 So, welcome to the second session of managerial economics, so we are on the first module of managerial economics which talks about the introduction and fundamentals of managerial economics. So, in the previous class we introduced the concept of economics basically what is economics, what is managerial economics, how managerial economics is related to other business discipline. Then we discuss about few economic concepts like economic rationality, economic scarcity, three basic questions what the firms addresses and three basic questions what the economy addresses. And then we discuss about the different type of market processes like capitalism, socialism and mixed economy. So, in today's class we will introduce few more concept of economics that what we will be dealing during our course in a different module of managerial economics. So, the first one what we will discuss today is opportunity cost, then we discuss about the profit, then understand the incentive, then marginal and incremental analysis and finally, we discuss that how the model of an economy actually works or what are the different flows into the different sector and practically how the economy works with when there are a number of sectors in the economy. So, starting with opportunity cost I think in everyday life when it comes to using or discussing about the different cost we always talk about a fixed cost or a variable cost. So, opportunity cost is somehow different from this fixed cost and the variable cost. So, if you look at many time we never consider this when you talk about the different cost of production associated with the production of a goods or with the production of the services. Now, how this opportunity cost comes into picture? In last class we are discussing there is always a gap between the ones and the whatever the resources available to satisfy this one. And since there is a gap all the economic agents whether it is a consumer whether it is a producer whether it is a investor or whether it is a economy as a whole they has to make a rational choice in all aspects of business simply because resources are scarce and ones are unlimited. So, since they have to make a choices among all these alternatives it is necessary for them to choose one alternative among various alternatives. So, how they basically do this choice they rank all the alternatives on a priority basis then choose the alternatives which is on the top of the priority list. Resources are scarce, ones are unlimited. So, there are different alternatives to use the resources and they can choose only one alternative among various alternative and how to do that or what is the process to do that basically the economic agent they rank all the alternatives on priority basis then choose the alternatives which is on the top of the priority list. Now, what is the cost associated with this? The cost of this choice is the benefit of the next based alternative foregone and this is opportunity cost. So, when they are making the choice any economic agent when they are making the choice as the first alternative where they are going to utilize use the resources or utilize the resources. Now, what is the cost associated for the choice of this alternative? The choice of this alternative or the cost of the choice of this alternative is the benefit of the next based alternative foregone and this is basically the cost what is associated with choosing this alternative which called opportunity cost. So, choice of this alternative implies sacrifice of other alternatives hence cost of this choice will be evaluated in term of the sacrifice alternative or whatever the benefit the economic agent would have been got from the other alternatives that is the cost associated with this typical choice of alternative. So, the basis is resources are scarce and wants are unlimited. So, any economic agent they have to make a choice on what they have to utilize is the resources and on that basis they choose one alternative where they will utilize the resources and the cost associated for choosing that alternative is basically the opportunity cost and which is generally evaluated in term of the benefit associated with the other alternatives. So, the opportunity cost is the highest valued benefit that must be sacrificed as a result of choosing the alternative. Now, we will take an example suppose a machine it can produce either x or y. So, whatever the resources available with that resources either they can produce x or they can produce y. Now, the opportunity cost of producing a given quantity of x is the quantity of y which the resources should have produced because resources are fixed either they can use that resources to produce x or produce y. So, when we calculate or when we evaluate what is the opportunity cost associated with producing one unit of x or one unit of y it is always in term of the other variable. If we are discussing or if you are evaluating the cost associated with x opportunity cost associated with x it is in term of y and if you are evaluating the opportunity cost associated with y that is always in term of x. So, if the machine can produce if it is either x or y the opportunity cost of producing any given quantity of x is in term of y and the opportunity cost of producing any given quantity of y is in term of x. Suppose, we are assuming that the machine can produce either 10 unit of x or 20 unit of y with the available resources. So, what is the opportunity cost of one x? The opportunity cost of producing one unit of x is 2 y and similarly the opportunity cost of producing one unit of y is 0.5 unit of x because with the available resources either the machine can produce 10 unit of x or it can produce 20 units of y. So, opportunity cost of one unit of opportunity cost of producing one unit of x is 2 unit of y and the opportunity cost of producing one unit of y is 0.5 or half unit of x and when particularly there is no information about the price or no information about the quantity is produced then in that case the opportunity cost is the ratio of their respective prices. So, when there is lack of information about the price or lack of information about the quantity is produced generally the opportunity cost to be evaluate in term of the their price associated with the products or prices to the goods and this is the ratio of their respective prices. We can take one more example which will explain the opportunity cost. Suppose, there is one option that you may be working in your hometown and you have got another job offer which is not in the hometown in a city away from your hometown. Now, what are the choices available over there? The choices available to you is either to continue with the existing job which is there in the hometown or the other offer is to take the offer job offer in the city away from your hometown. Now, if you are selecting the new offer which is away from your hometown you would be forgoing the benefit of staying at home. So, there is sacrifice associated with the new offer you will be away from home and the benefit what you would have got by staying at home you are going to sacrifice that. So, benefit of staying at home is the opportunity cost of selecting the new job. So, this is a scenario where you cannot calculate directly the cost associated with the selection, the cost associated with the taking a new offer rather there is the opportunity cost associated with this decision. So, in this case the opportunity cost of selecting new job is the benefit of staying at home. So, whenever we choose one alternative over another alternative in this case the cost associated with the chosen alternative is always in term of the benefit with the other or the sacrifice with the attach with the other alternative. And the same thing what we have applied over here that the opportunity cost of selecting a new job is the benefit of staying at home. Suppose, we take one more example where the firm has make a choice between the buying new computer for its employing and installing a new server, we are assuming that whatever the funds available for the firm that is limited. So, with the limited fund either the firm can buy a new computer for his employee or they can install new server. So, if the firm opts to purchase the server the alternative of buying computer is foregone and would be opportunity cost of buying the server. So, either they can use this fund to purchase the server or they can use this fund for buying the computers. So, if the firm is choosing over buying computer to purchase the server then the opportunity cost of buying the server is equal to the whatever the alternatives of buying computer. So, there are always so this whatever in the previous two examples we have taken only there are two choices. But when it comes in the reality we have many choices and we when it comes to decide about the utilization of the resources or utilization of the fund we always rank them on the basis of priority and we take the first one and the opportunity cost of the first alternative is always whatever the benefit associated with the other alternatives what we have not chosen for utilizing this resources. So, maybe in this case we can take one more example particularly from the student perspective. See you have to study maybe the number of subject in a day and maybe you assign two hours for each of these subjects. When you spend more than two hours on a typical subject then basically in this case you are sacrificing whatever the time you would have spent for studying the other subject. So, now what is the opportunity cost of study a typical subject for more than two hours whatever the benefit you would have got by spending that time in studying the other subjects. So, opportunity cost is that there are always two choices or the number of choices the economic has agent has to be rational and they have to identify which one is the rational decision where they can utilize the resources in order for in order to get the optimal output or in order to get the optimal outcome. Next we will discuss about the profit because if you look at now what is the optimization problem for the firm or what is the objective firm objective of the firm or what is the goal of a manager to maximize the profit from their production. So, whether it is the goal of the manager whether it is the goal of the firm it is always the maximization of profit is the objective or maximization of profit is their optimization problem. So, to reach to the profit we will first find out what is the cost associated with the resources. There are three types of cost associated with the resources one is opportunity cost about which we have just discussed now then market supplied resources and the third category is owner supplied resources. So, in case of opportunity cost as you have discussed when you narrow down into the case of a firm now what is the opportunity cost what the firm owners give up to use resources to produce goods and services. Whatever the resources they are utilizing to produce goods and services that has some alternate use or alternate utilization the benefit of the alternate use or alternate utilization is the opportunity cost to produce the goods and services by the firm. So, the first category of cost associated with the firm is the opportunity cost what the firm owners give up to use resources to produce goods and services because the same resources could have been used to produce some other goods and services or may be the resources could have been used for some other economic activity. The second type of cost comes here is that cost associated with the market supplied resources. Now, what is market supplied resources there are two kind of resources one is market supplied resources and second is owner supplied resources. In case of market supplied resources it is owned by others basically these resources are higher rented or leased and this is being used by the firm. This is not the firm's resources this is not the owner's resources. This resources owned by the other economic agent and in order to use that in order to utilize that basically the firm highest rents or they get this in the form of the lease. The second category of resources is owner supplied resources. This is basically owned and used by the firm. In case of market supplied resources it is owned by others but used by the firm but in case of owner supplied resources it is also used by the firm and it also owned by the firm. So, this is basically the firm's resources used by the firm itself. Now, how we will find out the economic cost associated with the resources? Basically this is the sum of the opportunity cost of both market supplied resources and owner supplied resources. Now, two type of cost again comes here. Total economic cost is always the cost of both market supplied resources and owner supplied resources. We are saying it opportunity cost because in case of owner supplied resources this is owned by the firm and sometimes it may happen that there is no valuation because this is owned by the firm and there is always a opportunity cost even if there is no direct cost associated with the firm. Now, two category of cost. One is explicit cost and second one is the implicit cost. Explicit cost is one where there is a direct monetary payment to the owners of the market supplied resources. Because this is not owned by the firm, this is owned by the some other economic agent whenever the firm uses this they have to make the payment. If you remember in last class we discussed about four type of factor of production. All factor of production is one kind of resources. If the land belongs to someone else then we have to pay the rent which comes under this monetary payment which comes under the explicit cost. If the capital is has been taken from a financial institution we have to make get the interest rate or we have to pay the interest rate to the financial institution that comes under the monetary payment which comes under the explicit cost. Similarly, if you look at if the manager is not the owner then the manager has to be the owner has to pay the salary and part of its profit because he is doing the manager is doing the one of the factor of production if you remember the entrepreneurship. So similarly, whatever the skilled or non-skilled manpower required to produce the product there is monetary payment associated with that for the non-skilled labor, non-skilled manpower it is always wages and for skilled manpower it is always the salary. So, monetary payments to owners for market supply resources that comes under the explicit cost. Then we come to the second category of cost that is implicit cost, non-monetary opportunity cost of using owner supplied resources. So, if you look at many time we do not add this implicit cost when you decide the cost of production for the product or cost of production for the services because in case of implicit cost there is all no direct cost there is a opportunity cost. So, implicit cost takes care of all the non-monetary opportunity cost of using the owner supplied resources. So, total economic cost is the sum of opportunity cost of both market supplied resources and owner supplied resources. Then we get two types of cost, one is explicit cost another is implicit cost, explicit cost is the monetary payment for the owners for the market supply resources and implicit cost is associated with the owner supplied resources that is the non-monetary opportunity cost. Now, all the activity that comes under the direct payment that is always in the under the explicit cost. Now, what are the different types of implicit cost? We will take few examples. Opportunity cost of cash provided by the owners like whatever the equity capital if you look at it is firms own resources there is no payment for this this is owned by the firm and used by the firm. So, opportunity cost of the cash provided by the owner this is one kind of implicit cost if you look at the there is no direct payment for this. The second one comes second example comes here opportunity cost of using the land or the capital owned by the firm. Suppose, the product is getting produced in the owner's resources the owner is having a piece of land and that economic activity or the production activities is by using that particular piece of land. In this case there is no payment associated for using the land or using this typical input. So, there is a opportunity cost of using that land if the land is not being used by the firm itself there is alternate value of this the land may be has the land may have got some amount of rent if it is getting used by some other firms or for some other economic activity. Similarly, opportunity cost of owners time spend in managing or working of the firm it comes when the owner is managing or the owner is the manager of the firm in that case the owner whatever the time spent by the owners or what on managing and working for the firm there is no value or the owner is not charging any money or owner is not getting any payment for this. So, there is no direct cost rather there is a opportunity cost of owners time spend in the managing or working for the firm. So, these are the type of cost where there is no direct cost there is opportunity cost and these are all comes under the implicit cost. Now, we will see after discussing the different types of cost how we get into the profit as we know profit is always revenue minus cost the difference between the revenue and the cost is profit. We will see two types of profit here one is economic profit and second one is accounting profit. In case of economic profit it is the difference between the total revenue and the total economic cost. In case of this total economic cost again this such two part one is explicit cost another is implicit cost. The second kind of profit accounting profit it is more straightforward more general here we are not considering the implicit cost only we are considering the explicit cost. So, accounting profit is the total revenue minus the explicit cost. So, economic profit is total revenue minus total economic cost total economic cost it includes both the explicit cost and the implicit cost. In case of accounting profit we are not including the implicit cost we are including only the explicit cost. So, accounting profit is the difference between the total revenue and the explicit cost. Accounting profit does not subtract the implicit cost from the total revenue we are discussing just that. Farm owners must cover all cost all resources used by the firm. But what is a rational way the rational way is when the owners where the firm owners they are considering the all the type of cost associated for all resources used by the firm. What is the background for this? The background for is that objective is to maximize the economic profit not the accounting profit. What is the goal of the firm? The goal of the firm is profit maximization. Now, what profit maximization? Economic profit maximization. Economic profit maximization because it consider all this type of cost explicit and implicit cost. If the maximization is accounting profit then in that case they are ignoring the implicit cost they are not considering the implicit cost. So, objective of the firm is to maximize the economic profit and for that they should cover all cost associated with all resources used by the firm. Let us consider one example what we take as the implicit cost what we take as the explicit cost what is accounting profit and what is economic profit. Consider a simple example an individual who has a CA degree and considering venturing into the spare part business rather than going for a corporate job. So, a typical individual who is having a qualification of CA degree the always the first choice or the first best choice is that if he is getting a job according to his own qualification. In this case this typical individual is getting into a business venture of spare parts rather than taking a corporate job. He invests 3 lakhs in the business. So, initial capital is 3 lakhs in the business. Now, this is the projected income statement for the year. Total sales is 1 lakh, cost of the goods sold is 40000, the cost of the production gross profit is 60000. So, this is the income statement for the year. The total sales is 1 lakh, the cost of production is 40000. So, revenue minus cost is the gross profit that is rupees 60000. We add few more expenses minus depreciation which is 5000, utility expenditure another 4000, advertising expenditure 10000 and miscellaneous expenses another 5000. This total comes to 24000. So, if you take this expenses deducted from the gross profit then the net account profit is 36000. So, sales is 1 lakh, cost of production is 40000, gross profit is 60000. Few more expenses what we deduct from the gross profit in order to reach the accounting profit, depreciation 5000, utility 4000, advertising 10000, miscellaneous expenses is 5000. The total is 24000. So, if you deduct this from 60000 that the net accounting profit is 36000. Now, what the firm should do? Whether it is matching with their maximization of the profit or there is a mismatch. Please note that this is accounting profit. This is not the economic profit. Why this is accounting profit? Because in this case we have taken revenue minus explicit cost. We have not added the implicit cost over here. Now, if you add implicit cost over here then we will see what is economic profit and whether the firm is maximizing the profit or whether it is in the matching with their objective or matching with their goal or not. Now, what is the implicit cost in this case? The owner has invested 3 lakhs in this business. What is the alternate use of this typical 3000 rupees? If you are putting it in the bank account paying a 5 percent interest rate, assuming the interest rate is 5 percent. If you are not, if the owner is not investing this in the business the other use is this money is to pay in the, to keep it in the bank account and get a 5 percent interest rate. So, assuming this the investment would return 15000 annually. So, this is the opportunity cost associated with the owner supplied resources. This owner supplied resources is the capital what is owned by the firm which is getting used for the production of goods and services. So, it has alternate use and if it is not getting used in the firm then it can get a return of 15000 annually. So, this is one component of the implicit cost and or may be this the opportunity cost of having 3 lakhs invested in the spare part business. So, this 15000 is the part of implicit cost in this case. Then the what is the second implicit cost here? The manager the owner is the manager. So, the second implicit cost is the manager what is the opportunity cost associated with the manager's times and talent. Now, the individual is holding a CA degree. If he is not into this spare part business he would have been working in a corporate and if he is working in a corporate what is the annual wage return or a CA degree may be that is 50000 per month. So, the implicit cost of managing the business rather than working on someone else. So, this is the opportunity cost of doing the business rather than a full time job in the corporate. So, implicit the second implicit cost includes manager times and talent and this is the cost of managing the business rather than working for someone else or working for the corporate. So, if you add this to implicit cost now what is the real economic profit? Accounting profit minus return on invested capital plus the foregone wages these are the two components of implicit cost in this specific case. So, economic cost is economic profit is 36000 minus 15000 what would we have been the cost or the 50000 is the whatever the salary what the individual would have got by taking this taking a job in the corporate. So, that comes to economic profit comes to minus 29000. So, there is a small correction here in the last case we are saying that this is 50000 per month, but this is not 50000 per month this is 50000 per year because we are considering all other figure in a annual basis. So, this 50000 would have been the salary per year and that is why this is the part of the implicit cost. So, now look at the difference between the accounting profit and the economic profit. When we didn't consider the implicit cost in that case the profit is 36000, but in order to maximize the profit one has to add all the cost associated with the resources and when we added the implicit cost the economic profit is coming as minus 29000 which is not as a profit rather this is a loss for the firm. So, doing this venture the individual is not generating profit rather it is incurring loss in the spare business part. So, this is the difference between the accounting profit and the economic profit and firm has to always focus on the maximization of economic profit rather than the accounting profit. Because rational decision making requires that all relevant cost for both explicit and implicit be recognized because if you remember all the economic theory the basis is rationality and rational decision is all the cost has to be included. So, the concept of economic profit accounts for all cost therefore, therefore, is a useful management tool rather than more normally defined concept of economic profit. So, basically if you look at the general understanding is profit is revenue minus cost may be in many cases the implicit cost is not added in the part of cost and that is the reason when the implicit cost is added the concept of economic profit is very useful management tool when it comes to the optimization problem of the firm or the matching the goal and profit matching the goal and objective of the firm.