Post on 04-Apr-2018
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GROUP
AKSHITA JAIN
SHRUTI PATWA
SUMAN MAHAPATRO
ANUSHA REDDY
SANTOSH SINGH
DEEPAK K S
GANESH MAHARA
AZAM ZIA
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Managerial Economics
Module 4
Analysis of Costs
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CONTENT
Pricing of Factors of Production Factor Markets Land Pricing
Theory, Ricardian Theory of Rent, Opportunity Cost Theory of Rent
Market Demand and Supply of Labour Pricing of Labour Theory,
Marginal Productivity of Labour Theory, Wage bill Theory,
Subsistence Theory of Wage Differential Wages and skills.
Pricing of Capital
Demand and Supply of Loanable funds, Cost of
Capital, Opportunity Cost of Capital, Rewards of Capital, Theory of
Interest Rate and Liquidity preference.
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Factors of Production
Factors of production are the inputs to the
production process. Finished goods are
the output.
Eg. Land, labor, capital and technology are
required in combination at a time to produce
a commodity
Factors of production are any commodities or
services used to produce goods and services.
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Pricing of Factors of Production
When all factors are specific there is no principleof pricing that can be used.
It depends on the fixity or variability in theproportions of the combined factors used perunit of product.
If the factors can be combined only in certainfixed proportions to produce a given quantity ofproduct, then there can be no determinate price
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If the proportions of the factors can be varied
to produce a given result, then the pricing ofeach factor can be isolated and determined.
The prices are usually determined bybargaining, and it is obvious that the
variability in the proportions of the factors
does not aid in any determination of thespecific value or share of each particular
product.
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Example of rise in price
If the price of factor A increases compared to
B, the firm will use less of A and more of B in
producing its product. From this, demand
curves for each factor are deduced, and thepricing of each factor established.
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Factor Markets
'"Factor market'" refers to markets whereservices of the factors of production arebought and sold.
Eg. The market for construction workers bringstogether the buyers and sellers ofconstruction workers services.
The interaction between product and factormarkets involves the principle of deriveddemand.
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Derived demand
Derived demand refers to the demand for
productive resources, which is derived from
the demand for final goods and services or
output.
For example, if consumers demand for new
cars rose, producers will respond by increasing
their demand for the productive inputs orresources used to produce new cars.
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Ricardian Theory of rent
Proposed by - David Ricardo (1772-
1823)
Economic rent on land is the value ofthe difference in productivitybetween
a given piece of land and the poorest
[and/or most distant], most costly
piece of land producing the same
goods (e.g. bushels of wheat) underthe same conditions (of labour, capital,
technology, etc.).
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Opportunity Cost
The opportunity cost of doing A is the value of
any benefit foregone, or given up, by not
doing B; i.e., the value that would have beenproduced by using that factor of production in
the next best alternative opportunity.
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6 suppositions involved in the
concept of economic rent(1) In the initial stage of development, our starting point, with
a stable and low level of population, only the very bestlands are under cultivation: lands that are the most fertile,
the most easily worked, and the closest to the market --the lowest cost lands for producing grain.
(2) With population growth, the eventual diminishing returnson existing cultivated lands force into cultivation new, butinferior or marginal lands: lands that are less fertile,more difficult to work, and further from the market,involving higher production and transportation costs.
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(3) Thus the necessary consequence of addingon more and more inferior or marginal land isthe rising cost of producing those extra bushelsof grain to feed that growing population. We
assume that all people are fed.
(4) We must also assume that for any given
region, for any one given market zone, there isonly one price, the prevailing price that clearsthe market in that region.
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(5) The final or equilibrium market price for grain willthus equal the cost of producing that last bushel of grain
(under diminishing returns) on that last unit of landforced into production to feed that larger population.
Nobody is going to produce grain for very long at a costhigher than the market price;
Nobody will be foolish enough to sell grain at lowerprice than the prevailing market price.
In fact, as you can now deduce, the level of populationand of demand has really determined the market price ofgrain; for without that increased demand, that last unit ofland would not be producing grain for the market.
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(6) On that last piece of land put under cultivation, total sales
revenue equals total costs, with no surplus or profit. Thefarmer earns just enough to keep him in production, without
seeking alternative employment.
But conversely, on the other lands -- the more productive
and lower cost lands that were put into cultivation earlier --total sales revenues exceed total costs, because costs on
those better lands are lower -- very much lower on the best
lands.
That differential produces a surplus or a profit called
ECONOMIC RENT
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Opportunity cost & Economic Rent
Thus economic rent is the extra amount of earnings that afactor production earns over and above its transfer earnings:
For Ricardos agrarian model: that land had only one use ---
growing grains so: no transfer earnings were possible
Thus: all rent is surplus to what was necessary to keep thatland in its present use growing grain
The difference between the market price for grain and the
costs of producing it was therefore pure economic rent,
which was expropriated by the landlord The tenant would stay on the land so long as his own
transfer earnings were met: so long as he earned enough
not to seek alternative employment.
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Demand for the labour is thenumber of hours of hiringthat an employee is willing to
do based on the variousexternally determinedvariables it is faced with,such as the wage rate.
There is normally an inverserelationship betweendemand for labour and thewage rate.
Demand for labour
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SHIFTS IN THE LABOUR DEMAND
CURVE
MRP will increase when there is
1) an increase in labour productivity.
2) A higher demand for the product.
3) The price of a substitute input.
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The supply of labour
It refers to the number of hours that the
population desires to work in gainful activities.
Labour supply curve is always upward sloping.
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ELASTICITY OF LABOUR SUPPLY
The elasticity of labour supply measures theextent to which labour supply responds to a
change in the wage rate in a given time
period.
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MARGINAL PRODUCTIVITY OF
LABOUR THEORY
Also referred to as the marginal revenue product of labor and
the value of the marginal product .
Is the change in total revenue earned by a firm that results
from employing one more unit of labor.
The marginal revenue product (MRP) of a worker is equal to
the product of the marginal product of labor (MP) and
the marginal revenue (MR), given by MRMP = MRP.
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Mathematical relation MR = TR/Q
MPL= Q/L
MR x MPL= (TR/Q) x (Q/L) = TR/L
As above noted the firm will continue to add units of laboruntil the MRPL = w
Mathematically until :
MRPL = w MR(MPL) = w
MR = w/MPL
MR = MC which is the profit maximizing rule.
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Marginal Revenue Product in a
perfectly competitive market
Under perfect competition, marginal revenue product
is equal to marginal physical product (extra unitproduced as a result of a new employment) multiplied
by price.
MRP = MP * PRICE
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MRP in monopoly or
imperfect competition The MRP curve of a firm in monopoly or imperfect competition
will slope downwards at a faster rate than in perfect
competition. This can be explained as follows:
MPP slopes downwards because of the operation of the Law of
Diminishing Returns. MRP depends on MPP.
Because the firm faces a downward sloping demand curve for
its product, it must lower price to sell extra units of output.
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SUBSISTENCE THEORY OFWAGES
AND DIFFERENTIAL WAGES
AND SKILLS
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The subsistence theory of wages, advanced by David
Ricardo and other classical economists, was based on the
population theory of Thomas Malthus.
It held that the market price of labour would always tend
toward the minimum required for subsistence. If the supply
of labour increased, wages would fall, eventually causing a
decrease in the labour supply if the wage rose above the
subsistence.
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CRITICISM FOR THE THEORY
One-sided
Ambiguous
Unrealistic
Wages not uniform
Exploitation tendency
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WAGE
DIFFERENTIAL
Wage differential is an
element of location selection
that is a wage scalereflecting the average
schedule of workers' pay in
an area that takes into
account the performance of
related tasks or services.
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CLASSIFICATION OF WAGE DIFFERENTIALS
Occupational Differentials
Inter-occupational differentials
Inter-firm Differentials
Inter-area or Regional Differentials
Inter-industry Differentials
Personal Wage Differentials
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COMPENSATING
DIFFERENTIAL WAGES
A compensating differential, which is also called
a compensatingwage differential or
an equalizing difference, is defined as the
additional amount of income that a given worker
must be offered in order to motivate them toaccept a given undesirable job, relative to other
jobs that worker could perform.
The idea of compensating differentials has been
used to analyze issues such as the risk of futureunemployment,the risk of injury, the risk of
unsafe sex, the monetary value workers place
on their own lives.
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DEMAND AND SUPPLY OF LOANABLE
FUNDS
It brings SAVER and BORROWERS together
All HOUSE HOLD and BANKS to finance
Savers supply the loanable funds
Some times borrower use Bonds for loanablefunds
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INTEREST RATE
The interest rate is the cost of borrowing or
demanding loanable funds
It is measured in Annual Percentage Rate
If the firm borrows funds for more than twoyears compound interest is charged
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Compound interest is calculated on both
principal and accumulated unpaid interest
Formula to calculate
Amount repaid = X(1+r)2= time period
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Cost of capital
Cost of capital is a combined cost ofeach type of source by which a firm
raises funds.
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Importance of Cost of capital
Capital Budgeting Decisions
Designing the Corporate Financial Structure
Deciding about the method of financing in
lieu with capital market fluctuations Performance of top management
Other areas eg., dividend policy, working
capital
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Measuring cost of capital
Account for general uncertainty
Various degree of uncertainty
Effects of uncertainty
Differential effects of financing
It must reflect the changes in capital market
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Basic costs of capital
1. Cost of Equity Capital
2. Cost of Preference Shares
3. Cost of Debt
4. Cost of Retained Earnings
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Cost of equity capital
Cost of equity capital is acknowledged as the
rate of return that is necessary to satisfy
commitments made to the common
shareholders of the company.
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Cost of Preference Shares
The preference shareholders carry a prior right to receivedividends over the equity shareholders.
Moreover, preference shares are usually cumulative whichmeans that preference dividend will keep getting
accumulated unless it is paid.
Further, non-payment of preference dividend may entitletheir holders to participate in the management of the firmas voting rights are conferred on them in such cases.
Above all, the firm may encounter difficulty in raisingfurther equity capital mainly because the non-payment ofpreference dividend adversely affects the prospects ofordinary shareholders.
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Cost of debt
Cost of debt is the after-tax cost of long-term
funds through borrowing.
Net cash proceeds are the funds actually
received from the sale of security.
Flotation cost is the total cost of issuing and
selling securities.
Cost of perpetual/irredeemable debt
Cost of redeemable debt
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Cost of Retained Earnings
Retained earnings are dividends withheld,
that is, if they were in the hands of the
investors (shareholders) they could have
earned on these by investing somewhere else.
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Opportunity cost of capital
Opportunity cost of capital is rate of return on
our capital which we get on the investment in
one of best alternative.
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RETURN ON CAPITAL
&RETURN ON INVESTED CAPITAL
ROC = Net operating profit- Adjusted taxes
BV of Debt + BV of Equity- cash
ROIC = Net Operating Profit Adjusted taxes
Invested capital
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RETURN ON INVESTED CAPITAL
Return on invested capital (ROIC) is a financial
measure that quantifies how well a company
generates cash flow relative to the capital it
has invested in its business.
It is defined as net operating profit less
adjusted taxes divided by invested capital andis usually expressed as a percentage.
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LIQUIDITY PREFERENCE THEORY OF
INTEREST
Keynes defines the rate of interest as the reward for
parting with liquidity for a specified period of time.
According to him, the rate of interest is determined by
the demand for and supply of money.
Demand for money: Liquidity preference means the
desire of the public to hold cash. According to Keynes,
there are three motives behind the desire of the publicto hold liquid cash: (1) the transaction motive, (2) the
precautionary motive, and (3) the speculative motive.
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Transactions Motive: The transactions motive relates to
the demand for money or the need of cash for the
current transactions of individual and businessexchanges. Individuals hold cash in order to bridge the
gap between the receipt of income and its expenditure.
This is called the income motive.
Precautionary motive: Precautionary motive for holding
money refers to the desire to hold cash balances for
unforeseen contingencies. Individuals hold some cash to
provide for illness, accidents, unemployment and other
unforeseen contingencies. Similarly, businessmen keep
cash in reserve to tide over unfavourable conditions or
to gain from unexpected deals.
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Speculative Motive: The speculative motive
relates to the desire to hold ones resources inliquid form to take advantage of future changes
in the rate of interest or bond prices. Bond
prices and the rate of interest are inverselyrelated to each other. If bond prices are
expected to rise, i.e., the rate of interest is
expected to fall, people will buy bonds to sell
when the price later actually rises. If, however,
bond prices are expected to fall.
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Thankyou !!!