Costs and production

Detailed course schedule Day no   Topic Textbook ch. 1 (24 Nov; 3 hrs) 1. Introduction. Decision making process and its elements. The scope of economic decision making. Application of marginal analysis Chs. 1-2 2 (25 Nov; 3 hrs) 2. Demand analysis and demand elasticities Ch. 3 3 (26 Nov; 3 hrs) 3. Buyer product valuation and choices. Consumer surplus. Buyer pricing decisions Ch. 4 4 (27 Nov; 2 hrs) 4. Production/transformation process. Production technologies and input-output structure Ch. 5 5 (28 Nov; 2 hrs) 5. Cost structure and cost drivers of producer pricing strategies. Production scale and scope. Chs. 5 and 7 6 (1 Dec; 3 hrs) 6. Structure-conduct-performance. Market structures: competition and contestability. Pricing strategies of buyers and sellers Ch. 8 7 (2 Dec; 3 hrs) 7. Market structures: monopoly/monopsony, monopolistic competition and oligopoly. Pricing strategies and strategic behaviour Chs. 9-10 8 (3 Dec; 3 hrs) 8. Input sourcing and investment. Pricing and market power Chs. 6 and 11 9 (4 Dec; 2 hrs) 9. Decision making under conditions of uncertainty. Informational asymmetries and risk management Ch. 12 10 (5 Dec; 2 hrs) 10. Market research and market analysis. Auction and rings. Strategic behaviour Ch. 13 11 (8 Dec; 2 hrs ) 11. Public sector perspective Ch. 14 12 (9 Dec; 2 hrs) 12. Revision 13. Examination 13 (11 Dec; 2 hrs) Examination

Topic 5: Cost structure and cost drivers of producer pricing strategies Production scale and scope Topic Contents 5.1 Managerial perspective 5.2 Profit maximisation rule 5.3 Economic and accounting costs and profits 5.4 The supply schedule for a price taker 5.5 Price maker’s supply decision 5.6 Supply elasticity 5.7 Multi-plant supplier 5.8 Producer surplus 5.9 Multi-product pricing 5.10 Pricing in practice 5.11 Questions for self- assessment and review 5.12 Further reading

5.1 Managerial perspective Supply decision - here we focus on price and quantity Market power price takers price makers (extreme case - monopoly) Multi-plant suppliers Multi-product suppliers

5.2 Profit maximisation rule Chose the level of output such that marginal revenue equals marginal cost, providing that the total revenue (or average revenue) is greater than the total cost (or the average cost) at that output level MR = MC subject to TR > TC or AR > AC

5.2 Profit maximisation rule Revenues Costs Total Costs Total Revenue Loss Breakeven Profit Breakeven Output

5.2 Profit maximisation rule Optimal Input Combination Capital Isocost line 6 4 Expansion path 2 Q2 Isoquant Q1 3 6 9 12 15 Labour

5.3 Economic and accounting costs and profits Accountants focus on historical records of explicit costs Economists consider explicit and implicit (opportunity) costs, especially the marginal cost (sunk costs are irrelevant as bygones are bygones) Zero or normal profit is the minimum/necessary rate of return needed by a competitive supplier to stay in a particular business in the long run It is an ambiguous concept as “zero” means zero above normal profit Note that profit is a residual difference between the revenue and cost at the end of the accounting period so maximising it beforehand is also ambiguous

5.4 The supply schedule for a price taker Costs and Prices Marginal Cost P2 b Average Total Cost P1 a Average Variable Cost Quantity

5.4 The supply schedule for a price taker Suppliers maximise profits where MR = MC s.t. AR > AC For a price taker MR = AR = Price Supply curve is therefore the locus of points where MC = P which is the segment of the MC curve above the Average Variable Cost Curve Short-run Supply Curve - is shown as the segment of the MC curve above the Average Variable Cost (above point a in the figure above) Long-run Supply Curve - is shown as the segment of the MC curve above the Average Total Cost (above point b in the figure)

5.4 The supply schedule for a price taker Shut-down decision if prices drop below P1 in the short-run if prices drop below P2 in the long-run Entry Decision - if prices are expected to be no less than P2 in the long run (above normal profits)

5.4 The supply schedule for a price taker Movement Along and Shifts of the Supply Curve Price Supply C Supply A Supply B P0 Decrease in Increase in supply supply Quantity

5.4 The supply schedule for a price taker Market Supply Price Supplier A Supplier B Market Supply P0 horizontal addition Qa Qb SQa+Qb Quantity

5.5 Price maker’s supply decision Market power to influence price Business Decision Rule MR = MC s.t. AR > AC But MR = AR = Price Price maker has no supply curve He/she sets a particular price-quantity combination for each market demand schedule

5.5 Price maker’s supply decision Costs and Prices Marginal Cost P* Average Total Cost Demand = Average Revenue Q* Marginal Revenue Quantity Economics for Managers

5.6 Supply elasticity Price Elasticity of Supply % Change in Quantity Supplied PES = % Change in the Product Price PES may be sensitive to changes in the supply lead time supply less elastic in short-run supply more elastic in long-run

5.6 Supply elasticity Price Perfectly Inelastic Inelastic Elastic Quantity

Multi-plant, horizontally-integrated firm (single product) 5.7 Multi-plant supplier Multi-plant, horizontally-integrated firm (single product) Costs/Revenue MCa MCb MCfirm = MCa+MCb P* Demand Qa* Qb* Q* MR Quantity Economics for Managers

5.7 Multi-plant supplier Add (horizontally) all plant marginal cost curves (e.g., MCa and MCb) to obtain MCfirm = MCa+MCb Set MR = MCfirm to determine Q* and P* Set MCa = MCb = P* to determine Qa* and Qb*

5.8 Producer surplus Producer surplus is the difference between the revenue obtained by the supplier and its full cost of production. It is a measure of the profitability of supply The supply curve shows the seller’s willingness to sell different product quantities at various prices

5.8 Producer surplus Price Supply Producer Surplus Quantity

5.9 Multi-product pricing Suppliers should consider economies of scope and advantages of tied sales Tied sales - selling goods together rather than separately, especially complements Bundling - selling a package of own products with those of other firms (eg, an own boat and another firm’s boat trailer)

5.10 Pricing in Practice Mark-up pricing - adding a percentage to the cost Price lining - targeting a price or price band to reduce the cost of marketing and product tailoring to buyers Skimming - introducing a new product at an initially high price to gradually reduce it over time (eg, CD market) Prestige pricing - targeting those who judge quality by price

5.11 Questions for self-assessment and review Basic concepts and applications (1) Define the following (a) Production function (b) Marginal product of an input/factor of production (c) Returns to scale (d) Economies of scale (e) Returns to scope (f) Diseconomies of scope (2) What is the difference between economic and business profits? (3) What is the difference between the 'short run' and the 'long run' in economics?

5.11 Questions for self-assessment and review (4) Why does the 'conventional' supply curve slope upward? (5) Can you give an example of a flat (horizontal) supply curve? Why is it flat? (6) How is the supply schedule related to the supply curve? (7) What factors determine the quantity of a good that a seller is willing to supply? (8) Define (own) price elasticity of supply (9) Why is the price elasticity of supply likely to be lower in the short run than in the long run? (10) What does producer/seller surplus measure? (11) Draw an illustrative supply curve for: (a) price taker (b) price maker

5.11 Questions for self-assessment and review (12) What does mark-up pricing involve? (13) Consider the following production function and fill in the values for marginal product of labour: Output 0 10 20 28 35 41 46 Number of 0 1 2 3 4 5 6 operatives Marginal product … … … … … … … of labour With which operative does diminishing marginal product set in?

5.11 Questions for self-assessment and review (14) Sketch a figure that represents each of the following situations: (a) the production function exhibits increasing returns to scale and diminishing marginal product for both of its two inputs (b) the production function exhibits constant returns to scale and constant marginal products for both inputs Although you do not need to draw the figures to scale, be sure to label your axes and indicate why your figure illustrates the situation (15) Does a change in the technology of making computer keyboards lead to a movement along or a shift in the supply of PCs? (16) What is the price elasticity of supply of 'land' in central business districts (CBDs) of European capital cities?

5.12 Further reading Baye (2010): chs. 5 and 7