Business Economics - Unit-4 - Osmania University

Business
Economics
Unit - 4
PRESENTED BY
K.BALASRI PRASAD
B.Sc(KU), M.B.A(OU), NET(UGC), (Ph.D)(MGU)

COURSE NO. DSC – 102
BUSINESS ECONOMICS
COURSE OBJECTIVES : 1. The purpose of this course is to apply micro economic concepts and tools for analyzing business problems. 2. To make
students aware of cost concepts. 3. To make accurate decision pertaining to individual firms. 4. To understand tools and techniques of micro
economics. 5. To make the student understand market structure and dynamics.
UNIT - I : BUSINESS ECONOMICS NATURE AND SCOPE :
Introduction to Business Economics-Characteristics-Nature and scope, concept of opportunities
Cost- Incremental Cost- Time perspective-Discounting and Equi-Marginal Principle.
UNIT – II : DEMAND CONCEPTS & ELASTICITY OF DEMAND :
Concept of Demand, Determinants of Demand- Law of Demand- Exception to the law of demand-
Elasticity of Demand- Types of demand elasticity- Uses of demand elasticity-Concept of Supply-
Determinants of Supply-Law of Supply-Elasticity of Supply.
UNIT – III : PRODUCTION AND COST CONCEPTS :
Theory of production- Production function- Input output combination-Short run production laws,
Law of diminishing marginal returns to scale- ISO-quant curves, ISO-cost curves
UNIT – IV : BUDGET LINE :
Cost concepts- Cost classification-CVP Analysis-short run cost curves and long run cost curves
Experience curve-Economies and diseconomies to the scale- Economies of scope.
UNIT – V : MARKET STRUCTURES AND PRICING :
Concept of market structures- Perfect competition market and price determination- Monopoly and
abnormal profits- Monopolistic Competition-Price Discrimination-Oligopoly-Features of oligopoly-
Syndicating in oligopoly - Kinked demand curve- Price leadership and market positioning.
SUGGESTED BOOKS :
1. Dominik Salvotore, “(2015) Principal of Micro Economics 7th Ed. oxford University Press.
2. Dr. D N Mithani, (2018) Managerial Economics Theory and Appliocation, HPH
3. Varshiney & Maheswari, Managerial Economics, Juptan Publication, New Delhi
4. Lipsey and Crystal (2008) Economics International 15th Ed.Oxford University Press.
5. Kutosynnis (1979) Modern Micro Economics 5th Ed Mac Millan Publishers 6. Rubin field and Mehathe (Micro Economics 7th Ed. Pearson
Publishers.
22-Mar-22
2

UNIT – IV : BUDGET LINE
Cost concepts
Cost classification
CVP Analysis
Short run cost curves and long run cost curves
Experience curve
Economies and diseconomies to the scale
Economies of scope

Cost concepts
Cost: A cost is an expenditure incurred by a firm
to produce goods and services for sale in the
market.
In other words, a cost is the outflow of
money from the business to gain inflow of money
after sale of the commodity.
A producer has to incur various costs in
order to produce goods and services.

Types of cost:
1. Direct costs or explicit costs
2. Indirect costs or implicit costs
3. Fixed costs
4. Variable costs
5. Accounting costs
6. Economic costs
7. Total costs
8. Average costs
9. Marginal costs
10.Opportunity costs
11.Operating costs

Direct cost or explicit cost:
Explicit costs are those costs which are met by
cash payments for employing various factors of
production.
The producer actually pays money to produce
his goods and services.
A direct or explicit cost is the material, labor,
expenses, overheads, selling and distribution,
administrative cost related to production of a
commodity.
It is accurate in nature.
An explicit cost can be easily traceable.

Indirect costs or implicit costs
Implicit costs are those costs which the firm
lets go or sacrifices in order to hire an
alternative factor of production.
These costs are opportunity costs of the
factors of production.
Implicit cost is also called as imputed cost.
Here cash outflow does not happen.
An implicit cost is defined as “An implicit
cost is the factor of production sacrificed by
the producer for an alternative factor
production.”
The opportunity foregone is the implicit cost.

Fixed costs
Fixed costs are those costs that do not change
in the short run period of time.
Fixed costs remain the same regardless of the
amount of production and sale of commodities.
These costs are incurred by the company
irrespective of its production, i.e. even at zero
production, the firm incurs fixed cost.
A fixed cost can be defined as “A fixed cost is
the cost that remains the same and fixed
irrespective of the production of goods.”

Variable Cost
A variable cost is that cost which changes in
short – run and long – run time period.
It always keeps on changing.
These costs are incurred during production
process and thus are the costs incurred for
employing various factors of production.
A fixed cost becomes a variable cost in the long
– run.
A variable cost is defined as “A variable cost is
the expenditure incurred on the production of
goods and therefore is ever changing.”

ACCOUNTING AND ECONOMIC COSTS
An economist’s idea of cost of production differs
from that of an accountant.
In economics, the cost of production consists of
remuneration to all the factors of production,
viz., wages to labour, rent to land, interest to
capital and normal profits to the entrepreneur.
An accountant on the other hand would include
in the cost of production only the cash payments
to the factors of production, made by the
entrepreneur, for the services rendered by these
factors in the productive process.

The accountant’s concept of cost includes
wage, interest and rent payment but not the
profits made by the entrepreneur because no
entrepreneur even makes cash payment to
themselves.
But in economic theory, however, normal
profits form a part of business firm’s cost of
production.
Again in the calculation of normal profits
which are in economics part of a firm’s cost,
implicit costs must be included.

These costs include rent on land owned by the
entrepreneur himself since he would have
received rent on his land if he had rented it
out to someone.
Implicit costs also include wages of
management.
While an accountant includes only explicit
costs in his cost calculations, an economist
includes in it explicit and implicit costs.

Total costs
 Total cost, in economics, the sum of all costs incurred by a firm in
producing a certain level of output.
 It is typically expressed as the combination of all fixed costs (e.g., the
costs of a building lease and of heavy machinery), which do not
change with the quantity of output produced, and all variable
costs (e.g., the costs of labour and of raw material), which do change
with the level of output.
 If fixed costs are not altered (e.g., by obtaining a larger building or by
acquiring more heavy machinery), the rate of increase of variable
costs with increasing output will be progressively greater in the long
run, owing to diminishing returns on additional units of output.
 The formula is the average fixed cost per unit plus the average
variable cost per unit, multiplied by the number of units.
 The calculation is: (Average fixed cost + Average variable cost) x
Number of units = Total cost.

Average costs
 In economics, average cost or unit cost is equal to total cost (TC) divided
by the number of units of a good produced (the output Q): Average cost
has strong implication to how firms will choose to price their
commodities.
 The cost of producing a firm’s output depends on how much labor and
capital the firm uses.
 The breakdown of total costs into fixed and variable costs can provide a
basis for other insights as well.

Cost classification
Cost classification is the logical process of
categorizing the different costs involved in a
business process according to their type, nature,
frequency and other features to fulfil accounting
objectives and facilitate economic analysis.
Cost refers to the value sacrificed with the aim of
gaining something in return.
A particular cost can be allocated under multiple
categories. For instance; salary paid to an employee
is a labour cost as well as a fixed cost.

Basis of Classification
1. Cost Classification by Nature
2. Cost Classification by Relation to Cost Centre
3. Cost Classification by Functions
4. Cost Classification by Behaviour
5. Cost Classification by Management Decision Making
6. Cost Classification by Production Process
7. Cost Classification by Time

1. Cost Classification by Nature
 The cost can be differentiated by its nature or the purpose for which it
has occurred.
 It can be treated as an expense under this category and the expenses
so incurred is divided as follows:
Material: Material cost is the cost of the raw material and its
related cost such as procurement cost, taxes, insurance, freight
inwards, etc.
Labour: Labour cost is the salary and wages paid to the employees,
i.e. permanent, temporary or contractual employees working in an
organisation. It also includes PF contribution, bonus, commission,
incentives, allowances, overtime pay, etc.
Other Expenses: All the other overheads excluding material and
labour comes under this head. Some of these are packaging,
promotion, job processing charges, etc.

2. Cost Classification by Relation to Cost Centre
Cost classification by nature are used under this category to
further sub-categorize the elements of this category.
Direct Cost: Direct cost is the significant cost immediately
associated with a production process.
It can be seen as a prime cost for any business.
It is sub-divided into direct material cost, direct labour
cost and other direct expenses.
Indirect Cost: Indirect cost is the cost which cannot be
directly allocated to a particular process of production.
It is a secondary cost and is majorly seen as of three types
– indirect material cost, indirect labour cost and other
indirect expenses.

Cost Classification by Functions
There are five significant functions of a business which involves some expense
and are essential to the organization in their way.
 Production: Production cost comprises of all the direct and indirect costs
incurred in the production of goods and services.
 Administration: The costs involved in the management activities of an
organization like electricity, stationery, telephone expenses, rent etc.
 These are also known as administrative overheads.
 Selling: The indirect costs incurred on the sales function of the goods and
services like advertisement, promotion, market research, customer service,
etc. are clubbed under selling cost.
 Distribution: Distribution cost refers to the cost incurred for making the
goods or services available to the customers.
 These are warehousing, delivery service, transportation, etc.
 Research and Development: Research is essential to develop a new product
or modify an existing one.
 The cost incurred on the research team, research implementation, findings, etc.
comes under this category.

Cost Classification by Behaviour
 The cost involved in any business process can be differentiated on the
grounds of its volatility concerning the fluctuation in business activity in the
short run.
 The following classification of cost by its behaviour will give a clear
illustration:
 Fixed Cost: The cost which is hardly affected by the temporary change
taking place in business activity is known as a fixed cost.
 It includes rent, depreciation, lease, salary, etc.
 Variable Cost: The cost which changes proportionately with the change in
production quantity or other business activity is termed under variable cost.
 Raw material, packaging, sales commissions, wages, etc. are variable
costs.
 Semi-Variable Cost: The cost which is moderately influenced by the
change in business activity is called semi-variable cost.
 It includes power consumption, maintenance cost, management cost,
supervision cost, etc.

Cost Classification by ManagementDecision Making
 Cost is not just a price paid to generate some value, but it is also
used as a tool by the management for decision making.
 Managerial decisions are framed depending upon the following
types of cost involved in carrying out of business:
Marginal Cost: Marginal cost is the cost of producing an
additional unit and its impact on the total cost of production.
Differential Cost: When there is an increment or decrement in
the cost of bulk production, the change in the cost of a single
unit is also determined which is known as differential cost.
Opportunity Cost: The value of one or more products given up
to acquire the desired product or service is known as
opportunity cost. For instance; while choosing green tea, a
person has to give up the value he must have derived from
coffee or regular tea.

 Replacement Cost: When machinery or any other asset becomes
obsolete or involve high maintenance cost, and simultaneously a
better asset is available in the market which can replace it, then
the cost involved in such substitution is known as replacement
cost.
For example; a transportation company needs to replace its
trucks from time to time to avoid excessive repairing expenses.
 Sunk Cost: The cost which has been born by the organization in the
past and cannot be recovered at any stage of the business process
is termed as a sunk cost.
Freight inwards paid at the time of buying machinery has to be
written off at the time of selling it.
 Normal Cost: The routine cost associated with the manufacturing
of goods or services under usual circumstances is called a normal
cost.
It includes all direct expenses such as salary, material, rent, etc.

Abnormal Cost: The cost that arises suddenly and
unknowingly under unfavourable situations is known as
abnormal cost.
For instance; workers go on strike, theft or robbery,
fire in the premises, etc.
Avoidable Cost: Such costs are under the control of
management and can be prevented as per the
organizational need.
For example; an enterprise upgrades its technology by
installing self-operative machines to avoid the labour
charges it pays.
Unavoidable Cost: The cost which is pre-determined
and inevitable is called an unavoidable cost.

CostClassificationbyProductionProcess
All production or manufacturing activities involve different types of costs.
 Batch Cost: The cost incurred while producing a whole lot comprising of identical products
(batch) is known as batch cost. Each batch differs from the other, and the units lying under
a batch are identified by their batch number. Pharmaceuticals, automobiles, electronic
products are some of the examples.
 Process Cost: The cost incurred on performing different operations in a streamlined
production process is termed as a process cost. By dividing the total cost of a process with
the number of units produced, we can derive the process cost of a single unit or product.
 Operation Cost: The cost involved in a particular business function contributing to the
production process is known as operation cost. It helps in regulating the mechanism of
business activities by monitoring the cost incurred on each business operation.
 Operating Cost: Operating cost refers to the day to day expenses incurred by an
organisation to ensure uninterrupted functioning of the business is known as an operating
cost.
 Contract Cost: The cost of entering into a contract with a buyer or seller by mutually
agreeing to the terms and conditions so mentioned is called a contract cost. It includes a
bidding contract, price escalation contract, tenders, etc.
 Joint Cost: The combined cost involved in the production of two or more useful products
simultaneously is known as the joint cost. For example; the cost of processing milk to get
cottage cheese and buttermilk.

Cost Classification by Time
 The nature, importance and liability of a cost vary as per the time it takes place
or has been assessed.
 A cost which is a priority today, may not be that important tomorrow or a cost
which has been overlooked today, may be considered as a relevant cost
tomorrow.
 Historical Cost: Any actual cost ascertained and evaluated after it has been
incurred, is termed a historical cost. It can be committed either on the
production of goods and services or asset acquisition.
 Pre-determined Cost: The cost which can be identified and calculated before
the production of goods and services based on the cost factors and data is
called a pre-determined cost. It can be either a standard cost or an estimated
cost.
 Standard Cost: An actual cost which is pre-determined as per certain norms and
guidelines to provide as a base for cost control, is termed as a standard cost.
 Estimated Cost: The cost of business operation presumed on the grounds of
experience is known as an estimated cost. It is merely based on assumptions
and therefore considered to be less accurate to determine the actual cost.

CVP Analysis
 Cost-volume-profit (CVP) analysis is a method of cost accounting
that looks at the impact that varying levels of costs and volume
have on operating profit.
 Cost-volume-profit (CVP) analysis is a way to find out how
changes in variable and fixed costs affect a firm's profit.
 Companies can use CVP to see how many units they need to sell
to break even (cover all costs) or reach a certain minimum
profit margin.
 CVP analysis makes several assumptions, including that the
sales price, fixed and variable cost per unit are constant.
 The cost-volume-profit analysis, also commonly known as
breakeven analysis, looks to determine the breakeven point for
different sales volumes and cost structures, which can be useful
for managers making short-term business decisions.

The CVP formula can be used to calculate the
breakeven point.
The breakeven point is the number of units that
need to be sold, or the amount of sales revenue
that has to be generated, in order to cover the
costs required to make the product.

CVP analysis also manages product contribution margin.
The contribution margin is the difference between total
sales and total variable costs.
CVP analysis is only reliable if costs are fixed within a
specified production level.
All units produced are assumed to be sold, and all
fixed costs must be stable in a CVP analysis.
Cost-volume-profit analysis is used to determine
whether there is an economic justification for a
product to be manufactured.
The decision-maker compares the product's sales
projections to the target sales volume to see if it is
worth manufacturing the product.

Short run cost curves
 A short-run cost curve shows the minimum cost impact of output
changes for a specific plant size and in a given operating environment.
 Such curves reflect the optimal or least-cost input combination for
producing output under fixed circumstances.
 Wage rates, interest rates, plant configuration, and all other operating
conditions are held constant.
 Any change in the operating environment leads to a shift in short-run
cost curves.
 For example, a general rise in wage rates leads to an upward shift; a fall
in wage rates leads to a downward shift.
 Short-run cost curves are a useful guide to operating decisions.
 Both fixed and variable costs affect short-run costs.
 Total cost at each output level is the sum of total fixed cost (a constant)
and total variable cost. Using TC to represent total cost, TFC for total
fixed cost, TVC for total variable cost, and Q for the quantity of output
produced, various unit costs are calculated.

Long run cost curves
In the short‐run, some factors of production are fixed.
Corresponding to each different level of fixed factors, there will
be a different short‐run average total cost curve (SATC).
The average total cost curve is just one of many SATCs that can
be obtained by varying the amount of the fixed factor, in this
case, the amount of capital.
Long‐run average total cost curve. In the long‐run, all factors
of production are variable, and hence, all costs are variable.
The long‐run average total cost curve (LATC) is found by
varying the amount of all factors of production.
However, because each SATC corresponds to a different level
of the fixed factors of production, the LATC can be constructed
by taking the “lower envelope” of all the SATCs.

The LATC is shown to be tangent to each of five
different SATCs, labeled SATC 1 through SATC 5 .
In general, there will be a large number of SATCs, each of
which corresponds to a different level of the fixed factors the
firm can employ in the short‐run.
Because there is such a large number of SATCs—more than
just the five illustrated in Figure —the lower envelope of all
the SATCs, which makes up the LATC, can be approximated by
a smooth, U‐shaped curve.

Experience curve
 The experience curve is based on the premise that the more you do
something, the easier and better you do it. In other words, the more
“experience” you have making a product, the faster and cheaper it is to
make.
 Research has shown that as the cumulative number of units of a product
rises (cumulative means the total number of units produced since the
business was formed,) the cost of producing a unit drops at a predictable
rate. For example, as shown in Figure 1, every time production doubles
(from 1X to 2X and from 2X to 4X), the cost of making a unit drops by 40
percent (C1 to C2 and from C2 to C4).
 To provide a numeric example, with a 40% experience curve the cost per
unit declines from $20.00 per unit at 10,000 units of cumulative production
to $12.00 ($20 x 40% = $8, $20 - $8 = $12) at a cumulative production of
20,000 units (2 x 10,000 units).
 As can be observed, the experience curve concept is more applicable to
some products than to others, and the rate of reduction varies greatly
depending on the product and the business.

Economies and diseconomies to the
scale
 When we talk about the scale of production of a firm, we often hear about
the fact that large-scale production, usually, helps in reducing the cost of
production.
 Economies of scale refer to these reduced costs per unit arising due to an
increase in the total output.
 Diseconomies of scale, on the other hand, occur when the output increases
to such a great extent that the cost per unit starts increasing.
Internal and External Economies
When a firm opts for large-scale production, the economies arising out of it are
grouped into two categories:
 Internal economies – economies of production that the firm accrues when it
increases the output leading to a drop in the cost of production.
 These arise due to endogenous factors like entrepreneurial efficiency,
talents of the management team, type of machinery, etc.
 External economies – these are the benefits that each member firm of the

Internal Diseconomies and Economies of Scale
 While studying returns to scale, we observed that they increase
during the initial stages, remain constant for a while, and then start
decreasing.
 The reason is simple – initially, the firm enjoys internal economies of
scale and after a certain limit, it suffers from internal diseconomies of
scale.
Technical
 Large-scale production is linked to technical economies.
 When a firm increases its scale of operations, it needs to use a more
specialized and efficient form of capital equipment and machinery.
 Such machinery helps to produce larger outputs at a lower unit cost.
 Further, as the scale of production increases and the amount of labor
and other factors becomes larger, the firm manages to reduce costs
by introducing a degree of division of labor and specialization.

Managerial
 As the output increases, the firm can apply the division of labor to the
management as well.
 When the scale of production increases further, the firm divides each
department into sub-departments like sales is divided into advertising,
exports, and service.
 Thus helps in increasing the efficiency and productivity of the
management team since a specialist manages each sub-department.
 However, as the firm increases its scale of operations beyond a certain
limit, the management finds it difficult to control and coordinate
between departments.
 This leads to managerial diseconomies.
Risk-bearing
 A firm enjoys the economies of risk-bearing if it has a large-scale
operation with diverse and multi-production capabilities.
 However, if the diversification increases the economic disturbances
rather than covering them, then the risk increases.

External Diseconomies and Economies of Scale
 External diseconomies and economies of scale are very important to a
firm.
 These are a result of the expansion of output of the entire industry
and not limited to an individual firm.
Cheaper Raw materials and Capital Equipment
 At times, the expansion of an industry results in new and cheaper
sources of raw material, machinery, and other capital equipment.
 It also results in an increased demand for the various types of
materials and equipment required by the industry.
 Hence, such materials/equipment can be purchased from other
industries on a large scale.
 This, eventually, leads to a lower cost of production and lower price.
 Therefore, firms using these materials/equipment get them at lower
prices.

Technological External Economies
 Usually, when an entire industry expands, new technical knowledge is
discovered leading to new and improved machinery for the said industry.
 This changes the technological coefficient of production and enhances the
productivity of the firms in the industry. Hence, the cost of production
reduces.
Development of Skilled Labor
 As the industry expands, the labor gets accustomed to managing various
production processes and learns from the experience. This increases the
number of skilled workers which in turn has a favorable effect on the levels
of productivity.
Growth of Ancillary Industries
 When a certain industry expands, many ancillary industries start specializing in the
production of raw materials, tools, machinery, etc.
 These ancillary industries offer the materials/machinery at a low price.
 Similarly, some ancillary industries also start processing industrial waste and create
a useful product out of it. Overall, it leads to a lower cost of production.

Better Transportation and Marketing Facilities
 An expanding industry, usually, results in better transportation and
marketing networks.
 These aspects help reduce the cost of production in the firms from
the industry.
 It is important to note that, certain disadvantages can neutralize
the advantages of the expansion of industry and cease the external
economies of scale.
 These are external diseconomies.
 When an industry expands, the demand for certain materials and
skilled labor increases.
 If these factors are in short supply, then their prices can increase.
 Further, the geographical concentration of firms from the industry
can lead to higher transportation costs, marketing costs, pollution
control costs, etc.

Economies of scope
 An economy of scope means that the production of one good
reduces the cost of producing another related good.
 Economies of scope occur when producing a wider variety of
goods or services is more cost effective for a firm than producing
less of a variety, or producing each good independently.
 In such a case, the long-run average and marginal cost of a
company, organization, or economy decreases due to the
production of complementary goods and services.
 While economies of scope are characterized by efficiencies
formed by variety, economies of scale are instead characterized
by volume.
 Economies of scope describe situations where producing two or
more goods together results in a lower marginal cost than
producing them separately.

Economies of scope differ from economies of scale, in that
the former means producing a variety of different products
together to reduce costs while the latter means producing
more of the same good in order to reduce costs by
increasing efficiency.
Economies of scope can result from goods that are co-
products or complements in production, goods that have
complementary production processes, or goods that share
inputs to production.
Economies of scope can occur because the products are co-
produced by the same process, the production processes
are complementary, or the inputs to production are shared
by the products.

Different Ways to Achieve Economies of Scope
 Real-world examples of the economy of scope can be seen in mergers and
acquisitions (M&A), newly discovered uses of resource byproducts (such as
crude petroleum), and when two producers agree to share the same factors
of production.
 Economies of scope are essential for any large business, and a firm can go
about achieving such scope in a variety of ways.
 First, and most common, is the idea that efficiency is gained through
related diversification.
 Products that share the same inputs or that have complementary productive
processes offer great opportunities for economies of scope through
diversification.
 Horizontally merging with or acquiring another company is another a way to
achieve economies of scope.
 Two regional retail chains, for example, may merge with each other to
combine different product lines and reduce average warehouse costs.
 Goods that can share common inputs like this are very suitable for
generating economies of scope through horizontal acquisitions.

Business Economics - Unit-4 - Osmania University

Business Economics - Unit-4 - Osmania University

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Business Economics - Unit-4 - Osmania University

Similar to Business Economics - Unit-4 - Osmania University (20)

More from Balasri Kamarapu

More from Balasri Kamarapu (20)

Recently uploaded

Recently uploaded (20)

Business Economics - Unit-4 - Osmania University