costs & revenue, 2011
TRANSCRIPT
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Cost of Production
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Marginalism
Independent variable to be changed by just one unit at a time to see impact on the dependent variable
In real world situations difficult to apply concept of Marginalism
Independent variable may be subject to chunk changes rather than unit changes
In such cases concept of marginalism is replaced by “Incrementalism”
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Incrementalism Incremental is about change, not necessarily
one unit e.g. additional revenue due to a change in
packaging, advertizing - incremental revenue Additional cost of packaging, advertizing,
computerization- incremental costs Incrementalism is more general, marginalism is
more specific All marginal concepts are incremental concepts
but all incremental concepts may not be marginal concepts
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Time Perspective Short Run
period of time in which some productive resources are fixed
Change in output can be achieved by changing the intensity of use of fixed factors
Long Run period of time in which all productive resources
(including machinery, buildings, other capital items) are variable
Change in output achieved by adjusting the scale of output, size of firm etc
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Cost concepts relevant for Managerial Decisions & Corporate Planning
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Historic costs Historic cost: the original amount the firm paid for
factors it now owns When firm has paid for a machine – it is historic cost -
is irrelevant Not using it will not bring the money back Money spent- sometimes referred to as “sunk costs” Sunk costs do not change so irrelevant for decision
making Replacement cost: what the firm would have to pay to
replace factors it currently owns
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The Fallacy of Using Historic Costs: there’s no point crying over split milk
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Incremental costs Incremental cost: change in total cost due to change in total output,
revenue etc Incremental Revenue: change in total revenue due to change in level of
output, prices etc Costs which would not be incurred if a particular project is not
undertaken Avoidable costs or added cost Differences in total costs resulting from a change in policy- Differential
costs Variable costs are generally incremental But all incremental costs are not variable, it may include fixed costs
also Incremental costs to be compared with incremental revenue – added
revenue due to change. This is called incremental income Incremental costs are relevant for decision making
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Illustration of Incremental Income
Results of present operation
Expected operating results based on price decrease
Incremental revenue, cost & income
Sales less Variable cost
Rs 10,00,000
Rs 6,00,000
Rs14,00,000
Rs 8,40,000
Rs 4,00,000
Rs 2,40,000
Contribution Margin less Fixed costs
Rs 4,00,000
Rs 2,00,000
Rs 5,60,000
Rs 2,00,000
Rs 1,60,000
Rs ----------
Income Rs 2,00,000 Rs 3,60,000 Rs 1,60,000
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Marginal cost and Incremental cost
Marginal cost deals with unit by unit change in output
Incremental cost is not restricted to a unit change
MC is amount added to TC by a unit increase in output
Incremental cost is related to change in any number of units of output or even change in its quality
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Opportunity Costs
Costs measured in terms of the next best alternative forgone
A manager chooses one course of action sacrificing the other alternative course
All trade off concepts are based on opportunity cost reasoning
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Examples
A machine can produce either ‘A’ or ‘B’ products. The opportunity cost of producing a given quantity of ‘A’ is the quantity of ‘B’ which it would have produced; if that machine can produce 20 units of ‘A’ or 10 units of ‘B’ , then opportunity cost of ‘20A’ is ‘10B’
The opportunity cost of holding Rs 1lakh as cash in hand for one year is 10% interest, which could have been earned had it been kept in the form of fixed deposit in the bank
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What opportunity cost am I experiencing now?
The most money that you could be making if you were somewhere else instead of studying these slides
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Scarcity
Choice
OpportunityCost
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Distinction between Main Cost Concepts
Actual Costs (outlay costs) & Opportunity Costs: Actual costs are costs which the firm incurs while
producing or acquiring a good or service e.g. cost on raw materials, labor, rent, interest etc.
Books of account record this Also called outlay cost, acquisition cost or absolute cost Opportunity costs are the return from the second best
use of firm’s resources which the firm forgoes to avail the return from the best use of resources
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Explicit costs: factors not owned by the firm
Involve direct payment of money to outsiders Expenditures for production that result from
agreements or contracts Payments to non owners of a firm for their
resources Out of pocket costs All explicit costs like rent, wages, salaries,
interest, transport are out of pocket costs
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Implicit costs: factors already owned by the firm
When firm already owns them (e.g. machinery) it does not have to pay money for them
The opportunity costs of using resources owned by the firm
Equal to what the factors could earn for the firm in some alternative use, either within the firm or hired out
Not recognized by accounting system but very important for firms
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Implicit costs: factors already owned by the firm
Examples: A firm owns buildings: opportunity cost of using
them is the rent forgone A firm draws 1 lakh from the bank to invest in
equipment: opportunity cost of this investment is not just the1 lakh(explicit cost) but also the interest forgone(implicit cost)
Owner of the firm could have earned Rs 20000 per mth by working for someone: implicit cost
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Opportunity & Imputed Costs
Opportunity cost is concerned with the cost of sacrificed opportunities
It is comparison between policy that was chosen & policy that was rejected
Imputed costs are a sub division of opportunity costs
Opportunity cost more comprehensive as it relates to all the resources (both borrowed & owned) whereas imputed costs applies only to the self use of the self owned resource
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Incremental & Sunk costs
Incremental costs are the additions to costs resulting from a change in the nature & level of business activity e.g.; change in product line or output level, adding or replacing a machine etc.
Sunk costs are those that do not change by varying the nature or level of business activity e.g. all past costs are sunk costs
Irrelevant for decision making
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Book costs & Out-of pocket costs
Out of pocket costs are those expenses which are current cash payments to outsiders
E.g. explicit costs – wages, salaries, interest, transport etc
Book costs are those which do not involve any cash payments but for them a provision is made in the books of accounts to include them in profit & loss accounts & take tax advantages
They are imputed costs
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Accounting & Economic costs
Accounting costs are the actual or outlay costs Expenditure already incurred on a particular
process or on production Economic costs are both imputed & explicit
costs as well as opportunity costs Costs that matter for business decisions are the
economic costs
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Direct (traceable or assignable ) & Indirect (non- traceable , non- assignable or common) costs
Direct costs have a direct relationship with a unit of operation like a product, process or department of a firm
Indirect costs are those whose source cannot be easily traced to a plant, product , process or department
All direct costs are linked to a particular product/process/deptt , vary with changes in them
All direct costs are variable Indirect costs are both variable & fixed
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Private & social costs
Private costs are those which are actually incurred by a firm for its business activity
Social cost is the total cost to the society due to production of a good e.g. pollution, congestion etc
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To understand profit, what is necessary?
To distinguish between the way economists measure costs and the way accountants measure costs
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What is economic profit?
Economic profit :Total revenue minus total explicit + implicit costs
Accounting profit : Total revenue minus explicit costs
Economic profit is important for decision-making purposes because it includes implicit costs and accounting profit does not
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Profits A carpenter makes accounting profit of Rs 500 Has own shop, also used his own capital- Rs 12000 If he had not started his own business he would have
earned say Rs 100 per month as hired carpenter, Rs 1200 as interest per annum(Rs 100 per month) on his capital, and rent of Rs 200 per month on his shop
Total earnings Rs 400 per month This is opportunity cost of running his business So his economic profit is Rs 100 only
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Costs & inputs
The relationship depends on two elements: The productivity of factors: greater their
productivity the smaller will be the quantity of them needed
Direct link between TP, AP & MP & costs of production
The price of factors: higher their price higher will be the costs of production
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Classifications of Production Costs Fixed Costs
costs that remain constant as output varies Must be paid even if output is zero such as rent
Average Fixed Costs (AFC) =
Variable Costs costs that vary as output changes Costs that are zero when output is zero and vary as output
varies such as wages
Average Variable Costs (AVC) =
produced units ofnumber cost fixed total
produced units ofnumber cost variable total
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Food for Thought…. The following are some costs incurred by a shoe manufacturer.
Decide whether each one is a fixed cost or a variable cost or has some element of both.
(a) The cost of leather (b) The fee paid to an advertising agency (c) Wear and tear on machinery (d) Rent of the factory (e) Electricity for heating and lighting (f) Electricity for running the machines (g) Basic minimum wages agreed with the union (h) Overtime pay.
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Food for Thought The cost of leather The fee paid to an advertising
agency Wear and tear on machinery Rent of the factory Electricity for heating and
lighting Electricity for running the
machines Basic minimum wages agreed
with the union Overtime pay.
Variable Fixed (unless the fee negotiated depends on
the success of the campaign) Variable (the more that is produced, the more
the wear and tear) Fixed Fixed if the factory will be heated and lit to the
same extent irrespective of output, but variable if the amount of heating and lighting depends on the amount of the factory in operation, which in turn depends on output
Variable Variable (although the basic wage is fixed per
worker, the cost will still be variable because the total cost will increase with output if the number of workers is increased)
Variable.
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Classifications of Production Costs
Total Cost (TC) the sum of total fixed cost
and total variable cost at a particular level of output
TC= TFC + TVC Marginal Cost (MC)
the change in total cost resulting from production of one more unit of output
TC/Q = TVC/Q
Average Total Cost (ATC) = AFC+AVC = TC/Q
produced units of numbercost total
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Relationship of AFC, AVC, ATC, and MC
The average variable cost curve decreases, reaches a minimum and then rises in value because of the principle of diminishing returns
The average fixed cost curve continuously declines as total fixed costs are spread over a larger and larger amount of output
The average total cost curve declines until the increase in average variable costs offsets the decrease in average fixed costs then it begins to rise
The marginal cost curve decreases, reaches a minimum, and then rises
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400300200100
1 2 3 4
500600700800
5 6 7 8 9
Short-Run Cost Curves
TCTVC
TFC
TFCCo
st p
er u
nit
Q
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40302010
1 2 3 4
50607080
5 6 7 8 9
Short-Run Cost Curves
ATC
AVC
MC
AFC
Co
st p
er u
nit
AFC
Q
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The Marginal-Average rule When the MC is less than the AC, the AC falls When the MC is greater than the AC, the AC
rises Following this rule, the MC curve intersects
the ATC & AVC curves at their minimum points
When MC decreases it pulls AC down & when MC increases it pushes AC up
When AC is at its minimum it becomes equal to MC
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Short-Run Cost Curves
ATC
AVC
MCC
ost
per
un
it Minimum
Q
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Putting on a Duplicate:Marginal costs of an extra coach
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What is the relationship between the minimum and maximum points of the MR and MP curves?
The maximum point of the MP curve corresponds to the minimum point of the MC curve
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8
2
1 2 4
Marginal Product Curve
6
4
5
10
63
12
To
tal O
utp
ut
Quantity of Labor
Maximum
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Relationship Between Product Curves and Cost Curves
Output
Output
Input
Cost
0
0
B
B
AP
AVC
When average product is increasing, fewer resources are needed per unit of output average variable cost is falling
When average product is declining, more resources are needed per unit of output average variable cost will be increasing
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Relationship Between Product Curves and Cost Curves
Output
Output
Input
Cost
0
0
A
A
MC
MP
Diminishing marginal productivity marginal product increases and marginal cost declines up to point A, and then marginal product decreases marginal cost increases
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Relationship Between Product Curves and Cost Curves
Output
Output
Input
Cost
0
0
A
A
B
B
MC
MPAP
AVC
(a)
(b)
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Optimum output & cost curves
In short run optimum output is one which can be produced at a minimum average cost
Where AC & MC curves intersect AC = MC
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What is the long-run average cost curve?
When all inputs become variable The curve that traces the lowest cost per unit
at which a firm can produce any level of output when the firm can build any desired plant size
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Long-run average cost curve…
When the LAC decreases as output increases, the firm experiences economies of scale
If the LAC curve remains unchanged as output increases, the firm experiences constant returns to scale
If the LAC curve increases, the firm experiences diseconomies of scale
Also called planning curve or envelope curve
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Long Run Average Cost Curve
For every plant size, there is a different short-run average cost curve
Infinite number of plant sizes to choose from infinite number of associated ATC curves
Long run average cost curve, envelopes the short-run cost curves and forms a U-shaped long-run cost curve
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40302010
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Short and Long-run Average Cost Curves
Short-run average total cost curves
Long-run average cost curveQ
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Rs40
Rs30
Rs20
Rs10
2 4 6 8
Rs50
Rs60
Rs70
Rs80
10 12 14 16 18
Long-run Average Cost Curve
Constant returns to scale
Diseconomies of scale
Economies of scale
Q
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Long run Marginal Cost Curve
Derived from short run MC curves LMC intersects LAC at its minimum point-
one & only one plant size whose minimum SAC coincides with minimum LAC
Where SAC = SMC = LAC = LMC This point is the optimum scale of the firm in
the long run
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40302010
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10 12 14 16 18Long-run average & marginal cost curves Q
LRMC
LRAC
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Modern view: L shaped Long Run Average Cost curve
Long run cost can be divided into Production cost & Managerial cost
Modern theory says long run cost curve likely to be L shaped than U shaped
Production costs fall continuously with increases in output while Managerial costs may rise at very large scales of output
The fall in production costs more than offsets the increase in managerial costs, so that LAC continuously falls with increases in scale
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Revenue
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Profit Total Profit is the difference between total
revenue and total cost
total revenue – total cost = profit Normal Profit
amount of profit necessary to induce an entrepreneur to stay in business
Economic Profit revenue in excess of all costs, including normal profit
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Revenue Average revenue (AR)
revenue per unit of output sold AR = TR/Q AR = P
Total revenue (TR) amount of revenue or income received from the sale of a given quantity
of goods or services TR = P x Q
Marginal revenue (MR) change in TR that results from the sale of one more unit of output MR = change in TR/change in Q
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Marginal Revenue Versus Marginal Cost
Marginal revenue (MR) Measures the change in total revenue per additional unit of
output Marginal cost (MC)
Measures the change in total cost per additional unit of output
If MR > MC, profits will increase or losses will decrease as output is expanded
If MR < MC, profits will decrease or losses will increase when output is expanded
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Revenue curves when price is not affected by the firm’s output
Average Revenue: If firm is very small relative to the total market it is likely
to be a price taker Accept the price given by market demand & supply Faces a horizontal demand curve or AR curve Marginal Revenue: In case of horizontal demand curve MR = AR curve Selling one more unit at constant price (AR) merely
adds that amount to TR
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Revenue curves when price is not affected by the firm’s output
Total Revenue: Effect on TR of different levels of sales with a
constant price
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Deriving TR
Quantity(units) Price=AR=MR(Rs) TR(Rs)
020040060080010001200
5555555
0100020003000400050006000
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TR curve for a price taking firm
Output
200
150
100
50
0 10 20 30 40 50 60 70 80 90
Tot
al R
even
ue
TR
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Revenue curves when price varies with output
If firm has relatively large share of the market it will face a downward sloping demand curve- to sell more it must lower the price, raise the price – lower sales
AR = P so AR falls as output increases MR will be less than AR & may even be
negative Why?
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Relationship between price elasticity of demand & MR
If demand is price elastic, a decrease in price will lead to a proportionately larger increase in quantity demanded & hence an increase in revenue
MR will thus be positive Inelastic demand- decrease in price- proportionately
smaller increase in sales- revenues will fall. MR will be negative
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Total Revenue Unlike in case of a price taking firm, the TR
curve is not a straight line It is a curve that rises first then falls As long as MR is positive(demand is price
elastic), a rise in output will raise TR Once MR becomes negative(demand is
inelastic), TR will fall Peak of TR where MR = 0 (price elasticity will
be = to 1)
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Revenues for a firm facing a downward sloping demand curve
Q (units) P = AR (Rs) TR (Rs) MR (Rs)
1234567
8765432
8141820201814
---6420-2-4
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Demand and Marginal-Revenue Curves for a Monopoly
Q
Price, AR, MR
1110
9876543210
–1–2–3–4
Demand(averagerevenue)
Marginalrevenue
1 2 3 4 5 6 7 8
r
Elastic
Inelastic
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8
2
1 2 4
TR of a firm facing a downward sloping demand curve
6
4
5
10
63
12
Q
TR TR
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Total Revenue, Total Cost,and Profit Maximization
The firm will want to produce the quantity that maximizes the difference between total revenue and total cost
Determining the profit maximizing level of output through TR & TC Profit = Total Revenue - Total Cost Total Revenue (R) = Pq Total Cost (C) = Cq Therefore:
)()()( qCqRq
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Profit Maximization in the Short Run
0
Cost,Revenue,
Profit(Rs per year)
Output (units per year)
R(q)Total Revenue
Slope of R(q) = MR
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0
Cost,Revenue,
Profit(Rs per year)
Output (units per year)
Profit Maximization in the Short Run
C(q)
Total Cost
Slope of C(q) = MC
Why is cost positive when q is zero?
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Comparing R(q) and C(q) Output levels: 0-
q0:
C(q)> R(q) Negative profit
FC + VC > R(q)
MR > MC Indicates higher
profit at higher output
0
Cost,Revenue,
Profit(Rs per year)
Output (units per year)
R(q)
C(q)
A
B
q0 q*
)(q
Total Revenue, Total Cost,and Profit Maximization
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Comparing R(q) and C(q) Question: Why is
profit negative when output is zero?
Total Revenue, Total Cost,and Profit Maximization
R(q)
0
Cost,Revenue,
Profit (Rs per year)
Output (units per year)
C(q)
A
B
q0 q*
)(q
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C - R
Total Revenue, Total Cost,and Profit Maximization
q
R MR
q
CMC
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Profit Maximization
Break-Even Point the output level at which total revenue
equals total cost
=
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Short run profit maximization: using total curves
Output
200
150
100
50
0 10 20 30 40 50 60 70 80 90
Cos
t a
nd
Rev
enue
TFC
TC
TR
Distance between TR and TC is the largest
Break-even point output level at which total revenue equals total cost
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Short run profit maximization: using average & marginal curves: to be done separately under each market structure