marginal Analysis for Management

Most of the microeconomic theory of marginalism was developed by Cambridge University professor and economist Alfred Marshall. He stated that production is only beneficial for a firm when marginal revenue exceeds marginal cost, and it is most beneficial when the difference is largest.

For instance, a toy manufacturer should only produce toys until marginal expense is equal to marginal benefit. By breaking down decisions into measurable, smaller pieces, the toy manager can optimize profits.

Marginal analysis has applicability well outside the range of for-profit production processes. Every resource allocation decision can benefit from marginal analysis as long as costs and benefits are identifiable.

Attaining the Highest Net Benefit

Suppose a company is able to measure the additional benefits and costs of extra economic activity. The theory of marginal analysis states that whenever marginal benefit exceeds marginal cost, a manager should increase activity to reach the highest net benefit. Similarly, if marginal cost is higher than marginal benefit, activity should be decreased.

Sunk costs, fixed costs, and average costs do not affect marginal analysis. They are irrelevant to future optimal decision-making. Marginal analysis can only address what happens if the firm hires one additional employee, produces one additional product, devotes additional space to research and so forth.

Marginal Analysis and Opportunity Cost

Managers should also understand the concept of opportunity cost. Suppose a manager knows that there is room in the budget to hire an additional worker. Marginal analysis tells the manager that an additional factory worker provides net marginal benefit. This does not necessarily make the hire the right decision.

Suppose the manager also knows that hiring an additional salesperson yields an even larger net marginal benefit. In this case, hiring a factory worker is the wrong decision because it is sub-optimal.

Market demand is similar to industry demand. It is a broader concept and it involves total demand of a product in an industry. For example, demand of two wheelers in India implies demand of two wheelers produced and marketed by all the companies. It reveals the broader picture of demand. Marketer should keep in mind the wider scenario of industry/market demand to see his position, often called market share of company in an industry. Market demand plays a vital role in formulating the broad marketing programme.

Philip Kotler: “Market demand for the product is the total volume that would be bought by a defined customer group in a defined geographical area in a defined time period in a defined marketing environment under a defined marketing programme.”

Thus, market demand indicates total sales of the product to the specific groups of buyers in a specific period and in defined geographical areas in a given marketing environment.

Elements of Market Demand

Systematic analysis of above stated definitions necessarily reveals following elements:

1. Product

Market demand indicates the total demand of specific products in an industry. The place or scope of product must be specified. In which category or industry the product of company falls. It can be decided on the basis of who are the users and the purpose of using the product. Thus, we must mention the market demand in relation to the specific product.

2. Total Volume

It shows the total volume of sales in form of unit or value. It suggests the total sales of the product in the industry. For example, total volume means the amount (or units) of total demand of refrigerator in India.

3. Purchase or Buying

Only the quantity, that is ordered and purchased is included in market demand. Market demand includes units, which are ordered, delivered, or consumed.

4. Customer Groups

Market demand is expressed in term of different users. Total volume demanded by different groups of customers, such as industrial customers, institutional customers, and individual customers.

5. Geographic Area

Market demand can be specified in term of different geographical areas or localities. It may be in term of country, state, region, district, or any geographic unit.

6. Fixed Time Duration

Market demand is meaningful only if it is expressed in relation to time. For example, demand of two-wheeler during the year 2007. Time may be in term of week, months, quarter, or year.

7. Marketing Environment

Obviously, market demand is influenced by several factors. These factors constitute the marketing environment. So, it is necessary to mention assumptions about marketing environment comprising economic, cultural, social, political, etc., forces.

8. Definition of Marketing Programme

Market demand is affected by marketing programme/strategy. So, it is clarified with reference to a specific marketing programme including product, price, promotion, and distribution. Thus, market demand is stated in context with the definite marketing programme.

While estimating market demand, these all elements should be considered for meaningful picture of total demand. Here, we must distinguish market demand from company demand. Market demand is total demand of the product in an industry, and company demand means demand of the individual business unit’s products. Market forecast relates with market demand and sales forecast relates with company demand. However, market demand forecast and sales forecast are taken loosely (i.e., more or less similar).