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Cost of production
Chapter 15
Cost of production Chapter takeaways After completion of this chapter the reader would be able to 1. 2. 3. 4. 5.
Understand the various elements of production cost and their interrelationship. Appreciate the vacuous stages at which the cost gets added. Distinguish between the direct and indirect elements of labor and material costs. Appreciate the economic theories and laws of demand and pricing. Understand the pattern of change in average fixed cost and the variable cost as the output of a firm increases. 6. Be able to draw cost curves that affect factory costing. 7. Understand the term equilibrium price and appreciate how it influences product pricing.
15.1 Definitions of terms related to production cost 1. Short run: The production situation where the firm’s operations are restricted by one or more inputs that are fixed in size. For example, in the short run, a firm must confine its operations to buildings of a certain size. In the short run, both fixed and variable costs are significant for the price fixation. 2. Long run: When the firm has the opportunity to vary the size of all its inputs—for example, the firm may build or rent any size building but the fixed costs have less bearing in the unit price. 3. Fixed costs: These are the costs the firm incurs whether or not it operates during the period. For example, building cost, equipment cost, and also property taxes. 4. Variable costs: Those costs increase with each additional unit produced, for example, material and labor costs. 5. Accounting costs: Those costs are the monetary value of economic resources used in performing an activity. See also economic costs. 6. Economic costs: When all costs of using resources to produce some output are included. This usually requires adding some implicit resources costs to accounting costs. For example, if a building is owned by the firm, rent expenses are not an accounting cost, but it must be included in economic cost. Production Planning and Control. DOI: https://doi.org/10.1016/B978-0-12-818364-9.00015-9 Copyright © 2019 BSP Books Pvt. Ltd. Published by Elsevier Inc. All rights reserved.
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7. Opportunity cost: It is a cost figure determined by considering what a resource would be worth if it was being used in its next best alternative. Opportunity costs should be used to compute the true economic costs of production. 8. Total cost (TC): Total fixed cost (TFC) plus total variable cost (TVC). 9. Average fixed cost: TFC divided by output (fixed cost per unit). 10. Average variable cost: TVC divided by output (variable cost/unit). 11. Average TC: TC divided by output (TC per unit). 12. Marginal cost (MC): The additional cost required to produce another unit of output. 13. Diminishing marginal returns: When an additional unit of an input adds less to total output than a previously added input. When this occurs, MCs will begin increasing. 14. Economies of scale: When a larger size plant produces output at a lower unit cost. These economies can be attributed to specialization and technological advantages. 15. Diseconomies of scale: When a larger size plant produces output at a higher unit cost. Problems of coordination are usually blamed for diseconomies. 16. Physical plant capacity: That output level when no more output can be produced from a given-sized plant. 17. Economic capacity: That output level where short-run average costs (LRACs) are minimized. This frequently occurs before physical capacity is reached.
15.2 Components of cost 15.2.1 Material costs 1. Direct materials: These are materials that when operated or processed in factory shops through various stages form the final useful shape of the main product or the component part of the main product. These are also known as productive materials. 2. Indirect materials: These are materials that are essentially needed in various shops for helping the materials to be converted into final useful shapes.
15.2.2 Labor costs 1. Direct labor: The laborers who actually work and process the different materials manually or with the aid of machines are known as direct labor or productive labor. The nature of their duties is such that their wages can be directly charged to the job they are manufacturing. The wages of workers engaged to operate various production machines in machine
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shops, welding shops, pattern-making shops, electric winding shops, and assembly shops, etc., are known as direct labor. 2. Indirect labor: Any other laborer who helps the productive labor in performing their duties is known as indirect labor. The nature of their duties is such that their wages cannot be charged directly to a particular job but are charged on the total number of products produced in the plant during a particular period. Foremen, supervisors, inspectors, security staff, gatekeepers, storekeepers, crane drivers, and gang men, etc., are classified as indirect labor.
15.2.3 Expense costs 1. Direct expenses: These are expenses that can be charged directly to a particular job and done for that specific job only. For example, the cost of specific jigs and fixtures, costs of some special patterns, and costs of experimental work on a particular job, etc. 2. Indirect expenses: These are also known as overhead charges, burden, or indirect charges. These can be further classified as a. Factory expenses, including indirect materials or indirect labor b. Administrative expenses or overhead c. Selling expenses d. Distribution expenses
15.3 How the sales price is built up Having understood the individual elements that contribute to the cost of production, let us see how the sales price is built up based on these elements.
15.3.1 The philosophy of fixing of selling price During the sellers’ market era of the mid-20th century, the philosophy in fixing the selling price was Selling price 5 cost of production 1 profit: In other words, whatever may be the cost of production, the required profit is added and the selling price is fixed, irrespective of customers’ choice. The profit is the deciding factor in this philosophy. However, during the buyer’s era, the philosophy has changed to Production cost 5 selling price
profit:
Meaning that the selling price cannot be fixed at random. It is determined by the customers’ choice. You must control the cost of production if you want higher profits, but never by increasing the selling price. Hence, the production cost is the deciding factor in this philosophy.
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15.4 Economic laws governing pricing policy We have seen the cost factors that govern the fixing of selling price. However, there are other non cost factors like demand and supply that indirectly govern the price fixing. For example, for the same production cost, if the demand is high and supply is low, we can take advantage of the situation, though unethical, and increase our profits by increasing the sales price. These are governed by laws of economics as discussed in the following paragraphs. In economics, the cost of production features the payments or expenditures essential to get the factors of production of land, labor, capital, and management needed to produce a commodity. Just as there are physical laws governing the behavior of matter, and similarly there are economic laws governing the behavior of society, a scientific law is a statement to the effect that every cause tends to produce some definite result if nothing happens to prevent it. Economic laws are statements of tendencies, statements that under certain conditions suggest that we should expect a definite course of action from a group of human beings. If there is a combination of hydrogen and oxygen, other things being equal, we get water. In economics, other things being equal, if the price of a commodity rises, the demand for it will fall. While Fig. 15.1 indicates how the sales price of a product can be built up based on the cost, the price structure is largely governed by the laws of economics.
FIGURE 15.1 Illustration of how the sales price is built up.
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Let us first distinguish among the terms cost, value, and price. The term cost refers to the actual rupee value spent on all forms to produce the product; price refers to the rupee rate at which it is offered for sale. The term value has two meanings: the “value in use,” which is generally given by utility of the item, is normally referred to as the value in short; the other meaning is the “value in exchange,” which otherwise is called the price.
15.5 Laws of demand and supply In general, it is the forces of demand and supply that determines the price of any goods in the market.
15.6 Law of demand “Other things remaining constant the quantity demanded of any good is inversely related to the price of the good.” In other words, as the price of the good alone is changed, the quantity demanded of that good changes in the opposite direction (it falls when the price is raised and rises when the price is lowered).
15.6.1 Factors influencing demand By demand, in economics, we mean the willingness on the part of a purchaser to buy backed by his ability to pay. The quantity demanded of a good by a household is influenced by four main factors: 1. The price of the goods in the market: A higher market price of a commodity would lead to a reduction in the quantity demanded. This is the law of demand. 2. The size of the household’s income: The larger the household’s income, the greater would be the quantity demanded. 3. Prices of other goods: The degree and nature of this influence depend on the relationship that other goods bear to the good in question. 4. The household’s demand for a good depends on its tastes and preferences.
15.7 The law of diminishing utility Each unit of a commodity gives less utility to the consumer than the foregoing unit, other things being equal, implying the following conditions: 1. The units of the commodity must be similar in quality and quantity. 2. The period of consumption must be the same. 3. The mental outlook of the consumer should remain the same.
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4. The price of the commodity and its substitutes should remain the same. 5. If the period of consumption is long, the fashion, habit, and income of the consumer should remain the same.
15.8 Market demand curve Market demand is the total demand of an item of all the households put together in a community. Hence, market demand curve is the graphical representation of the relationship between the price of the good and the corresponding quantity of the good demanded by all households.
15.9 Elasticity of demand We have seen that a change in the price would result in a change in demand. The rate at which the demand will change when the price changes is called the elasticity of demand. In other words, the elasticity of demand is defined as the percentage change in quantity divided by the percentage change in the price. That is, Ed 5
% change in quantity demanded %change in price
The above equation is the measure of the degree to which the quantity supplied responds to price changes. Note that the elasticities of demand can vary from zero to infinity. If a change in price has no effect on the change in quantity (demanded or supplied), then the elasticity will be zero. At the other extreme, if a small change in price leads to an infinitely large change in quantity (demanded or supplied), the elasticity will be infinity. For example, whatever may be the increase in the price of rice, people cannot reduce their demand and the elasticity is almost zero. However, if there is an increase in the price of one brand of a normally luxury item, like that of a TV, people would immediately stop buying it and switch to other brands. The case where a change in price leads to the same proportion of change in quantity is called unit elasticity. For a single item, the elasticity of demand is unity when the amount demanded at a price multiplied by the price remains constant, irrespective of the price.
15.9.1 Factors governing the elasticity of demand 1. 2. 3. 4.
The The The The
demand demand demand demand
for luxuries is elastic, while that of necessities is inelastic. of a commodity is elastic if it has substitutes. is elastic if the commodity has a variety of uses. is elastic if the use of commodity can be postponed.
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5. The demand is elastic for high and moderately high prices but is inelastic for very low prices. 6. Demand is inelastic if the total sum spent on a commodity forms only a very small part of the total income. 7. Sensibility, acquired tastes, and distances also affect the elasticity of demand. We can see that these factors also indicate the exception for the law of demand.
15.9.2 Uses of the concept of law of demand The concept of elasticity is very important in the theory of value and taxation. 1. It enables the study of the effects of a given rise or a fall of prices on the consumption of a particular commodity. 2. To the monopolist, the concept is still more important. For if the demand is inelastic, it will pay him or her more to fix the price at a high level and thus maximize his monopoly profit. But if the demand is highly elastic, his or her monopoly profits would be maximized if the price is kept low. 3. Similarly, in problems of taxation, we are able to watch the effect of the various taxes on consumption by observing the elasticity of demand for each of the taxed articles.
15.10 Law of supply Supply price is the price at which a certain quantity of a commodity is offered for sale by the sellers. Demand price is the price at which each particular unit will find a buyer. Supply varies with a change in price. If the price increases, supply also increases, and if price falls, supply also falls. Thus both supply and price move together. This is known as the law of supply.
15.10.1 Factors influencing supply 1. 2. 3. 4. 5. 6.
Goals and objectives of the firm Market price of the item Price of other goods Costs of production State of technology Characteristics of the item like perishability
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15.11 Concepts of pricing 1. A change in price will only cause a movement along the demand and supply curves and will not cause either of these curves to shift. 2. Among the economic variables that will shift the demand curve are changes in tastes, incomes, expectations, prices of other goods, and the number of buyers. 3. Among the economic variables that will shift the supply curve are changes in costs, expectations, and the number of sellers. 4. Changes in the equilibrium price and quantity will occur when the demand and/or supply curves shift. These changes are as follows: a. An increase in demand yields a price increase and a quantity increase. b. A decrease in demand yields a price decrease and quantity decrease. c. An increase in supply yields a price decrease and a quantity increase. d. A decrease in supply yields a price increase and a quantity decrease.
15.12 Equilibrium price and competition 15.12.1 Equilibrium price In Sections 15.8 and 15.10, we have compared the demand and supply position. Now let us see their combined effect on the price. Fig. 15.2 is a graphical representation of the demand curve and supply curve. We find that at the point of intersection X, the quantity demanded and the quantity supplied are equal. At this point, there is neither a shortage of demand nor an excess of supply. The market price at which demand just equals the supply is called the equilibrium price. In other words, equilibrium price occurs when the price is such that buyers are willing to buy and the sellers are willing to sell exactly the same
FIGURE 15.2 Equilibrium price.
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quantity. The price will ultimately settle down at a figure that will be known as the equilibrium price.
15.13 General glossary of terms related to demand and supply 1. Demand: A schedule showing the quantity that buyers are willing and able to purchase at each and every price, all other factors remaining unchanged. 2. Demand curve: A graphical presentation of the demand schedule. 3. Complement material: A material is a complement to good X if it is used along with material X. 4. Substitute material: A material is a substitute to good X if it can be used in place of material X. 5. Normal material: A material is normal if the demand for it rises as income rises. 6. Inferior material: A material is inferior if the demand for it falls even as income rises. 7. Supply: A schedule showing the quantity that sellers are willing and able to sell at each and every price, all other factors remaining unchanged. 8. Supply curve: A graphical presentation of the supply schedule. 9. Cost of production: The TC of the resources used by a firm to produce a good. Some costs require immediate money payments; others do not. 10. Equilibrium: The price quantity combinations such that the market is stable and there are no incentives for price and quantity to change. 11. Surplus: The amount by which the quantity supplied is greater than the quantity demanded. Surpluses occur when the price is above the equilibrium price. 12. Shortage: The amount by which the quantity demanded is greater than the quantity supplied. Shortages occur when the price is below the equilibrium price. 13. Price ceiling: (Maximum price) A price ceiling occurs when a regulation stops the price from rising above a given price. 14. Price floor: (Minimum price) A price floor occurs when a regulation stops the price from falling below a given price.
15.14 Equilibrium price versus competition 15.14.1 Equilibrium price under perfect competition Under perfect competition, any firm can sell as much of the product at the market price as it would like. Thus the average revenue (AR) of the firm remains the same irrespective of the quantity of sale. A small increase in price by any one seller drives all the buyers to the other sellers, so that the seller is not able to sell any quantity above the market price.
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15.14.2 Equilibrium price under monopoly A monopolist may be defined as one who is the only seller of a product that has no close substitutes. The industry’s output is entirely supplied by the monopolist. Moreover, the demand curve for the monopolists product becomes the AR curve of the monopolists. Because demand curves are downward sloping, the more he charges, the less he will be in a position to sell.
15.14.3 Equilibrium price under monopolistic competition The two important distinguishing features of monopolistic competition are that there are many sellers and that the goods made by them are close substitutes; that is, their products are similar (not identical). But in sharp contrast to perfect competition, where there is only one homogeneous product being produced by the firms, in monopolistic competition there is product differentiation. On account of differentiation of products, a firm under monopolistic competition has some influence over the price of its product, as in the case of monopoly. But unlike monopoly, there is no barrier to entry of other firms in the long run. The price and output determination under monopolistic competition proceeds on the same basis as in monopoly in the short period.
15.14.4 Equilibrium price under oligopoly Oligopoly, as defined by Investopedia, is a market structure in which a small number of firms has the large majority of market share. An oligopoly is similar to a monopoly, except that rather than one firm, two or more firms dominate the market. It is often noticed that prices in oligopolistic industries are stable. For instance, if demand increases, no firm ventures to raise the price for fear that other firms may not raise the price and it may lose the market. Nor will it lower the price for the fear that other firms may also lower their price and deprive it of any initial advantage.
15.15 Total cost/marginal costs under long-run/short-run conditions In economic theory, there exist several cost concepts related to production. As the output of a firm increases, the average fixed costs and the variable costs get reduced. The control of the cost of production ensures higher profits for a firm, as explained by the concept of economic batch quantity in Chapter 14, Break-even and make or buy analyses. The following discusses in detail the pattern of changes in the short-run costs on account of change in the output being generated by a firm.
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15.15.1 Total costs under short-run conditions Fig. 15.3 shows the relationship of the three short-run TCs output. The dotted lines show the two major components of TCs: TVC and TFC. TC is the summation of these two costs. As you can see, all variations in TC are caused by variations in TVC. The TC curve in Fig. 15.3 is drawn to show traditional assumptions about production cost behavior. TCs first increase at a decreasing rate (increasing returns) and then increase at an increasing rate (diminishing returns). Whereas the TFC of an actual firm would be exactly like that shown in Fig. 15.3, TVC and TC might have considerably different shapes. (However, regardless of shape, TVC and TC must be higher at each higher output.)
15.15.2 Short-run average and marginal costs Fig. 15.4 shows the relationship of the two major short-run costs, average TC (ATC) and MC, to output. The shape of the MC curve corresponds to the assumptions of increasing and diminishing returns that were made when
FIGURE 15.3 Total costs under short-run conditions.
MC
Total Costs
C
ATC
B A O
A’
B’ Output
FIGURE 15.4 Marginal and average total costs under short-run conditions.
C’
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drawing TVC and TC in Fig. 15.4. Diminishing returns occur at output OA. Average TC falls until it equals MC; it is then pulled up by increasing MCs. Output OC, where no more additional output can be produced, is physical capacity.
15.15.3 Long-run average cost curve Fig. 15.5 shows a LRAC curve with three selected short-run ATC curves, each showing a different-sized plant. The long-run average total cost (LATC) is really a planning curve that shows the lowest cost of producing with different-sized plants. Average TCs (ATC2) shows the optimal plant size for this firm; no other plant size can produce at a lower cost per unit. On the other hand, if a firm were operating with ATC1, it could achieve economies of scale by expanding. Finally, we see that ATC3 is experiencing diseconomies of scale from overexpansion. The LATC in Fig. 15.5 has been drawn as U-shaped curve to show both economies and diseconomies of scale. Actual LATCs may have different shapes.
15.15.4 Why the average cost curve is always cup-shaped The total average costs have two elements: the variable average costs that increase with production quantity and the fixed average costs that decrease as the production quantity increases. Thus the total average cost—FC 1 VC is always cup-shaped, reaching a minimum value at what is known as economic batch productions quantity. This is similar to economic order quantity in materials management.
15.16 Total average and marginal revenue Every increase in output by a firm adds to its costs, but it also enables it to earn more revenue if the increased output can be sold in the market (Fig. 15.6).
FIGURE 15.5 Average total costs under long-run conditions.
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FIGURE 15.6 Marginal revenue and marginal cost curves.
15.16.1 Total revenue The income earned by a producer from selling a given amount of a good is called the total revenue (TR) from the sales of the good. For example, if a producer sells 50 units of a good at a price of Rs. 2/- per unit, then the TR would be Rs. 100/-. Or in symbols, TR 5 P 3 Q, where TR denotes total revenue, P is the price, and Q is the number of units of the goods sold.
15.16.2 Average revenue AR is the revenue earned per unit of output or AR: AR 5
TR Q 5P3 5P Q Q
From this, we see that the AR is equal to the price.
15.16.3 Marginal revenue Marginal revenue (MR) is the additional or extra revenue earned as a result of the sale of one additional unit.
15.16.4 Relationship among total revenue, average revenue, and marginal revenue The relationship between AR and MR thus may be summed up as follows: 1. When AR is falling, MR is less than AR. 2. When AR is rising, MR is greater than AR. 3. When AR is constant (neither increasing nor falling), MR 5 AR.
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15.17 Conclusion While selling prices are determined by the tangible cost factors like cost of production, other economic factors like demand and supply also play a role in determining the selling price by adjusting the profit margin. An appreciation of this fact helps the companies to stay ahead in competition.
Further reading 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.
https://en.wikipedia.org/wiki/Cost-of-production www.businessdictionary.com/definition/cost-of-production www.economicsonline.co.uk/Business_economics www.whatiseconomics.org www.dummies.com/.../how-to-calculate-product-costs www.accountingtools.com www.investopedia.com https://en.wikipedia.org/wiki/Supply_and_demand www.britannica.com https://en.wikipedia.org/wiki/Economic_equilibrium_price www.tutor2u.net/economics/reference/equilibrium www.yourarticlelibrary.com/...average-and-marginal-revenue www.economicsdiscussion.net https://en.wikipedia.org/wiki/Marginal_revenue Kaul, S., 1978. An Introduction to Economic Theory. NCERT.
Criteria questions (The figures in the bracket provide a clue to the answer.) 1. Distinguish among: (15.1) a. Fixed costs and variable costs b. Economic costs and opportunity costs c. Average costs and MC 2. Explain with a diagram the various components of sales price. (15.3) 3. (a) Describe the various classifications of costs in production. (15.15.3) i. Represent how selling price is built up. 4. (a)Why the average cost curve is U-shaped. (15.14) i. Explain the nature long-run average cost curve. ii. Explain short-run average and MCs. 5. Explain with illustrations the law of demand and supply. (15.6) 6. What is your concept of the philosophy of determining the selling price? (15.3) 7. Explain the equilibrium conditions in (15.14) a. Perfect competition b. Monopolistic competition c. Oligopoly 8. Distinguish among: (15.15)
Cost of production Chapter | 15 a. Economies of scale and diseconomies of scales b. Short-run and long-run production situations c. Physical capacity and economic capacity of a plant 9. Answer if the following statements are true or false. (15.14) In monopolist competition, the long-period equilibrium occurs when a. Average Cost (AC) 5 AR 5 MC 5 MR b. In perfect competition at all levels of the firm, AR 5 MR.
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Cost of production Chapter takeaways After completion of this chapter the reader would be able to 1. 2. 3. 4. 5.
Understand the various elements of production cost and their interrelationship. Appreciate the vacuous stages at which the cost gets added. Distinguish between the direct and indirect elements of labor and material costs. Appreciate the economic theories and laws of demand and pricing. Understand the pattern of change in average fixed cost and the variable cost as the output of a firm increases. 6. Be able to draw cost curves that affect factory costing. 7. Understand the term equilibrium price and appreciate how it influences product pricing.
15.1 Definitions of terms related to production cost 1. Short run: The production situation where the firm’s operations are restricted by one or more inputs that are fixed in size. For example, in the short run, a firm must confine its operations to buildings of a certain size. In the short run, both fixed and variable costs are significant for the price fixation. 2. Long run: When the firm has the opportunity to vary the size of all its inputs—for example, the firm may build or rent any size building but the fixed costs have less bearing in the unit price. 3. Fixed costs: These are the costs the firm incurs whether or not it operates during the period. For example, building cost, equipment cost, and also property taxes. 4. Variable costs: Those costs increase with each additional unit produced, for example, material and labor costs. 5. Accounting costs: Those costs are the monetary value of economic resources used in performing an activity. See also economic costs. 6. Economic costs: When all costs of using resources to produce some output are included. This usually requires adding some implicit resources costs to accounting costs. For example, if a building is owned by the firm, rent expenses are not an accounting cost, but it must be included in economic cost. Production Planning and Control. DOI: https://doi.org/10.1016/B978-0-12-818364-9.00015-9 Copyright © 2019 BSP Books Pvt. Ltd. Published by Elsevier Inc. All rights reserved.
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7. Opportunity cost: It is a cost figure determined by considering what a resource would be worth if it was being used in its next best alternative. Opportunity costs should be used to compute the true economic costs of production. 8. Total cost (TC): Total fixed cost (TFC) plus total variable cost (TVC). 9. Average fixed cost: TFC divided by output (fixed cost per unit). 10. Average variable cost: TVC divided by output (variable cost/unit). 11. Average TC: TC divided by output (TC per unit). 12. Marginal cost (MC): The additional cost required to produce another unit of output. 13. Diminishing marginal returns: When an additional unit of an input adds less to total output than a previously added input. When this occurs, MCs will begin increasing. 14. Economies of scale: When a larger size plant produces output at a lower unit cost. These economies can be attributed to specialization and technological advantages. 15. Diseconomies of scale: When a larger size plant produces output at a higher unit cost. Problems of coordination are usually blamed for diseconomies. 16. Physical plant capacity: That output level when no more output can be produced from a given-sized plant. 17. Economic capacity: That output level where short-run average costs (LRACs) are minimized. This frequently occurs before physical capacity is reached.
15.2 Components of cost 15.2.1 Material costs 1. Direct materials: These are materials that when operated or processed in factory shops through various stages form the final useful shape of the main product or the component part of the main product. These are also known as productive materials. 2. Indirect materials: These are materials that are essentially needed in various shops for helping the materials to be converted into final useful shapes.
15.2.2 Labor costs 1. Direct labor: The laborers who actually work and process the different materials manually or with the aid of machines are known as direct labor or productive labor. The nature of their duties is such that their wages can be directly charged to the job they are manufacturing. The wages of workers engaged to operate various production machines in machine
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shops, welding shops, pattern-making shops, electric winding shops, and assembly shops, etc., are known as direct labor. 2. Indirect labor: Any other laborer who helps the productive labor in performing their duties is known as indirect labor. The nature of their duties is such that their wages cannot be charged directly to a particular job but are charged on the total number of products produced in the plant during a particular period. Foremen, supervisors, inspectors, security staff, gatekeepers, storekeepers, crane drivers, and gang men, etc., are classified as indirect labor.
15.2.3 Expense costs 1. Direct expenses: These are expenses that can be charged directly to a particular job and done for that specific job only. For example, the cost of specific jigs and fixtures, costs of some special patterns, and costs of experimental work on a particular job, etc. 2. Indirect expenses: These are also known as overhead charges, burden, or indirect charges. These can be further classified as a. Factory expenses, including indirect materials or indirect labor b. Administrative expenses or overhead c. Selling expenses d. Distribution expenses
15.3 How the sales price is built up Having understood the individual elements that contribute to the cost of production, let us see how the sales price is built up based on these elements.
15.3.1 The philosophy of fixing of selling price During the sellers’ market era of the mid-20th century, the philosophy in fixing the selling price was Selling price 5 cost of production 1 profit: In other words, whatever may be the cost of production, the required profit is added and the selling price is fixed, irrespective of customers’ choice. The profit is the deciding factor in this philosophy. However, during the buyer’s era, the philosophy has changed to Production cost 5 selling price
profit:
Meaning that the selling price cannot be fixed at random. It is determined by the customers’ choice. You must control the cost of production if you want higher profits, but never by increasing the selling price. Hence, the production cost is the deciding factor in this philosophy.
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15.4 Economic laws governing pricing policy We have seen the cost factors that govern the fixing of selling price. However, there are other non cost factors like demand and supply that indirectly govern the price fixing. For example, for the same production cost, if the demand is high and supply is low, we can take advantage of the situation, though unethical, and increase our profits by increasing the sales price. These are governed by laws of economics as discussed in the following paragraphs. In economics, the cost of production features the payments or expenditures essential to get the factors of production of land, labor, capital, and management needed to produce a commodity. Just as there are physical laws governing the behavior of matter, and similarly there are economic laws governing the behavior of society, a scientific law is a statement to the effect that every cause tends to produce some definite result if nothing happens to prevent it. Economic laws are statements of tendencies, statements that under certain conditions suggest that we should expect a definite course of action from a group of human beings. If there is a combination of hydrogen and oxygen, other things being equal, we get water. In economics, other things being equal, if the price of a commodity rises, the demand for it will fall. While Fig. 15.1 indicates how the sales price of a product can be built up based on the cost, the price structure is largely governed by the laws of economics.
FIGURE 15.1 Illustration of how the sales price is built up.
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Let us first distinguish among the terms cost, value, and price. The term cost refers to the actual rupee value spent on all forms to produce the product; price refers to the rupee rate at which it is offered for sale. The term value has two meanings: the “value in use,” which is generally given by utility of the item, is normally referred to as the value in short; the other meaning is the “value in exchange,” which otherwise is called the price.
15.5 Laws of demand and supply In general, it is the forces of demand and supply that determines the price of any goods in the market.
15.6 Law of demand “Other things remaining constant the quantity demanded of any good is inversely related to the price of the good.” In other words, as the price of the good alone is changed, the quantity demanded of that good changes in the opposite direction (it falls when the price is raised and rises when the price is lowered).
15.6.1 Factors influencing demand By demand, in economics, we mean the willingness on the part of a purchaser to buy backed by his ability to pay. The quantity demanded of a good by a household is influenced by four main factors: 1. The price of the goods in the market: A higher market price of a commodity would lead to a reduction in the quantity demanded. This is the law of demand. 2. The size of the household’s income: The larger the household’s income, the greater would be the quantity demanded. 3. Prices of other goods: The degree and nature of this influence depend on the relationship that other goods bear to the good in question. 4. The household’s demand for a good depends on its tastes and preferences.
15.7 The law of diminishing utility Each unit of a commodity gives less utility to the consumer than the foregoing unit, other things being equal, implying the following conditions: 1. The units of the commodity must be similar in quality and quantity. 2. The period of consumption must be the same. 3. The mental outlook of the consumer should remain the same.
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4. The price of the commodity and its substitutes should remain the same. 5. If the period of consumption is long, the fashion, habit, and income of the consumer should remain the same.
15.8 Market demand curve Market demand is the total demand of an item of all the households put together in a community. Hence, market demand curve is the graphical representation of the relationship between the price of the good and the corresponding quantity of the good demanded by all households.
15.9 Elasticity of demand We have seen that a change in the price would result in a change in demand. The rate at which the demand will change when the price changes is called the elasticity of demand. In other words, the elasticity of demand is defined as the percentage change in quantity divided by the percentage change in the price. That is, Ed 5
% change in quantity demanded %change in price
The above equation is the measure of the degree to which the quantity supplied responds to price changes. Note that the elasticities of demand can vary from zero to infinity. If a change in price has no effect on the change in quantity (demanded or supplied), then the elasticity will be zero. At the other extreme, if a small change in price leads to an infinitely large change in quantity (demanded or supplied), the elasticity will be infinity. For example, whatever may be the increase in the price of rice, people cannot reduce their demand and the elasticity is almost zero. However, if there is an increase in the price of one brand of a normally luxury item, like that of a TV, people would immediately stop buying it and switch to other brands. The case where a change in price leads to the same proportion of change in quantity is called unit elasticity. For a single item, the elasticity of demand is unity when the amount demanded at a price multiplied by the price remains constant, irrespective of the price.
15.9.1 Factors governing the elasticity of demand 1. 2. 3. 4.
The The The The
demand demand demand demand
for luxuries is elastic, while that of necessities is inelastic. of a commodity is elastic if it has substitutes. is elastic if the commodity has a variety of uses. is elastic if the use of commodity can be postponed.
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5. The demand is elastic for high and moderately high prices but is inelastic for very low prices. 6. Demand is inelastic if the total sum spent on a commodity forms only a very small part of the total income. 7. Sensibility, acquired tastes, and distances also affect the elasticity of demand. We can see that these factors also indicate the exception for the law of demand.
15.9.2 Uses of the concept of law of demand The concept of elasticity is very important in the theory of value and taxation. 1. It enables the study of the effects of a given rise or a fall of prices on the consumption of a particular commodity. 2. To the monopolist, the concept is still more important. For if the demand is inelastic, it will pay him or her more to fix the price at a high level and thus maximize his monopoly profit. But if the demand is highly elastic, his or her monopoly profits would be maximized if the price is kept low. 3. Similarly, in problems of taxation, we are able to watch the effect of the various taxes on consumption by observing the elasticity of demand for each of the taxed articles.
15.10 Law of supply Supply price is the price at which a certain quantity of a commodity is offered for sale by the sellers. Demand price is the price at which each particular unit will find a buyer. Supply varies with a change in price. If the price increases, supply also increases, and if price falls, supply also falls. Thus both supply and price move together. This is known as the law of supply.
15.10.1 Factors influencing supply 1. 2. 3. 4. 5. 6.
Goals and objectives of the firm Market price of the item Price of other goods Costs of production State of technology Characteristics of the item like perishability
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15.11 Concepts of pricing 1. A change in price will only cause a movement along the demand and supply curves and will not cause either of these curves to shift. 2. Among the economic variables that will shift the demand curve are changes in tastes, incomes, expectations, prices of other goods, and the number of buyers. 3. Among the economic variables that will shift the supply curve are changes in costs, expectations, and the number of sellers. 4. Changes in the equilibrium price and quantity will occur when the demand and/or supply curves shift. These changes are as follows: a. An increase in demand yields a price increase and a quantity increase. b. A decrease in demand yields a price decrease and quantity decrease. c. An increase in supply yields a price decrease and a quantity increase. d. A decrease in supply yields a price increase and a quantity decrease.
15.12 Equilibrium price and competition 15.12.1 Equilibrium price In Sections 15.8 and 15.10, we have compared the demand and supply position. Now let us see their combined effect on the price. Fig. 15.2 is a graphical representation of the demand curve and supply curve. We find that at the point of intersection X, the quantity demanded and the quantity supplied are equal. At this point, there is neither a shortage of demand nor an excess of supply. The market price at which demand just equals the supply is called the equilibrium price. In other words, equilibrium price occurs when the price is such that buyers are willing to buy and the sellers are willing to sell exactly the same
FIGURE 15.2 Equilibrium price.
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quantity. The price will ultimately settle down at a figure that will be known as the equilibrium price.
15.13 General glossary of terms related to demand and supply 1. Demand: A schedule showing the quantity that buyers are willing and able to purchase at each and every price, all other factors remaining unchanged. 2. Demand curve: A graphical presentation of the demand schedule. 3. Complement material: A material is a complement to good X if it is used along with material X. 4. Substitute material: A material is a substitute to good X if it can be used in place of material X. 5. Normal material: A material is normal if the demand for it rises as income rises. 6. Inferior material: A material is inferior if the demand for it falls even as income rises. 7. Supply: A schedule showing the quantity that sellers are willing and able to sell at each and every price, all other factors remaining unchanged. 8. Supply curve: A graphical presentation of the supply schedule. 9. Cost of production: The TC of the resources used by a firm to produce a good. Some costs require immediate money payments; others do not. 10. Equilibrium: The price quantity combinations such that the market is stable and there are no incentives for price and quantity to change. 11. Surplus: The amount by which the quantity supplied is greater than the quantity demanded. Surpluses occur when the price is above the equilibrium price. 12. Shortage: The amount by which the quantity demanded is greater than the quantity supplied. Shortages occur when the price is below the equilibrium price. 13. Price ceiling: (Maximum price) A price ceiling occurs when a regulation stops the price from rising above a given price. 14. Price floor: (Minimum price) A price floor occurs when a regulation stops the price from falling below a given price.
15.14 Equilibrium price versus competition 15.14.1 Equilibrium price under perfect competition Under perfect competition, any firm can sell as much of the product at the market price as it would like. Thus the average revenue (AR) of the firm remains the same irrespective of the quantity of sale. A small increase in price by any one seller drives all the buyers to the other sellers, so that the seller is not able to sell any quantity above the market price.
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15.14.2 Equilibrium price under monopoly A monopolist may be defined as one who is the only seller of a product that has no close substitutes. The industry’s output is entirely supplied by the monopolist. Moreover, the demand curve for the monopolists product becomes the AR curve of the monopolists. Because demand curves are downward sloping, the more he charges, the less he will be in a position to sell.
15.14.3 Equilibrium price under monopolistic competition The two important distinguishing features of monopolistic competition are that there are many sellers and that the goods made by them are close substitutes; that is, their products are similar (not identical). But in sharp contrast to perfect competition, where there is only one homogeneous product being produced by the firms, in monopolistic competition there is product differentiation. On account of differentiation of products, a firm under monopolistic competition has some influence over the price of its product, as in the case of monopoly. But unlike monopoly, there is no barrier to entry of other firms in the long run. The price and output determination under monopolistic competition proceeds on the same basis as in monopoly in the short period.
15.14.4 Equilibrium price under oligopoly Oligopoly, as defined by Investopedia, is a market structure in which a small number of firms has the large majority of market share. An oligopoly is similar to a monopoly, except that rather than one firm, two or more firms dominate the market. It is often noticed that prices in oligopolistic industries are stable. For instance, if demand increases, no firm ventures to raise the price for fear that other firms may not raise the price and it may lose the market. Nor will it lower the price for the fear that other firms may also lower their price and deprive it of any initial advantage.
15.15 Total cost/marginal costs under long-run/short-run conditions In economic theory, there exist several cost concepts related to production. As the output of a firm increases, the average fixed costs and the variable costs get reduced. The control of the cost of production ensures higher profits for a firm, as explained by the concept of economic batch quantity in Chapter 14, Break-even and make or buy analyses. The following discusses in detail the pattern of changes in the short-run costs on account of change in the output being generated by a firm.
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15.15.1 Total costs under short-run conditions Fig. 15.3 shows the relationship of the three short-run TCs output. The dotted lines show the two major components of TCs: TVC and TFC. TC is the summation of these two costs. As you can see, all variations in TC are caused by variations in TVC. The TC curve in Fig. 15.3 is drawn to show traditional assumptions about production cost behavior. TCs first increase at a decreasing rate (increasing returns) and then increase at an increasing rate (diminishing returns). Whereas the TFC of an actual firm would be exactly like that shown in Fig. 15.3, TVC and TC might have considerably different shapes. (However, regardless of shape, TVC and TC must be higher at each higher output.)
15.15.2 Short-run average and marginal costs Fig. 15.4 shows the relationship of the two major short-run costs, average TC (ATC) and MC, to output. The shape of the MC curve corresponds to the assumptions of increasing and diminishing returns that were made when
FIGURE 15.3 Total costs under short-run conditions.
MC
Total Costs
C
ATC
B A O
A’
B’ Output
FIGURE 15.4 Marginal and average total costs under short-run conditions.
C’
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drawing TVC and TC in Fig. 15.4. Diminishing returns occur at output OA. Average TC falls until it equals MC; it is then pulled up by increasing MCs. Output OC, where no more additional output can be produced, is physical capacity.
15.15.3 Long-run average cost curve Fig. 15.5 shows a LRAC curve with three selected short-run ATC curves, each showing a different-sized plant. The long-run average total cost (LATC) is really a planning curve that shows the lowest cost of producing with different-sized plants. Average TCs (ATC2) shows the optimal plant size for this firm; no other plant size can produce at a lower cost per unit. On the other hand, if a firm were operating with ATC1, it could achieve economies of scale by expanding. Finally, we see that ATC3 is experiencing diseconomies of scale from overexpansion. The LATC in Fig. 15.5 has been drawn as U-shaped curve to show both economies and diseconomies of scale. Actual LATCs may have different shapes.
15.15.4 Why the average cost curve is always cup-shaped The total average costs have two elements: the variable average costs that increase with production quantity and the fixed average costs that decrease as the production quantity increases. Thus the total average cost—FC 1 VC is always cup-shaped, reaching a minimum value at what is known as economic batch productions quantity. This is similar to economic order quantity in materials management.
15.16 Total average and marginal revenue Every increase in output by a firm adds to its costs, but it also enables it to earn more revenue if the increased output can be sold in the market (Fig. 15.6).
FIGURE 15.5 Average total costs under long-run conditions.
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FIGURE 15.6 Marginal revenue and marginal cost curves.
15.16.1 Total revenue The income earned by a producer from selling a given amount of a good is called the total revenue (TR) from the sales of the good. For example, if a producer sells 50 units of a good at a price of Rs. 2/- per unit, then the TR would be Rs. 100/-. Or in symbols, TR 5 P 3 Q, where TR denotes total revenue, P is the price, and Q is the number of units of the goods sold.
15.16.2 Average revenue AR is the revenue earned per unit of output or AR: AR 5
TR Q 5P3 5P Q Q
From this, we see that the AR is equal to the price.
15.16.3 Marginal revenue Marginal revenue (MR) is the additional or extra revenue earned as a result of the sale of one additional unit.
15.16.4 Relationship among total revenue, average revenue, and marginal revenue The relationship between AR and MR thus may be summed up as follows: 1. When AR is falling, MR is less than AR. 2. When AR is rising, MR is greater than AR. 3. When AR is constant (neither increasing nor falling), MR 5 AR.
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15.17 Conclusion While selling prices are determined by the tangible cost factors like cost of production, other economic factors like demand and supply also play a role in determining the selling price by adjusting the profit margin. An appreciation of this fact helps the companies to stay ahead in competition.
Further reading 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.
https://en.wikipedia.org/wiki/Cost-of-production www.businessdictionary.com/definition/cost-of-production www.economicsonline.co.uk/Business_economics www.whatiseconomics.org www.dummies.com/.../how-to-calculate-product-costs www.accountingtools.com www.investopedia.com https://en.wikipedia.org/wiki/Supply_and_demand www.britannica.com https://en.wikipedia.org/wiki/Economic_equilibrium_price www.tutor2u.net/economics/reference/equilibrium www.yourarticlelibrary.com/...average-and-marginal-revenue www.economicsdiscussion.net https://en.wikipedia.org/wiki/Marginal_revenue Kaul, S., 1978. An Introduction to Economic Theory. NCERT.
Criteria questions (The figures in the bracket provide a clue to the answer.) 1. Distinguish among: (15.1) a. Fixed costs and variable costs b. Economic costs and opportunity costs c. Average costs and MC 2. Explain with a diagram the various components of sales price. (15.3) 3. (a) Describe the various classifications of costs in production. (15.15.3) i. Represent how selling price is built up. 4. (a)Why the average cost curve is U-shaped. (15.14) i. Explain the nature long-run average cost curve. ii. Explain short-run average and MCs. 5. Explain with illustrations the law of demand and supply. (15.6) 6. What is your concept of the philosophy of determining the selling price? (15.3) 7. Explain the equilibrium conditions in (15.14) a. Perfect competition b. Monopolistic competition c. Oligopoly 8. Distinguish among: (15.15)
Cost of production Chapter | 15 a. Economies of scale and diseconomies of scales b. Short-run and long-run production situations c. Physical capacity and economic capacity of a plant 9. Answer if the following statements are true or false. (15.14) In monopolist competition, the long-period equilibrium occurs when a. Average Cost (AC) 5 AR 5 MC 5 MR b. In perfect competition at all levels of the firm, AR 5 MR.
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