ECNE610 Managerial Economics APRIL 2014 1 Dr. Mazharul Islam Chapter-7.
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Transcript of ECNE610 Managerial Economics APRIL 2014 1 Dr. Mazharul Islam Chapter-7.
ECNE610ManagerialEconomics
APRIL 2014
1
Chapter-7
2
57The Theory and
Estimation of Cost
Lesson Objectivesdefine the cost function. distinguish between economic cost and
accounting cost.explain how the concept of relevant cost is
used.understand total, variable, average and
fixed cost.distinguish between short-run and long-run
cost.provide reasons for the existence of
economies of scale.
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Definition and use of cost in economic analysis:
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Economic Costs:A firm’s economic costs are the opportunity
costs of the resources used, whether those resources are owned by others or by the firm.Explicit costs (Accounting Costs)
Refer to the firm’s actual cash payments for resources wages, rent, interest, insurance, taxes, etc. Such money payments are for the use of resources owned by others.
Definition and use of cost in economic analysis:
Implicit costs Refer to the opportunity costs of using its
self-owned, self-employed resources. Implicit costs are the money payments that self-employed resources could have earn in their best alternative use.
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EconomicProfit (Actual profit)
TotalRevenue
Economic Cost
ECONOMIC PROFITSTotal Revenue: It is the amount received from the sale of the product; it is equal to the number of units sold (Q) times the price received per unit (P).
TR = QxP
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EconomicProfit
Implicit costs
ExplicitCosts
Accountingcosts (explicit
costs only)
AccountingProfit
Ec
on
om
ic (
op
po
rtu
nit
y) C
os
ts
TOTAL
REVENUE
Profits to anEconomist
Profits to anAccountant
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A particular example to clarify the distinction between explicit and implicit costs.Khalid Al Ghamdi runs a small furniture firm. He hires one assistant at SAR21,000 per year, pays annual rent of SAR5000 a year for his shop, an invested SAR20,000 from his savings on materials that could have earn him SAR1000 per year as interest rate. He has been offered SAR24,000 per year to work as a manager for competitor. He estimates his entrepreneurial talents are worth SAR 3000 per year. Total annual revenue from furniture sales is SAR 100,000.
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Total revenue $100,000explicit costs:
Assistant's salary 21,000Material and equipment 20,000Shop rent 5,000
Equals accounting profit $54,000
implicit costs:Adnan's forgone salary 24,000Forgone interest on savings 1,000Entrepreneurial profit 3,000
Equals economic profit ___________ $26,000
Accounting profit equals total revenue minus explicit costs used to determine a firm’s taxable income
However, this ignores the opportunity cost of Ghamdi’s own resources His forgone salary of $24,000 Annual interest of $1,000 from the savings used to start the business Entrepreneurial profit $5,000
Economic profit equals total revenue minus all costs, both explicit and implicit Accounting profit of $54,000 less implicit costs of $28,000 economic
profit of $26,000
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When the demand for a firm’s product changes, the firm’s profitability depends on how quickly it can adjust the amount of the various resources that it employed. Some resources can easily and quickly adjust such as labor, raw material, fuel and power but some resources need much more time to adjust such as building, machinery and equipment. Because of this differences in adjustment time, economists consider everything into two conceptual periods: the short run and the long run.
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Short run at least one resource (Capital) is fixed.
Long run all resources are variable.
Resources can be divided into two categories
Variable resources can be varied quickly to change the output rate.
Fixed resources are those resources which cannot be easily changed.
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Cost function is simply the production function expressed in monetary rather than physical units.
We assume the firm is a ‘price taker’ in the input market
Relationship between production and cost
Marginal Cost = MC
Total Fixed Costs = TFCTotal Variable Costs = TVC
Average Variable Costs = AVC
Total Costs = TC
Average Total Costs = ATC
Average Fixed Costs = AFC
SHORT-RUN PRODUCTION COSTS
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Costs of production usually divided into two sections such as fixed costsfixed costs and variable costsvariable costs.Fixed costs are those costs that do not vary with the quantity of output produced, e.g. the cost of the factory.Variable costs are those costs that do vary with the quantity of output produced, e.g. the cost of workers.
Total, fixed, and variable costs
Chapter Seven15
Short-run cost function For simplicity use the following assumptions:
the firm employs two inputs, labor and capital the firm operates in a short-run production
period where labor is variable, capital is fixed the firm produces a single product the firm employs a fixed level of technology the firm operates at every level of output in the
most efficient way the firm operates in perfectly competitive input
markets and must pay for its inputs at a given market rate (it is a ‘price taker’)
the short-run production function is affected by the law of diminishing returns
Fixed Costs: Total cost of using the fixed input
(K). Total Fixed Costs = Total costs – Total Variable costs. This costs also be found by multiplying the number of fixed inputs by the price of the input.
Average Fixed Costs =Total Fixed Costs
Quantity
Variable Costs: total cost of using the variable input, labor (L).
Total Variable Costs = Total costs – Total Fixed costs. This costs also be found by multiplying the number of variable inputs by the input price.
Average Variable Costs = Total Variable Costs
Quantity
Short-run cost function
Total Cost = Total Fixed + Variable Costs
Average Total Cost =Total Costs
Quantity
Marginal Cost: the rate of change in total variable cost.
Marginal Cost =Change in Total Costs
Change in Quantity
So Average Cost (AC) = AFC + AVC = TC/Q
TC/Q
Quantity
Co
sts
(do
llar
s)TC
TotalCost
Fixed CostTVC
Variable Cost
TFC
Combining TVCWith TFC to get
Total Cost
SHORT-RUN COSTS GRAPHICALLY
The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand
Copyright©2004 South-Western
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Graphical example of the cost variables
The average total-costaverage total-cost curve is U-shaped.At very low levels of output average total
cost is high because fixed cost is spread over only a few units.
Average total cost declines as output increases.
Average total cost starts rising because average variable cost rises substantially.
The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scaleefficient scale of the firm.
Explaining Cost Curves and Their Shapes
Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising.
Whenever marginal cost is equal to average total cost, ATC is minimum.
The same three rules apply for average variable cost (AVC) as for ATC
Relationship between Marginal Cost and Average Total Cost
Chapter Seven23
Chapter Seven24
Chapter Seven25
Long-run cost function In the long run, all inputs to a firm’s
production function may be changed
because there are no fixed inputs, there are no fixed costs.
at first increasing returns to scale, then as firms mature they achieve constant returns, then ultimately decreasing returns to scale
Chapter Seven26
Economies of scale: situation where a firm’s long-run average cost (LRAC) declines as output increases
Diseconomies of scale: situation where a firm’s LRAC increases as output increases
In general, the LRAC curve is u-shaped.
Chapter Seven27
Reasons for economies of scale
specialization of labor and capitalprices of inputs may fall with volume
discounts in firm’s purchasinguse of capital equipment with better
price-performance ratios larger firms may be able to raise
funds in capital markets at a lower cost
larger firms may be able to spread out promotional costs
Chapter Seven28
Reasons for diseconomies of scale
scale of production becomes so large that it affects the total market demand for inputs, so input prices rise
transportation costs tend to rise as production grows, due to handling expenses, insurance, security, and inventory costs
Chapter Seven29
Economies of scope
Economies of scope: reduction of a firm’s unit cost by producing two or more goods or services jointly rather than separately.
Chapter Seven30
Supply chain managementSupply chain management (SCM):
efforts by a firm to improve efficiencies through each link of a firm’s supply chain from supplier to customer.
• transaction costs are incurred by using resources outside the firm.
• coordination costs arise because of uncertainty and complexity of tasks.
• information costs arise to properly coordinate activities between the firm and its suppliers.
Chapter Seven31
Supply chain managementWays to develop better supplier relationships
strategic alliance: firm and outside supplier join together in some sharing of resources
competitive tension: firm uses two or more suppliers, thereby helping the firm keep its purchase prices under control
Chapter Seven32
Ways companies cut costs to remain competitive
the strategic use of cost reduction in cost of materials using information technology to reduce
costs reduction of process costs relocation to lower-wage countries or
regions mergers, consolidation, and subsequent
downsizing layoffs and plant closings
Do you have any question? Do you have any question?
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