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

2. 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

3. 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

4. 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?

5. 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?

6. 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?

7. 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.

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

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

10. 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

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

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

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

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

15. 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)

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

17. The Short Run Cost Function
ATC = AFC + AVC

18. The Short Run Cost Function
Production cost graph or map is

19. 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?

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

21. 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

22. 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

23. 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

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

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

26. 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

27. 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?

28. 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

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

30. 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.

31. 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

32. Production Cost Homework
Page 378
Problem 10