1

Ch 6 COSTCh 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 down2) how much to produce

Also, this chapter supports the theory of supply.

2

““Buy low and sell high”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:Choosing Output:COSTS REVENUES

Technology & costs of

hiring factors of production

TC curves(short & long run)

AC(short &long run)

MC

Demandcurve

AR

MR

CHECK: produce in SR?close down in LR?

Choose output level

4

Which Costs Matter?Which Costs Matter?

Opportunity vs. accounting cost Opportunity cost is the cost associated with

opportunities that are foregone by not putting resources in their highest valued use

Accounting cost considers only explicit cost, the out of pocket cost for such items as wages, salaries, materials, and property rentals

Sunk vs. incremental cost 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 RunCosts in the Short Run Total output is a function of variable

inputs and fixed inputs

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)

Fixed costs– costs that do not vary with output levels

Variable costs– costs that do vary with output levels

TC = FC + VC

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Costs in the Short Run Costs in the Short Run continuedcontinued

Q

TC

Q

VC MC

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 Costs in the Short Run continuedcontinued

Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC)

This can be written:

Q

TC

Q

TVC

Q

TFC ATC

8

The Determinants of Short-Run The Determinants of Short-Run CostCost

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

With increasing returns, output is increasing relative to input and variable cost and total cost will fall relative to output

Decreasing returns and cost With decreasing returns, output is

decreasing relative to input and variable cost and total cost will rise relative to output

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Cost Curves for a FirmCost Curves for a Firm

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

25

50

75

100

0 1 2 3 4 5 6 7 8 9 10 11

AFC

AVCATC

MC

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The Firm’s Short-Run Output The Firm’s Short-Run Output DecisionDecision

Firm sets output at Q1, where SRMC=MR

subject to checking the average condition:– if price is above

SRATC1 firm produces Q1 at a profit

– if price is between SRATC1 and SRAVC1 firm produces Q1 at a loss

– if price is below SRAVC1, firm produces zero output

SRAVC1

£

Output

MR

SRAVC

SRMC

Q1

SRATCSRATC1

SMC = MR

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The firm’s long-run output The firm’s long-run output decisiondecision

The decision:– If the price is at or

above LAC1, the firm produces Q1.

– If the price is below LAC1

– the firm goes out of business

NB: LMC always passes through the minimum point of LAC.

AC1

£

Output(goods per week)

MR

LAC

LMC

Q1

LMC = MR

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The firm’s output decisions – a The firm’s output decisions – a summarysummary

Marginal condition Check whether to produce

Short-rundecision

Long-rundecision

Choose the output levelat which MR = SRMC

Choose the output levelat which MR = LRMC

Produce this output unlessprice lower than SRAVC. Ifit is, produce zero

Produce this output unlessprice is lower than LRAC. Ifit is, produce zero.

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Long-Run Cost FunctionLong-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).

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Long-Run Average CostLong-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

Av

era

ge

co

st

Output

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Economies of ScaleEconomies of Scale

However, economies of scale occur when long-run average costs decline as output rises:

LRAC

Av

era

ge

co

st

Output

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Economies of ScaleEconomies of Scale

A cost related concept1

When a company is experiencing economies of scale its LRAC declines as output is increasing

Diseconomies of scale:LRAC increasing as output increasing

1 Compare with returns to scale which is a production concept!

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Long-Run Cost Function: Displaying Long-Run Cost Function: Displaying Economies/Diseconomies of ScaleEconomies/Diseconomies of Scale

LRAC

$

Economies of scale Diseconomies of scaleQ

MC increasing

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Economies of scale can be Economies of scale can be classified asclassified as

a) External economies of scaleadvantages that a firm gains

from the expansion and size of the industry as whole industrial clusters

b) Internal economies of scaleadvantages that a firm gains

from increasing the scale of its own operation

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Why a firm can become more Why a firm can become more efficient efficient as the scale of as the scale of production rises?production rises?

Technical economies

Marketing economies

Financial economies

Managerial economies

Risk-bearing economies

Administrative economies

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Why a firm can become more Why a firm can become more inefficient inefficient as the scale of production as the scale of production rises?rises?

Diseconomies of scale: Large enough operation may increase

input prices Disproportionate rise in

transportation costs Red tape Management coordination problems Labor specialization and repetitive

work too little stimulation, productivity suffers

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

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Using LRAC as Decision-Making Using LRAC as Decision-Making ToolTool

Which plant size to choose? Both production cost information

and accurate demand forecasts are necessary

The cost structure of the industry will determine the competitive structure of the industry

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The long-run average cost curve The long-run average cost curve LRAC: LRAC: an envelope of short-run cost an envelope of short-run cost

curvescurves

Output

Ave

rage

cos

t SRATC1

Each plant sizeis designed fora given outputlevel

SRATC2

SRATC3

SRATC4

So there is a sequence of SRATCcurves, eachcorresponding toa 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

TU-91.113 Managerial Economics / Hannele Wallenius

The existence of The existence of economies of scaleeconomies of scale means that in the long run, as the firms means that in the long run, as the firms increases its scale of operation, the LRAC increases its scale of operation, the LRAC of production falls.of production falls.

SRMC

SRMC

SRMC

SRAC

SRAC

SRAC

Units of output

Cos

ts p

er u

nit

($)

LRAC

Each individual scale of the firm will still be subject to diminishing returns and have a U-shaped SRAC curve.

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Minimum Efficient ScaleMinimum Efficient Scale 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

$

TU-91.113 Managerial Economics / Hannele Wallenius

Increasing LRAC: Diseconomies of Increasing LRAC: Diseconomies of ScaleScale

SRMCSRAC

SRMCSRAC

SRMCSRAC

Units of output

Cos

ts p

er u

nit

($)

LRAC

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Constant Returns to ScaleConstant Returns to Scale

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

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Production with Two Production with Two (or more)(or more) Outputs--Economies of ScopeOutputs--Economies of Scope

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

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Why Advantages May ExistWhy 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

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Economies of Scope Economies of Scope continuedcontinued

Examples:– Chicken farm--poultry and eggs– Automobile company--cars and

trucks– University--teaching and

research

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An Example: PepsiCo, Inc.

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Economies of Scope Economies of Scope continuedcontinued

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

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Degree of Economies of ScopeDegree of Economies of Scope The degree of economies of scope

measures the savings in cost:

– C(Q1) is the cost of producing product Q1

– C(Q2) is the cost of producing product Q2

– C(Q1Q2) is the joint cost of producing both products

– If SC > 0 -- Economies of scope– If SC < 0 -- Diseconomies of scope

)QC(Q

)QC(Q)C(Q)C(Q SC

21,

21,21

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Dynamic Changes in Costs--Dynamic Changes in Costs--The Learning CurveThe Learning Curve

The learning curve measures the impact of worker’s experience on the costs of production

It describes the relationship between a firm’s cumulative output and amount of inputs needed to produce a unit of output

The learning curve implies:

1) The labor requirement falls per unit

2) Costs will be high at first and then will fall with learning

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The Learning CurveThe Learning Curve

Cumulative number of machine lots produced

Hours of laborper machine lot

10 20 30 40 500

2

4

6

8

10

36

The Learning CurveThe Learning Curve

Cumulative number of machine lots produced

Hours of laborper machine lot

10 20 30 40 500

2

4

6

8

10

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The Learning CurveThe Learning Curve

Cumulative # of machine lots produced

Hours of laborper machine lot

10 20 30 40 500

2

4

6

8

10

The horizontal axis measures the cumulative number of hours of machine tools the firm has produced

The vertical axis measures the number of hours of labor needed to produce each lot

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Economies of ScaleEconomies of ScaleVersus LearningVersus Learning

Output

Cost($ per unitof output)

AC1

A

39

Economies of ScaleEconomies of ScaleVersus LearningVersus Learning

Output

Cost($ per unitof output)

AC1

AB

Economies of Scale

40

Economies of ScaleEconomies of ScaleVersus LearningVersus Learning

Output

Cost($ per unitof output)

AC1

AB

Economies of Scale

AC2

Learning C