Cost Analysis and Supply

1
Session 2
Managerial Economics

• Cost Analysis and Supply

Professor Changqi Wu
2
Topics for Today

• Production and Cost
• Cost Concepts
• Cost Analysis
• Firms Production Decision
• Supply Curve
• Market Mechanism

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1. Production and Cost

• Production process utilizes productive inputs to
  produce useful output for buyers
• Categories of production inputs
• labor (skilled and unskilled)
• capital
• technology
• Management skills

4
Production Function

• Production Function indicates the highest output
  that a firm can produce for every specified
  combination of inputs given the state of
  technology.
• The production function for two inputs
• Q F(K,L)
• Q Output, K Capital, L Labor

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Production with One Variable Input
Output per Month
Output per Month
D
112
Marginal product
30
C
Average product
Total product
E
20
60
B
10
A
Labor per Month
Labor per Month
0
2
3
4
5
6
7
8
9
10
1
8
0
2
3
4
5
6
7
9
10
1
6
Diminishing Marginal Returns

• As the use of an input increases in equal
  increments, a point will be reached at which the
  resulting additions to output decreases (i.e.
  Marginal Product declines).

7
From Production to Cost

• A production function measures the relationship
  between inputs and output.
• To determine the optimal level of output, we must
  translate the production technology to dollar
  value of costs.

8
Cost is not Waste

• A cost curve depicts the relationship between
  output and the most efficient way of producing
  that output.
• A cost curve is the mirror image of the
  production function
• Input price change moves cost curve
• Technology change moves cost curve

9
Economic and Accounting Concepts of Cost

• Accounting Cost
• Actual expenses plus depreciation charges for
  capital equipment
• Historical records
• Economic Cost
• Cost of utilizing economic resources in
  production, including opportunity cost
• Forward looking

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Opportunity Cost

• Business decision making requires information on
  future alternative courses of action
• Opportunity cost measures the forgone net revenue
  from the best alternative course of action
• Example of opportunity cost
• Shanghai Petrochemicals

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Shanghai Petrochemicals

• Shanghai Petrochemicals is a listed company at
  the Stock Exchanges of both New York and Hong
  Kong.
• Its 1994 Annual Report shows that the company
  made a profit of RMB 1.77 billion.
• In that year Shanghai Petrochemicals bought 4.5
  million ton of crude oil at the subsidized price
  of RMB670/ton while the crude oil price in the
  international market was at average RMB1100/ton.
• Indirect cost savings due to the government
  subsidies amounted to RMB 1.93 billion.
• The company actually lost RMB 150 million in that
  year.

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2. Concepts of Cost

• The total cost of production equals the fixed
  cost (the cost of the fixed inputs) plus the
  variable cost (the cost of the variable inputs)

13
Total Cost Curves of a Firm
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Average Total Cost

• Average Total Cost (ATC) is the cost per unit of
  output, or average fixed cost (AFC) plus average
  variable cost (AVC). This can be written

15
Marginal Cost

• Marginal Cost (MC) is the cost of expanding
  output by one unit. Since fixed cost have no
  impact on marginal cost, it can be written as

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Unit Cost Curves
Cost ( per unit)
100
MC
75
50
ATC
AVC
25
AFC
Output (units/yr.)
1
0
2
3
4
5
6
7
8
9
10
11
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Fixed Cost and Sunk Cost

• Expenditure that has been made and cannot be
  recovered.
• Sunk cost should not influence a firms decision.
• An example
• A firm pays 500,000 of deposit for an option to
  buy a building.
• The cost of the building is 5 million or a total
  of 5.5 million.
• The firm finds another building for 5.25
  million.
• Which building should the firm buy?

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3. Cost Analysis

• Economy of scale
• Economy of scope
• Economy of experience
• Economy of time

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3.1 Economy of Scale

• Economy of scale means
• Average cost declines when the scale of
  production expands
• Economy of scale may arise at different levels of
  production
• product level, plant level, firm level
• Economy of scale may arise at different aspects
  of business operations
• production, marketing, RD

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Economy of Scale
Unit Costs (/unit)
10
5
LAC (including cost of capital)
Annual Sales Volume (units per year)
4000
5000
1000
Your current sales volume.
Small firms current sales volume.
MES
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Sources of Economy of Scale

• Production requires significant fixed inputs
• indivisibility
• Physical laws the two third rule
• construction cost k (throughput)2/3
• Economy of mass reserves
• Specialized labor
• Economy of scales in purchasing

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Minimum Efficient Scale is ...

• the smallest production scale at which minimum
  unit cost is attained
• Methods to assess MES in an industry
• Statistical estimation of cost function
• The survivor principle
• Profitability and firm size
• Engineering approach
• MES may change when technology advances

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Economy of Scale in Action

• Take advantages of economy of scale
• Building inventory
• Contracting out
• Developing backlog
• Strategic implications of economy of scale

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3.2 Economy of Experiences
Unit Cost

• Experience curves are characterized by their
  slope
• (also called BCG slope or progress ratio)
• Slope by how much do unit costs fall
• --- as a percentage of a baseline level ---
  when
• cumulative output doubles.

1.00/unit
0.80/unit
Experience Curve with 80 Slope
Cumulative Production Volume (total number
of units produced to date)
100
200
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Sources of Experience Effect

• Labor efficiency
• New processes and improved methods
• Product redesign
• Product standardization

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Economy of Experience in Action

• We can use experience curve to forecast cost
  changes
• Forward pricing pricing based on future cost
• strategic effect moving down quickly along
  experience curve to gain competitive advantage
• Using pre-launch announcement to prevent rivals
  from taking advantage of economy of learning
• A firms enjoying a experience based low cost
  should take measures to reduce employee turnovers

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Economy of Experience in Action

• Earlier-mover advantage refers to the idea that
  "the rich get richer
• Because your business unit has entered a market
  early (either by happenstance or superior
  foresight), your past success in the market
  sustains a dynamics whereby your cost or benefit
  advantage becomes more pronounced over time.

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Economies of Scale Versus Learning

• Production capacity
• Time span

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Economies ofScale Versus Learning
Cost ( per unit of output)
Output
30
3.3 Economy of Scope

• Economy of scope exists when the total cost of a
  single firm with multiple products is lower than
  the sum of the total costs of two independent
  firms with each producing the a single product.
• Examples
• Chicken farm--poultry and eggs
• Automobile company--cars and trucks
• Universal banking

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Degree of Economies of Scope

• The degree of economies of scope measures the
  savings in cost and can be written
• If SC gt 0 -- Economies of scope
• If SC lt 0 -- Diseconomies of scope

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3.4 Economy of Time

• The Case of PC Market
• Moores Law dominates
• Highly competitive with modulization
• Product life cycle is only 3 months
• Price of components falls 50 a year. One
  percent a week.

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What is Dell doing?
Price
B1
B
V1
Sales Line (price now fixed)
V
Time Line
W
A
U
X
Rate of Price Decline
X1
Y
Rate of Price Decline
Y1
Time
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Implications

• Can we apply the Dell model to other businesses?
• Toyota introduced the build-to-order system in
  1999
• Costs were lowed
• Client satisfaction rose.

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4. Output Decision and Supply
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Choosing Output in the Short Run

• A competitive firm acts as a price-taker, its
  marginal revenue is a horizontal line
• P D MR AR
• Observations
• P MR
• MR MC
• P MC

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A Competitive FirmMaking a Positive Profit
Price ( per unit)
60
50
40
30
20
10
0
1
2
3
4
5
6
7
8
9
10
11
Output
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A Competitive FirmIncurring Losses
Price ( per unit)
Would this producer continue to produce with a
loss?
Output
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Summary of Production Decisions

• Profit is maximized when MC MR
• If P gt ATC the firm is making profits.
• If AVC lt P lt ATC the firm should produce at a
  loss.
• If P lt AVC lt ATC the firm should shut-down.

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Supply Curve

• Supply curve depicts the relationship between
  price and quantity supplied
• Supply curve depend on the time needed for
  production adjustment
• Short-run supply curve replicates part of a
  firms marginal cost curve
• Industry supply curve is horizontal add-up of
  individual firms supply curves

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A Firms Supply Curve
S MC above AVC
Price ( per unit)
MC
ATC
P2
AVC
P1
P AVC
Shut-down
Output
q1
q2
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Observations

• Supply is upward sloping due to diminishing
  returns.
• Higher price compensates the firm for higher cost
  of additional output and increases total profit
  because it applies to all units.

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Industry Supply
per unit
Question If increasing output raises
input costs, what impact would it have on market
supply?
Quantity
0
2
4
8
10
5
7
15
21
44
Supply Elasticity

• Supply elasticity is
• Responsiveness of supply of a good to changes in
  price
• measured as change of the supply for an item if
  the price changes by 1
• Property
• Price elasticity of supply gt 0

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Producer Surplus

• Firms earn a surplus on all but the last unit of
  output.
• The producer surplus is the sum over all units
  produced of the difference between the market
  price of the good and the marginal cost of
  production.
• Producer surplus is very sensitive to price
  changes

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Producer Surplus of a Firm
Price ( per unit of output)
0
Output
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5. The Market Mechanism

• Characteristics of a competitive market
• Many buyers and sellers in the marketplace.
• All sellers sell identical products.
• Free entry and exit.
• Perfect information

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The Market Mechanism

• A market is at equilibrium when market demand
  equals market supply
• When demand or supply conditions change, market
  equilibrium will change.
• Price may deviate from market equilibrium. When
  that happens, market participants react to the
  new market conditions. That restores the market
  equilibrium.

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The Market Equilibrium
Price ( per unit)
Quantity
50
The Market Mechanism
51
The Market Mechanism
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Changes In Market Equilibrium

• Raw material prices fall
• S shifts to S
• Surplus _at_ P1 of Q1, Q2
• Equilibrium _at_ P3, Q3

P
Q
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Changes In Market Equilibrium
P

• Income Increases
• Demand shifts to D
• Shortage _at_ P1 of Q1, Q2
• Equilibrium _at_ P3, Q3

P3
P1
Q3
Q2
Q
Q1
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Intervention in the Marketplace

• Price control creates shortages/surplus
• To solve the shortage problem
• Rationing
• Queuing and searching non-price competition
• Black market solution

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Key Learning Points

• Cost is not waste, it reflects the technical
  aspects of production and input prices.
• Opportunity cost is vital for decision-making,
  but is hardly reflected in financial statements.
• A profit seeker sets his marginal cost equal to
  his marginal revenue
• Market mechanism can lead to efficient allocation
  of resources.