Economic Efficiency & Cost IMBA NCCU Managerial Economics Jack Wu

Economic Efficiency

CASE: AIRPORTS IN NEW YORK AREA, 2008 Newark , Continental Airlines (72% of takeoff and landing slots), 35.4 million passengers Kennedy , Delta Airline (31% of takeoff and landing slots), 47.8 million passengers LaGuardia, US Airways (32% of takeoff and landing slots), 23.1 million passengers

OUTCOMES OF LANDING FEE POLICY The Port Authority charges airlines landing fees based on aircraft weight. The fees are on average of $6 per passenger and do not vary with the time of day. During peak hours, the demand for takeoffs and landings at Newark exceeds capacity. FAA presented a 10-year plan limiting scheduled takeoffs and landings to 81 per hour and establishing an auction for landing and takeoff slots. However, the Port Authority, major airlines resisted the FAA plan. FAA abandoned the plan and sought other ways to relieve congestion at Newark.

APPLICATION OF MANAGERIAL ECONOMICS Takeoff and landing slots at an airport with limited runway capacity are a scarce resource. However, if the slots are allocated by administrative rule, the allocation of resources might not be economically efficient.

Econ Efficiency: Conditions for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost

Economic efficiency v.s. Technical Efficiency Contrast economic efficiency vis-à-vis technical efficiency Technical efficiency producing at lowest possible cost doesn’t consider how much benefit the item provides

Adam Smith’s Invisible Hand: Price Competitive market achieves three sufficient condition for economic efficiency: buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient i) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.

Invisible Hand Outcome of price competition in market Marginal benefit = price Marginal cost = price Single price in market Competitive market achieves three sufficient condition for economic efficiency: buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient i) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.

Example of Invisible Hand Major policy issue: how to allocate licenses for 3G wireless telecommunications; “beauty contest” -- France auction – Germany, UK, US pioneer: in early 1990s, US Federal Communications Commission showed that spectrum licenses were worth billions; created pressure on other governments to allocate by auction and not favoritism. Auction ensures that item goes to user with highest marginal benefit.

UCLA Anderson School, 1989 Half an invisible hand is worse than none priced photocopying paper free bond paper

Price Ceiling Upper limit that sellers can charge and buyers can pay rent control regulated price for electricity

RENT CONTROL: EQUILIBRIUM 1100 supply Price ($ per month) b 1000 equilibrium 900 excess demand demand 290 300 310 Quantity (Thousand units a month)

RENT CONTROL: SURPLUSES buyer surplus gain = cfeg buyer surplus loss = dgb seller surplus loss = cfeg + geb d 1100 supply Price ($ per month) b 1000 c g 900 f e demand 290 300 310 Quantity (Thousand units a month)

Rent Control: Losses deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur price elasticities of demand and supply _demand more inelastic --> larger loss _ supply more elastic --> larger loss Deadweight loss is the economic cost of government intervention with free market; demand more inelastic --> larger loss supply more elastic --> larger loss

Price Floor Lower limit that sellers can charge and buyers can pay minimum wage agricultural price supports

MINIMUM WAGE: EQUILIBRIUM excess supply supply Wage ($ per hour) 4.20 b 4.00 equilibrium c demand 8 10 11 Quantity (Billion worker-hours a week)

MINIMUM WAGE: SURPLUSES seller surplus gain = fdge seller surplus loss = ghb buyer surplus loss = fdge + egb a supply Wage ($ per hour) f e 4.20 b 4.00 d g h c demand 8 10 11 Quantity (Billion worker-hours a week)

Minimum Wage: Losses deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur price elasticities of demand and supply _supply more inelastic --> larger loss _demand more elastic --> larger loss

Tax: Commodity Tax “the only two sure things in life are death and taxes” buyer’s price - tax = seller’s price payment vis-à-vis incidence US: airlines pay tax Asia: passengers pay

TAX: EQUILIBRIUM $10 804 e supply Price ($ per ticket) 800 b 794 h demand 900 920 Quantity (Thousand tickets a year)

TAX: SURPLUSES buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg $10 804 f e supply Price ($ per ticket) 800 d g b 794 j h demand 900 920 Quantity (Thousand tickets a year)

Incidence incidence and deadweight loss depend on price elasticities of demand and supply ideal tax (no deadweight loss): inelastic demand/supply who pays the tax not relevant

Costs

Introduction Cost and economies of scale Cost and economies of scope Relevant / Opportunity costs 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 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

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

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