Production and Cost Analysis for Managerial Economics

1. Cost Theory and Estimation
An important consideration in decision making

2. Cost Theory and Estimation
Nature of Costs
Short-Run Cost Functions
Long-Run Cost Curves
Learning Curves
Cost-Volume-Profit Analysis
The New Economies of Scale
Supply-Chain Management
Empirical Estimation of Cost Functions

3. Nature of Costs
•What is relevant?

4. A cost is relevant if it is
affected by a
management decision
• Opportunity cost
• Marginal cost
• Incremental cost
• Sunk cost http://article.wn.com/view/2014/06/24/Three_Graphs_that_Show_the
_Chinese_Mobile_Technology_Revolut/

5. https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K
Revenue
Revenue
Total Opportunity Costs

6. Explicit Costs
• The actual expenditures of the firm
• Accounting costs

7. Implicit Costs
• Value of the inputs owned
and used by the firm
• Economic costs
• Cost that does not require the
firm to give up money, but
rather opportunity

8. Nature of Costs
Implicit costs
https://mrski-apecon-2008.wikispaces.com/Chapter+13+Emily+K

9. The opportunity costassociated with choosing a particular decision is measured by the benefits foregone in the next- best alternative

10. Consider this…
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Profit
Php140,000
12,000
-36,000
-18,000-24,000
74,000
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Interest rate @ 8%
Current value at job
Profit(Loss)
Php140,000
12,000
36,000
18,000
24,000
6,400
56,000
11,600

11. Consider this…
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Profit
Php140,000
12,000
-36,000
-18,000-24,000
74,000
Management Fees
Miscellaneous revenues
Less:
Office rent
Other office expenses
Staff wages (excluding self)
Interest rate @ 8%
Current value at job
Profit(Loss)
Php140,000
12,000
36,000
18,000
24,000
6,400
80,000
(12,400)

12. The sunk costis an expense that has already been incurred and cannot be recovered

13. Nature of Costs
Incremental costs are associated with a choice and therefore only ever include forward-looking costs
sunk costs not included
Marginal costs refer to the cost to produce one more unit of product or service.
Marginal and Incremental costs are used to help management evaluate different potential future courses of action

14. Cost functions
•Factors that determine costs

15. Short-Run
•Some of the firm’s inputs are fixed
•Cost curves are operating curvesTC = TFC + TVC

16. Short-Run(per-unit)
•ATC = TC/Q
•AVC = TVC/Q
•AFC = TFC/Q
= ATC -AVC
•MC = ΔTC/ΔQ
= ΔTVC/ΔQ
AFC

17. Table 7-1 Short-Run total and Per-Unit Cost Schedules
Ch.7 Cost Theory and Estimation, Salvatore. P.283QTFCTVCTCAFCAVCATCMC
0
$60
$0
$60
--
--
--
--
1
60
20
80
$60
$20
$80
$20
2
60
30
90
30
15
45
10
3
60
45
105
20
15
35
15
4
60
80
140
15
20
35
35
5
60
135
195
12
27
39
55

18. 0
1
2
3
4
5
TFC
$60
60
60
60
60
60
TVC
$0
20
30
45
80
135
TC
$60
80
90
105
140
195
$0
$50
$100
$150
$200
$250

19. 1
2
3
4
5
AFC --
$60
30
20
15
12
AVC --
$20
15
15
20
27
ATC --
$80
45
35
35
39
MC --
$20
10
15
35
55
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90

20. 1
2
3
4
5
AFC --
$60
30
20
15
12
AVC --
$20
15
15
20
27
ATC --
$80
45
35
35
39
MC --
$20
10
15
35
55
$0
$10
$20
$30
$40
$50
$60
$70
$80
$90
AVC, ATC, and MCare
U-shaped
AFCcontinues to decline as output increases
MCcurve reaches its minimum before intercepting AVCand ATCcurves at their lowest points

21. Q1
Q2
Q3
(1)AVCfirst declines, reaches a minimum at Q2, and rises thereafter
•AVC at its minimum, MC = AVC
(2)ATCfirst declines, reaches a minimum at Q3, and rises thereafter
•ATC at its minimum, MC = ATC(3)MCfirst declines, reaches a minimum at Q1, and rises thereafter
•MC equals both AVC and ATC at their minimum values
•MC lies below AVC and ATC over the range for which these curves decline, but lies above them when they are rising

22. QTFCTVCTCAFCAVCATCMC
0
$60
$0
$60
--
--
--
--
1
60
20
80
$60
$20
$80
$20
2
60
30
90
30
15
45
10
3
60
45
105
20
15
35
15
4
60
80
140
15
20
35
35
5
60
135
195
12
27
39
55
AVC = TVC= wL= w = w
QQQ/LAPL
AVC
TVC
Q
w
L
APL
–average variable cost
–total variable cost
–output level
–wage rate
–quantity of labor used
–average physical product of labor

23. QTFCTVCTCAFCAVCATCMC
0
$60
$0
$60
--
--
--
--
1
60
20
80
$60
$20
$80
$20
2
60
30
90
30
15
45
10
3
60
45
105
20
15
35
15
4
60
80
140
15
20
35
35
5
60
135
195
12
27
39
55
MC = ΔTVC= Δ(wL)= w(ΔL)= w= w a
ΔQΔQΔQΔQ/ΔLMPL
MPL
–marginal product of labor

24. Long-Run
•All inputs are variable
•Cost curves are planning curvesLAC = LTCQ

26. LAC = LTCQLMC = ΔLTCΔQ
•The U-shape of the LAC curve depends on increasing, constant, and decreasing returns to scale
•The relationship of the LMC-LTC is the same as the short-run MC-ATC.

27. Relationship of Long-Run and Short-Run Average Cost Curves
•Long-Run average cost curve shows the minimum average cost of producing any given level of output
•LAC curve is the tangent line to each of the short-run average curves

28. Returns to Scale
Constantreturns to scale
Increasing returns to scale
Decreasing returns to scale
INPUT
OUTPUT
INPUT
OUTPUT
INPUT
OUTPUT

29. Returns to Scale
Constantreturns to scale
Increasing returns to scale
Decreasing returns to scale
INPUT
OUTPUT
INPUT
OUTPUT
INPUT
OUTPUT

33. Minimum Efficient Scale (MES)
•The lowest output at which minimum average cost can be achieved
•Important in determining how many firms a particular market can support

34. Economies of Scope
•The cost of producing multiple goods is less than the aggregate cost of producing each item separately
•An important source of economies of scope is transferable know-how

35. Learning Curves
•As firms gain experience in the production of a commodity or service, their average cost of production usually declines
•from many experiences gained
•used to forecast needs for personnel, machinery, raw materials and for scheduling production

37. Cost-Volume-Profit Analysis
•Breaking it even and then some

38. Cost-Volume-Profit Analysis(CVP Analysis / breakeven analysis)
Examines the relationship among total revenue, total costs, and total profits of the firm at various levels of output
TR = (P)(Q)
TC = TFC + (AVC)(Q)
TR=TC

40. QB= TFC .
P-AVC
Solve:
(P)(QB) –(AVC)(QB) = TFC
(QB)(P-AVC) = TFC
Q TR = (P)(Q) TC = TFC + (AVC)(Q) TR=TC(P) (QB) = TFC + (AVC) (QB)

41. QB= TFC .
P-AVC
Q
TFC = $200
P= $10
AVC = $5
Solve:
QB= $200 .
$10-$5
QB = 40
Contribution margin per unit
•Portion of the selling price that can be applied to cover fixed costs and provide for profits

42. QT= TFC + πT.
P-AVC
Q
TFC = $200
P= $10
AVC = $5
Solve:
QT= $200 + $100 .
$10-$5
QT= 60

43. Operating Leverage (OL)
Refers to the ratioof the firms total fixed costs to total variable costs
Higher ratio = more leveraged
= profits are more sensitive to changes in output or sales
퐷푂퐿= %Δ휋 %Δ푄 = Δ휋/휋 Δ푄/푄 = Δ휋 Δ푄 . 푄 휋
DOL –degree of operating leverage

44. Q
FC= $200
FC’ = $300
AVC = $5
AVC’= $3.33
QB’ = 45
TC’ has a higher DOL than TC and therefore a higher QB

45. 퐷푂퐿= 60($10−$5) 60$10−$5−$200= $300$100=3
Given:
Increase in output from 60 to 70 units
Find:
DOL with TC

46. 퐷푂퐿= 60($10−$5) 60$10−$5−$200= $300$100=3
퐷푂퐿′= 60($10−$3.33) 60$10−$3.33−$300≅ $400$100=4
The degree of operating leverage (DOL) increases as the firm becomes more leveraged or capital intensive

47. New Economies of ScaleMinimizing costs internationally
International trade in inputs
Foreign sourcing of inputs -requirement to remain competitive
New international economies of scale
Firms must constantly explore sources of cheaper inputs and overseas production
Product development, purchasing, production, demand management, order fulfillment
Immigration of skilled labor

48. Logistics or supply-chain management
Merging at the corporate level of the purchasing, transportation, warehousing, distribution and customer services functions rather than dealing with them separately at division levels
Development of new and much faster algorithms that greatly facilitate the solution of complex logistic problems
Growing use of just-in-time inventory management
Increasing trend toward globalization of production and distribution

49. Empirical Estimation of Cost Functions
•Planning for the long haul

50. Empirical EstimationData Collection Issues
Opportunity costs must be extracted from accounting cost data
Costs must be apportioned among products
Costs must be matched to output over time
Costs must be corrected for inflation
퐶=푓(푄,푋1,푋2,…,푋푛)

51. Empirical EstimationFunctional Form for Short-Run Cost Functions
Theoretical Form
푀퐶=푎+2푏푄+3cQ2

53. Empirical EstimationFunctional Form for Short-Run Cost Functions
Linear Approximation

55. Empirical EstimationEfficiency of Operation in Estimating the LAC curve

56. Architecture of Ideal Firm
Core Competencies
Outsourcing of Non-Core Tasks
Learning Organization
Efficiency and Flexibility
Location Near Markets
Agility in Responding to Market Forces

57. References
Salvatore, D. (2007). Managerial Economics In A Global Economy(Sixth ed.). New York: Oxford University Press.
Samuelson, W. F., & Marks, S. G. (2010). Managerial Economics(Sixth ed.). New Jersey: John Wiley & Sons, Inc.
Thomas, C. R., & Maurice, S. (2011). Managerial Economics Foundations of Business Analysis and Strategy(Tenth ed.). New York: McGraw-Hill Co.
*Web site sources for other graphs