Lecture 8 Production Costs and Firm Financeflash.lakeheadu.ca/~kyu/B5017/B8.pdf · Kam Yu (LU)...

Lecture 8 Production Costs and Firm FinanceBusiness 5017 Managerial Economics

Kam Yu

Fall 2013

Outline

1 Short-Run Cost Structure of a FirmDefinitionsExample

2 Long Run CostsDefinitionsLong-Run Cost CurvesShifts in Cost CurvesThe Very Long Run

3 Firm FinanceOptions in Firm FinancingContractual Hazards and Safeguards in the Bond MarketsEquity FinancingCase StudyThe Housing Bubble of the Early 2000s

Kam Yu (LU) Lecture 8 Production Costs and Firm Finance Fall 2013 2 / 29

Short-Run Cost Structure of a Firm Definitions

Short Run Costs

Short Run — One or more input factors are fixed (usually capital Kand land T ). Input factors like labour L, energy E , materials M, andother services S are flexible.

Fixed Cost — The implicit and explicit costs of the fixed factors, suchas

FC = rK ,

where r is the rental or opportunity cost of capital.

Variable Cost — Costs that vary with the output level Q, such as

VC = wL.

Total Cost — The total cost to produce an output level Q:

TC = FC + VC.


Short-Run Cost Structure of a Firm Definitions

Short Run CostsAssuming that a firm uses only one fixed input K and one variable input L.

Average Fixed Cost — Fixed cost per unit of output:

AFC =FC

Q=

rK

Q.

Average Variable Cost — Variable cost per unit of output:

AVC =VC

Q=

wL

Q.

Average Total Cost — Total cost per unit of output:

ATC =TC

Q=

FC

Q+

VC

Q=

rK

Q+

wL

Q.

Marginal Cost — The cost of producing one more unit:

MC =d(TC)

dQ=

d(rK )

dQ+

d(wL)

dQ= w

dL

dQ.


Short-Run Cost Structure of a Firm Example

An Example



Short-Run Costs

Graphically,

Fixed cost is a horizontalline.

Variable cost is concave inshape at low output levels.After diminishing marginalreturns kicks in it becomesconvex.

Total cost is the sum of thetwo.



Average and Marginal Costs

AFC is decreasing.

AVC first decreases withoutput but increases afterdiminishing marginal returnskicks in.

ATC is the sum of the AFCand AVC.

MC is the value of the slopeof the TC curve in the lastdiagram.

Note: The vertical intercepts are o↵.

ATC should be 130 and AFC should be

100 at Q = 1.



Relation Between Average and Marginal Costs

When an average curve is decreasing (going down), the marginalcurve must be below it.

When an average curve is increasing (going up), the marginal curvemust be above it.

Consequence: The marginal curve must cut the average curve at thelatter’s minimum point.

The property holds for any average curve and marginal curve.


Long Run Costs Definitions

Definitions

In the long run all input factors can change with respect to theoutput level Q.

Suppose that in the short run capital is fixed at K1.

With increasing output Q, ATC first drops and then rises at anincreasing rate.

Production becomes more and more ine�cient at higher output.

Eventually the firm will invest in more capital, with total equal to K2.

ATC shifts to the right from ATC1 to ATC2.



When Firms Invest in More Capital



Economies of Scale

As capital increases, it is possible that there is a range of outputlevels that the ATC become lower than before.

In this case production exhibits economies of scale (often calledincreasing returns to scale).

This happens when, say, the firm want to increase output from Q to2Q, it uses less than double of all inputs.

Assuming that the input prices do not change, ATC will fall.

Eventually, when firm size become bigger and bigger, internal agencyproblems arise and ATC starts to increase.

The result is called diseconomies of scale.


Long Run Costs Long-Run Cost Curves

Long-Run Average Cost

The output level q1 is the most e�cient scale of the firm given thetechnology of production, internal coordination costs, and externalcontractual hazards. It is equivalent to the optimal firm size in Chapter 7.



Long-Run Average Cost and Marginal Cost

In the long run there is nodistinction between fixedcost and variable cost.

Marginal cost is also definedas the cost of producing onemore unit when all inputfactors are flexible.

For a typical U-shapedLRAC, the marginal costcurve cuts the LRAC at itsminimum point as before.



More Examples



Market Structure

For a U-shaped LRAC curve, the minimum point is called minimume�ciency scale (MES). In a competitive market with many firms,each firm operates at its MES. The market demand then determinesthe number of firms in the market.

For a LRAC with a long horizontal range, e�ciency is constant withinthe range. Firm size in this case is indeterminate.

A falling LRAC will likely result in a natural monopoly. Production ismost e�cient if there is only a single firm in the market.

Exercise: Can you draw the marginal cost curve in each of the abovecases?


Long Run Costs Shifts in Cost Curves

Change in Input Prices

So far we have assumed that input prices such as wage rate andrental rate of capital remain the same.

Consider the e↵ect of an increase in an input price on the short-runcost structure of the firm.

It turns out that the e↵ect depends on whether the price increase ison a fixed input such as capital or a variable input such as labour.

In both cases the average total cost curves shift up but the marginalcost curves behave di↵erently.



Two Cases

1 Increase in variable cost:I Suppose wage rate w goes up. ATC1 shifts up to ATC2 since

ATC =rK

Q+

wL

Q.

I Marginal cost also shifts up from MC1 to MC2 since

MC = wdL

dQ.

I Consequence: Short-run supply curve shifts up.2 Increase in fixed cost:

I Rental rate of capital r goes up. ATC1 shifts up to ATC2.I MC, however, does not change because it is independent of r .I Consequence: Short-run supply curve is una↵ected.



Rises in Input Prices


Long Run Costs The Very Long Run

Evolutionary Economics

In the very long run survival and adaptation to the economicenvironment is more important than short-term profit maximization.

Technology, formal institutions, and informal institutions will evolvetogether.

Results are highly unpredictable (unknown unknowns).

Some thoughts:I The development of IBM Watson on health care and other service

sectors.I Robotic engineering and the future of manufacturing.I The e↵ects of mobile devices on social and economic networking.I Global climate change and energy policy.I Are we running out of fresh water?

For more discussion see Chapter 13 and 14 in Beinhocker.


Firm Finance Options in Firm Financing

Cost Structure and Management Decisions

Cost structure of a firm depends on technology, internal coordinationcosts, and external contractual hazards.

These factors, however, are a↵ected by management decisions.

The behaviours of the managers of a firm of course depend on theincentive structure they face.

In particular, a firm’s financial structure can directly influence therisk-taking behaviour of the executives.

Two broad categories of financing:1 Debt (bank credit or bond issuing)2 Equity


Firm Finance Options in Firm Financing

Debt and Equity

Debt is money borrowed from a bank or corporate bonds issued bythe firm.

The borrower agrees to pay the lenders on certain periods with apredetermined interest rate.

In case of insolvency or bankruptcy, the employees usually have thefirst priority to file a claim on the firm’s remaining assets. Then thebond holders and lenders come next.

Equity owners (or stock holders for a listed company) are investorswho buy shares of the firm and become its residual claimant. That is,the firm’s explicit profit belongs to the equity owners.

Investors choose between bonds and equities to optimize theirinvestment portfolios under risk and uncertainty.

Generally, equities are riskier than bonds. And for this reason theexpected returns on equities are higher than those of bonds.


Firm Finance Contractual Hazards and Safeguards in the Bond Markets

Moral Hazards in the Bond Market

Daily decisions made by a firm, whether short run or long run, carryrisks and uncertainties.

As in investment, riskier decisions on the average result in higherexpected returns.

Imagine a firm issues some bond to raise money for a new project.After the terms are settled, the firm has the incentive to put themoney in another riskier project.

If the project is successful, the firm owners will get the extra returns.If the project fails and the firm is highly leveraged, the bond holderswill bear the consequence.

This moral hazard is the typical contractual hazard faced by bondholders. Naturally, the bond holders want some safeguards built intothe contract.

If the safeguards are not credible, the bonds will be rated asnon-investment grade or “junk bond”.


Firm Finance Contractual Hazards and Safeguards in the Bond Markets

Contractual Safeguards

In the long run it is the firm’s interest to install safeguards in the bondcontracts. Otherwise it would su↵er the high interest cost of being in thejunk bond rating. Common tools available are:

Rights for the bond holders to monitor and/or to constrain the firm’sdegree of leverage.

Use the firm’s general assets as collaterals. General assets usuallyhave high resale values.

Regular briefing and disclosure to the bond holders on the progress ofall investment projects and business strategies.

Generally, firms with a long history of steady revenue stream receive highratings in the bond market.


Firm Finance Equity Financing

Incentive of the Firm Owners

Why would entrepreneurs want to sell part of their companies?

It takes a lot of money to turn an innovation into a commercialsuccess. Just ask Mark Zuckerberg.

The original owners of the firm may also want to diversify theirinvestment when the firm grows bigger. Even Bill Gates owns AppleInc. shares.

Increased fund from equity reduces the firm’s leverage, whichincreases credibility in the bond market.


Firm Finance Case Study

The Saving and Loan Crisis

S&L companies started out in 1930s in the U.S.

The goal was to channel household saving into the mortgage marketmore e�ciently.

Under heavy government regulation, S&L companies had highleverage up to 97%. That is, only 3% of the fund came from theequity owners.

The government provided deposit insurance up to $10,000 in the1970s.

In the early 80s, there were changes in the economic environmentthat made the S&L deposits less attractive (high interest rate,competition from mutual funds, etc.).

President Ronald Reagan (1981–89) initiated a number ofderegulation policies and increased the deposit insurance to $100,000.

The incentive structure created an investment bubble. When thebubble burst, about one quarter of the S&L firms went under.


Firm Finance Case Study

Free Cash Flow Problem

For a firm with steady revenue in a mature industry, the CEO cansometimes find the company awash with cash.

The CEO then faces the incentive to do one or more of the following:1 Increase his or her own perks: buy a corporate jet with a golden

parachute.2 Invest in some pet projects outside the firm’s expertise.3 Promote “corporate social responsibility” by spending money on

charities and social programs.

There are two ways the shareholders can remove the temptation fromthe CEO:

1 Indebtedness as a tool to channel money to the bond holders instead.The reduction in discretionary spending keep the company in focus andenhance it market value.

2 Transfer the free cash flow to the shareholders as dividends.


Firm Finance The Housing Bubble of the Early 2000s

Background

After the S&L crisis, mortgage loans started to move to otherfinancial institutions.

Two quasi-government firms, Freddie Mac and Fannie Mae,underwrote the majority of mortgage loans.

The federal government, under Presidents Bill Clinton and George W.Bush promoted home ownership for Americans, particularly forminority groups.

Financial companies, such as CountryWide Home Loan increased theirmarket shares by lending money to home buyers with low creditratings.

The so-called subprime market ballooned.

Meanwhile, middle class workers used the inflated asset value of theirhouses to support consumption spending.



Pouring Gasoline into the Fire

On the macroeconomic side, the Federal Reserve under AlanGreenspan implemented an expansionary monetary policy to counterthe recession after the burst of the IT bubble in the early 2000s.

China emerged as one of the world top exporters. The cheap importskept the inflation rate in the U.S. at low levels.

To keep exchange rate low and to promote export, China began toaccumulate U.S. Treasury bonds, further depressed the interest rate.

The global financial market was flooded with capital.

Wall Street bankers invented new financial instruments based onsecuritization of mortgage loans.

A perfect storm was thus created.



And the Rest is History


Lecture 8 Production Costs and Firm Financeflash.lakeheadu.ca/~kyu/B5017/B8.pdf · Kam Yu (LU)...

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Transcript of Lecture 8 Production Costs and Firm Financeflash.lakeheadu.ca/~kyu/B5017/B8.pdf · Kam Yu (LU)...