TUMAINI UNIVERSITY FACULTY OF BUSINESS ADM Managerial Economics G. Loth

Theory of Firms Costs, Revenues and Objectives

Theory of Firms  Profit: Difference between Revenue and Cost Π = TR - TC

Theory of Firms  Revenue = amount received from the sale of goods or services TR = P x Q

Theory of Firms  Total Cost is the sum of all costs – fixed, variable and semi-fixed  Fixed Costs – do NOT depend on quantity produced- Rent, Rates, Insurance, etc.  Variable Costs –vary directly with the amount produced – raw materials  Semi–Fixed Costs - may vary with output but not directly – some types of labour, energy costs

Theory of Firms  Factor Costs :  Labour – wages/salaries  Land – rent  Capital – interest  Enterprise - profit

Theory of Firms  Average Cost = Total cost divided by the number of units produced AC = TC/Q AVC = TVC/Q AFC = TFC/Q

Theory of Firms  Marginal Cost  The cost of producing one extra or one less unit of output MC = TC n units – TC n-1 / Q  If TC of 100 units = £500 and TC of producing 101 units is £505, MC = £5.00  Important concept

Theory of Firms  Short and Long run:  Short run – some factors fixed and cannot be increased/reduced  Long Run – time taken to vary all factors of production  Short and long run vary in all industries:

Theory of Firms  Railways – short run –’easy’ to increase labour, long lead times for new rolling stock – 5 years?  Supermarkets – short run – can buy new shelving, hire staff, etc but opening of new stores takes several years  Local Builder – short run buys new tools, hires assistant; long run – purchasing a new van – a couple of months?

Theory of Firms  Diminishing Marginal Returns  Assumptions – some factors fixed (e.g. capital and land)  Adding variable factor – (labour)  Total Product  Average Product – TP / Q variable factor (Qv)  Marginal Product ΔTP/ΔQv

Theory of Firms  Increasing the variable factor:  TP rises at first, slows then falls  AP rises at first then starts to fall  MP rises, then falls, cuts AP at highest point of AP, cuts horizontal axis at point where TP starts to fall

Theory of Firms Objectives of firms:  Profit maximisation  Profit satisficing  Long term survival  Share price maximisation  Revenue maximisation  Brand loyalty  Expansion and market dominance

The Theory and Estimation of Cost  Definition of Cost  The Short Run Relationship Between Production and Cost The Short Run Cost Function  The Long Run Relationship Between Production and Cost The Long Run Cost Function  The Learning Curve

Definition of Cost  A cost is relevant if it is affected by a management decision. Historical cost is incurred at the time of procurement Replacement cost is necessary to replace inventory  Are historical costs relevant?

Definition of Cost  There are two types of cost associated with time Incremental cost varies with the range of options available in the decision making process. Sunk cost does not vary with decision options.  Is sunk cost relevant?

Definition of Cost  There are two types of cost associated with economic analysis Opportunity cost is the value that is forgone in choosing one activity over the next best alternative Out-of-pocket cost is actual transfer of value that occur  Which cost is relevant?

SR Relationship Between Production and Cost  A firm’s cost structure is related to its production process. Costs are determined by the production technology and input prices.  Assuming that the firm is a “price taker” in the input market.

SR Relationship Between Production and Cost  Total variable cost (TVC) is associated with the variable input Assume w=$500 per unit (price-taker)

SR Relationship Between Production and Cost  TP and TVC are mirror images of each other Kings Dominion Example

SR Relationship Between Production and Cost  Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC. TC=TFC+TVC  Marginal Costs  Average Costs Tool Set for Production Cost Analysis vs. Production Process Analysis

SR Relationship Between Production and Cost  Marginal cost (MC) is the change in total cost associated a change in output.

SR Relationship Between Production and Cost  Add marginal cost to the table

SR Relationship Between Production and Cost  Observe that: When MP is increasing, MC is decreasing. When MP is decreasing, MC is increasing.

SR Relationship Between Production and Cost  The relationship between MP and MC is Law of diminishing returns implies that MC will eventually increase! Why?

The Short Run Cost Function  Average total cost (ATC) is the average per- unit cost of using all of the firm’s inputs (TC/Q) Average variable cost (AVC) is the average per- unit cost of using the firm’s variable inputs (TVC/Q) Average fixed cost (AFC) is the average per-unit cost of using the firm’s fixed inputs (TFC/Q)

The Short Run Cost Function  Add ATC = AFC + AVC to the table

The Short Run Cost Function  ATC = AFC + AVC

The Short Run Cost Function  Production cost graph or map is

The Short Run Cost Function  Important Map Observations AFC declines steadily over the range of production. Why? In general, ATC is u-shaped. Why? MC intersects the minimum point (q*) on ATC. Why?

The Short Run Cost Function  Important Map Observations What is the economic significance of q*?

The Short Run Cost Function  Average total cost (ATC) is the average per- unit cost of using all of the firm’s inputs (TC/Q) At Q* - ATC is minimized or inputs are used most efficiently given the production function

The Short Run Cost Function  A change in input prices will shift the cost curves. If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip Case

The Short Run Cost Function  A change in input prices will shift the cost curves. If variable input costs are reduced then MC, AVC, and AC will all shift downward. Airline Industry Case

The Short Run Cost Function  Yahoo Group Discussion What is different about dot.com businesses? Irrational Exuberance

The LR Relationship Between Production and Cost  In the long run, all inputs are variable. What makes up LRAC?

The Long-Run Cost Function  LRAC is made up for SRACs SRAC curves represent various plant sizes Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve

The Long-Run Cost Function  The LRAC is the lower envelope of all of the SRAC curves. Minimum efficient scale is the lowest output level for which LRAC is minimized Is LRAC a function of market size? What are implications?

The Long-Run Cost Function  Reasons for Economies of Scale… Increasing returns to scale Specialization in the use of labor and capital  Economies in maintaining inventory  Discounts from bulk purchases  Lower cost of raising capital funds  Spreading promotional and R&D costs Management efficiencies

The Long-Run Cost Function  Reasons for Diseconomies of Scale… Decreasing returns to scale Input market imperfections Management coordination and control problems

The Learning Curve  Measures the percentage decrease in additional labor cost each time output doubles. An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.

The Learning Curve  A downward slope in the learning curve indicates the presence of the learning curve effect Why? Workers improve their productivity with practice  The learning curve effect shifts the SRAC downward