1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Costs 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 13

2. Output and Productivity Costs –Costs of resource services needed to produce output The more productive the resources –The fewer that are required to produce any given amount of output Productivity –Output per unit of a resource’s services 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Output and Productivity Labor productivity –Quantity of output divided by the number of hours worked by labor Everything else held constant Land productivity –Quantity of output divided by the quantity of land Everything else held constant 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Output and Productivity Capital productivity –Total output divided by total capital Total factor productivity –Total output divided by total inputs Productivity –The efficiency with which inputs are converted into output 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Figure 13.1 Productivity growth and economic growth are positively correlated. When productivity rises, so do living standards. Productivity Growth Has a Big Impact on Living Standards 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Output and Productivity Increases in productivity –From improvements in the quality of resources –Technological change – enables resources to be more efficient –Human capital 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. From Production to Costs When productivity is rising –Costs are declining The same amount of output can be produced using fewer resources When productivity is falling –Costs are rising The same amount of output requires more resources 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. From Production to Costs Total factor productivity –Measure of the change in output resulting from a change in all resources Marginal productivity –Change in output that results from a change in just one resource –Everything else held constant 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. From Production to Costs Law of diminishing marginal returns –As a variable resource is increased and combined with a fixed quantity of other resources –Marginal productivity will initially rise but eventually will decline 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Table 13.1 The combinations of total output (thousands of daily passenger miles) that can be produced by an airline using different combinations of mechanics and airplanes. If one resource is fixed, such as number of airplanes fixed at 10, then increasing the number of mechanics increases output but by decreasing amounts. This is diminishing marginal returns. Production and Diminishing Marginal Returns 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. From Production to Costs Average total cost (ATC) –Cost per unit of output –Total cost divided by quantity of output –Falls initially and then rise as output rises Law of diminishing marginal returns Marginal cost (MC) –Change in total cost divided by the change in the quantity of output Additional cost that comes from producing an additional unit of output 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. From Production to Costs Marginal product of labor (MP) –Additional quantity that comes from an additional unit of labor services Marginal cost of output, MC = W/MP –W – the wage rate Additional cost of labor –MP – marginal product of labor –Falls initially and then rises as output rises Law of diminishing marginal returns 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. From Production to Costs MC and MP –When marginal productivity (MP) is rising Fewer additional resources are used to produce a certain amount of additional output Marginal cost is falling –When marginal productivity is falling Marginal cost is rising 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Table 13.2 a- This is the average of the individual unit marginal cost. The marginal cost of $10 for the first 99 units indicates that the average marginal cost of units 1 through 100 is $101, and so on for units 101–250, units 251–360, etc. Total, Average, and Marginal costs 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Fixed and Variable Costs Fixed costs, TFC –Costs that do not change as the quantity of output changes Variable costs, TVC –Costs that depend on the quantity of output Total costs, TC = TFC + TVC 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Table 13.3 This table shows the calculation of the various cost measures. Average costs (average fixed, average variable, average total) are derived by dividing total costs (fixed, variable, total) by output. Marginal cost is the change in total cost divided by the change in output. Cost Schedules 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Fixed and Variable Costs Average total cost curve –U-shaped As output rises, per-unit costs initially fall but eventually rise Law of diminishing marginal returns Marginal cost curve –U-shaped As output rises, incremental costs initially fall but eventually rise Law of diminishing marginal returns 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Figure 13.2 The figures in Table 13.3 are plotted. MC, AVC, and ATC all fall initially and then rise. AFC continually falls. MC intersects AVC and ATC at their minimum points. Average Total Cost (ATC) and Marginal Cost (MC) are U- shaped Due to The Law of Diminishing Marginal Returns 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Operating Leverage, Sunk Costs Operating leverage –Ratio of fixed costs to variable costs –If it is high – the firm has less flexibility Sunk costs –Costs that have already been incurred and that cannot be recovered –Gone and not retrievable –Should not influence decisions 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Operating Leverage, Sunk Costs Sunk cost fallacy, the Concorde Effect –Sunk costs are used to justify continued action Sunk costs –Often enter into strategic decisions –Developers - get work underway Build foundations, clear areas Once money has been spent - difficult for financiers to do anything except scream and holler 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Business Insight A Builder’s View of Sunk Costs Jonathan Ward, a remodeler –Humans seem to be the only animals that don’t understand the concept of sunk costs Waste time trying to find someone to blame –Or someone to sue Go on TV talk shows to weep about their misfortune Attempt to “seek closure” 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Business Insight A Builder’s View of Sunk Costs Jonathan Ward, a remodeler –It is important to know when a situation is untenable And when to walk away from a project –You must continually ask yourself if, knowing what you know now, you would have funded the venture in the beginning 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. The Planning Horizon: The Long Run Short run –Operating period –Fixed costs - firm is constrained Long run –Planning period –Time period just long enough that everything is variable –No fixed costs 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. The Planning Horizon: The Long Run Long run –Manager - can choose any size of plant or building Any combination of other resources Planning –Manager compares all short-run situations –Expand, contract, relocate, enter a new business, exit any line of business, or quit doing business altogether 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Figure 13.3 The company is currently operating at 5,000 units of output per year. To increase to 100,000 would require an increase in the capacity or scale of the firm. Morita’s Long-Run Average Total Cost Curve 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Figure 13.4 Producing 5,000 units can be done efficiently using the capacity of short-run average total cost (SRATC 1 ). To generate 100,000 units per year would require an increase in scale. But once having increased scale to SRATC 2, it would be virtually impossible— very expensive—to move back to 5,000 units. The Long-Run and Short Run Average Total Cost Curves 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Costs in the Long Run Long run –Is a planning period Any combination of resources can be selected –A firm can choose to operate at any size Choose the level of output it wants to produce Then select the least-cost combination of resources with which to produce the chosen output level Once it has built that given capacity, then it is constrained to operate at that level 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Economies and Diseconomies of Scale Economies of scale –Cost per unit of output decreases as output rises Diseconomies of scale –Cost per unit of output increases when the quantity of production increases Constant returns to scale –Cost per unit of output is constant as output rises 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Economies and Diseconomies of Scale Long-run average total cost curve –Downward sloping Economies of scale –Constant Constant returns to scale –Upward sloping Diseconomies of scale 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Economies and Diseconomies of Scale Economies of scale - result from –Ability to use larger machines that are more efficient than small ones –Specialization Primary reason for diseconomies of scale –Managerial inefficiencies 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Large Scale Is Not Always Best Efficiency and specialization –Are limited by the size of the market Larger firm – produce more than what the market can buy –Inefficient Larger size –Not necessarily beneficial for individual firms Diseconomies of scale - Bureaucracy, quarterly reporting, rent seeking 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Economies of Scope Economies of scope –Firm obtains a production advantage from producing more than one product The cost of producing two (or more) products jointly is less than the cost of producing each one alone 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Economies of Scope Economies of scope –Advantages may arise: Production facility used to make one product - can also be used to make another By-products of one product - useful in the production of another product People trained to produce one product - can use their training in the production of another product 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. The Experience Curve Experience curve, learning curve –Declining costs as output rises The result of learning, of gaining experience –Confused with economies of scale Aircraft manufacturers –Learning curve Broiler chickens –Misleading learning curve –Better technology 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Figure 13.5 If the more experience a firm has in producing a particular good results in lower per- unit costs, then the firm has an experience, or learning curve, that slopes downward. In this diagram, experience curves for two industries are shown, one for aircraft and one for chickens. The Experience Curve 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.