Managerial Economics: Economic Tools for Today’s Decision Makers, 4/e By Paul Keat and Philip Young

Before We Start…Group Presentation So popular? Q = aLbK1-b or c b+c > 1 IRTS b+c = 1 CRTS b+c < 1 DRTS Short Run Analysis: MPK = c Q/K & MPL = b Q/L b & c are elasticities of K & L factors LogQ=loga+blogL+clogK + dlogT where T  technology

The Theory and Estimation of Cost Definition of Cost The Short Run Relationship Between Production and Cost The Short Run Cost Function The Long Run Relationship Between Production and Cost The Long Run Cost Function The Learning Curve

A cost is relevant if it is affected by a management decision. Definition of Cost A cost is relevant if it is affected by a management decision. Historical cost is incurred at the time of procurement Replacement cost is necessary to replace inventory Are historical costs relevant?

There are two types of cost associated with economic analysis Definition of Cost There are two types of cost associated with economic analysis Opportunity cost is the value that is forgone in choosing one activity over the next best alternative Out-of-pocket cost is actual transfer of value that occur Which cost is relevant?

There are two types of cost associated with time Definition of Cost There are two types of cost associated with time Incremental cost varies with the range of options available in the decision making process. Sunk cost does not vary with decision options. Is sunk cost relevant?

SR Relationship Between Production and Cost A firm’s cost structure is related to its production process. Costs are determined by the production technology and input prices. Assuming that the firm is a “price taker” in the input market.

SR Relationship Between Production and Cost Total variable cost (TVC) is associated with the variable input Assume w=$500 per unit (price-taker)

SR Relationship Between Production and Cost TP and TVC are mirror images of each other Kings Dominion Example

SR Relationship Between Production and Cost Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC. TC=TFC+TVC Marginal Costs Average Costs Tool Set for Production Cost Analysis vs. Production Process Analysis

SR Relationship Between Production and Cost Marginal cost (MC) is the change in total cost associated a change in output.

SR Relationship Between Production and Cost Add marginal cost to the table

SR Relationship Between Production and Cost Observe that: When MP is increasing, MC is decreasing. When MP is decreasing, MC is increasing.

SR Relationship Between Production and Cost The relationship between MP and MC is Law of diminishing returns implies that MC will eventually increase! Why?

The Short Run Cost Function Average total cost (ATC) is the average per-unit cost of using all of the firm’s inputs (TC/Q) Average variable cost (AVC) is the average per-unit cost of using the firm’s variable inputs (TVC/Q) Average fixed cost (AFC) is the average per-unit cost of using the firm’s fixed inputs (TFC/Q)

The Short Run Cost Function Add ATC = AFC + AVC to the table

The Short Run Cost Function ATC = AFC + AVC

The Short Run Cost Function Production cost graph or map is

The Short Run Cost Function Important Map Observations AFC declines steadily over the range of production. Why? In general, ATC is u-shaped. Why? MC intersects the minimum point (q*) on ATC. Why?

The Short Run Cost Function Important Map Observations What is the economic significance of q*?

The Short Run Cost Function Average total cost (ATC) is the average per-unit cost of using all of the firm’s inputs (TC/Q) At Q* - ATC is minimized or inputs are used most efficiently given the production function Going at 55 MPH

The Short Run Cost Function A change in input prices will shift the cost curves. If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip Case

The Short Run Cost Function A change in input prices will shift the cost curves. If variable input costs are reduced then MC, AVC, and AC will all shift downward. Airline Industry Case

The Short Run Cost Function Yahoo Group Discussion What is different about dot.com businesses? Irrational Exuberance

The LR Relationship Between Production and Cost In the long run, all inputs are variable. What makes up LRAC?

The Long-Run Cost Function LRAC is made up for SRACs SRAC curves represent various plant sizes Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve

The Long-Run Cost Function The LRAC is the lower envelope of all of the SRAC curves. Minimum efficient scale is the lowest output level for which LRAC is minimized Is LRAC a function of market size? What are implications?

The Long-Run Cost Function Reasons for Economies of Scale… Increasing returns to scale Specialization in the use of labor and capital Economies in maintaining inventory Discounts from bulk purchases Lower cost of raising capital funds Spreading promotional and R&D costs Management efficiencies

The Long-Run Cost Function Reasons for Diseconomies of Scale… Decreasing returns to scale Input market imperfections Management coordination and control problems

The Learning Curve Measures the percentage decrease in additional labor cost each time output doubles. An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.

The learning curve effect shifts the SRAC downward A downward slope in the learning curve indicates the presence of the learning curve effect Why? Workers improve their productivity with practice The learning curve effect shifts the SRAC downward

Production Cost Homework Page 378 Problem 10