Costs of production Outline 1.The economic concept of cost and profit 2.Fixed and sunk cost 3.Profit maximization with limited capacity 4.The cost of production 5.Long run cost 6.Economies of scale 7.Economies of scope 8.The learning curve 9.Cost analysis and optimal decisions

Opportunity cost Economists would count the following as a part of cost: Explicit, out-of-pocket costs such as tuition, books, and fees Implicit, or opportunity, cost, --i.e., the income (or utility) lost by not pursuing your next best alternative, such as a fulltime job. What is the true cost of pursuing a MBA degree?

Entrepreneurs have opportunity costs as well. For example, if I put my energy and talent into the restaurant business, I am giving up profits I could earn somewhere else.

Economists treat a normal profit as an implicit cost— that is, the cost of attracting entrepreneurship. Normal profit A normal profit is the minimum profit sufficient to compensate entrepreneurs for profits lost by not pursuing their next best business opportunity

Accounting Profit We accountants would subtract explicit, or accounting cost, from revenues to compute profit. Accounting  = Revenues – Explicit (Accounting) Cost

Economic Profit Economists would subtract economic cost (including a normal profit) from revenues to compute an economic profit Economic  = Revenues – (Explicit + Implicit Cost)

Fixed and Sunk Costs Fixed costs (FC) are elements of cost that do not vary with the level of output. Examples: Interest payments on bonded indebtedness, fire insurance premiums, salaries and benefits of managerial staff. Sunk costs are costs already incurred and hence non-recoverable. Examples: Research & development costs, advertising costs, cost of specialized equipment.

 -maximization with limited capacity: Ordering a best seller Consider a bookseller with a limited amount of shelf space. How many copies of a best seller should be ordered? Suppose the bookseller’s estimated (inverse) demand equation is given by: P = 24 – Q, where P is dollars and Q is quantity in hundreds of copies per month. The cost to the bookseller is $12 per copy.

3 questions 1.How many copies of the bestseller should the merchant order, and what price should she charge, assuming there is unlimited shelf space to stock the bestseller? 2.Now suppose shelf space is limited, so that carrying the bestseller means “crowding out” other books? Assuming the average profit on books already shelved is $4, what is the optimal price and quantity of the bestseller? 3.What if actual demand is less than estimated demand, say: P = 18 – 2Q. The publisher is obligated to refund returned copies for $6 each. How many copies should be returned (if any), and how many should be sold and at what price?

An Optimal Book Order

The key to 2 nd problem is in understanding that the $4 in profit lost for stocking each unit of the bestseller is an implicit cost Hence marginal cost is given by: MC = $12 + $4 = $16 Problem 2

Problem 3 Thus marginal cost is given by: MC = $4 + $6 = $10 To solve problem 3 you need to recognize 2 things: (1) Since the books have already been ordered, the $12 price is a sunk cost; and (2) the $6 return charge is an implicit cost of stocking the bestseller

Firm’s Costs in the Short Run

Figure 7.1 3, Output (Thousands of Units) Total Cost (Thousands of Dollars) ,000 1,000 Cost function

Definitions Variable cost (VC) is the sum of the firm’s expenditure for variable inputs such as hourly employees, raw materials or semi-finished articles, or utilities. Average total cost (SAC) is total cost divided by the quantity of output. Average variable cost (AVC) is variable cost divided by the quantity of output. Marginal cost (SMC) is the addition to total cost attributable to the last unit produced

Figure Output (Thousands of Units) Cost/Unit (Thousands of Dollars) SMC SAC 60

Relationship between Average and Marginal  When average cost is falling, marginal cost lies everywhere below average cost.  When average cost is rising, marginal cost lies everywhere above average cost.  When average cost is at its minimum, marginal cost cost is equal to average cost. If your most recent (marginal) grades are higher than your GPA at the start of the term, your GPA will rise

What explains rising (short-run) marginal cost? If labor is the only variable input then marginal cost can be expressed by: [7.1] Recall that the marginal product of labor will begin to fall at some point due to the law of diminishing returns.

Behavior of Average Fixed Cost As output increases, fixed cost can be spread more thinly

Production costs is the long run In the long run there are no fixed inputs; hence all costs are “variable.” The long run average cost curve shows the minimum average cost achievable at each level of output in the long run—that is, when all inputs are variable.

Constant Returns to Scale $5 0 Output (Thousands of Units) Long-Run Average Cost SAC 1 (9,000-square- foot plant) - SAC 2 (18,000-square foot plant) ( SAC 3 27,000-square- foot plant) SMC 1 SMC 2 SMC 3 LAC = LMC

The U-Shaped Long Run Average Cost Function Increasing returns Decreasing returns

Notice on the previous slide that up to a scale of Q MIN, the firm experiences decreasing (long run) unit cost. Economies of scale are exhausted at the point

Minimum Efficient Scale (Q MES ) Q MES is the minimum scale of operation at which long unit production costs can be minimized.

LAC Demand Q MES is large relative to he “size of the market.” Q Cost per unit To produce on an efficient scale, you must supply 50% of the product demanded at a price equal to minimum unit cost

How large do you have to be to minimize unit costs? 1  Not very large (as a percent of U.S. consumption) : Bricks, flour milling, machine tools, cement, glass containers, cigarettes, shoes, bread baking.  Fairly large (as a percent of U.S. consumption): Synthetic fibers, passenger cars, household refrigerators and freezers, commercial aircraft.  Very large (as a percent of U.S. consumption): Turbine generators, diesel engines, electric motors, mainframe computers. 1 F.M. Scherer and D. Ross. Industrial Market Structure and Performance, 3 rd edition, 1990, pp

Figure7.5a

Figure 7.5b

Figure 7.5c Local telephone service, electricity distribution, and cable TV distribution are well represented by this cost function.