SVKMs Narsee Monjee Institute of Management Studies SCHOOL OF DISTANCE EDUCATION

Name: Anees Abdul Aziz Merchant Programme: PGDMM Semester: SEM I

G.R.No./SAP ID: ________________________

Year of Registration: July 2011

Study centre: VileParle, Mumbai

Subject: Business Economics

1. Explain (with the help of diagram & examples) different types of short run and log run costs. Also, explain (with the help of examples for each) the different type of economies and diseconomies scale. In any economy a business leader needs to analyze his costs from various points of view. In formal economic theory output price is defined as a function of input costs. As the output is derived from combining all the inputs which includes the fixed and variable costs. Costs, therefore will rise or fall if the ratio of output to input changes. One cannot draw a timeline to differentiate the short run and long run costs such as 3 months or 3 years. The difference between the short and long run, flexibility that the decision makers have. The 2nd edition of Parkin and Bade's "Economics" gives an excellent distinction between the two. The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. The long run is a period of time in which the quantities of all inputs can be varied. The short run and long run distinction varies industries. In Short Run, total cost is derived by aggregating total fixed cost (TFC) and total variable costs (TVC). Also in short run the total cost would rise or fall as the firm bring in efficiencies to improve the output to input ratio. Average cost (AC) of is the cost per unit of output and is in place to prevent any changes in the alternative inputs. Similarly Marginal cost (MC) of an additional unit of output is the cost of the additional inputs needed to produce that output. Marginal cost and average cost can differ greatly. For example, suppose it costs Rs. 1000 to produce 100 units and Rs. 1020 to produce 101 units. The average cost per unit is Rs 10, but the marginal cost of the 101st unit is Rs. 20. To understand this better, fixed cost gets spread over a larger volume of outputs. But at the same time variable costs start going up because of diminishing returns to factors. Hence Average Variable costs (AVC) would go down with the drop in the Average Fixed costs (AFC) in the start but would start increasing and if the rise is not proportionate to drop in AFC there by increasing the AC, it would start reflecting diseconomies, i.e. diminishing returns to variable factors. To get in economies of scale and take advantage of ATC, companies can open additional plants to improve scale there by changing the fixed to variable costs. In the long run all inputs are variable. So in the long run, the Long run Average Cost (LAC) is the curve showing the average of cost of production at different levels of output by different plans / units. Long run Marginal Cost (LMC) curve would be lower than the LAC for some phase and then would experience an increase when the firm starts seeing an increase in LAC, the organization starts seeing diseconomies of scale.

Difference between economies and diseconomies of scale is a firm appreciating or depreciating their margins based on costs. Appreciation of margins can achieved by either extending the scale of production or exploring alternative and cheaper means of production. Disadvantages may arise in situations in which firms may start incurring more costs to produce marginally more output or the with the flux of competitions has resulted in supply to go up and demand to go down thereby resulting in the prices to drop. Hence economies and diseconomies can be internal and external. Let us take an example to understand the difference between Short run Cost, Long Run and economies and diseconomies of scale. A company multi touch tablet industry will need the following to manufacture tablets: Raw materials, Labor, Machinery. For example Apple Inc. when they started manufacturing IPADs, they setup their factory in China. Since they were the market leaders to come up with an innovative product there were able to get maximum benefits and able to capitalize the demand.

Figure 1 - Short run and economies of scale

Based on Figure 1, Apple Inc, in short run were able to capitalize the market conditions and able to earn profits as denoted in the shaded area as A1. However with the demand growing and company forced to bring in economies of scale, Apple Inc, chose to open multiple factories bringing down the cost and thereby getting the cost advantage and maximize profits.

Figure 2 - Long Run and Economies of Scale

In Figure 2, a sample demonstration of the efficiencies bring bought in by introducing new plants where the firm is able to produce more and earn more profits denoted by A2. Firms who are early adopters of economies of scale can see such benefits. If firms fail to do so, competition would realize the same and start taking benefit of the economies of scale. Similar to Apple Inc. they got severely impacted because competition reacting to such market conditions, and there by introducing products at lower prices. This was followed by demand shifting to other bases there by reducing the causing a surplus of IPAD products. These external diseconomies caused direct pain on profits and Apple was forced to reduce the price to meet market and competitive threats. However Apple was smart to leverage its large market share and was able to shift its long run average costs by introducing new and cheaper variants of IPAD.

Figure 3 - Taking advantage of economies

The movement from a to b was due to external economies which forced Apple to reduce the prices; however Apple was able to leverage this situation and internalized the external economies thereby introducing IPAD2. Firms should take advantage of economies of scale and if they refuse to do so, they can reason that other firms would take advantage of the economies of scale, the supply would increase, prices of goods would go down and companies not taking advantage would run out of business.

2. In perfect competition, P = AR = MR = MC = AC in the long run. Explain in detail with the help of example & diagram. In perfect competition there is complete absence of rivalry among the individual firms. The model of perfect competition is built on the following assumptions a) b) c) d) e) f) There is a large number of buyers and sellers of the commodity Homogeneity of the product Perfect knowledge Perfect mobility of product Freedom of entry and exit for firms It must be easily possible to buy and sell any quantity of products at the prevailing market price g) No government intervention, 0% government involvement h) Transport costs are negligible hence dont affect pricing. As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given. Buyers and sellers in competitive markets are said to be price takers. When we analyze any market conditions we look at the following o o o o o AR, MR AC, MC The point where MR = MC ( Profit maximum ) Q* ( Equilibrium Output ) P* ( Equilibrium Price )

Total revenue (TR) for a firm is the selling price times the quantity sold, TR = (P X Q). Similarly Average Revenue (AR) tells us how much a company typically gets by selling a single unit. However in perfect competition average revenue equals the price of good sold by a company. Illustrated below ( )

Similarly Marginal Revenue (MR) is the change in total revenue from an additional unit sold, ie. . However in competitive firms marginal revenue equals the price of the goods. Let us take an example of a pencil selling

Quantity (Q) 1 2 3 4 5 6 7 8

Price (P) INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00

Total Revenue (TR=PxQ) INR6.00 INR12.00 INR18.00 INR24.00 INR30.00 INR36.00 INR42.00 INR48.00

Average Revenue ( INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 )

Marginal Revenue

INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00 INR6.00

The goal of any organization is to maximize profits. That means the firm would want to produce quantities that maximizes the difference between total revenue and total cost. Maximizing profits can be illustrated as

Figure 4 - Profit Maximization

Q1 > Q = MC > MR => continue to produce because the firm is gaining profits Q2=>MC = MR => profit maximized = output Q3 => MR < MC => loss incurred => stop production If the firm shows a sub-normal profit conditions or higher profits, then new firms will be attracted to enter the industry, or the existing organizations will try to expand their scale or production to garner benefits. Note, under perfect competition firms may have freedom to enter and exit the market

Figure 5 - Long Run Supernormal Profits

If the existing firms can make supernormal profit by increasing the scale of productions, they will do so, since in the long run all costs pertaining to production are variable. The effect of entry of new firms or existing firms to increase the production is to increase the market supply. This is show in figure 5, when more firms or existing firms expand, the supply of product would increase which will cause the supply curve from SS to S1S1. Thus this would lead to fall in price and if this continues the price will continue falling until the firms make normal profit. This would be a point where demand curve (AR) for the firm touches the bottom of its Long run Average Curve (LRAC). As show in the figure 5, Q3 is the equilibrium output of the firm and P2 is the long run equilibrium price. Similarly if the firms are making subnormal profits (loss) in the short run, they are able to continue producing as long as variable costs can be covered but in the long run they will

leave the market. The effect of existing firms leaving the market is that the supply will be lesser in the market. For example

Figure 6 Long Run Subnormal Loss

In figure 6, when the existing firms start leaving the market, it would make the supply curve shift from SS to S1S1. This would tend to increase the price. As supply will go on decreasing the price would go on increasing until the firms start making normal profits. This is when the price has risen to a point where the Average Revenue (AR) curve touches the bottom of the Long run Average Cost (LRAC) curve. As illustrated in the diagram, Q3 is the long term equilibrium output level with P2 being the long run equilibrium price. Hence in long term equilibrium will exists when the supernormal and subnormal profits are eliminated. There is no incentive for the firms to enter or leave the market as the firms would continue to make profits with price being constant. Long run equilibrium would then occur when no firms are entering or exiting the industry because no one believes that it can earn higher profits by entering the market. Or no firms would want to exit the market as there are no legitimate reasons for it to do so. Then in the long run all the firms in the market would have P = AR = MR = MC = AC.