1 Ch 6 COST The theory of cost is important to a manager because it provides the foundation for two important production decisions: 1) whether or not to shut down 2) how much to produce Also, this chapter supports the theory of supply.

2 “Buy low and sell high” Increasing competitive pressures, changing technology, and customer demand have made it harder for firms to achieve high profit margins by raising their prices –cost management, restructuring, downsizing etc. –outsourcing and relocation of manufacturing facilities to low-wage countries –mergers, consolidations, and then reduced headcount

3 Choosing Output: COSTSREVENUES Technology & costs of hiring factors of production TC curves (short & long run) AC (short & long run) MC Demand curve AR MR CHECK: produce in SR? close down in LR? Choose output level

4 Which Costs Matter? n Opportunity vs. accounting cost n Opportunity cost is the cost associated with opportunities that are foregone by not putting resources in their highest valued use n Accounting cost considers only explicit cost, the out of pocket cost for such items as wages, salaries, materials, and property rentals n Sunk vs. incremental cost n A sunk cost is an expenditure that has been made and cannot be recovered--they should not influence a firm’s decisions

5 Costs in the Short Run n Total output is a function of variable inputs and fixed inputs n Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs) n Fixed costs –costs that do not vary with output levels n Variable costs –costs that do vary with output levels n TC = FC + VC

6 Costs in the Short Run continued Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:

7 Costs in the Short Run continued n Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC) n This can be written:

8 The Determinants of Short-Run Cost n The relationship between the production function and cost can be exemplified by either increasing returns and cost or decreasing returns and cost: –Increasing returns and cost n With increasing returns, output is increasing relative to input and variable cost and total cost will fall relative to output  Decreasing returns and cost n With decreasing returns, output is decreasing relative to input and variable cost and total cost will rise relative to output

9 Cost Curves for a Firm n Unit Costs –AFC falls continuously and –MC = AVC and ATC at their minimum –Minimum AVC occurs at a lower output than minimum ATC due to FC Output P AFC AVC ATC MC

10 The Firm’s Short-Run Output Decision n Firm sets output at Q 1, where SRMC=MR n subject to checking the average condition: –if price is above SRATC 1 firm produces Q 1 at a profit –if price is between SRATC 1 and SRAVC 1 firm produces Q 1 at a loss –if price is below SRAVC 1, firm produces zero output SRAVC 1 £ Output MR SRAVC SRMC Q1Q1 SRATC SRATC 1 SMC = MR

11 The firm’s long-run output decision n The decision: –If the price is at or above LAC 1, the firm produces Q 1. –If the price is below LAC 1 –the firm goes out of business n NB: LMC always passes through the minimum point of LAC. AC 1 £ Output (goods per week) MR LAC LMC Q1Q1 LMC = MR

12 The firm’s output decisions – a summary

13 Long-Run Cost Function The long-run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels. One of the first decisions to be made by the owner/manager of a firm is to decide the scale of operation (size of the firm).

14 Long-Run Average Cost The LAC is a graph that shows the different scales on which a firm can choose to operate in the long run. Long-run average cost (LRAC) is often assumed to be U-shaped: LRAC Average cost Output

15 Economies of Scale However, economies of scale occur when long-run average costs decline as output rises: LRAC Average cost Output

16 Economies of Scale n A cost related concept 1 n When a company is experiencing economies of scale its LRAC declines as output is increasing n Diseconomies of scale: LRAC increasing as output increasing 1 Compare with returns to scale which is a production concept!

17 Long-Run Cost Function: Displaying Economies/Diseconomies of Scale LRAC $ Economies of scale Diseconomies of scale Q MC increasing

18 Economies of scale can be classified as a)External economies of scale advantages that a firm gains from the expansion and size of the industry as whole  industrial clusters b)Internal economies of scale advantages that a firm gains from increasing the scale of its own operation

19 Why a firm can become more efficient as the scale of production rises? n Technical economies n Marketing economies n Financial economies n Managerial economies n Risk-bearing economies n Administrative economies

20 Why a firm can become more inefficient as the scale of production rises? Diseconomies of scale: n Large enough operation may increase input prices n Disproportionate rise in transportation costs n Red tape n Management coordination problems n Labor specialization and repetitive work too little stimulation, productivity suffers

21 n Primary reason for long-run scale economies is the underlying pattern of returns to scale in the firm’s long-run production function

22 Using LRAC as Decision-Making Tool n Which plant size to choose? n Both production cost information and accurate demand forecasts are necessary n The cost structure of the industry will determine the competitive structure of the industry

23 The long-run average cost curve LRAC: an envelope of short-run cost curves Output Average cost SRATC 1 Each plant size is designed for a given output level SRATC 2 SRATC 3 SRATC 4 So there is a sequence of SRATC curves, each corresponding to a different optimal output level. LRAC In the long-run, plant size itself is variable, and the long-run average cost curve LRAC is found to be the ‘envelope’ of the SRATCs

The existence of economies of scale means that in the long run, as the firms increases its scale of operation, the LRAC of production falls. SRMC SRAC Units of output Costs per unit ($) LRAC Each individual scale of the firm will still be subject to diminishing returns and have a U- shaped SRAC curve.

25 Minimum Efficient Scale n A firm can not expect always to achieve economies of scale when it expands: at some point it is likely that the further increase in size does not produce any reduction in the average cost per unit –minimum efficient scale (MES) LRAC MES Scale of firm $

Increasing LRAC: Diseconomies of Scale SRMC SRAC SRMC SRAC SRMC SRAC Units of output Costs per unit ($) LRAC

27 Constant Returns to Scale n Constant RTS refers to when an increase in scale of operation leads to no change in average costs per unit produced  LRAC is horizontal –when the firm doubles the use of inputs, it will double output

28 Production with Two (or more) Outputs--Economies of Scope n Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output –producing related products, products that are complementary the average total cost of production decreases as a result of increasing the number of different goods produced

29 Why Advantages May Exist For example: 1)Both use capital and labor 2)The firms share management resources 3)Both use the same labor skills and type of machinery

30 Economies of Scope continued n Examples: –Chicken farm--poultry and eggs –Automobile company--cars and trucks –University--teaching and research

31 An Example: PepsiCo, Inc.

32 Economies of Scope continued n Another example is a company like Proctor & Gamble, which produces hundreds of products from soap to toothpaste. They can afford to hire expensive graphic designers and marketing experts who can use their skills across the product lines. Because the costs are spread out, this lowers the average total cost of production for each product

33 Degree of Economies of Scope n The degree of economies of scope measures the savings in cost: –C(Q 1 ) is the cost of producing product Q 1 –C(Q 2 ) is the cost of producing product Q 2 –C(Q 1 Q 2 ) is the joint cost of producing both products –If SC > 0 -- Economies of scope –If SC < 0 -- Diseconomies of scope

34 Dynamic Changes in Costs-- The Learning Curve n The learning curve measures the impact of worker’s experience on the costs of production n It describes the relationship between a firm’s cumulative output and amount of inputs needed to produce a unit of output n The learning curve implies: 1) The labor requirement falls per unit 2)Costs will be high at first and then will fall with learning

35 The Learning Curve Cumulative number of machine lots produced Hours of labor per machine lot

36 The Learning Curve Cumulative number of machine lots produced Hours of labor per machine lot

37 The Learning Curve Cumulative # of machine lots produced Hours of labor per machine lot n The horizontal axis measures the cumulative number of hours of machine tools the firm has produced n The vertical axis measures the number of hours of labor needed to produce each lot

38 Economies of Scale Versus Learning Output Cost ($ per unit of output) AC 1 A

39 Economies of Scale Versus Learning Output Cost ($ per unit of output) AC 1 A B Economies of Scale

40 Economies of Scale Versus Learning Output Cost ($ per unit of output) AC 1 A B Economies of Scale AC 2 Learning C