microecon Cost

8/13/2019 microecon Cost

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BUSINESS ECONOMICS

Topic 7: Cost Analysis

Dr Sarath Divisekera

Business Decision Problems

How many Widgets should we produce?

Using what input combinations?

How to price our Widgets?

Should we expand our capacity?

How to protect our markets from erosion? Should we branch out into Gadgets also?

Should we invest in R&D? What projects?

How to assess and deal with uncertainties?

Dr sarath Divisekera

Cost Analysis3

Aim: we examine costs and their importance indecision making.

In the last lecture we examined how firmsdecide how much to produce and the conditionsfor efficient production.

Efficient production means firms produce a givenquantity at the lowest possible cost

Now we concentrate on cost structure and itsvariants to better understand the firms goal ofprofit maximisation and associated pricingstrategies

12/27/2011Dr Sarath Divisekera


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The nature of costs:

Perhaps the most difficult decision to make in

developing pricing strategies is how to classify thewide variety of costs borne by seller and producers

Standard accounting techniques are not suitable formaking pricing or output decisionswe need totake into account Economic costs

Explicit - actual spending on inputs -

Implicit - opportunity costs.

Here we define costs to include both explicit andimplicit costs - economic costs.

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Economic ProfitsEconomic TR Economic CostsEconomic Cost = Explicit + Implicit costs

Economic if TR > TC)

Doing better than next best alternative.

Serves as a signal for resources.

Economic

if TR < TC)

Doing worse than next best alternative.

May have positive Accounting.Serves as a signal for resources.


What are the costs borne by producers?

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Costs that have already been paid are considered to be

sunk. Cost that have not been paid should be considered as

fixedif not directly related to output level expansion,marginalif borne with sales or production increased by one

unit.

Sunk costs is the expenditure that has been made and cannot

be recovered, it should not influence firms pricing/output

decisions.

Note: Unlike the opportunity cost which is hidden (but need

to take into account when decisions are made), sunk cost is

visible but should always be ignored when making future

economic decisions



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Cost Structures

First distinction:

(1) fixed costs vs.

(2) variable costs.

Fixed Costs

Independent of output level

examples:

cost of borrowed money

rental or mortgage payments on office/factory space

corporate HQ costs.

Variable Costs

Depend in some way on production levels within

the organization

examples:

materials

some labor (depends on the contract)

Power


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Fixed vs Variable cost

Note that the line between fixed and variable costs is

not always sharp and costs may be fixed for one

analysis and variable for another

Variable costs linear in output:

VC(N) = N

Then AC = FC/N + is declining in N

When are variable costs likely to rise

proportionally to output? When more than

proportionally? Less?

Variable cost proportional to output

Averagecost

Output

FC/N +

Large firms have costadvantage over smallerones.


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Variable costs quadratic in output:

VC(N) = N + N2

Then AC = FC/N+ + N

This is -shaped as a function of N, falling for small

N and then rising for large N.

Variable cost quadratic in output

Averagecost

Output

FC/N ++N

Next Distinction

Marginal (or incremental) vs.

Average costs. MC is probably the most import cost concept


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What is the relationship between

average and marginal costs?

If MC < AC, then AC is falling

If MC > AC, then AC is rising

If MC = AC, then AC is constant

SR costs: Summary20

Total Fixed Costs (TFC);

Total variable costs (TVC);

Total costs (TC = TFC+TVC);

Average costs (AC);

Marginal Costs (MC).

ATC = TC/Q

TC = TFC + TVC


Cost Summary

Q L VC FC TC MC AC AFC AVC

0 0 0 120 120 U U U U

1 4 40 120 160 40 160 120 40

2 7 70 120 190 30 95 60 35

3 9 90 120 210 20 70 40 30

4 10 100 120 220 10 55 30 25

5 12.5 125 120 245 25 49 24 25

6 18 180 120 300 55 50 20 30

7 28 280 120 400 100 57.14 17.14 40

8 40 400 120 520 120 65 15 50

9 54 540 120 660 140 73 12.5 60

10 70 700 120 820 160 82 12 70

12/27/201121 Dr Sarath Divisekera


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COST IN THE SHORT RUN7.2

The Shapes of the Cost Curves

Cost Curves for a Firm

In (a)total cost TC is thevertical sum of fixed costFC and variable cost VC.

In (b)average total costATC is the sum ofaverage variable costAVC and average fixedcost AFC.

Marginal cost MC crossesthe average variable costand average total costcurves at their minimumpoints.

Figure 7.1

COST IN THE SHORT RUN7.2

The Shapes of the Cost Curves

The Average-Marginal

Relationship

Consider the line drawn fromorigin to point A in (a). Theslope of the line measuresaverage variable cost (a totalcost of $175 divided by anoutput of 7, or a cost per unitof $25).Because the slope of the VC

curve is the marginal cost ,the tangent to the VC curveat A is the marginal cost ofproduction when output is 7.At A, this marginal cost of$25 is equal to the averagevariable cost of $25 becauseaverage variable cost isminimized at this output.

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SR Costs and Law of Diminishing Returns

Shape of SR Cost Relationships is due to Law of

Diminishing Returns.

When MC is falling, MPLis rising. Likewise, MC is rising

as MPLis falling.



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Long-run Costs28

LR: in the LR all inputs are variable, so the firmscan plan their scale of plants. So the LR may be

considered as a planning horizon.

LR AC shows the minimum cost per unit of

producing each output when any desired level of

plant can be built.


LONG-RUN VERSUS SHORT-RUN COST CURVES7.4

The Relationship Between Short-Run and Long-Run Cost

Long-Run Cost withEconomies and Diseconomiesof Scale

The long-run averagecost curve LAC is theenvelope of the short-run average cost

curves SAC1, SAC2,and SAC3.

.

Figure 7.9

Long Run Average cost curve30

(LAC) shows the lowest average cost of producingeach level of output when the firm can build themost appropriate plant to produce each level ofoutput.

So the LAC is important for practical decision makingas it shows whether, and to what extent, large plantshave cost advantages smaller ones.

This is what we call, ECONOMIES OF SCALE.



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LONG-RUN VERSUS SHORT-RUN COST CURVES7.4

Economies and Diseconomies of Scale

economies of scale Situation

in which output can be doub ledfor less than a doubling of cost.

diseconomies of scale

Situation in which a doubling ofoutput requires more than adoubling of cost.

Increasing Returns to Scale: Output more than doubles whenthe quantities of all inputs aredoubled.

Economies of Scale: A doubling of output requires lessthan a doubling of cost.

Economies of Scale32

Economies of scale exist whenever LRAC

declines as output is increased.

When we are operating under IRS, output is goingup faster than inputs.

Diseconomies of scale exist whenever LRACsrise as output is increased.

When we are operating under DRS, output is going

up slower than inputs.


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Scale Economies and LRAC

Scale Economies can also be defined in terms of a LRAC

curve. LRAC=LRTC/Q

Q

LRAC

IRS

CRS

DRS

MES QMES

$



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Why is the Minimum Efficient Scale

(MES) Important?

MES of plant is the smallest output at which long-run

average cost is a minimum.

This shows where the smallest producer can compete

with larger producers.


Returns to scale

A.k.a. Economies of scale

Increasing returns to scale - AC falls as output

rises.

Decreasing returns - AC rises with output

Constant returns - AC does not change withoutput.

Returns to scale & cost structure

Large fixed costs imply increasing returns - e.g.,

autos, telecoms, networks.

Small fixed costs and VCs rising with o/p imply

diminishing returns - e.g farming.

Assembly operations usually show constant

returns.

Large fixed costs - economies of scale - make

entry of competitors difficult.


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Scale economies & competition

Autos - history of consolidation.

Telecom networks prior to fiber optics - entry of

MCI & Sprint into long distance after ATT

deregulation

Microsoft and Windows

Economies of Scale: LRAC - U

LRACs can takedifferent shapes

U-shape: ES prevail atsmall levels of output

and diseconomies of

scale (cost increases -decreasing returns)prevail at larger levelsof output.

LRAC -U

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LRAC

Economies

of scaleDiseconomies

of scale

Q*


Economies of Scale: LRAC - L

L-shaped (more realistic):

implies that economies of

scale are rather quickly

exhausted and constant or

near constant RS prevailfor a long period of time.

So small firms coexist with

large firms.

LRAC -L

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Q



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ES LRAC : Downward Sloping

There are some industries where

the LAC curve declinescontinuously as the firm expandsoutput, to the point where a

single firm could satisfy the total

market for the product or

service more efficiently than two

or more firms

Examples:Naturalmonopolies, public

transport, electricity.

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Q

LRAC


Multiple-Output Cost Functions & ECONOMIES OF

SCOPE41

Multiple-output cost functions - a function that defines thecost of producing given levels of two or more types ofoutputs.

C(Q1, Q2),

where Q1 is the number units produced of product 1

Note that multi-product cost function has the same basicinterpretation as as a single-output cost function. However, the cost of production depends on how much of each

type of output is produced.


PRODUCTION WITH TWO OUTPUTS

ECONOMIES OF SCOPE7.5

Economies and Diseconomies of Scope

economies of scope Situation inwhich joint output of a single firm isgreater than output that could beachieved by two different firms wheneach produces a single product.

diseconomies of scope Situationin which joint output of a single firmis less than could be achieved byseparate firms when each producesa single product.


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PRODUCTION WITH TWO OUTPUTS

ECONOMIES OF SCOPE7.5

The Degree of Economies of Scope

degree of economies of scope (SC)

Percentage of cost savings resultingwhen two or more products areproduced jointly rather thanIndividually.

To measure the degreeto which there are economies of scope, weshould ask what percentage of the cost of production is saved whentwo (or more) products are produced jointly rather than individually.

(7.7)

Economies of Scope vs Economies of Scale44

The concept of Economies of Scope(ES) mustbe distinguished from the concept ofEconomies of Scale.

The ES refer to the lowering of costs that a

firm often experiences when it produces twoor more products together rather than eachalone. (A smaller commuter aircraft).


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Economies of Scope

Economies of scope result when the cost of

production falls when multiple products areproduced by the firm.

Reasons for Economies of Scope

Inputs may be jointly used in production

(e.g., by-products in production).

Volume discounts on inputs

Shared resources (R&D, Marketing,

Production, etc.)



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DYNAMIC CHANGES IN COSTS

THE LEARNING CURVE*7.6

Learning Curve for AirbusIndustrie

The learning curve relatesthe labor requirement peraircraft to the cumulativenumber of aircraftproduced.

As the production processbecomes better organizedand workers gainfamiliarity with their jobs,labor requirements falldramatically.

Figure 7.13

ESTIMATING AND PREDICTING COST7.7

cost function Function relating cost ofproduction to level of output and othervariables that the firm can control.

Variable Cost Curve for theAutomobile Industry

An empirical estimate of thevariable cost curve can beobtained by using data for

individual firms in an industry.The variable cost curve forautomobile production isobtained by determiningstatistically the c urve that bestfits the points that relate theoutput of each firm to the firms

variable cost of production.

Figure 7.14

The learning curve implies:

1) The labor requirement falls per unit.

2) Costs will be high at first and then will fall with

learning.

Dynamic Changes inCosts--The Learning Curve


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The Empirical Findings

Study of 37 chemical products

Average cost fell 5.5% per year

For each doubling of plant size, average production costsfall by 11% (economies of scale)

For each doubling of cumulative output, the average costof production falls by 27% (learning)

The Learning Curve in Practice

Other Empirical Findings

In the semi-conductor industry a study of seven

generations of DRAM semiconductors from 1974-

1992 found learning rates averaged 20%.

In the aircraft industry the learning rates are as high

as 40%.

The Learning Curve in Practice

Example55

Douglas Aircraft and production of DC-9

Production of DC-9 was planned assuming that the workforce would

learn at particular rate.

When production began in LA, labour market was very tight.

Douglas lost 12,000 of 35,000 initial hires.

Costs did not fall as quickly as expected, and firm was forced into a

merger (McDonald-Douglas)



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How do cost concepts relate to

pricing? Price should never be below marginal costs.

Can it make sense for price to be above marginal

cost but below average costs?

Yes, but do not renew your investment in this case.

This is a situation where you can stay in the business

but it was a mistake to get into it in the first place.

In this case we cover variable costs but dont

recover fixed costs.

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Applications of cost functions

Break-Even (or Cost-volume profit) Analysis:examines the relationship among the total revenue,total costs, and the total profits of the firm atvarious levels of output.

This concept is used to determine the sales volume

required for the firm to break even and the totalprofits and losses at other sales levels.

Breakeven:

Occurs at the output level at which total cost

equals total revenue.

Let P(N) be the price at which N units can be sold.

Then breakeven means:

PQ = FC + VC(Q)


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Break-Even Analysis

BEP is the output at which total revenue equals total

costs. Derivation of BEP:

TR = P.Q;

TC = TFC + AVC.Q

TR = TC; P.Q = TFC + AVC.Q

(P - AVC)Q = TFC

Q = TFC/ (P - AVC)

Rules for Using Cost Data

Dont use Average Cost, or Average Variable Cost, as a

proxy for Marginal Cost. MC is the appropriate measure

for decisions about the scale of production

A single item of accounting costs can include both fixed

and variable costs. These must be separated to identify

MC

MC should include all relevant opportunity costs, even

those not identified explicitly in firms accounts

Ignore sunk costs, even if they are explicit

Concept of asset specificity can be a useful tool when

identifying which costs are truly sunk

Activity - Based Costing:

A method of trying to understand connections

between overhead costs and their drivers in terms

of levels of divisional activity.

To be covered in managerial accounting course.


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Changing Fixed to Variable Costs

Large fixed costs perceived as risky

Outsourcing a method of transforming fixed to

variable costs

E.G. - computer operations. Outsource to ADP, EDS,

IBM, PWC, etc. Pay on a usage basis so cost is now

variable.

Risk shifted to outsourcer.

Outsourcing as Business Model

Subcontract production to third-world companies

Subcontract distribution to othr firms (Fedex, UPS,

etc).

ranchises retail outlets (curfur??)

What does the corporation do?

Follows market trends

Designs products

Markets products

Assets - intellectual property. Hence emphasis on

intellectual property rights.


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Trend Spreading

Compaq, Dell always outsourced component

production.

Cisco has NO production facilities - all production is

outsourced.

Now outsourcing assembly, often to Asia, Mexico.

Even GM, Ford moving this way.

Motor Industry

GM has sold off components division.

Ford moving this way.

Both looking to suppliers to provide entire pre-

assembled subsystems.

GM has stated publicly that it wants to be out ofmanufacturing: to specialize in designing and

marketing cars. Subcontract manufacturing to third-

world countries.

Issues Raised

International mobility of jobs

Labor conditions in third world countries

Environmental issues in third world countries.


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Dematerialization of the

Corporation

Moving to situation where corporate assets are

intellectual property rather than bricks and mortar.

Quote CFO of GM when Microsoft first passed GM

in market cap:

Microsoft - hey, their assets could fit in our

executive parking lot!

complex questions for valuation, depreciation, etc.

Rules for Using Cost Data

Dont use Average Cost, or Average Variable Cost, as a

proxy for Marginal Cost. MC is the appropriate measure

for decisions about the scale of production

A single item of accounting costs can include both fixed

and variable costs. These must be separated to identify

MC

MC should include all relevant opportunity costs, even

those not identified explicitly in firms accounts

Ignore sunk costs, even if they are explicit

Concept of asset specificity can be a useful tool when

identifying which costs are truly sunk

Activity - Based Costing:

A method of trying to understand connections

between overhead costs and their drivers in terms

of levels of divisional activity.

To be covered in managerial accounting course.


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Changing Fixed to Variable Costs

Large fixed costs perceived as risky

Outsourcing a method of transforming fixed to

variable costs

E.G. - computer operations. Outsource to ADP, EDS,

IBM, PWC, etc. Pay on a usage basis so cost is now

variable.

Risk shifted to outsourcer.

Outsourcing as Business Model

Subcontract production to third-world companies

Subcontract distribution (Fedex, UPS, etc.)

franchises retail outlets

What does the corporation do?

Follows market trends

Designs products

Markets products

Assets - intellectual property. Hence emphasis on

intellectual property rights.


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Trend Spreading

Compaq, Dell always outsourced component

production.

Cisco has NO production facilities - all production is

outsourced.

Now outsourcing assembly, often to Asia, Mexico.

Even GM, Ford moving this way.

Motor Industry

GM has sold off components division.

Ford moving this way.

Both looking to suppliers to provide entire pre-

assembled subsystems.

GM has stated publicly that it wants to be out ofmanufacturing: to specialize in designing and

marketing cars. Subcontract manufacturing to third-

world countries.

Issues Raised

International mobility of jobs

Labor conditions in third world countries

Environmental issues in third world countries.


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Dematerialization of the

Corporation Moving to situation where corporate assets are

intellectual property rather than bricks and

mortar.

Quote CEO of GM when Microsoft first passed

GM in market cap:

Microsoft - hey, their assets could fit in our

executive parking lot!

complex questions for valuation, depreciation, etc.

SUMMARY79

Explicit costs refer to the actual expenditure ofthe firm required to purchase or hire inputs.

Implicit costs (opportunity costs) refer to thevalue (imputed from their best alternative use) ofthe inputs owned and used by the firm. In

managerial decisions both explicit and implicitcosts must be considered.


SUMMARY80

In the SR we have fixed and variable costs. Total costs

equal total fixed costs plus total variable costs. In the LR all

inputs are variable.

LR AVC curve is based on the assumption that economies

of scale prevail at small levels of output and diseconomies

of scale prevail at larger levels of output.

The firm can use cost-volume-profit or breakeven analysis

to determine the output and sales levels at which the firm

breaks even or earns a desired target profit.


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