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Transcript of 1 Ch 6 COST The theory of cost is important to a manager because it provides the foundation for two...
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Ch 6 COSTCh 6 COST
The theory of cost is important to a manager because it provides the foundation for two important production decisions:
1) whether or not to shut down2) how much to produce
Also, this chapter supports the theory of supply.
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““Buy low and sell high”Buy low and sell high”Increasing competitive pressures,changing technology, and customer demand have made it harder for firms to achieve high profit margins by raising their prices
– cost management, restructuring, downsizing etc.
– outsourcing and relocation of manufacturing facilities to low-wage countries
– mergers, consolidations, and then reduced headcount
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Choosing Output:Choosing Output:COSTS REVENUES
Technology & costs of
hiring factors of production
TC curves(short & long run)
AC(short &long run)
MC
Demandcurve
AR
MR
CHECK: produce in SR?close down in LR?
Choose output level
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Which Costs Matter?Which Costs Matter?
Opportunity vs. accounting cost Opportunity cost is the cost associated with
opportunities that are foregone by not putting resources in their highest valued use
Accounting cost considers only explicit cost, the out of pocket cost for such items as wages, salaries, materials, and property rentals
Sunk vs. incremental cost A sunk cost is an expenditure that has been
made and cannot be recovered--they should not influence a firm’s decisions
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Costs in the Short RunCosts in the Short Run Total output is a function of variable
inputs and fixed inputs
Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs)
Fixed costs– costs that do not vary with output levels
Variable costs– costs that do vary with output levels
TC = FC + VC
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Costs in the Short Run Costs in the Short Run continuedcontinued
Q
TC
Q
VC MC
Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:
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Costs in the Short Run Costs in the Short Run continuedcontinued
Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC)
This can be written:
Q
TC
Q
TVC
Q
TFC ATC
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The Determinants of Short-Run The Determinants of Short-Run CostCost
The relationship between the production function and cost can be exemplified by either increasing returns and cost or decreasing returns and cost:– Increasing returns and cost
With increasing returns, output is increasing relative to input and variable cost and total cost will fall relative to output
Decreasing returns and cost With decreasing returns, output is
decreasing relative to input and variable cost and total cost will rise relative to output
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Cost Curves for a FirmCost Curves for a Firm
Unit Costs– AFC falls
continuously and – MC = AVC and ATC
at their minimum – Minimum AVC
occurs at a lower output than minimum ATC due to FC
Output
P
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
AFC
AVCATC
MC
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The Firm’s Short-Run Output The Firm’s Short-Run Output DecisionDecision
Firm sets output at Q1, where SRMC=MR
subject to checking the average condition:– if price is above
SRATC1 firm produces Q1 at a profit
– if price is between SRATC1 and SRAVC1 firm produces Q1 at a loss
– if price is below SRAVC1, firm produces zero output
SRAVC1
£
Output
MR
SRAVC
SRMC
Q1
SRATCSRATC1
SMC = MR
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The firm’s long-run output The firm’s long-run output decisiondecision
The decision:– If the price is at or
above LAC1, the firm produces Q1.
– If the price is below LAC1
– the firm goes out of business
NB: LMC always passes through the minimum point of LAC.
AC1
£
Output(goods per week)
MR
LAC
LMC
Q1
LMC = MR
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The firm’s output decisions – a The firm’s output decisions – a summarysummary
Marginal condition Check whether to produce
Short-rundecision
Long-rundecision
Choose the output levelat which MR = SRMC
Choose the output levelat which MR = LRMC
Produce this output unlessprice lower than SRAVC. Ifit is, produce zero
Produce this output unlessprice is lower than LRAC. Ifit is, produce zero.
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Long-Run Cost FunctionLong-Run Cost Function
The long-run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels.
One of the first decisions to be made by the owner/manager of a firm is to decide the scale of operation (size of the firm).
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Long-Run Average CostLong-Run Average Cost
The LAC is a graph that shows the different scales on which a firm can choose to operate in the long run. Long-run average cost (LRAC) is often assumed to be U-shaped:
LRAC
Av
era
ge
co
st
Output
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Economies of ScaleEconomies of Scale
However, economies of scale occur when long-run average costs decline as output rises:
LRAC
Av
era
ge
co
st
Output
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Economies of ScaleEconomies of Scale
A cost related concept1
When a company is experiencing economies of scale its LRAC declines as output is increasing
Diseconomies of scale:LRAC increasing as output increasing
1 Compare with returns to scale which is a production concept!
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Long-Run Cost Function: Displaying Long-Run Cost Function: Displaying Economies/Diseconomies of ScaleEconomies/Diseconomies of Scale
LRAC
$
Economies of scale Diseconomies of scaleQ
MC increasing
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Economies of scale can be Economies of scale can be classified asclassified as
a) External economies of scaleadvantages that a firm gains
from the expansion and size of the industry as whole industrial clusters
b) Internal economies of scaleadvantages that a firm gains
from increasing the scale of its own operation
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Why a firm can become more Why a firm can become more efficient efficient as the scale of as the scale of production rises?production rises?
Technical economies
Marketing economies
Financial economies
Managerial economies
Risk-bearing economies
Administrative economies
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Why a firm can become more Why a firm can become more inefficient inefficient as the scale of production as the scale of production rises?rises?
Diseconomies of scale: Large enough operation may increase
input prices Disproportionate rise in
transportation costs Red tape Management coordination problems Labor specialization and repetitive
work too little stimulation, productivity suffers
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Primary reason for long-run scale economies is the underlying pattern of returns to scale in the firm’s long-run production function
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Using LRAC as Decision-Making Using LRAC as Decision-Making ToolTool
Which plant size to choose? Both production cost information
and accurate demand forecasts are necessary
The cost structure of the industry will determine the competitive structure of the industry
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The long-run average cost curve The long-run average cost curve LRAC: LRAC: an envelope of short-run cost an envelope of short-run cost
curvescurves
Output
Ave
rage
cos
t SRATC1
Each plant sizeis designed fora given outputlevel
SRATC2
SRATC3
SRATC4
So there is a sequence of SRATCcurves, eachcorresponding toa different optimal output level.
LRAC
In the long-run, plant size itself is variable, and the long-run average cost curve LRAC is found to be the ‘envelope’ of the SRATCs
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TU-91.113 Managerial Economics / Hannele Wallenius
The existence of The existence of economies of scaleeconomies of scale means that in the long run, as the firms means that in the long run, as the firms increases its scale of operation, the LRAC increases its scale of operation, the LRAC of production falls.of production falls.
SRMC
SRMC
SRMC
SRAC
SRAC
SRAC
Units of output
Cos
ts p
er u
nit
($)
LRAC
Each individual scale of the firm will still be subject to diminishing returns and have a U-shaped SRAC curve.
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Minimum Efficient ScaleMinimum Efficient Scale A firm can not expect always to
achieve economies of scale when it expands: at some point it is likely that the further increase in size does not produce any reduction in the average cost per unit– minimum efficient scale (MES)
LRAC
MES Scale of firm
$
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TU-91.113 Managerial Economics / Hannele Wallenius
Increasing LRAC: Diseconomies of Increasing LRAC: Diseconomies of ScaleScale
SRMCSRAC
SRMCSRAC
SRMCSRAC
Units of output
Cos
ts p
er u
nit
($)
LRAC
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Constant Returns to ScaleConstant Returns to Scale
Constant RTS refers to when an increase in scale of operation leads to no change in average costs per unit produced LRAC is horizontal
– when the firm doubles the use of inputs, it will double output
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Production with Two Production with Two (or more)(or more) Outputs--Economies of ScopeOutputs--Economies of Scope
Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output
– producing related products, products that are complementary
the average total cost of production decreases as a result of increasing the number of different goods produced
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Why Advantages May ExistWhy Advantages May Exist
For example:
1) Both use capital and labor
2) The firms share management resources
3) Both use the same labor skills and type of machinery
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Economies of Scope Economies of Scope continuedcontinued
Examples:– Chicken farm--poultry and eggs– Automobile company--cars and
trucks– University--teaching and
research
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An Example: PepsiCo, Inc.
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Economies of Scope Economies of Scope continuedcontinued
Another example is a company like Proctor & Gamble, which produces hundreds of products from soap to toothpaste. They can afford to hire expensive graphic designers and marketing experts who can use their skills across the product lines. Because the costs are spread out, this lowers the average total cost of production for each product
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Degree of Economies of ScopeDegree of Economies of Scope The degree of economies of scope
measures the savings in cost:
– C(Q1) is the cost of producing product Q1
– C(Q2) is the cost of producing product Q2
– C(Q1Q2) is the joint cost of producing both products
– If SC > 0 -- Economies of scope– If SC < 0 -- Diseconomies of scope
)QC(Q
)QC(Q)C(Q)C(Q SC
21,
21,21
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Dynamic Changes in Costs--Dynamic Changes in Costs--The Learning CurveThe Learning Curve
The learning curve measures the impact of worker’s experience on the costs of production
It describes the relationship between a firm’s cumulative output and amount of inputs needed to produce a unit of output
The learning curve implies:
1) The labor requirement falls per unit
2) Costs will be high at first and then will fall with learning
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The Learning CurveThe Learning Curve
Cumulative number of machine lots produced
Hours of laborper machine lot
10 20 30 40 500
2
4
6
8
10
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The Learning CurveThe Learning Curve
Cumulative number of machine lots produced
Hours of laborper machine lot
10 20 30 40 500
2
4
6
8
10
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The Learning CurveThe Learning Curve
Cumulative # of machine lots produced
Hours of laborper machine lot
10 20 30 40 500
2
4
6
8
10
The horizontal axis measures the cumulative number of hours of machine tools the firm has produced
The vertical axis measures the number of hours of labor needed to produce each lot
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Economies of ScaleEconomies of ScaleVersus LearningVersus Learning
Output
Cost($ per unitof output)
AC1
A
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Economies of ScaleEconomies of ScaleVersus LearningVersus Learning
Output
Cost($ per unitof output)
AC1
AB
Economies of Scale
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Economies of ScaleEconomies of ScaleVersus LearningVersus Learning
Output
Cost($ per unitof output)
AC1
AB
Economies of Scale
AC2
Learning C