Mba1014 production and costs 110513


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Production, Cost of production, Long Run

Mba1014 production and costs 110513

  1. 1. Go Global !Managerial Economics :Production & CostsByStephen OngVisiting Fellow, Birmingham City UniversityVisiting Professor, College ofManagement, Shenzhen UniversityMay 2013
  2. 2. Agenda1. Production2. Cost of production3. The Long Run
  3. 3. Learning ObjectivesTo discuss the production function and itsvarious formsTo provide examples of types of inputs into aproduction function for a manufacturing orservice companyTo understand the law of diminishing returnsTo discuss the cost function and distinguishbetween economic cost and accounting costTo explain how the concept of relevant cost isusedTo understand total, variable, average andfixed costTo distinguish between short-run and long-run costTo provide reasons for the existence ofeconomies of scale
  4. 4. 1Production
  5. 5. OverviewThe production functionShort-run analysis of averageand marginal productLong-run production functionImportance of productionfunction in managerialdecision making
  6. 6. Production FunctionA productionfunction describesthe relationshipbetween a flow ofinputs and theresulting flow ofoutputs in aproduction processduring a givenperiod of time.Q = f(L, K, M, …)whereQ = quantity of outputL = quantity of labourinputK = quantity of capitalinputM = quantity ofmaterials input
  7. 7. Production function Production function: defines therelationship between inputs and themaximum amount that can be producedwithin a given period of time with a givenlevel of technologyQ=f(X1, X2, ..., Xk)Q = level of outputX1, X2, ..., Xk = inputs used inproduction
  8. 8. Production functionKey assumptionsgiven ‘state of the art’production technologywhatever input or inputcombinations are included in aparticular function, the outputresulting from their utilization isat the maximum level
  9. 9. Production functionFor simplicity we will oftenconsider a production function oftwo inputs:Q=f(X, Y)Q = outputX = labourY = capital
  10. 10. Production function Short-run production function showsthe maximum quantity of output thatcan be produced by a set of inputs,assuming the amount of at least oneof the inputs used remainsunchanged Long-run production function showsthe maximum quantity of output thatcan be produced by a set of inputs,assuming the firm is free to varythe amount of all the inputs beingused
  11. 11. Short-run analysis of Total,Average, and Marginal product Alternative terms in reference to inputs‘inputs’‘factors’‘factors of production’‘resources’ Alternative terms in reference to outputs‘output’‘quantity’ (Q)‘total product’ (TP)‘product’
  12. 12. Fixed and Variable InputsA fixed inputis an inputwhosequantity amanagercannot changeduring a givenperiod of time.A variableinput is aninput whosequantity amanager canchange duringa given periodof time.
  13. 13. Short-Run vs. Long-RunThe short-run is a periodof time during which atleast one input is fixed,while the long-run is aperiod of time duringwhich all inputs arevariable.
  14. 14. Total ProductThe totalquantity ofoutput producedwith givenquantities offixed andvariable inputs.TP or Q = f(L, K ),whereTP or Q = total productor total quantityproducedL = quantity of labourinput (variable)K = quantity of capital(fixed)
  15. 15. Average ProductThe amountof output perunit ofvariableinput.APL = TP÷L or Q÷L,whereAPL = averageproduct of labour
  16. 16. Marginal ProductThe additionaloutputproduced withan additionalunit of variableinput.MPL = ΔTP÷ΔLor ΔQ÷ΔLwhereMPL = marginalproduct of labour
  17. 17. Total Product Curve
  18. 18. Average and MarginalProduct Curves
  19. 19. Short-run analysis of Total,Average, and Marginal productMarginal product (MP) = change inoutput (Total Product) resulting froma unit change in a variable inputAverage product (AP) = Total Productper unit of input usedXQMPXXQAPX
  20. 20. Short-run analysis of Total,Average, and Marginal productif MP > AP thenAP is risingif MP < AP thenAP is fallingMP=AP when APis maximized
  21. 21. Short-run analysis of Total,Average, and Marginal productLaw of diminishing returns:as additional units of a variable inputare combined with a fixed input, aftersome point the additional output (i.e.,marginal product) starts to diminishnothing says when diminishingreturns will start to take effectall inputs added to theproduction process have thesame productivity
  22. 22. Law of Diminishing MarginalReturnsThe phenomenon illustrated bythat region of the marginalproduct curve where the curveis positive, but decreasing, sothat total product is increasingat a decreasing rate.
  23. 23. Do increases in health care expendituresreflect increases in output or do theyreflect inefficiencies in the productionprocess? The United States is relativelywealthy, and it is natural for consumerpreferences to shift toward more healthcare as incomes grow. However, it maybe that the production of health care inthe United States is inefficient.A PRODUCTION FUNCTION FOR HEALTH CAREA PRODUCTION FUNCTIONFOR HEALTH CAREAdditional expenditures on healthcare (inputs) increase life expectancy(output) along the productionfrontier. Points A, B, and C representpoints at which inputs are efficientlyutilized, although there arediminishing returns when movingfrom B to C. Point D is a point of inputinefficiency.
  24. 24. MALTHUS AND THE FOOD CRISISTABLE 2INDEX OF WORLDFOOD PRODUCTIONPER CAPITAYEAR INDEX1948-521001961 1151965 1191970 1241975 1251980 1271985 1341990 1351995 1352000 1442005 1512009 155The law of diminishing marginalreturns was central to the thinking ofpolitical economist Thomas Malthus(1766–1834). Malthus predicted thatas both the marginal and averageproductivity of labor fell and therewere more mouths to feed, masshunger and starvation would result.Malthus was wrong (although he wasright about the diminishing marginalreturns to labour).Over the past century,technologicalimprovements have dramaticallyaltered food production in mostcountries (including developingcountries, such as India). As a result,the average product of labour and totalfood output have increased.Hunger remains a severe problem insome areas, in part because of the lowproductivity of labour there.
  25. 25. Cereal yields have increased. The average worldprice of food increased temporarily in the early1970s but has declined since.MALTHUS AND THE FOOD CRISISCEREAL YIELDS AND THE WORLD PRICE OF FOOD
  26. 26. Short-run analysis of Total,Average, and Marginal productThe Three Stages of Production inthe short run:Stage I: from zero units of thevariable input to where AP ismaximized (where MP=AP)Stage II: from the maximum APto where MP=0Stage III: from where MP=0 on
  27. 27. Short-run analysis of Total,Average, and Marginal productIn the short run, rational firms should beoperating only in Stage II Q: Why not Stage III?  firm uses morevariable inputs to produce less output Q: Why not Stage I?  underutilizingfixed capacity, so can increase output perunit by increasing the amount of the variableinput
  28. 28. Short-run analysis of Total,Average, and Marginal productWhat level of input usage within StageII is best for the firm? answer depends upon:• how many units of output the firm can• sell the price of the product• the monetary costs of employing thevariable input
  29. 29. Short-run analysis of Total,Average, and Marginal product Total revenue product (TRP) = marketvalue of the firm’s output, computedby multiplying the total product bythe market priceTRP = Q x P
  30. 30. Short-run analysis of Total,Average, and Marginal productMarginal revenue product (MRP) =change in the firm’s TRP resulting from aunit change in the number of inputs usedMRP = MP x P =XTRP
  31. 31. Short-run analysis of Total,Average, and Marginal product Total labour cost (TLC) = total cost of usingthe variable input labour, computed bymultiplying the wage rate by the number ofvariable inputs employedTLC = w x X Marginal labour cost (MLC) = change in totallabour cost resulting from a unit change inthe number of variable inputs usedMLC = w
  32. 32. Short-run analysis of Total,Average, and Marginal productSummary of relationship betweendemand for output and demand for asingle input:A profit-maximizing firm operating inperfectly competitive output and inputmarkets will be using the optimal amount ofan input at the point at which the monetaryvalue of the input’s marginal product isequal to the additional cost of using thatinput MRP = MLC
  33. 33. Short-run analysis of Total,Average, and Marginal productMultiple variable inputsConsider the relationship betweenthe ratio of the marginal product ofone input and its cost to the ratio ofthe marginal product of the otherinput(s) and their costkkwMPwMPwMP2211
  34. 34. Will the standard of living in the United States, Europe, andJapan continue to improve, or will these economies barely keepfuture generations from being worse off than they are today?Because the real incomes of consumers in these countriesincrease only as fast as productivity does, the answer dependson the labour productivity of workers.LABOUR PRODUCTIVITY AND THE STANDARD OF LIVINGTABLE 3LABOUR PRODUCTIVITY IN DEVELOPEDCOUNTRIESUNITEDSTATES JAPAN FRANCE GERMANYUNITEDKINGDOMGDP PER HOUR WORKED (IN 2009 USDOLLARS)$56.90 $38.20 $54.70 $53.10 $45.80Years Annual Rate of Growth of Labor Productivity (%)1960-1973 2.29 7.86 4.70 3.98 2.841974-1982 0.22 2.29 1.73 2.28 1.531983-1991 1.54 2.64 1.50 2.07 1.571992-2000 1.94 1.08 1.40 1.64 2.222001-2009 1.90 1.50 0.90 0.80 1.30
  35. 35. Long-run production function In the long run, a firm has enough time tochange the amount of all its inputs The long run production process isdescribed by the concept of returns to scaleReturns to scale = the resultingincrease in total output as allinputs increase
  36. 36. Long-run production functionIf all inputs into the production processare doubled, three things can happen:output can more than double ‘increasing returns to scale’ (IRTS)output can exactly double ‘constant returns to scale’ (CRTS)output can less than double ‘decreasing returns to scale’ (DRTS)
  37. 37. Long-run production functionOne way to measure returns to scaleis to use a coefficient of outputelasticity:if EQ > 1 then IRTSif EQ = 1 then CRTSif EQ < 1 then DRTSinputsallinchangePercentageQinchangePercentageQE
  38. 38. Long-run production functionReturns to scale can also bedescribed using the followingequationhQ = f(kX, kY)if h > k then IRTSif h = k then CRTSif h < k then DRTS
  39. 39. Long-run production functionGraphically, the returns to scaleconcept can be illustrated usingthe following graphsQX,YIRTSQX,YCRTSQX,YDRTS
  40. 40. Food grown on large farms in the UnitedStates is usually produced with acapital-intensive technology.However, food can also be producedusing very little capital (a hoe) and a lotof labour (several people with thepatience and stamina to work the soil).Most farms in the United States andCanada, where labor is relativelyexpensive, operate in the range ofproduction in which the MRTS isrelatively high (with a high capital-to-labour ratio), whereas farms indeveloping countries, in which labour ischeap, operate with a lower MRTS (anda lower capital-to-labour ratio).A PRODUCTION FUNCTION FOR WHEAT
  41. 41. A PRODUCTION FUNCTION FOR WHEATISOQUANT DESCRIBING THEPRODUCTION OF WHEATA wheat output of 13,800bushels per year can beproduced with differentcombinations of labour andcapital.The more capital-intensiveproduction process is shownas point A,the more labour- intensiveprocess as point B.The marginal rate of technicalsubstitution between A and Bis 10/260 = 0.04.
  42. 42. Estimation of productionfunctions Examples of production functions short run: one fixed factor, one variable factorQ = f(L)K cubic: increasing marginal returns followed bydecreasing marginal returnsQ = a + bL + cL2 – dL3 quadratic: diminishing marginal returns but noStage IQ = a + bL - cL2
  43. 43. Estimation of productionfunctionsExamples of production functionspower function: exponential for one inputQ = aLbif b > 1, MP increasingif b = 1, MP constantif b < 1, MP decreasingAdvantage: can be transformed into a linear(regression) equation when expressed in logterms
  44. 44. Estimation of production functions Examples of production functionsCobb-Douglas function:exponential for two inputsQ = aLbKcif b + c > 1, IRTSif b + c = 1, CRTSif b + c < 1, DRTS
  45. 45. Estimation of production functionsStatistical estimation of productionfunctionsinputs should be measured as ‘flow’rather than ‘stock’ variables, which isnot always possibleusually, the most important input islabourmost difficult input variable is capitalmust choose between time series andcross-sectional analysis
  46. 46. Estimation of production functionsAggregate production functions: wholeindustries or an economy gathering data for aggregatefunctions can be difficult: for an economy … GDP could beused for an industry … data fromCensus of Manufactures orproduction index from FederalReserve Board for labour … data from Bureauof Labour Statistics
  47. 47. The Made-in-China Effect
  48. 48. Importance of productionfunctions in managerialdecision makingCapacity planning: planning the amountof fixed inputs that will be used alongwith the variable inputsGood capacity planning requires:accurate forecasts of demandeffective communication between theproduction and marketing functions
  49. 49. Importance of productionfunctions in managerialdecision makingExample: cell phones Asian consumers want new phoneevery 6 months demand for 3G products Nokia, Samsung, SonyEricssonmust be speedy and flexible
  50. 50. Importance of productionfunctions in managerialdecision makingExample: Zara Spanish fashion retailer factories located close to stores quick response time of 2-4 weeks
  51. 51. Importance of productionfunctions in managerialdecision makingApplication: call centers service activity production function isQ = f(X,Y)where Q = number of callsX = variable inputsY = fixed input
  52. 52. Importance of productionfunctions in managerial decisionmakingApplication: China’sworkers Is Chinarunning out ofworkers? Effect ofindustrial boom eg bicyclefactory inGuangdongProvince
  53. 53. 2Cost of Production
  54. 54. OverviewDefinition and use of costRelating production and costShort run and long run costEconomies of scope and scaleSupply chain managementWays companies have cutcosts to remain competitive
  55. 55. Cost FunctionA mathematical orgraphic expression thatshows the relationshipbetween the cost ofproduction and the levelof output, all otherfactors held constant.
  56. 56. Opportunity CostThe economic measure ofcost that reflects the use ofresources in oneactivity, such as a productionprocess by one firm, in termsof the opportunities forgonein undertaking the next bestalternative activity.
  57. 57. Explicit and Implicit CostsA cost is explicit ifit is reflected in apayment to anotherindividual, such asa wage paid to aworker, that isrecorded in a firm’sbook keeping oraccounting system.A cost thatrepresents thevalue of using aresource that is notexplicitly paid outand is often difficultto measure becauseit is typically notrecorded in a firm’saccounting system.
  58. 58. ProfitThe differencebetween the totalrevenue a firm receivesfrom the sale of itsoutput and the totalcost of producing thatoutput.
  59. 59. Accounting vs.Economic Profit Accounting profit isthe differencebetween totalrevenue and totalcost where costincludes only theexplicit costs ofproduction. Economic profit isthe differencebetween totalrevenue and totalcost where costincludes both theexplicit and anyimplicit costs ofproduction.
  60. 60. Short Run Cost FunctionA cost function for ashort-run productionprocess in which there isat least one fixed input ofproduction.
  61. 61. Fixed vs. Variable CostsFixed cost is thetotal cost of usingthe fixedinput, whichremains constantregardless of theamount of outputproduced.Variable costis the totalcost of usingthe variableinput, whichincreases asmore output isproduced.
  62. 62. Short Run CostsCOST FUNCTION DEFINITIONTotal fixed cost TFC = (PK) x (K)Total variable cost TVC = (PL) x (L)Total cost TC = TFC + TVCAverage fixed cost AFC = TFC ÷ QAverage variablecostAVC = TVC ÷ QAverage total cost ATC = TC ÷ Q = AFC +AVCMarginal cost MC = ΔTC ÷ ΔQ = ΔTVC÷ ΔQ
  63. 63. Total Cost Curves
  64. 64. Average and Marginal CostCurves
  65. 65. Relationship Between ShortRun Production and CostACMCQ1 Q2
  66. 66. Importance of costin managerial decisionsWays to contain or cut costs popularduring the past decade -most common: reduce number ofpeople on the payrolloutsourcing components of thebusinessmerge, consolidate, then reduceheadcount
  67. 67. Definition and use ofcost in economic analysis Relevant cost: a cost that is affected by amanagement decision Historical cost: cost incurred at the time ofprocurement Opportunity cost: amount or subjective valuethat is forgone in choosing one activity overthe next best alternative Incremental cost: varies with the range ofoptions available in the decision Sunk cost: does not vary in accordance withdecision alternatives
  68. 68. Relationship betweenproduction and costCost function is simply theproduction function expressedin monetary rather thanphysical unitsWe assume the firm is a ‘pricetaker’ in the input market
  69. 69. Relationship betweenproduction and cost Total variable cost (TVC) = the costassociated with the variable input,found by multiplying the number ofunits by the unit price Marginal cost (MC) = the rate ofchange in total variable costThe law of diminishing returns implies that MCwill eventually increaseMPWQTVCMC
  70. 70. Relationship betweenproduction and costPlotting TP andTVC illustratesthat they aremirror images ofeach otherWhen TPincreases at anincreasing rate,TVC increases ata decreasing rate
  71. 71. Short-run cost functionFor simplicity use the followingassumptions: the firm employs two inputs, labour and capital the firm operates in a short-run production periodwhere labour is variable, capital is fixed the firm produces a single product the firm employs a fixed level of technology the firm operates at every level of output in themost efficient way the firm operates in perfectly competitive inputmarkets and must pay for its inputs at a givenmarket rate (it is a ‘price taker’) the short-run production function is affected by thelaw of diminishing returns
  72. 72. Short-run cost functionStandard variables in the short-run cost function:Quantity (Q) is the amount of outputthat a firm can produce in the shortrunTotal fixed cost (TFC) is the total costof using the fixed input, capital (K)
  73. 73. Short-run cost functionStandard variables in the short-runcost function:Total variable cost (TVC) is thetotal cost of using the variableinput, labour (L)Total cost (TC) is the total cost ofusing all the firm’s inputs,TC = TFC + TVC
  74. 74. Short-run cost functionStandard variables in the short-runcost function:Average fixed cost (AFC) is theaverage per-unit cost of using thefixed input KAFC = TFC/QAverage variable cost (AVC) is theaverage per-unit cost of using thevariable input LAVC = TVC/Q
  75. 75. Short-run cost functionStandard variables in the short-runcost function:Average total cost (AC) is the averageper-unit cost of all the firm’s inputsAC = AFC + AVC = TC/QMarginal cost (MC) is the change in afirm’s total cost (or total variablecost) resulting from a unit change inoutputMC = DTC/DQ = DTVC/DQ
  76. 76. Short-run cost functionGraphical example of the cost variables
  77. 77. Short-run cost functionImportant observationsAFC declines steadilywhen MC = AVC, AVC is at aminimumwhen MC < AVC, AVC is fallingwhen MC > AVC, AVC is risingThe same three rules apply foraverage cost (AC) as for AVC
  78. 78. Short-run cost functionA reduction in the firm’s fixed costwould cause the average cost line toshift downwardA reduction in the firm’s variable costwould cause all three cost lines (AC,AVC, MC) to shift
  79. 79. Short-run cost functionAlternative specifications of theTotal Cost function (relatingtotal cost and output)cubic relationshipas output increases, totalcost first increases at adecreasing rate, thenincreases at an increasingrate
  80. 80. Short-run cost functionAlternative specifications of theTotal Cost function (relating totalcost and output)quadratic relationshipas output increases, total costincreases at an increasing ratelinear relationshipas output increases, total costincreases at a constant rate
  81. 81. Innovations have reduced costs and greatly increased carpetproduction. Innovation along with competition have workedtogether to reduce real carpet prices.Carpet production is capital intensive. Over time, the majorcarpet manufacturers have increased the scale of theiroperations by putting larger and more efficient tufting machinesinto larger plants. At the same time, the use of labour in theseplants has also increased significantly. The result?Proportional increases in inputs have resulted in a more thanproportional increase in output for these larger plants.RETURNS TO SCALE IN THE CARPET INDUSTRYTABLE 5 THE U.S. CARPET INDUSTRYCARPET SALES, 2005 (MILLIONS OF DOLLARS PER YEAR)1. Shaw 43462. Mohawk 37793. Beaulieu 11154. Interface 4215. Royalty 298
  82. 82. It is important to understand the characteristics of production costsand to be able to identify which costs are fixed, which are variable,and which are sunk.Good examples include the personal computer industry (where mostcosts are variable), the computer software industry (where most costsare sunk), and the pizzeria business (where most costs are fixed).Because computers are very similar, competition is intense, andprofitability depends on the ability to keep costs down. Mostimportant are the cost of components and labour.A software firm will spend a large amount of money to develop a newapplication. The company can recoup its investment by selling asmany copies of the program as possible.For the pizzeria, sunk costs are fairly low because equipment can beresold if the pizzeria goes out of business. Variable costs are low—mainly the ingredients for pizza and perhaps wages for a workers toproduce and deliver pizzas.SUNK, FIXED, AND VARIABL E COSTS:COMPUTERS, SOFTWARE, AND PIZZAS
  83. 83. The production of aluminum begins with the mining of bauxite. The process used toseparate the oxygen atoms from aluminum oxide molecules, called smelting, is themost costly step in producing aluminum. The expenditure on a smeltingplant, although substantial, is a sunk cost and can be ignored. Fixed costs arerelatively small and can also be ignored.THE SHORT-RUN COST OF ALUMINUM SMELTINGTABLE 7 PRODUCTION COSTS FOR ALUMINUM SMELTING($/TON) (BASED ON AN OUTPUT OF 600TONS/DAY)PER-TON COSTS THAT ARECONSTANT FOR ALL OUTPUT LEVELSOUTPUT 600TONS/DAYOUTPUT 600TONS/DAYElectricity $316 $316Alumina 369 369Other raw materials 125 125Plant power and fuel 10 10Subtotal $820 $820PER-TON COSTS THAT INCREASE WHENOUTPUT EXCEENDS 600 TONS/DAYLabor $150 $225Maintenance 120 180Freight 50 75Subtotal $320 $480Total per-ton production costs $1140 $1300
  84. 84. 3The Long Run
  85. 85. Long Run Production FunctionA productionfunction showingthe relationshipbetween a flow ofinputs and theresulting flow ofoutput, where allinputs arevariable.Q = f(L, K)whereQ = quantity of outputL = quantity of labourinput (variable)K = quantity of capitalinput (variable)
  86. 86. Input SubstitutionA manager’s choice of inputswill be influenced by:The technology of theproduction processThe prices of the inputs ofproductionThe set of incentives facing thegiven producer
  87. 87. Technology of the ProductionProcessCapital-intensivemethod ofproduction is aprocess that useslarge amounts ofcapital equipmentrelative to theother inputs toproduce the firm’soutput.Labour-intensivemethod ofproduction is aprocess that useslarge amounts oflabour relative tothe other inputsto produce thefirm’s output.
  88. 88. The Incentives Facing a GivenProducerThe Role ofCompetitiveEnvironmentsLabour IssuesNonprofitOrganizationsPolitical andLegislativeInfluences
  89. 89. Long Run Average CostFunctionThis is defined as theminimum average or unitcost of producing any level ofoutput when all inputs arevariable.
  90. 90. Long-run cost function In the long run, all inputs to a firm’sproduction function may be changed because there are no fixed inputs, thereare no fixed costs the firm’s long run marginal costpertains to returns to scale at first increasing returns to scale, thenas firms mature they achieve constantreturns, then ultimately decreasing returnsto scale
  91. 91. Long Run Average CostCurveQ$SRAC1SRAC2SRAC3SRAC4LRAC
  92. 92. Long-run cost functionIn long run, the firm canchoose any level ofcapacityOnce it commits to alevel of capacity, at leastone of the inputs mustbe fixed. This thenbecomes a short-runproblemThe LRAC curve is anenvelope of SRACcurves, and outlines thelowest per-unit costs thefirm will incur over arange of output
  93. 93. Long-run cost functionWhen a firm experiencesincreasing returns to scale:a proportional increase in all inputsincreases output by a greaterproportionas output increases by somepercentage, total cost of productionincreases by some lesser percentage
  94. 94. Long-run cost functionEconomies of scale: situationwhere a firm’s long-run averagecost (LRAC) declines as outputincreasesDiseconomies of scale: situationwhere a firm’s LRAC increases asoutput increasesIn general, the LRAC curve is u-shaped.
  95. 95. Economies and Diseconomies ofScaleEconomies ofscale exist when thefirm can achievelower unit costs ofproduction byadopting a largerscale of production,represented by thedownward slopingportion of along-runaverage cost curve.Diseconomies ofscale exist when thefirm incurs higherunit costs ofproduction byadopting a largerscale of production,represented by theupward slopingportion of a long-runaverage cost curve.
  96. 96. Economies and Diseconomies ofScale - GraphicalSATC1SATC2SATC3LRAC$QQ1Economies of scaleDeclining LRACDiseconomies of scaleIncreasing LRAC
  97. 97. Long-run cost functionReasons for long-run economiesspecialization of labour and capitalprices of inputs may fall withvolume discounts in firm’spurchasinguse of capital equipment with betterprice-performance ratioslarger firms may be able to raisefunds in capital markets at a lowercostlarger firms may be able to spreadout promotional costs
  98. 98. Factors Creating Economies of ScaleSpecialization and division of labourTechnological factorsThe use of automation devicesQuantity discountsThe spreading of advertising costsFinancial factors
  99. 99. Long-run cost functionReasons for diseconomies of scalescale of production becomes so largethat it affects the total market demandfor inputs, so input prices risetransportation costs tend to rise asproduction grows, due to handlingexpenses, insurance, security, andinventory costs
  100. 100. Factors Creating Diseconomiesof ScaleThe inefficiencies of managinglarge-scale operations.The increased transportationcosts that result fromconcentrating production in asmall number of very largeplants.
  101. 101. Learning By DoingThe drop in unit costs astotal cumulative productionincreases because workersbecome more efficient asthey repeat their assignedtasks.
  102. 102. Learning curveLearning curve: line showingthe relationship between labourcost and additional units ofoutput• downward slope indicatesadditional cost per unit declinesas the level of output increasesbecause workers improve withpractice
  103. 103. Learning curve Learning curve:• measured in terms of percentage decrease inadditional labour cost as output doublesYx = KxnYx = units of factor or cost toproduce the xth unitK = factor units or cost to producethe Kth (usually first) unitx = product unit (the xth unit)n = log S/log 2S = slope parameter
  104. 104. Minimum Efficient ScaleThat scale ofoperation at whichthe long-runaverage cost curvestops declining orat whicheconomies ofscale areexhausted.$QLRACMES
  105. 105. Methods for Determining MESSurveys of expert opinion(engineering estimates)Statistical cost estimationThe survivor approach
  106. 106. Surveying Expert OpinionSurveying expert opinion is a time-consuming process that relies onthe judgments of those individualsclosely connected with differentindustries.Reporting biases may obviouslyoccur with this approach.
  107. 107. Statistical EstimationResearchers attempt to estimate therelationship between unit costs andoutput levels of firms of varying sizeswhile holding constant all otherfactors influencing cost in addition tosize.This is usually done with multipleregression analysis.
  108. 108. Survivor ApproachThe size distribution of firms isexamined to determine the scale ofoperation at which most firms in theindustry are concentrated.The underlying assumption is thatthis scale of operation is mostefficient and has the lowest costsbecause this is where most firmshave survived.
  109. 109. Economies of scopeEconomies of scope: reductionof a firm’s unit cost byproducing two or more goods orservices jointly rather thanseparatelyClosely related to economies ofscale
  110. 110. Supply chain management Supply chain management (SCM): efforts bya firm to improve efficiencies through eachlink of a firm’s supply chain from supplier tocustomer• transaction costs are incurred by usingresources outside the firm• coordination costs arise because ofuncertainty and complexity of tasks• information costs arise to properlycoordinate activities between the firm andits suppliers
  111. 111. Supply chain managementWays to develop better supplierrelationshipsstrategic alliance: firm and outsidesupplier join together in some sharingof resourcescompetitive tension: firm uses two ormore suppliers, thereby helping thefirm keep its purchase prices undercontrol
  112. 112. Ways companies cutcosts to remain competitive the strategic use of cost reduction in cost of materials using information technology to reduce costs reduction of process costs relocation to lower-wage countries orregions mergers, consolidation, and subsequentdownsizing layoffs and plant closings
  113. 113. Global applicationExample: manufacturingchemicals in China labour content relatively low high use of equipment andraw materials non cost reasons foroutsourcing
  114. 114. Conclusion“The British supermarkets are leadinga race to the bottom. Jobs are beinglost and producers are having to payless attention to social andenvironmental agreements…”Alistair Smith, Banana Link
  115. 115. Casestudy : FORD and the WorldAutomobile Industry (2009)1. Read and prepare theCasestudy on FORDfor discussion andpresentation nextweek.2. Identify and evaluatethe challenges facingFORD’s globalbusiness byconducting ExternalEnvironment analysis(PESTEL);andIndustry (5+1 Forces)analysis.
  116. 116. Core Reading• Keat, Paul G. and Young, Philip KY (2009)Managerial Economics, 6th edition, Pearson• Samuelson, William F. and Marks, StephenG.(2010) Managerial Economics, 6th edition, JohnWiley• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)Microeconomics, 8th edition, Pearson• Samuelson, P.A. and Nordhaus, W. D.(2010)“Economics” Irwin/McGraw-Hill, 19thEdition• Porter, Michael E. (2004)“Competitive Strategy –Techniques for Analyzing Industries and Competitors”Free Press
  117. 117. Questions?