1. Economic Efficiency & Cost
IMBA NCCU
Managerial Economics
Jack Wu

2. Economic Efficiency

3. 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

4. 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.

5. 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.

6. Econ Efficiency: Conditions
for all users, same marginal benefit
for all suppliers, same marginal cost
marginal benefit = marginal cost

7. Economic efficiency v.s. Technical Efficiency
Contrast economic efficiency vis-à-vis technical efficiency
Technical efficiency
producing at lowest possible cost
doesn’t consider how much benefit the item provides

8. Adam Smith’s Invisible Hand: Price
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.

9. Invisible Hand Outcome of price competition in market
Marginal benefit = price
Marginal cost = price
Single price in market
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.

10. Example of Invisible Hand
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.

11. UCLA Anderson School, 1989 Half an invisible hand is worse than none
priced photocopying paper
free bond paper

12. Price Ceiling Upper limit that sellers can charge and buyers can pay
rent control
regulated price for electricity

13. RENT CONTROL: EQUILIBRIUM
1100
supply
Price ($ per month) b
1000
equilibrium
900
excess demand
demand
290
300
310
Quantity (Thousand units a month)

14. RENT CONTROL: SURPLUSES
buyer surplus gain = cfeg
buyer surplus loss = dgb
seller surplus loss = cfeg + geb d
1100
supply
Price ($ per month) b
1000 c g
900 f e
demand
290
300
310
Quantity (Thousand units a month)

15. Rent Control: Losses
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
Deadweight loss is the economic cost of government intervention with free market;
demand more inelastic --> larger loss
supply more elastic --> larger loss

16. Price Floor Lower limit that sellers can charge and buyers can pay
minimum wage
agricultural price supports

17. MINIMUM WAGE: EQUILIBRIUM
excess supply
supply
Wage ($ per hour)
4.20 b
4.00
equilibrium c
demand 8 10 11
Quantity (Billion worker-hours a week)

18. MINIMUM WAGE: SURPLUSES
seller surplus gain = fdge
seller surplus loss = ghb
buyer surplus loss = fdge + egb a
supply
Wage ($ per hour) f e
4.20 b
4.00 d g h c
demand 8 10 11
Quantity (Billion worker-hours a week)

19. Minimum Wage: Losses
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

20. Tax: Commodity Tax
“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

21. TAX: EQUILIBRIUM $10 804 e supply Price ($ per ticket) 800 b 794 h
demand
900
920
Quantity (Thousand tickets a year)

22. TAX: SURPLUSES
buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb
revenue gain = fdge + djhg
$10
804 f e
supply
Price ($ per ticket)
800 d g b
794 j h
demand
900
920
Quantity (Thousand tickets a year)

23. Incidence
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

24. Costs

25. Introduction Cost and economies of scale Cost and economies of scope
Relevant / Opportunity costs
Irrelevant Costs/ Sunk costs

26. Economies 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

27. Expense Statement

28. Fixed and Variable Costs

29. Economies of scale
Economies of scale (increasing returns to scale): average cost decreases with scale of production
Marginal and average variable costs are identical and do not change with the scale of production.
Average cost decreases with the scale of production.
Distinguish economies of scale from
experience curve = costs fall with increases in cumulative production over time: economies of scale considers rate of production/operation at particular point of time;
economies of scope

30. Scale Economies: Sources
large fixed costs
research, development, and design
information technology
falling average variable costs
distribution of gas and water
container ships

31. Diseconomies of scale
Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

32. Economies of scale: Strategic implications
Either produce on large scale or outsource
Seller side – monopoly/oligopoly
Buyer side – monopsony/oligopsony
Industries with large scale economies:
semiconductor manufacturing
automobile manufacturing
conventional wisdom: manufacturing scale of at least 4 million vehicles/year (“Honda Motor Plans to Stay Small But Nearly Double Its Efficiency”, Wall Street Journal Interactive Edition, July 9, 1999)
increasing scale economies --> mergers and acquisitions: Daimler acquired Chrysler
civil aircraft manufacturing -- industry is duopoly -- Boeing and Airbus
banking services – in U.S., after state governments rescinded laws against inter-state banking, many institutions merged into super-regionals

33. Economies 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

34. Expenses for two products

35. Economies of Scope
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

36. Relevance 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

37. Opportunity Cost show alternatives report opportunity costs
definition -- net revenue from best alternative course of action
two approaches
show alternatives
report opportunity costs

38. Example
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.

39. INCOME STATEMENT SHOWING ALTERNATIVES
Income statement reporting opportunity costs

40. Sunk Cost
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.

41. Example
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, Their expected profit generated from ad is $400, ,000=$90,000.

42. Example: 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?

43. INCOME STATEMENT SHOWING ALTERNATIVES
Income statement omitting sunk costs