Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics in a Global Economy Chapter 7 Cost Theory and Estimation

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University The Nature of Costs  Explicit Costs  Accounting Costs: actual expenditures on resources  Economic Costs  Implicit Costs: returns on inputs owned by the firm  Opportunity Costs (Economic Costs): costs of all the inputs, whether owned by the firm or not.  Example 1.  Suppose that a firm purchased raw materials by 100, kept in the inventory.  If the price fell to 60.  Accountant cost = 100  Economic Cost (relevant) = 60  We can’t sell by more than 60.

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Example 2.  A machine purchased for If we use a linear depreciation for 10 years.  After 10 years, the accounting value = zero.  Suppose that after 10 years, the firm can sell the machine for 120.  The economic cost of the machine at year 11 = 120.  We can sell it at that value.  Relevant Costs  Incremental Costs: the change in total costs from implementing a particular managerial decision, e.g., introducing a new product line, undertaking a new advertising campaign, or the production of a previously purchased component.  Sunk Costs are Irrelevant: the costs that are not affected by the decision, they are irrelevant or Sunk Costs.

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Short-Run Cost Functions   Total Cost = TC = f(Q)   Total Fixed Cost = TFC   Total Variable Cost = TVC   TC = TFC + TVC   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

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Short-Run Cost Functions

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University

 Average Variable Cost  AVC = TVC/Q = w/APL  Note that AVC = TVC/Q = wL/Q  But APL = Q/L and 1/APL = L/Q  By substitution  AVC = w. 1/APL = w/APL  Marginal Cost   TC/  Q =  TVC/  Q = w/MPL  Note that  MC =  TVC/  Q = w (  L) /  Q  But  MPL =  Q /  L and 1/MPL =  L /  Q  Since w is constant and by substitution;  MC = W. 1/MPL = w/MPL

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University  Long-Run Total Cost = LTC = f(Q)  Long-Run Average Cost = LAC = LTC/Q  Long-Run Marginal Cost = LMC =  LTC/  Q

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Derivation of Long-Run Cost Curves

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Relationship Between Long-Run and Short-Run Average Cost Curves

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Possible Shapes of the LAC Curve

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Plant Size and Economies of Scale  Reasons of economies of scale:  Specialization  Technological reasons (diameter of pipes)  Financial Reasons  Quantity discounts  Interest discounts  Advertising discounts Economies of Scale Diseconomies of Scale Theoretical LAC

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Economies of Scope  Lowering costs when a firm produces tow or more products together than producing each one alone  S = {C(Q1) + C(Q2) – C(Q1+Q2)} / C(Q1+Q2)  (scope)  e.g.,  If Q1+Q2 = 15  If C(Q1) = 12 and C(Q2) = 6 then;  S = ((12+6)) – 15 / 15 =.2  There is a 20% saving in costs the bigger the economies of scope

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Learning Curve  Shows the decline in the average input cost of production with rising cumulative total outputs over time.  Average Cost of Unit Q = C = aQ b  C = average input cost  a = average cost of the first unit of output  b = negative  Note:  If b is high, the faster is the decline in input cost  If b is small the smaller is the decline in input cost

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University The Learning Curve

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Estimation Form:  log C = log a + b Log Q  e.g., if estimated regression is:  Log C = 3 – 0.3 log Q At Q = 100  Log C = 3 – 0.3 log(100) = 3 – 0.3(4.605) = 3 – 0.3(4.605) = 3 – = 3 – = = At Q = 200 Log C = log(200) = 3 – 0.3(5.2989) = 3 – = Average costs is going down as output is increasing over time.

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Cost-Volume-Profit Analysis (Break Even)  Note: Total Revenue = TR = (P)(Q) Total Cost = TC = TFC + (AVC)(Q) Breakeven Volume TR = TC Or: (P)(Q) = TFC + (AVC)(Q) Q BE = TFC/(P - AVC) Target output Q T = (TFC + Π T ) / (P – AVC)

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University  Cost-Volume-Profit Analysis P = 40 TFC = 200 AVC = 5 Q BE = 40

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University e.g., Break even output  If TFC = 200P = 10AVC = 5  Q BE = (200/(10-5) = 40  Since P = 10  TR = 10(40) = 400  TC = TFC + P(AVC) = (5) = 400 e.g., target output  If the firm wants to earn 100 as a target profit what is the target output  QT = ( ) / (10-5) = 60  Note that  TR = 10(60) = 600  TC = (60) = 500   Π = TR – TC = 600 – 500 =100   Which is the target profit

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University  Operating Leverage   Operating Leverage = TFC/TVC Degree of Operating Leverage = DOL

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University TC’ has a higher DOL than TC and therefore a higher Q BE

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Empirical Estimation Data Collection Issues  Opportunity Costs Must be Extracted from Accounting Cost Data  Costs Must be Apportioned Among Products  Costs Must be Matched to Output Over Time  Costs Must be Corrected for Inflation

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Empirical Estimation Functional Form for Short-Run Cost Functions Theoretical FormLinear Approximation

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Theoretical FormLinear Approximation

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Empirical Estimation long-Run Cost Curves  Cross-Sectional Regression Analysis  Engineering Method  Survival Technique Actual LAC versus empirically estimated LAC’

Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University