E CONOMIC E FFICIENCY & C OST MBA NCCU Managerial Economics Jack Wu

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.

E CON E FFICIENCY : C ONDITIONS for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost

E CONOMIC EFFICIENCY V. S. T ECHNICAL E FFICIENCY Contrast economic efficiency vis-à-vis technical efficiency Technical efficiency producing at lowest possible cost doesn’t consider how much benefit the item provides

A DAM S MITH ’ S I NVISIBLE H AND : P RICE 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.

I NVISIBLE H AND  Outcome of price competition in market  Marginal benefit = price  Marginal cost = price  Single price in market

E XAMPLE OF I NVISIBLE H AND 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.

P RICE C EILING Upper limit that sellers can charge and buyers can pay rent control regulated price for electricity

supply demand b equilibrium excess demand Quantity (Thousand units a month) Price ($ per month) RENT CONTROL: EQUILIBRIUM

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

R ENT C ONTROL : L OSSES 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

P RICE F LOOR Lower limit that sellers can charge and buyers can pay minimum wage agricultural price supports

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

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

M INIMUM W AGE : L OSSES 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

T AX : C OMMODITY T AX “ 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

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

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

I NCIDENCE 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

C OSTS

I NTRODUCTION Cost and economies of scale Cost and economies of scope Relevant / Opportunity costs Irrelevant Costs/ Sunk costs

E CONOMIES 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

E XPENSE S TATEMENT

F IXED AND V ARIABLE C OSTS

E CONOMIES OF SCALE  Economies of scale (increasing returns to scale): average cost decreases with scale of production

S CALE E CONOMIES : S OURCES large fixed costs research, development, and design information technology falling average variable costs distribution of gas and water container ships

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

E CONOMIES OF SCALE : S TRATEGIC IMPLICATIONS Either produce on large scale or outsource Seller side – monopoly/oligopoly Buyer side – monopsony/oligopsony

E CONOMIES 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

E XPENSES FOR TWO PRODUCTS

E CONOMIES OF S COPE 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

R ELEVANCE 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

O PPORTUNITY C OST definition -- net revenue from best alternative course of action two approaches  show alternatives  report opportunity costs

E XAMPLE 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 reporting opportunity costs INCOME STATEMENT SHOWING ALTERNATIVES

S UNK C OST 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.

E XAMPLE 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=$90,000.

E XAMPLE : 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 omitting sunk costs INCOME STATEMENT SHOWING ALTERNATIVES