Economic Analysis for Managers (ECO 501) Fall:2012 Semester Khurrum S. Mughal

Theme of the Lecture Cost Theory & Analysis Economic Concept of Cost Short-Run Cost Function Profit Contribution Analysis Breakeven Analysis Operating Leverage

Economic Concept of Cost Opportunity costs are the value of the other products that the resources used in production could have produced at their next best alternative Explicit costs include the ordinary items that an accountant would include as the firms expenses Implicit costs include opportunity costs of resources owned and used by the firm’s owner

Economic Concept of Cost Normal Profit and Costs Economic Profit is revenue less economic costs, where the economic costs also include the normal returns to management or capital of the owner. Cost of Long-Lived Assets The economic costs of such assets would be the change in market value from the beginning to the end of the period

Economic Concept of Cost Marginal Costs are the change in total cost due to one unit change in output Incremental Costs is the additional cost of implementing a managerial decision Sunk Costs are expenditures that have been made in the past or that are to be made in the future due to some contractual obligation

Theme of the Lecture Cost Theory & Analysis Economic Concept of Cost Short-Run Cost Function Profit Contribution Analysis Breakeven Analysis Operating Leverage

Short-Run A period of time so short that the firm cannot alter the quantity of some of its inputs Typically plant and equipment are fixed inputs in the short run Fixed inputs determine the scale of the firm’s operation

Total Variable Cost = TVC Short-Run Cost Functions Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC

Short-Run Cost Functions Q TFC TVC TC 60 1 20 80 2 30 90 3 45 105 4 140 5 135 195

Short-Run Cost Functions TFC

Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Short-Run Cost Functions Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions Q TFC TVC TC AFC AVC ATC MC 60 - 1 20 80 ? 2 30 90 3 45 105 4 140 5 135 195

Short-Run Cost Functions Q TFC TVC TC AFC AVC ATC MC 60 - 1 20 80 2 30 90 15 45 10 3 105 35 4 140 5 135 195 12 27 39 55

Short-Run Cost Functions

Rate of output resulting in minimum average variable cost? Total Cost Function TC = 1000 + 10Q – 0.9Q2 + 0.04Q3 Rate of output resulting in minimum average variable cost?

Theme of the Lecture Cost Theory & Analysis Economic Concept of Cost Short-Run Cost Function Profit Contribution Analysis Breakeven Analysis Operating Leverage

Profit Contribution Analysis Profit Contribution is the difference between price and average variable cost (P – AVC) You can find out the output rate necessary to cover all fixed costs and earn required profit (πR) FC = $10,000, P = $30, AVC = $28, πR = $20,000 18

Theme of the Lecture Cost Theory & Analysis Economic Concept of Cost Short-Run Cost Function Profit Contribution Analysis Breakeven Analysis Operating Leverage

Breakeven Analysis A special case where you find the breakeven point by placing πR= 0 FC = $10,000, P = $30, AVC = $28 TC = 10,000 + 28Q TR = 30Q 20

Linear Breakeven Analysis Revenue, Cost Rate of Output, Q Linear Breakeven Analysis 21

Theme of the Lecture Cost Theory & Analysis Economic Concept of Cost Short-Run Cost Function Profit Contribution Analysis Breakeven Analysis Operating Leverage

Operating Leverage If fixed costs are relatively large than variable costs the firm is said to be highly leveraged It experiences more variation in profit for a percentage change in output. Can be analyzed using profit elasticity Eπ 23