Mba1014 production and costs 110513

Go Global !Go Global !Managerial Economics :Managerial Economics :Production & CostsProduction & Costs

By

Stephen OngStephen OngVisiting Fellow, Birmingham City UniversityVisiting Fellow, Birmingham City UniversityVisiting Professor, College of Management, Visiting Professor, College of Management,

Shenzhen UniversityShenzhen UniversityMay 2013May 2013

AgendaAgenda

1.1. ProductionProduction

2.2. Cost of productionCost of production

3.3. The Long RunThe Long Run

Learning ObjectivesLearning Objectives

To discuss the production function and its To discuss the production function and its various formsvarious formsTo provide examples of types of inputs into a To provide examples of types of inputs into a production function for a manufacturing or production function for a manufacturing or service companyservice companyTo understand the law of diminishing returnsTo understand the law of diminishing returnsTo discuss the cost function and distinguish To discuss the cost function and distinguish between economic cost and accounting costbetween economic cost and accounting costTo explain how the concept of relevant cost is To explain how the concept of relevant cost is usedused

To understand total, variable, average and To understand total, variable, average and fixed costfixed cost

To distinguish between short-run and long-To distinguish between short-run and long-run costrun cost

To provide reasons for the existence of To provide reasons for the existence of economies of scaleeconomies of scale

11ProductionProduction

OverviewOverview

The production functionThe production functionShort-run analysis of average Short-run analysis of average

and marginal productand marginal productLong-run production functionLong-run production functionImportance of production Importance of production

function in managerial function in managerial decision makingdecision making

Production FunctionProduction Function

A A production production function function describes describes the relationship the relationship between a flow of between a flow of inputs and the inputs and the resulting flow of resulting flow of outputs in a outputs in a production production process during a process during a given period of given period of time.time.

Q = f(L, K, M, …)Q = f(L, K, M, …)wherewhere

Q = quantity of outputQ = quantity of output

L = quantity of labour L = quantity of labour inputinput

K = quantity of capital K = quantity of capital inputinput

M = quantity of M = quantity of materials inputmaterials input

Production functionProduction function

Production function: defines the Production function: defines the relationship between inputs and the relationship between inputs and the maximum amount that can be produced maximum amount that can be produced within a given period of time with a given within a given period of time with a given level of technologylevel of technology

Q=f(XQ=f(X11, X, X22, ..., X, ..., Xkk))

Q = level of output Q = level of output

XX11, X, X22, ..., X, ..., Xkk = inputs used in = inputs used in

productionproduction


Key assumptionsKey assumptions

given ‘state of the art’ given ‘state of the art’ production technologyproduction technology

whatever input or input whatever input or input combinations are included in a combinations are included in a particular function, the output particular function, the output resulting from their utilization is resulting from their utilization is at the maximum levelat the maximum level


For simplicity we will often For simplicity we will often consider a production function of consider a production function of two inputs:two inputs:

Q=f(X, Y)Q=f(X, Y) Q = outputQ = output

X = labourX = labour

Y = capitalY = capital


Short-run production function shows Short-run production function shows the maximum quantity of output that the maximum quantity of output that can be produced by a set of inputs, can be produced by a set of inputs, assuming the amount of at least one assuming the amount of at least one of the inputs used remains of the inputs used remains unchangedunchanged

Long-run production function shows Long-run production function shows the maximum quantity of output that the maximum quantity of output that can be produced by a set of inputs, can be produced by a set of inputs, assuming the firm is assuming the firm is free to vary free to vary the amount of all the inputs being the amount of all the inputs being usedused

Short-run analysis of Total, Short-run analysis of Total, Average, and Marginal productAverage, and Marginal product

Alternative terms in reference to inputsAlternative terms in reference to inputs‘‘inputs’inputs’‘‘factors’factors’‘‘factors of production’factors of production’‘‘resources’resources’

Alternative terms in reference to outputsAlternative terms in reference to outputs‘‘output’output’‘‘quantity’ (Q)quantity’ (Q)‘‘total product’ (TP)total product’ (TP)‘‘product’product’

Fixed and Variable InputsFixed and Variable Inputs

A A fixed input fixed input is an input is an input whose whose quantity a quantity a manager manager cannot change cannot change during a given during a given period of period of time.time.

A A variable variable input input is an is an input whose input whose quantity a quantity a manager can manager can change during change during a given period a given period of time.of time.

Short-Run vs. Long-RunShort-Run vs. Long-Run

The The short-runshort-run is a period is a period of time during which at of time during which at least one least one input is fixedinput is fixed,,

while the while the long-runlong-run is a is a period of time during period of time during which which all inputs are all inputs are variablevariable..

Total ProductTotal Product

The total The total quantity of quantity of output output produced with produced with given quantities given quantities of fixed and of fixed and variable inputs.variable inputs.

TP or Q = f(L, K ), TP or Q = f(L, K ), wherewhere

TP or Q = total product TP or Q = total product or total quantity or total quantity producedproduced

L = quantity of labour L = quantity of labour input (variable)input (variable)

K = quantity of capital K = quantity of capital (fixed)(fixed)

Average ProductAverage Product

The amount The amount of output per of output per unit of unit of variable variable input.input.

APAPLL = TP÷L or Q÷L, = TP÷L or Q÷L,

wwherehere

APAPLL = average = average product of labourproduct of labour

Marginal ProductMarginal Product

The additional The additional output output produced with produced with an additional an additional unit of variable unit of variable input.input.

MPMPLL = = ΔΔTP÷TP÷ΔΔL L or or ΔΔQ÷Q÷ΔΔLL

wherewhere

MPMPL L = marginal = marginal product of labourproduct of labour

Total Product CurveTotal Product Curve

Average and Marginal Average and Marginal Product CurvesProduct Curves


Marginal product (MP) = change in Marginal product (MP) = change in output (Total Product) resulting from output (Total Product) resulting from a unit change in a variable inputa unit change in a variable input

Average product (AP) = Total Product Average product (AP) = Total Product per unit of input usedper unit of input used

X

QMPX

X

QAPX

Short-run analysis of Total,Short-run analysis of Total,Average, and Marginal productAverage, and Marginal product

if MP > AP then if MP > AP then AP is risingAP is rising

if MP < AP then if MP < AP then AP is fallingAP is falling

MP=AP when AP MP=AP when AP is maximizedis maximized


Law of diminishing returns: Law of diminishing returns: as additional units of a variable input as additional units of a variable input

are combined with a fixed input, after are combined with a fixed input, after some point the additional output (i.e., some point the additional output (i.e., marginal product) starts to diminishmarginal product) starts to diminish

nothing says nothing says whenwhen diminishing diminishing returns will start to take effectreturns will start to take effect

all inputs added to the all inputs added to the production process have the production process have the same productivitysame productivity

Law of Diminishing Marginal Law of Diminishing Marginal ReturnsReturns

The phenomenon illustrated by The phenomenon illustrated by that region of the marginal that region of the marginal product curve where the curve product curve where the curve is positive, but is positive, but decreasingdecreasing, so , so that total product is increasing that total product is increasing at a decreasing rate.at a decreasing rate.

Do increases in health care Do increases in health care expendituresexpendituresreflect increases in output or do they reflect increases in output or do they reflect inefficiencies in the production reflect inefficiencies in the production process? The United States is relatively process? The United States is relatively wealthy, and it is natural for consumer wealthy, and it is natural for consumer preferences to shift toward more health preferences to shift toward more health care as incomes grow. However, it may care as incomes grow. However, it may be that the production of health care in be that the production of health care in the United States is inefficient.the United States is inefficient.

A PRODUCTION FUNCTION FOR HEALTH CAREA PRODUCTION FUNCTION FOR HEALTH CARE

A PRODUCTION FUNCTION A PRODUCTION FUNCTION FOR HEALTH CAREFOR HEALTH CARE

Additional expenditures on health Additional expenditures on health care (inputs) increase life expectancy care (inputs) increase life expectancy (output) along the production (output) along the production frontier. Points frontier. Points AA, , BB, and , and CC represent represent points at which inputs are efficiently points at which inputs are efficiently utilized, although there are utilized, although there are diminishing returns when moving diminishing returns when moving from from BB to to CC. Point . Point DD is a point of input is a point of input inefficiency.inefficiency.

MALTHUS AND THE FOOD CRISISMALTHUS AND THE FOOD CRISIS

TABLE 2INDEX OF WORLD FOOD PRODUCTION PER CAPITA

YEARYEAR INDEXINDEX

1948-521948-52 100100

19611961 115115

19651965 119119

19701970 124124

19751975 125125

19801980 127127

19851985 134134

19901990 135135

19951995 135135

20002000 144144

20052005 151151

20092009 155155

The law of diminishing marginal The law of diminishing marginal returns was central to the thinking of returns was central to the thinking of political economist Thomas Malthus political economist Thomas Malthus (1766–1834). Malthus predicted that (1766–1834). Malthus predicted that as both the marginal and average as both the marginal and average productivity of labor fell and there productivity of labor fell and there were more mouths to feed, mass were more mouths to feed, mass hunger and starvation would result. hunger and starvation would result. Malthus was wrong (although he was Malthus was wrong (although he was right about the diminishing marginal right about the diminishing marginal returns to labour).returns to labour).Over the past century,technological Over the past century,technological improvements have dramatically improvements have dramatically altered food production in most altered food production in most countries (including developing countries (including developing countries, such as India). As a result, countries, such as India). As a result, the average product of labour and the average product of labour and total food output have increased.total food output have increased.Hunger remains a severe problem in Hunger remains a severe problem in some areas, in part because of the low some areas, in part because of the low productivity of labour there.productivity of labour there.

Cereal yields have increased. The average world Cereal yields have increased. The average world price of food increased temporarily in the early price of food increased temporarily in the early 1970s but has declined since.1970s but has declined since.

MALTHUS AND THE FOOD CRISISMALTHUS AND THE FOOD CRISIS

CEREAL YIELDS AND THE WORLD PRICE OF FOODCEREAL YIELDS AND THE WORLD PRICE OF FOOD


The Three Stages of Production in The Three Stages of Production in the the shortshort run: run:Stage I: Stage I: from zero units of the from zero units of the

variable input to where AP is variable input to where AP is maximized (where MP=AP)maximized (where MP=AP)

Stage II: Stage II: from the maximum AP from the maximum AP to where MP=0to where MP=0

Stage III: Stage III: from where MP=0 onfrom where MP=0 on


In the short run, rational firms should be In the short run, rational firms should be operating only in operating only in Stage IIStage II

Q: Why not Q: Why not Stage IIIStage III? ? firm uses firm uses more more variable inputs to produce less outputvariable inputs to produce less output

Q: Why not Q: Why not Stage IStage I? ? underutilizingunderutilizing fixed capacity, so can increase output per fixed capacity, so can increase output per unit by increasing the amount of the variable unit by increasing the amount of the variable inputinput


What level of input usage within What level of input usage within Stage Stage II II is best for the firm?is best for the firm?

answer depends upon: answer depends upon: •how many units of output the firm canhow many units of output the firm can•sell the price of the product sell the price of the product •the monetary costs of employing the the monetary costs of employing the variable inputvariable input


Total revenue product (TRP) = market Total revenue product (TRP) = market value of the firm’s output, computed value of the firm’s output, computed by multiplying the total product by by multiplying the total product by the market pricethe market price

TRP = Q TRP = Q xx P P


Marginal revenue product (MRP) Marginal revenue product (MRP) = = change in the firm’s TRP resulting from a change in the firm’s TRP resulting from a unit change in the number of inputs usedunit change in the number of inputs used

MRP = MP MRP = MP xx P = P = X

TRP


Total labour cost (TLC) = total cost of using Total labour cost (TLC) = total cost of using the variable input labour, computed by the variable input labour, computed by multiplying the wage rate by the number of multiplying the wage rate by the number of variable inputs employedvariable inputs employed

TLC = w TLC = w xx X X

Marginal labour cost (MLC) = change in total Marginal labour cost (MLC) = change in total labour cost resulting from a unit change in labour cost resulting from a unit change in the number of variable inputs usedthe number of variable inputs used

MLC = wMLC = w


Summary of relationship between Summary of relationship between demand for output and demand for a demand for output and demand for a single input:single input:

A profit-maximizing firm operating in A profit-maximizing firm operating in perfectly competitive output and input perfectly competitive output and input markets will be using the optimal amount markets will be using the optimal amount of an input at the point at which the of an input at the point at which the monetary value of the input’s marginal monetary value of the input’s marginal product is equal to the additional cost of product is equal to the additional cost of using that inputusing that input

MRP = MLCMRP = MLC


Multiple variable inputsMultiple variable inputsConsider the relationship between Consider the relationship between

the ratio of the marginal product of the ratio of the marginal product of one input and its cost to the ratio of one input and its cost to the ratio of the marginal product of the other the marginal product of the other input(s) and their costinput(s) and their cost

k

k

w

MP

w

MP

w

MP

2

2

1

1

Will the standard of living in the United States, Europe, and Will the standard of living in the United States, Europe, and Japan continue to improve, or will these economies barely keep Japan continue to improve, or will these economies barely keep future generations from being worse off than they are today? future generations from being worse off than they are today? Because the real incomes of consumers in these countries Because the real incomes of consumers in these countries increase only as fast as productivity does, the answer depends increase only as fast as productivity does, the answer depends on the labour productivity of workers.on the labour productivity of workers.

LABOUR PRODUCTIVITY AND THE STANDARD OF LIVINGLABOUR PRODUCTIVITY AND THE STANDARD OF LIVING

TABLE 3LABOUR PRODUCTIVITY IN DEVELOPED COUNTRIES

UNITED STATES JAPAN FRANCE GERMANY

UNITED KINGDOM

GDP PER HOUR WORKED (IN 2009 US DOLLARS)

$56.90 $38.20 $54.70 $53.10 $45.80

Years Annual Rate of Growth of Labor Productivity (%)

1960-1973 2.29 7.86 4.70 3.98 2.84

1974-1982 0.22 2.29 1.73 2.28 1.53

1983-1991 1.54 2.64 1.50 2.07 1.57

1992-2000 1.94 1.08 1.40 1.64 2.22

2001-2009 1.90 1.50 0.90 0.80 1.30

Long-run production function Long-run production function

In the In the lonlong run, a firm has enough time to g run, a firm has enough time to change the amount of change the amount of allall its inputs its inputs

The long run production process is The long run production process is described by the concept of returns to scaledescribed by the concept of returns to scale

Returns to scale Returns to scale = the resulting = the resulting increase in total output as all increase in total output as all inputs increaseinputs increase

Long-run production functionLong-run production function

If all inputs into the production process If all inputs into the production process are doubled, three things can happen:are doubled, three things can happen:

output can more than doubleoutput can more than double ‘ ‘increasing returns to scale’ increasing returns to scale’ (IRTS)(IRTS)

output can exactly doubleoutput can exactly double ‘‘constant returns to scale’ constant returns to scale’ (CRTS)(CRTS)

output can less than doubleoutput can less than double ‘‘decreasing returns to scale’ decreasing returns to scale’ (DRTS)(DRTS)


One way to measure returns to scale One way to measure returns to scale is to use a coefficient of output is to use a coefficient of output elasticity:elasticity:

if Eif EQQ > 1 then IRTS > 1 then IRTS

if Eif EQQ = 1 then CRTS = 1 then CRTS

if Eif EQQ < 1 then DRTS < 1 then DRTS

inputsallinchangePercentage

QinchangePercentageQE


Returns to scale can also be Returns to scale can also be described using the following described using the following equationequation

hQ = f(kX, kY)hQ = f(kX, kY)

if h > k then IRTSif h > k then IRTS

if h = k then CRTSif h = k then CRTS

if h < k then DRTSif h < k then DRTS


Graphically, the returns to scale Graphically, the returns to scale concept can be illustrated using the concept can be illustrated using the following graphsfollowing graphs

Q

X,Y

IRTSQ

X,Y

CRTSQ

X,Y

DRTS

Food grown on large farms in the United Food grown on large farms in the United States is usually produced with a States is usually produced with a capital-intensive technology. capital-intensive technology. However, food can also be produced However, food can also be produced using very little capital (a hoe) and a lot using very little capital (a hoe) and a lot of labour (several people with the of labour (several people with the patience and stamina to work the soil). patience and stamina to work the soil). Most farms in the United States and Most farms in the United States and Canada, where labor is relatively Canada, where labor is relatively expensive, operate in the range of expensive, operate in the range of production in which the MRTS is production in which the MRTS is relatively high (with a high capital-to-relatively high (with a high capital-to-labour ratio), labour ratio), whereas farms in whereas farms in developing countries, in which labour is developing countries, in which labour is cheap, operate with a lower MRTS (and cheap, operate with a lower MRTS (and a lower capital-to-labour ratio).a lower capital-to-labour ratio).

A PRODUCTION FUNCTION FOR WHEATA PRODUCTION FUNCTION FOR WHEAT

A PRODUCTION FUNCTION FOR WHEATA PRODUCTION FUNCTION FOR WHEATISOQUANT DESCRIBING THE ISOQUANT DESCRIBING THE PRODUCTION OF WHEATPRODUCTION OF WHEAT

A wheat output of 13,800 A wheat output of 13,800 bushels per year can be bushels per year can be produced with different produced with different combinations of labour and combinations of labour and capital. capital.

The more capital-intensive The more capital-intensive production process is shown production process is shown as point as point AA,,

the more labour- intensive the more labour- intensive process as point process as point BB. .

The marginal rate of technical The marginal rate of technical substitution between substitution between AA and and BB is 10/260 = 0.04.is 10/260 = 0.04.

Estimation of production Estimation of production functionsfunctions Examples of production functionsExamples of production functions

short runshort run: one fixed factor, one variable factor: one fixed factor, one variable factor

Q = f(L)Q = f(L)KK

cubiccubic: increasing marginal returns followed by : increasing marginal returns followed by decreasing marginal returnsdecreasing marginal returns

Q = a + bL + cLQ = a + bL + cL22 – dL – dL33

quadraticquadratic: diminishing marginal returns but no : diminishing marginal returns but no Stage IStage I

Q = a + bL - cLQ = a + bL - cL22

Estimation of production functions Examples of production functionsExamples of production functions

power functionpower function: exponential for one input: exponential for one input

Q = aLQ = aLbb

if b > 1, MP increasingif b > 1, MP increasing

if b = 1, MP constantif b = 1, MP constant

if b < 1, MP decreasingif b < 1, MP decreasing

Advantage: can be transformed into a linearAdvantage: can be transformed into a linear

(regression) equation when expressed in log (regression) equation when expressed in log termsterms

Estimation of production functionsEstimation of production functions

Examples of production functionsExamples of production functions

Cobb-Douglas functionCobb-Douglas function: : exponential for two inputsexponential for two inputs

Q = aLQ = aLbbKKcc

if b + c > 1, IRTSif b + c > 1, IRTS

if b + c = 1, CRTSif b + c = 1, CRTS

if b + c < 1, DRTSif b + c < 1, DRTS


Statistical estimation of production functionsinputs should be measured as ‘flow’

rather than ‘stock’ variables, which is not always possible

usually, the most important input is labour

most difficult input variable is capitalmust choose between time series and

cross-sectional analysis


Aggregate production functions: whole Aggregate production functions: whole industries or an economyindustries or an economy

gathering data for aggregate gathering data for aggregate functions can be difficult:functions can be difficult: for an economy … GDP could be for an economy … GDP could be usedused

for an industry … data from for an industry … data from Census of Manufactures or Census of Manufactures or production index from Federal production index from Federal Reserve BoardReserve Board

for labour … data from Bureau for labour … data from Bureau of Labour Statisticsof Labour Statistics

The Made-in-China Effect The Made-in-China Effect

Importance of production Importance of production functions in managerial functions in managerial decision makingdecision making

Capacity planning: planning the amount Capacity planning: planning the amount of fixed inputs that will be used along of fixed inputs that will be used along with the variable inputs with the variable inputs

Good capacity planning requires:Good capacity planning requires:accurate forecasts of demandaccurate forecasts of demandeffective communication between the effective communication between the

production and marketing functionsproduction and marketing functions


ExampleExample: cell phones: cell phones

Asian consumers want new phone Asian consumers want new phone every 6 monthsevery 6 months

demand for 3G productsdemand for 3G products Nokia, Samsung, SonyEricsson Nokia, Samsung, SonyEricsson must be speedy and flexiblemust be speedy and flexible


ExampleExample: Zara: Zara

Spanish fashion retailerSpanish fashion retailer

factories located close to storesfactories located close to stores

quick response time of 2-4 weeksquick response time of 2-4 weeks


ApplicationApplication: call centers: call centers

service activityservice activity production function isproduction function is

Q = f(X,Y)Q = f(X,Y) where Q = number of callswhere Q = number of calls

X = variable inputsX = variable inputs

Y = fixed inputY = fixed input

Importance of production Importance of production functions in managerial decision functions in managerial decision makingmaking

ApplicationApplication: China’s : China’s workersworkers

Is China Is China running out of running out of workers?workers?

Effect of Effect of industrial industrial boomboom

eg bicycle eg bicycle factory in factory in Guangdong Guangdong ProvinceProvince

22Cost of ProductionCost of Production

Overview

Definition and use of costDefinition and use of costRelating production and costRelating production and costShort run and long run costShort run and long run costEconomies of scope and scaleEconomies of scope and scaleSupply chain managementSupply chain managementWays companies have cut Ways companies have cut

costs to remain competitivecosts to remain competitive

Cost FunctionCost Function

A mathematical or A mathematical or graphic expression that graphic expression that shows the relationship shows the relationship between the cost of between the cost of production and the level production and the level of output, all other of output, all other factors held constant.factors held constant.

Opportunity CostOpportunity Cost

The economic measure of The economic measure of cost that reflects the use of cost that reflects the use of resources in one activity, resources in one activity, such as a production process such as a production process by one firm, in terms of the by one firm, in terms of the opportunities forgone in opportunities forgone in undertaking the undertaking the next best next best alternative alternative activity.activity.

ExplicitExplicit and and ImplicitImplicit Costs Costs

A cost is explicit if A cost is explicit if it is reflected in a it is reflected in a payment to payment to another individual, another individual, such as a wage such as a wage paid to a worker, paid to a worker, that is recorded in that is recorded in a firm’s book a firm’s book keeping or keeping or accountingaccounting system. system.

A cost that A cost that represents the represents the value of using a value of using a resource that is not resource that is not explicitly paid out explicitly paid out and is often and is often difficult difficult to measure to measure because because it is typically not it is typically not recorded in a firm’s recorded in a firm’s accounting system.accounting system.

ProfitProfit

The difference The difference between the total between the total revenue a firm receives revenue a firm receives from the from the salesale of its of its output and the total output and the total cost of producing cost of producing that that output.output.

Accounting vs. Accounting vs. Economic ProfitEconomic Profit

Accounting profit is Accounting profit is the difference the difference between total between total revenue and total revenue and total cost where cost cost where cost includes only the includes only the explicit costs of explicit costs of production.production.

Economic profit is Economic profit is the difference the difference between total between total revenue and total revenue and total cost where cost cost where cost includes both the includes both the explicit and any explicit and any implicit costs of implicit costs of productionproduction..

Short Run Cost Short Run Cost FunctionFunction

A cost function for a A cost function for a short-run production short-run production process in which there is process in which there is at least at least one fixed input one fixed input of productionof production..

Fixed vs. Variable CostsFixed vs. Variable Costs

Fixed cost is the Fixed cost is the total cost of using total cost of using the fixed input, the fixed input, which remains which remains constant constant regardless of the regardless of the amount of output amount of output produced.produced.

Variable cost Variable cost is the total is the total cost of using cost of using the variable the variable input, which input, which increases as increases as more output more output is produced.is produced.

Short Run CostsShort Run Costs

COST FUNCTIONCOST FUNCTION DEFINITIONDEFINITION

Total fixed costTotal fixed cost TFC = (PTFC = (PKK) x (K)) x (K)

Total variable costTotal variable cost TVC = (PTVC = (PLL) x (L)) x (L)

Total costTotal cost TC = TFC + TVCTC = TFC + TVC

Average fixed costAverage fixed cost AFC = TFC ÷ QAFC = TFC ÷ Q

Average variable Average variable costcost

AVC = TVC ÷ QAVC = TVC ÷ Q

Average total costAverage total cost ATC = TC ÷ Q = AFC + ATC = TC ÷ Q = AFC + AVCAVC

Marginal costMarginal cost MC = MC = ΔΔTC ÷ TC ÷ ΔΔQ = Q = ΔΔTVC TVC ÷ ÷ ΔΔQQ

Total Cost CurvesTotal Cost Curves

Average and Marginal Cost Average and Marginal Cost CurvesCurves

Relationship Between Short Relationship Between Short Run Production and CostRun Production and Cost

AC

MC

Q1 Q2

Importance of costin managerial decisions

Ways to contain or cut costs popular Ways to contain or cut costs popular during the past decade -during the past decade -most common: reduce number of most common: reduce number of

people on the people on the payrollpayrolloutsourcingoutsourcing components of the components of the

businessbusinessmergemerge, consolidate, then reduce , consolidate, then reduce

headcountheadcount

Definition and use of Definition and use of cost in economic analysiscost in economic analysis

Relevant costRelevant cost: a cost that is affected by a : a cost that is affected by a management decisionmanagement decision

Historical costHistorical cost: cost incurred at the time of : cost incurred at the time of procurementprocurement

Opportunity costOpportunity cost: amount or subjective value : amount or subjective value that is forgone in choosing one activity over that is forgone in choosing one activity over the next best alternativethe next best alternative

Incremental costIncremental cost: varies with the range of : varies with the range of options available in the decisionoptions available in the decision

Sunk costSunk cost: does not vary in accordance with : does not vary in accordance with decision alternativesdecision alternatives

Relationship between Relationship between

production and costproduction and cost

Cost function is simply the Cost function is simply the production function expressed in production function expressed in monetary rather than physical monetary rather than physical unitsunits

We assume the firm is a ‘price We assume the firm is a ‘price taker’ in the input markettaker’ in the input market

Relationship between Relationship between production and costproduction and cost

Total variable cost (TVC) = the cost Total variable cost (TVC) = the cost associated with the variable input, associated with the variable input, found by multiplying the number of found by multiplying the number of units by the unit priceunits by the unit price

Marginal cost (MC) = the rate of Marginal cost (MC) = the rate of change in total variable costchange in total variable cost

The law of diminishing returns implies that The law of diminishing returns implies that MC will eventually increaseMC will eventually increase

MP

W

Q

TVCMC

Relationship between Relationship between production and costproduction and cost

Plotting TP and Plotting TP and TVC illustrates that TVC illustrates that they are mirror they are mirror images of each images of each otherother

When TP increases When TP increases at an increasing at an increasing rate, TVC increases rate, TVC increases at a decreasing at a decreasing raterate

Short-run cost Short-run cost functionfunction

For simplicity use the following For simplicity use the following assumptions:assumptions: the firm employs two inputs, labour and capitalthe firm employs two inputs, labour and capital the firm operates in a short-run production period the firm operates in a short-run production period

where labour is variable, capital is fixedwhere labour is variable, capital is fixed the firm produces a single productthe firm produces a single product the firm employs a fixed level of technologythe firm employs a fixed level of technology the firm operates at every level of output in the the firm operates at every level of output in the

most efficient waymost efficient way the firm operates in perfectly competitive input the firm operates in perfectly competitive input

markets and must pay for its inputs at a given markets and must pay for its inputs at a given market rate (it is a ‘price taker’)market rate (it is a ‘price taker’)

the short-run production function is affected by the the short-run production function is affected by the law of diminishing returnslaw of diminishing returns

Short-run cost functionShort-run cost function

Standard variables in the Standard variables in the shortshort--run cost function:run cost function:

Quantity (Q) is the amount of output Quantity (Q) is the amount of output that a firm can produce in the short that a firm can produce in the short runrun

Total fixed cost (TFC) is the total cost Total fixed cost (TFC) is the total cost of using the fixed input, capital (K)of using the fixed input, capital (K)


Standard variables in the short-run Standard variables in the short-run cost function:cost function:

Total variable cost (TVC) is the Total variable cost (TVC) is the total cost of using the variable total cost of using the variable input, labour (L)input, labour (L)

Total cost (TC) is the total cost of Total cost (TC) is the total cost of using all the firm’s inputs, using all the firm’s inputs,

TC = TFC + TVCTC = TFC + TVC



Average fixed cost (AFC) is the Average fixed cost (AFC) is the average per-unit cost of using the average per-unit cost of using the fixed input Kfixed input K AFC = TFC/Q AFC = TFC/Q

Average variable cost (AVC) is the Average variable cost (AVC) is the average per-unit cost of using the average per-unit cost of using the variable input Lvariable input L AVC = TVC/Q AVC = TVC/Q



Average total cost (AC) is the average Average total cost (AC) is the average per-unit cost of all the firm’s inputsper-unit cost of all the firm’s inputs AC = AFC + AVC = TC/Q AC = AFC + AVC = TC/Q

Marginal cost (MC) is the change in a Marginal cost (MC) is the change in a firm’s total cost (or total variable firm’s total cost (or total variable cost) resulting from a unit change in cost) resulting from a unit change in outputoutput MC = DTC/DQ = DTVC/DQ MC = DTC/DQ = DTVC/DQ


Graphical example of the cost variablesGraphical example of the cost variables


Important observationsImportant observations

AFC declines steadilyAFC declines steadilywhen MC = AVC, AVC is at a when MC = AVC, AVC is at a

minimumminimumwhen MC < AVC, AVC is fallingwhen MC < AVC, AVC is fallingwhen MC > AVC, AVC is risingwhen MC > AVC, AVC is rising

The same three rules apply for The same three rules apply for average cost (AC) as for AVCaverage cost (AC) as for AVC


A reduction in the firm’s fixed cost A reduction in the firm’s fixed cost would cause the average cost line to would cause the average cost line to shift downwardshift downward

A reduction in the firm’s variable cost A reduction in the firm’s variable cost would cause all three cost lines (AC, would cause all three cost lines (AC, AVC, MC) to shiftAVC, MC) to shift

Short-run cost Short-run cost functionfunctionAlternative specifications of the Alternative specifications of the

Total Cost function (relating Total Cost function (relating total cost and output)total cost and output)

cubiccubic relationship relationshipas output increases, total as output increases, total cost first increases at a cost first increases at a decreasing rate, then decreasing rate, then increases at an increasing increases at an increasing raterate

Short-run cost functionShort-run cost functionAlternative specifications of the Alternative specifications of the

Total Cost function (relating total Total Cost function (relating total cost and output)cost and output)

quadratic quadratic relationshiprelationshipas output increases, total cost as output increases, total cost increases at an increasing rateincreases at an increasing rate

linearlinear relationship relationshipas output increases, total cost as output increases, total cost increases at a constant rateincreases at a constant rate

Innovations have reduced costs and greatly increased carpet Innovations have reduced costs and greatly increased carpet production. Innovation along with competition have worked production. Innovation along with competition have worked together to reduce real carpet prices.together to reduce real carpet prices.

Carpet production is capital intensive. Over time, the major Carpet production is capital intensive. Over time, the major carpet manufacturers have increased the scale of their carpet manufacturers have increased the scale of their operations by putting larger and more efficient tufting machines operations by putting larger and more efficient tufting machines into larger plants. At the same time, the use of labour in these into larger plants. At the same time, the use of labour in these plants has also increased significantly. The result? plants has also increased significantly. The result? Proportional increases in inputs have resulted in a more than Proportional increases in inputs have resulted in a more than proportional increase in output for these larger plants.proportional increase in output for these larger plants.

RETURNS TO SCALE IN THE CARPET INDUSTRYRETURNS TO SCALE IN THE CARPET INDUSTRY

TABLE 5 THE U.S. CARPET INDUSTRY

CARPET SALES, 2005 (MILLIONS OF DOLLARS PER YEAR)

1. Shaw 4346

2. Mohawk 3779

3. Beaulieu 1115

4. Interface 421

5. Royalty 298

It is important to understand the characteristics of production costs It is important to understand the characteristics of production costs and to be able to identify which costs are fixed, which are variable, and to be able to identify which costs are fixed, which are variable, and which are sunk.and which are sunk.

Good examples include the personal computer industry (where most Good examples include the personal computer industry (where most costs are variable), the computer software industry (where most costs costs are variable), the computer software industry (where most costs are sunk), and the pizzeria business (where most costs are fixed).are sunk), and the pizzeria business (where most costs are fixed).

Because computers are very similar, competition is intense, and Because computers are very similar, competition is intense, and profitability depends on the ability to keep costs down. Most profitability depends on the ability to keep costs down. Most important are the cost of components and labourimportant are the cost of components and labour..

A software firm will spend a large amount of money to develop a new A software firm will spend a large amount of money to develop a new application. The company can recoup its investment by selling as application. The company can recoup its investment by selling as many copies of the program as possible.many copies of the program as possible.

For the pizzeria, sunk costs are fairly low because equipment can be For the pizzeria, sunk costs are fairly low because equipment can be resold if the pizzeria goes out of business. Variable costs are low—resold if the pizzeria goes out of business. Variable costs are low—mainly the ingredients for pizza and perhaps wages for a workers to mainly the ingredients for pizza and perhaps wages for a workers to produce and deliver pizzasproduce and deliver pizzas..

SUNK, FIXED, AND VARIABL E COSTS: SUNK, FIXED, AND VARIABL E COSTS: COMPUTERS, SOFTWARE, AND PIZZASCOMPUTERS, SOFTWARE, AND PIZZAS

The production of aluminum begins with the mining of bauxite. The process used to The production of aluminum begins with the mining of bauxite. The process used to separate the oxygen atoms from aluminum oxide molecules, called smelting, is the separate the oxygen atoms from aluminum oxide molecules, called smelting, is the most costly step in producing aluminum. The expenditure on a smelting plant, most costly step in producing aluminum. The expenditure on a smelting plant, although substantial, is a sunk cost and can be ignored. Fixed costs are relatively although substantial, is a sunk cost and can be ignored. Fixed costs are relatively small and can also be ignored.small and can also be ignored.

THE SHORT-RUN COST OF ALUMINUM SMELTINGTHE SHORT-RUN COST OF ALUMINUM SMELTING

TABLE 7 PRODUCTION COSTS FOR ALUMINUM SMELTING ($/TON) (BASED ON AN OUTPUT OF 600 TONS/DAY)

PER-TON COSTS THAT ARE CONSTANT FOR ALL OUTPUT LEVELS

OUTPUT 600 TONS/DAY

OUTPUT 600 TONS/DAY

Electricity $316 $316

Alumina 369 369

Other raw materials 125 125

Plant power and fuel 10 10

Subtotal $820 $820

PER-TON COSTS THAT INCREASE WHENOUTPUT EXCEENDS 600 TONS/DAY

Labor $150 $225

Maintenance 120 180

Freight 50 75

Subtotal $320 $480

Total per-ton production costs $1140 $1300

33The Long RunThe Long Run

Long Run Production Long Run Production FunctionFunction

A production A production function showing function showing the relationship the relationship between a flow of between a flow of inputs and the inputs and the resulting flow of resulting flow of output, where all output, where all inputs are inputs are variable.variable.

Q =Q = ff((LL, , KK))wherewhere

Q Q = quantity of output= quantity of output

L L = quantity of labour = quantity of labour input (variable)input (variable)

K K = quantity of capital = quantity of capital input (variable)input (variable)

Input SubstitutionInput Substitution

A manager’s choice of inputs A manager’s choice of inputs will be influenced by:will be influenced by:The The technologytechnology of the of the

production processproduction process

The The pricesprices of the inputs of of the inputs of productionproduction

The set of The set of incentivesincentives facing the facing the given producergiven producer

Technology of the Production Technology of the Production ProcessProcess

Capital-intensive Capital-intensive method of method of production is a production is a process that uses process that uses large amounts of large amounts of capital equipment capital equipment relative to the relative to the other inputs to other inputs to produce the firm’s produce the firm’s output.output.

Labour-intensive Labour-intensive method of method of production is a production is a process that uses process that uses large amounts of large amounts of labour relative to labour relative to the other inputs the other inputs to produce the to produce the firm’s output.firm’s output.

The Incentives Facing a Given The Incentives Facing a Given ProducerProducer

The Role of The Role of Competitive Competitive EnvironmentsEnvironments

Labour IssuesLabour Issues

Nonprofit Nonprofit OrganizationsOrganizations

Political and Political and Legislative Legislative InfluencesInfluences

Long Run Average Cost Long Run Average Cost FunctionFunction

This is defined as the This is defined as the minimum average or unit minimum average or unit cost of producing any level cost of producing any level of output of output when all inputs are when all inputs are variable.variable.

Long-run cost functionLong-run cost function

In the In the lonlong run, all inputs to a firm’s g run, all inputs to a firm’s production function may be changedproduction function may be changed

because there are no fixed inputs, there because there are no fixed inputs, there are no fixed costsare no fixed costs

the firm’s long run marginal cost the firm’s long run marginal cost pertains to returns to scalepertains to returns to scale

at first increasing returns to scale, then at first increasing returns to scale, then as firms mature they achieve constant as firms mature they achieve constant returns, then ultimately decreasing returns returns, then ultimately decreasing returns to scaleto scale

Long Run Average Cost Long Run Average Cost CurveCurve

Q

$

SRAC1

SRAC2SRAC3

SRAC4

LRAC

Long-run cost functionLong-run cost function In long run, the firm can In long run, the firm can

choose any level of choose any level of capacitycapacity

Once it commits to a Once it commits to a level of capacity, at least level of capacity, at least one of the inputs must one of the inputs must be fixed. This then be fixed. This then becomes a short-run becomes a short-run problemproblem

The LRAC curve is an The LRAC curve is an envelope of SRAC envelope of SRAC curves, and outlines the curves, and outlines the lowest per-unit costs the lowest per-unit costs the firm will incur over a firm will incur over a range of outputrange of output


When a firm experiences When a firm experiences increasing returns to scale:increasing returns to scale:a proportional increase in all inputs a proportional increase in all inputs

increases output by a greater increases output by a greater proportionproportion

as output increases by some as output increases by some percentage, total cost of production percentage, total cost of production increases by some lesser percentageincreases by some lesser percentage


EconomiesEconomies of scale of scale: situation : situation where a firm’s long-run average where a firm’s long-run average cost (LRAC) declines as output cost (LRAC) declines as output increasesincreases

Diseconomies of scaleDiseconomies of scale: situation : situation where a firm’s LRAC increases as where a firm’s LRAC increases as output increasesoutput increases

In general, the LRAC curve is u-In general, the LRAC curve is u-shaped.shaped.

Economies and Diseconomies of Economies and Diseconomies of ScaleScale

Economies of Economies of scale scale exist when the exist when the firm can achieve firm can achieve lower unit costs of lower unit costs of production by production by adopting a larger adopting a larger scale of production, scale of production, represented by the represented by the downward sloping downward sloping portion of along-run portion of along-run average cost curve.average cost curve.

Diseconomies of Diseconomies of scale scale exist when the exist when the firm incurs higher firm incurs higher unit costs of unit costs of production by production by adopting a larger adopting a larger scale of production, scale of production, represented by the represented by the upward sloping upward sloping portion of a long-run portion of a long-run average cost curve.average cost curve.

Economies and Diseconomies of Economies and Diseconomies of Scale - GraphicalScale - Graphical

SATC1

SATC2

SATC3

LRAC

$

QQ1

Economies of scaleEconomies of scaleDeclining LRACDeclining LRAC

Diseconomies of scaleDiseconomies of scaleIncreasing LRACIncreasing LRAC

Long-run cost functionLong-run cost functionReasons for long-run economiesReasons for long-run economies

specializationspecialization of labour and capital of labour and capitalprices of inputs may fall prices of inputs may fall with with

volume discounts in firm’s volume discounts in firm’s purchasingpurchasing

use of use of capital equipment capital equipment with with better price-performance ratiosbetter price-performance ratios

larger firms may be able to raise larger firms may be able to raise fundsfunds in capital markets at a in capital markets at a lower lower costcost

larger firms may be able to spread larger firms may be able to spread out out promotional costspromotional costs

Factors Creating Economies of ScaleFactors Creating Economies of Scale

Specialization and division of labourSpecialization and division of labour

Technological factorsTechnological factors

The use of automation devicesThe use of automation devices

Quantity discountsQuantity discounts

The spreading of advertising costsThe spreading of advertising costs

Financial factorsFinancial factors


Reasons for Reasons for diseconomies of scalediseconomies of scalescale of production becomes so large scale of production becomes so large

that it affects the total market demand that it affects the total market demand for inputs, so for inputs, so input prices riseinput prices rise

transportation costs transportation costs tend to rise as tend to rise as production grows, due to handling production grows, due to handling expenses, insurance, security, and expenses, insurance, security, and inventory costsinventory costs

Factors Creating Diseconomies Factors Creating Diseconomies of Scaleof Scale

The The inefficienciesinefficiencies of managing of managing large-scale operations.large-scale operations.

The increased transportation The increased transportation costs that result from costs that result from concentratingconcentrating production in a production in a small number of very large small number of very large plants.plants.

Learning By DoingLearning By Doing

The drop in unit costs as The drop in unit costs as total cumulative production total cumulative production increases because workers increases because workers become more efficient as become more efficient as they they repeatrepeat their assigned their assigned taskstasks..

Learning curveLearning curve

Learning curve: line showing Learning curve: line showing the relationship between labour the relationship between labour cost and additional units of cost and additional units of outputoutput

• downward slope indicates downward slope indicates additional cost per unit declines additional cost per unit declines as the level of output increases as the level of output increases because workers improve with because workers improve with practicepractice

Learning curveLearning curve

Learning curve:Learning curve:• measured in terms of percentage decrease in measured in terms of percentage decrease in

additional labour cost as output doublesadditional labour cost as output doubles

YYxx = Kx = Kxnn

YYxx = units of factor or cost to = units of factor or cost to

produce the xth unitproduce the xth unit

K = factor units or cost to produce K = factor units or cost to produce

the Kth (usually first) unitthe Kth (usually first) unit

x = product unit (the xth unit)x = product unit (the xth unit)

n = log S/log 2n = log S/log 2

S = slope parameterS = slope parameter

Minimum Efficient ScaleMinimum Efficient Scale

That scale of That scale of operation at which operation at which the long-run the long-run average cost curve average cost curve stops declining or stops declining or at which at which economies of economies of scale are scale are exhausted.exhausted.

$

Q

LRAC

MES

Methods for Determining MESMethods for Determining MES

Surveys of expert opinion Surveys of expert opinion (engineering estimates)(engineering estimates)

Statistical cost estimationStatistical cost estimation

The survivor approachThe survivor approach

Surveying Expert OpinionSurveying Expert Opinion

Surveying expert opinion is a Surveying expert opinion is a time-consumingtime-consuming process that process that relies on the judgments of those relies on the judgments of those individuals closely connected with individuals closely connected with different industries. different industries.

Reporting biases Reporting biases may obviously may obviously occur with this approach.occur with this approach.

Statistical EstimationStatistical Estimation

Researchers attempt to estimate the Researchers attempt to estimate the relationship between unit costs and relationship between unit costs and output levels of firms of varying sizes output levels of firms of varying sizes while holding constant all other while holding constant all other factors influencing cost in addition to factors influencing cost in addition to size.size.

This is usually done with This is usually done with multiple multiple regression analysis.regression analysis.

Survivor ApproachSurvivor Approach

The size distribution of firms is The size distribution of firms is examined to determine the scale of examined to determine the scale of operation at which operation at which most firms most firms in the in the industry are concentrated.industry are concentrated.

The underlying assumption is that The underlying assumption is that this scale of operation is most this scale of operation is most efficient and has the lowest costs efficient and has the lowest costs because this is where most firms because this is where most firms have have survivedsurvived..

Economies of scopeEconomies of scope

Economies of scope: reduction Economies of scope: reduction of a firm’s unit cost by of a firm’s unit cost by producing producing two or more goods or two or more goods or services jointly rather than services jointly rather than separatelyseparately

Closely related to economies of Closely related to economies of scalescale

Supply chain managementSupply chain management

Supply chain management (SCM): efforts by Supply chain management (SCM): efforts by a firm to improve efficiencies through each a firm to improve efficiencies through each link of a firm’s supply chain from supplier link of a firm’s supply chain from supplier to customerto customer

• transaction costs transaction costs are incurred by using are incurred by using resources outside the firmresources outside the firm

• coordination costs coordination costs arise because of arise because of uncertainty and complexity of tasksuncertainty and complexity of tasks

• information costs information costs arise to properly arise to properly coordinate activities between the firm and coordinate activities between the firm and its suppliersits suppliers

Supply chain Supply chain managementmanagement

Ways to develop better supplier Ways to develop better supplier relationshipsrelationships

strategic alliancestrategic alliance: firm and outside : firm and outside supplier join together in some sharing supplier join together in some sharing of resourcesof resources

competitive tensioncompetitive tension: firm uses two or : firm uses two or more suppliers, thereby helping the more suppliers, thereby helping the firm keep its purchase prices under firm keep its purchase prices under controlcontrol

Ways companies cut Ways companies cut costs to remain competitivecosts to remain competitive

the the strategicstrategic use of cost use of cost reduction in cost of reduction in cost of materialsmaterials using using information technology information technology to reduce to reduce

costscosts reduction of reduction of process process costscosts relocationrelocation to lower-wage countries or to lower-wage countries or

regionsregions mergers, consolidation, and subsequent mergers, consolidation, and subsequent

downsizingdownsizing layoffslayoffs and plant closings and plant closings

Global Global applicationapplication

ExampleExample: manufacturing : manufacturing chemicals in Chinachemicals in China

labour content relatively lowlabour content relatively low

high use of equipment and high use of equipment and raw materialsraw materials

non cost reasons for non cost reasons for outsourcingoutsourcing

ConclusionConclusion

““The British supermarkets The British supermarkets are leading a race to the are leading a race to the bottom. Jobs are being lost bottom. Jobs are being lost and producers are having to and producers are having to pay less attention to social pay less attention to social and environmental and environmental agreements…” agreements…” Alistair Smith, Banana LinkAlistair Smith, Banana Link

Casestudy : FORD and the Casestudy : FORD and the World Automobile Industry World Automobile Industry (2009)(2009)1.1. Read and prepare the Read and prepare the

Casestudy on FORD Casestudy on FORD for discussion and for discussion and presentation next presentation next week. week.

2.2. Identify and evaluate Identify and evaluate the challenges facing the challenges facing FORD’s global FORD’s global business by business by conducting External conducting External Environment analysis Environment analysis (PESTEL);and (PESTEL);and Industry (5+1 Forces) Industry (5+1 Forces) analysis.analysis.

Core ReadingCore Reading

• Keat, Paul G. and Young, Philip KY (2009) Managerial Economics, 6th edition, Pearson

• Samuelson, William F. and Marks, Stephen G.(2010) Managerial Economics, 6th edition, John Wiley

• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013) Microeconomics, 8th edition, Pearson

• Samuelson, P.A. and Nordhaus, W. D. Samuelson, P.A. and Nordhaus, W. D. (2010)(2010)“Economics”“Economics” Irwin/McGraw-Hill, 19Irwin/McGraw-Hill, 19thth EditionEdition

• Porter, Michael E. (2004)Porter, Michael E. (2004)“Competitive Strategy – “Competitive Strategy – Techniques for Analyzing Industries and Competitors”Techniques for Analyzing Industries and Competitors” Free PressFree Press

Questions?Questions?

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