Managerial Economics Jack Wu Costs Managerial Economics Jack Wu

Introduction Cost and economies of scale Cost and economies of scope Experience Curve Relevant / Opportunity costs Transfer Pricing Irrelevant Costs/ Sunk costs

Economies of scale Fixed cost: cost of inputs that do not change with production rate Variable cost: cost of inputs that change with the production rate Fixed/variable costs concepts apply in Short run Long run

Expense Statement

Fixed and Variable Costs

Economies of scale Economies of scale (increasing returns to scale): average cost decreases with scale of production Marginal and average variable costs are identical and do not change with the scale of production. Average cost decreases with the scale of production. Distinguish economies of scale from experience curve = costs fall with increases in cumulative production over time: economies of scale considers rate of production/operation at particular point of time; economies of scope

Scale Economies: Sources large fixed costs research, development, and design information technology falling average variable costs distribution of gas and water container ships

Diseconomies of scale Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

Economies of scale: Strategic implications Either produce on large scale or outsource Seller side – monopoly/oligopoly Buyer side – monopsony/oligopsony Industries with large scale economies: semiconductor manufacturing automobile manufacturing conventional wisdom: manufacturing scale of at least 4 million vehicles/year (“Honda Motor Plans to Stay Small But Nearly Double Its Efficiency”, Wall Street Journal Interactive Edition, July 9, 1999) increasing scale economies --> mergers and acquisitions: Daimler acquired Chrysler civil aircraft manufacturing -- industry is duopoly -- Boeing and Airbus banking services – in U.S., after state governments rescinded laws against inter-state banking, many institutions merged into super-regionals

Economies of scale: Google vis-à-vis library Which link(s) in service chain are scaleable? Compilation of information Providing service: servers and network Responding to enquiries Google compiles information by machine cost of compilation may have low marginal cost (maintenance of machines, bandwidth) once compiled, information is a fixed cost  scaleable Providing service involves some fixed costs basic system but other parts – number of servers, bandwidth -- must be scaled up with number of users Responding to enquiries: human response is not scaleable so Web services try to steer users to FAQs and other automated responses

Economies of scope Economies of scope: total cost of production is lower with joint than with separate production Diseconomies of scope: total cost of production is higher with joint than with separate production

Expenses for two products

Economies of Scope source -- joint cost: cost of inputs that do not change with scope of production examples: cable television + telephone banking + insurance manufacturing: refrigerator + air-conditioner strategic implication -- produce/deliver multiple products

Economies of scope: Core competence Technology – apply common technology to multiple products LCDs – watches, PDAs Manufacturing – apply same process to multiple products LCDs, semiconductors Marketing – brand extensions spread promotional costs over multiple products/businesses Example: Casio applied small LCDs to watches pocket calculators handheld computers Other examples: laser engine – printer, fax, copier compressor – refrigerator, air-conditioner

HORIZONTAL BOUNDARIES Economies of scale Should bank merge with competitor? Should trucking company acquire smaller rivals? Economies of scope Should airline run catering service? Should bank sell insurance? Should university open a medical school?

Experience curve Incremental cost falls with cumulative production run over time Unit cost falls with cumulative production run Distinguish from economies of scale within one production period

Experience curve Figure: unit cost is indexed at 100 for production of 1 unit.

Relevance consider only relevant costs and ignore all other costs which costs are relevant depends on course of action relevant costs may be hidden irrelevant costs may be shown in accounts

Opportunity Cost show alternatives report opportunity costs definition -- net revenue from best alternative course of action two approaches show alternatives report opportunity costs

Example Williams bought a warehouse and paid $300,000 for it. She used her own money $200,000 and made a bank loan of $100,000. A developer were willing to buy warehouse for 2 million. If Williams sells warehouse, she could invest proceeds in government bonds and get a secure income $160,000 (2 million*8%). She could work elsewhere for salary $400,000.

INCOME STATEMENT SHOWING ALTERNATIVES Income statement reporting opportunity costs

Transfer pricing Generally, for internal economic efficiency, set transfer price = marginal cost Special cases Perfectly competitive market: transfer price = market price Production subject to full capacity: transfer price = highest marginal benefit from internal use Compare marginal benefit across internal users First mentioned transfer pricing in Chapter 6: Economic Efficiency With perfectly competitive market, marginal cost = market price, hence set transfer price = market price; Full capacity: marginal cost not defined, so set transfer price = marginal benefit of input

Transfer pricing Production subject to full capacity: transfer price = highest marginal benefit from internal use Compare marginal benefit across internal users

Sunk Cost definition -- cost that has been committed and cannot be avoided alternative courses of action prior commitments planning horizon Fewer commitments  fewer sunk costs; longer planning horizon  fewer sunk costs.

Example Jupiter Athletic is about to launch a line of new athletic shoes. Some month ago, management prepared an ad campaign with total budget of $310,000. They forecast the ad would generate sales of 20,000 units. Each sale’s unit contribution margin (price- average variable cost) is $20. The total contribution margin is $20*20000=$400,000. Their expected profit generated from ad is $400,000-310,000=$90,000.

Example: continued Recently, a major competitor launch a new shoe. Jupiter estimates sales fall to 15,000 units. The contribution margin becomes $20*15,000=$300,000. Should Jupiter cancel the launch?

INCOME STATEMENT SHOWING ALTERNATIVES Income statement omitting sunk costs

Sunk vis-à-vis Fixed Costs Not all sunk costs are fixed Not all fixed costs are sunk

DISCUSSION QUESTIONS Qantas operates a fleet of over 100 Boeing jet aircraft. Commercial passenger jets must be operated by a pilot and co-pilot. Many jets carry cargo in their "bellies", under the passenger seating areas. Consider each of the following costs. Identify which are joint costs of passenger and belly cargo services, which are fixed costs of passenger service, and which are both.

DISCUSSION QUESTIONS (A)Cockpit personnel: All jets, large and small, require a pilot and co-pilot. Belly cargo service requires no additional officers in the cockpit. (B)Airport landing fees: Some airports charge landing fees by weight of the aircraft, while others levy a fixed fee, regardless of weight. (C)Fuel: Larger aircraft and those carrying heavier loads will consume relatively more fuel.