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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
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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.
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Example 2. A machine purchased for 1000. 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.
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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
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Short-Run Cost Functions
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University
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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
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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
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Derivation of Long-Run Cost Curves
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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
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Possible Shapes of the LAC Curve
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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
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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
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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
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University The Learning Curve
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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 – 1.382 = 3 – 1.382 = 1.616 = 1.616 At Q = 200 Log C = 3- 0.3 log(200) = 3 – 0.3(5.2989) = 3 – 1.589 = 1.411 Average costs is going down as output is increasing over time.
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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)
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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
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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) = 200 + 40(5) = 400 e.g., target output If the firm wants to earn 100 as a target profit what is the target output QT = (200 + 100) / (10-5) = 60 Note that TR = 10(60) = 600 TC = 200 + 5(60) = 500 Π = TR – TC = 600 – 500 =100 Which is the target profit
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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
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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
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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
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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
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Theoretical FormLinear Approximation
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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’
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Managerial Economics Prof. M. El-Sakka CBA. Kuwait University Managerial Economics Prof. M. El-Sakka CBA. Kuwait University
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