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# The Analysis of Cost y

Hirschey: Economics for Managers, 2009 (Fifth Indian Reprint), South-Western Cengage Learning Chapter 9 Hubbard & OBrian: Microeconomics (First Edition), Pearson Education India Chapter 10 Mansfield, Allen, Mansfield Allen Doherty and Weigelt: Managerial Economics: Theory, Applications and Cases (Seventh Edition), Viva-Norton Student Edition Chapter 5 Thomas and Maurice: Managerial Economics: Concepts and Applications (Eighth Edition), Tata McGraw-Hill Chapters 8 &9

Session Objectives:

Explain and illustrate the relationship between marginal cost and average total cost in the short run Graph average total cost, average variable cost, average fixed cost, and marginal cost. Understand how firms use the long-run average cost curve to plan. What are economies of scope and Learning Curve?

## From the Production Function to the Total-Cost Curve

Recollect the farmers story in Production Theory

Af farmer grows wheat. h He has 5 acres of land. He can hire as many workers as he wants.

Farmer must pay Rs.1000 per month for the land, regardless of how much wheat he grows. The market wage for a farm worker is Rs.2000 per month. month So the farmers costs are related to how much wheat he produces produces.
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## From the Production Function to the Total-Cost Curve

L Q (no. of (bushels workers) of wheat) k ) 0 1 2 3 4 5 0 1000 1800 2400 2800 3000 cost of land 1,000 1,000 1,000 1,000 1 000 1,000 1,000 cost of labor 0 2,000 4,000 , 6,000 8,000 10,000 Total Cost 1,000 3,000 5,000 7,000 7 000 9,000 11,000
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## The Farmers Total-Cost Curve

Q (bushels ( of wheat) 0 1000 1800 2400 2800 3000 Total Cost 1,000 3,000 5,000 5 000 7,000 9,000 , 11,000
\$12,000 \$10,000

Total cos st

## \$8,000 \$6,000 \$4,000 \$4 000 \$2,000 \$0

1000

2000

3000

Quantity of wheat
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## The Various Types of Costs in Short Run

Costs of production may be divided into fixed costs and variable costs.

Fixed costs (FC) are those costs that do not vary with the quantity of output produced.
For the farmer, FC = Rs.1000 for his land Other examples: cost of equipment, loan payments, rent, property taxes

Variable V i bl costs (VC) are those costs that d vary with th quantity t th t th t do ith the tit of output produced. They go up as the firms output rate rises, since higher output rates require higher variable inputs, which means bigger variable costs.
For the farmer, VC = wages he pays workers Other example: cost of materials the larger the product of a woolen mill, the larger the quantity of wool that must be used, and the higher the total cost of wool
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## Total Costs in Short Run

Total Fixed Costs (FC) Total Variable Costs (VC) ( ) Total Costs (TC) TC = FC + VC

## The Average Costs

Average costs can be determined by dividing the firm s firms costs by the quantity of output it produces produces. The average cost is the cost of each typical unit of product. product

Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) g ( ) ATC = AFC + AVC

## The Average Costs

AFC AVC Fixed cost FC Quantity Q Variable cost VC Quantity Q Total cost TC Quantity Q

ATC

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Marginal Costs

Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question:

How much does it cost to produce an additional unit of output? MC is the slope of the total cost curve

## (change in total cost) TC MC (change in quantity) Q

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Marginal Costs
Why is MC important?

In the earlier example, the farmer is rational and wants to e ea e e a p e, e a e s a o a a d a s o maximize his profit. To increase profit, should he produce more wheat, or less? To find the answer the farmer needs to think at the margin answer, think margin. If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then farmers profits rise if he produces more. d

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## Shapes of Cost Curves

Average fixed cost (AFC) is always downward sloping. Since AFC= F / Q and F is constant, as Q increases, AFC decreases.
Also, AFC x Q = F, a constant. So AFC curve is a rectangular hyperbola. As output increases, AFC gets smaller and smaller. Firms often refer to this process of lowering average fixed cost by selling more output as spreading the overhead. By overhead they mean fixed costs.

IF AVC is the average variable cost, VC total variable cost, Q is the quantity of output, L is the quantity of labour (variable input), and w is the price of the variable input (wage rate); then
AVC = VC / Q = wL / Q = w / APL

If the firm is the price taker in the input market, then the shape of APL determines the shape of AVC Since APL generally rises AVC. and then falls with increases L (and hence increase in output), AVC must decrease and then go up with increases in output. 15

## Shapes of Cost Curves

Average total Cost (AC) is the total cost divided by output. AC also equals AFC plus AVC.
For those levels of output where both average fixed cost and average variable cost decrease, average total cost must decrease too. However, average total cost reaches its minimum after average variable cost, because the increases in average variable cost are for a time more than offset by decreases in average fixed cost

Marginal cost is the addition to total cost resulting from the M i l t i th dditi t t t l t lti f th addition of the last unit of output.
MC= TVC/Q = w L / Q = w / MPL

If the firm is the price taker in the input market, then the shape p g y of MPL determines the shape of MC. Since MPL generally rises and then falls with increases L (and hence increase in output), MC must decrease and then go up with increases in output. 16

## Shapes of Cost Curves

Relationship between Marginal Cost and Average Total Cost

Whenever marginal cost is less than average total cost, average total cost i f lli t is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. The marginal cost curve crosses the average cost curve at the minimum point of the average cost curve, i.e., at the efficient scale. Efficient scale is the quantity that minimizes average total cost. Summary: Marginal cost eventually rises with the quantity of output The average-total-cost curve is U-shaped. The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. g
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## Shapes of Cost Curves

Shapes of Total Variable Cost and Total Cost Curve

Marginal cost is the slope of total variable cost curve and total cost g p curve. Given that MC is U-shaped, it follows that total variable cost increases at a decreasing rate upto a certain output rate (in our example, 1.5 units of output, denoted by point G on the TVC curve); beyond that f d db h C ) b d h output, total variable costs increase at an increasing rate. This later characteristic of total variable cost function follows from the law of di i i hi l f diminishing marginal returns. At small l i l t ll levels of output, l f t t increases in the employment of variable inputs may result in increases in their productivity, so the total variable costs increase with output at a decreasing rate. Once diminishing returns set in, though, variable costs increase with output at an increasing rate. h Finally, total costs are the sum of TFC and TVC. TC curve is derived by adding the total fixed costs to the total variable costs at each level of output. The t t l cost curve and t t l variable cost curve h t t Th total t d total i bl t have the th same shape, since they differ by only a constant amount, which is total fixed cost. 18

Quick Activity - 1
(a) Consider the total cost function of an engineering firm: TC = 100 + 50Q 11Q2 + Q3

Comment on the shapes of the TFC, TVC, AFC, AVC, AC and MC p , , , , curves.

(b) Examine the validity of the following statement: I am currently producing 10,000 copies per day at a total cost of Rs.500. If I produce 10,001 copies my total cost will rise to Rs.500.11. Therefore, my marginal cost of producing copies must be increasing.

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## Short Run and Long Run

Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC. Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones). The only costs are VC. While operating in the short run, the firm must continually be planning ahead and deciding its strategy in the long-run. Its decision concerning the long run determine the sort of short-run position that the firm will occupy in the future. For example, before the IBM Corporation makes the decision to add a new type of product to its line the firm is in a long-run situation, since line, long run situation it can choose among a wide variety of types and sizes of equipment to produce the new product. But once the investment is made, IBM is confronted with a short-run situation, since the type and size of short run situation equipment are, to a considerable extent, frozen.
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## Long Run Average Cost

Firm can choose from 3 plant sizes: S, M, L. Each size has , , its own SAC curve. The firm can change to a different plant size in the l diff t l t i i th long run, but not in the short run. In the short run, given the run level of plant size (K), the firm is stuck to one of these curves. However curves However, in the long run, the firm is free to choose the level of K that minimizes the cost for a particular level of output.

AC
ACS ACM ACL

Q
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## Long Run Average Cost

In the long run, the firm could decide to operate on any of these plants, but which scale would be most profitable? If the firm wants to produce where the average cost is minimum, the answer y obviously depends on how much the firm wants to produce in the long run.
To T produce less th QA, fi will d l than firm ill choose size S in the long run. To produce between QA and QB, firm will choose size M in the long run run. To produce more than QB, firm will choose size L in the long run.

AC
ACS ACM ACL

LAC

QA

QB

Q
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## Long Run Average Cost

In the real world, plants come in many sizes, each with its own SAC curve. The long-run AC (LAC) curve is constructed tangent to each shortrun average cost curve. At each point of tangency, the related scale of plant is optimal; no other plant can produce that particular level of output at so low a total cost. t t t l t t l t A typical LAC curve looks like an envelope of several SAC curves.. As A such LAC curve i called an h is ll d envelope curve. It is also called a planning curve, since it reflects firm s firms decision to whether continue production with the existing plant, or shift to a higher capacity plant.

AC LAC

Q
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Quick Activity - 2
Suppose that a firm is thinking of buying a printer for one of its p y j printer which costs employees. It can choose between an inkjet p Rs.5000 or a laser printer which costs Rs.8000. The per page printing cost for an inkjet is Rs.1.80 and that for a laser printer is Rs.1.50. Which one should the firm buy?

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If q denotes the number of pages printed, the total costs will be Cij = 5000 + 1 8q 1.8q CL = 8000 + 1.5q The average cost curves are given by ACij = 5000/q + 1.8 ACL = 8000/q + 1.5 It can be seen that ACL - ACij = 3000/q 0.3, and therefore, for q>10,000, ACL < ACij. Whether the firm should buy the inkjet printer or the laser printer will then depend on its expected rate of printing of pages. If, for example, only 10 pages are to be printed every day, then it will take 1000 days (almost three years) before the laser printer becomes cost-effective. On the other hand, if the expected rate of usage is (say) 100 pages hand per day, then the laser-printer will become cost-effective after 100 days.
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## Long-Run Average Cost Curve

The law of returns to scale determine the shape of long-run average cost curve (LAC). LAC = C/q = (wL + rK)/q = w(L/q) + r(K/q) Case 1: Under CRS
Any proportionate change i L and K results in equiproportionate changes in A ti t h in d lt i i ti t h i q, leaving (L/q) & (K/q) unchanged. Thus LAC does not change despite change in output.

## Case 2: Under IRS (Economies of Scale)

Any proportionate change in L and K results in more than proportionate changes in q; (L/q) & (K/q) falls with increase in output. Thus LAC declines as output i increases.

## Case 3: Under DRS (Diseconomies of Scale)

Any proportionate change in L and K results in less than proportionate changes in q; (L/q) & (K/q) rises with increase in output. Thus LAC rises as output increases.
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## Long Run Average Cost

Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases.

ATC LRATC

Q
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## Long Run Average Cost

Economies of scale occur when increasing production allows greater specialization and division of labour. The workers more efficient when focusing on a narrow task.
To the extent that these efficiencies exist and can be exploited, the long-run average-cost function declines as output climbs. The range over which the average cost function declines varies from industry to industry, and it can change from time to time in response to the advent i d t d h f ti t ti i t th d t of new technology.

Diseconomies of scale are due to coordination problems in large organizations. More and more responsibility and power must b given d bl d be to lower-level employees. Coordination becomes more difficult. Red tape increases. Flexibility can be reduced. Management becomes stretched, can t stretched cant control costs costs.
It is not easy to determine just when these diseconomies of scale begin to offset the economies of scale already cited. Empirical studies seem to indicate that long-run average cost can be constant over a long run considerable range of output. Economists generally expect, however, that the LAC will eventually begin to rise.
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## Minimum Efficient Scale

In general, the empirical studies have found that there are very significant economies of scale at low output levels, but that these economies of scale tend to diminish as output increases, and that the long-run average cost function eventually becomes close to horizontal at high output levels. g p Given that this is the case, managers and others are p particularly interested in estimating the minimum efficient scale y g (MES) of plant or firm in a particular industry. The MES of plant is defined as the smallest output at which LAC is a minimum. One reason why managers are interested in the MES is that plants below this size are at a competitive disadvantage, since their costs are higher than those of their larger rivals. g g
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Application - 1
Economies of Scale in Nursing Homes in US

A long-un average cost (LAC) curve is important for practical o g u a e age cos ( C) cu e s po a o p ac ca decision making by managers because it shows whether, and to what extent, larger plants have cost advantages over small ones. In cases in which this occurs, we often say that there are economies of scale scale. To illustrate, consider nursing homes, which are a huge industry with annual sales of over \$70 billion. Based on Texas data, d t if a nursing home provides only 10,000 patient-days of i h id l 10 000 ti t d f service per year, the cost per patient-day is almost \$29; if it provides about 50,000 patient-days of service per year, the cost per patient-day is under \$26 patient day \$26. For nursing homes with under 60,000 patient-days, there seem to be substantial economies of scale.
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Application - 1
What could be the plausible reason for such economies of scale?

In many industries, firms can operate more than one plant, and there may b economies of scale at the fi be i f l h firm (i contrast to the plant) l (in h l ) level. l This seems to be true in the nursing home industry. Because of advantages due to centralized purchasing of inputs and a more sophisticated staff, firms with many nursing homes seem to have hi ti t d t ff fi ith i h t h lower costs than those with only one nursing home. Beyond nursing homes, other examples of economies of scale exist. Mergers are happening in many industries The oil industry has industries. recently seen mergers with BP Amoco and ExxonMobil, among others. Renault and Nissan and GM and Fiat are among numerous automobile company mergers. While there are many reasons for firms to merge, one may be economies of scale by becoming larger, average costs may become smaller.
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Application - 2
The Crosby Corporation: A Numerical Example

To illustrate the relationship between a firms long-run and short-run cost f functions, consider the C i id h Crosby C b Corporation, a h i hypothetical h i l producer of flashlights. Crosbys engineers have determined that the firms production function is Q = 4(KL)0.5, where Q is output (in thousands of flashlights per month), K is the amount of capital used per month (in thousands of units), and L is the number of hours of labour employed per month (in thousands) thousands).

Because Crosby must pay \$8 per hour for labour and \$2 per unit for capital, its total cost (in thousands of dollars per month) equals TC = 8L + 2K = Q2/2K + 2K [since L = Q2/16K] In the short run, which is a time period so brief that a firm cannot vary the quantity of its plant and equipment, K is fixed. Suppose the y q y p q p , pp Crosby Corporation has a plant size of 10 thousand square foot, K=10.
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Application - 2

## Substituting 10 for K, the short-run cost function is TCs = Q2/20 + 20

Thus the short-run average total cost function is ACs = Q/20 + 20/Q and short-run marginal cost function is MCs = Q/10

In the long run, no input is fixed. To determine the optimal amount of capital input to be used to produce an output of Q units per month month, Crosbys managers should minimize total cost, i.e., set dTC/dK = 0. This implies that the cost-minimizing value of K is K* = Q/2. We see that the long-run cost function is TCL = 2Q; long-run average cost equals \$2 per flashlight. Because LAC is constant, the Crosby Corporation exhibits CRS in the long run
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Application - 3
Should US Continue to Make Autos from Steel?

In recent years, automakers have begun to substitute synthetic y , g y materials for steel. Engineers at the Materials Systems Laboratory of the Massachusetts Institute of Technology have made careful studies of the costs of producing an automobile fender. fender Assuming that the annual production volume of the fender is 1,00,000, the average cost of a fender is as shown below if sheet steel or four alternative plastics fabrication technologies h t t l f lt ti l ti f b i ti t h l i are used to make the fender.

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Application - 3
Cost Steel Sheet \$4.25 0.24 0 24 0.66 2.57 \$7.71 Injection Moulding \$8.50 0.42 0 42 2.62 0.86 \$12.39 Compression Moulding \$4.84 0.63 0 63 1.57 0.71 \$7.75 Reaction Injection Moulding M ldi \$4.89 0.83 0 83 1.40 0.57 \$7.70 Thermoplastic sheet h \$5.75 0.52 0 52 2.18 0.71 \$9.17

aFigures

## do not sum to totals because of rounding errors

If the annual production is 2,00,000 rather than 1,00,000, the cost per fender, if sheet metal is used in its production, is less than \$7 and less than the cost if any of the plastics are used at this production 36 volume.

Application - 3
Questions:

If 10,000 fenders are made per year, does the cost per fender , p y , p differ significantly if sheet steel is used from the cost if reaction moulding (or compression moulding) is used? Compared with reaction injection moulding (or compression moulding), sheet steel uses less (or less costly) materials, labour and capital. Why then doesnt it have lower average total costs? If sheet steel is used, are there economies of scale in fender production? Steel i St l is commonly thought to b th most advantageous l th ht t be the t d t material for high-volume production of auto fenders. Does this seem to be true?

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Application - 3

No. The cost is \$7.71 for sheet steel versus \$7.70 for reaction \$ \$ injection moulding (and \$7.75 for compression moulding). Sheet steel has much higher tooling costs per fender than does reaction injection moulding (or compression moulding). Yes. Whereas the cost per fender is \$7.71 when 1,00,000 fenders are produced per year, it is less than \$7 when 2,00,000 are produced per year year. Yes. For a production volume of 2,00,000 per year, sheet steel, according to the figures quoted, has a lower average cost than any of the plastics fabrication techniques. f th l ti f b i ti t h i

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Economies of Scope

Firms commonly produce more than one product. Oil firms like Exxon Mobil and BP Amoco produce both petroleum and chemical products; drug firms like Merck and Smith-Kline Beecham produce both vaccines and tranquilizers; and p publishers like Oxford and Penguin p g produce both mysteries and y biographies. In many cases, a firm obtains production or cost advantages y p g when it produces a combination of products rather than just one. These advantages sometimes arise because certain production facilities used to make one product can also be used to make another product; or because by-products resulting from the p ; y p g making of one product are useful in making other products.
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Economies of Scope
Economies of scope arise from complementarities in the production or distribution of distinct goods or services

A firm will produce products that are complimentary when producing them together is more efficient than producing them individually. individually

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Economies of Scope
Economies of Scope can be measured as

## C (Q1 ) C (Q2 ) C (Q1 , Q2 ) SC C (Q1 ) C (Q2 )

where C(Q1,Q2) is the cost of jointly producing goods 1 and 2 in the respective quantities; C(Q1) is the cost of producing good 1 alone, and similarly for C(Q2). If there are economies of scope, SC is greater than zero because the cost of producing both products together - C(Q1,Q2) is less than the cost of producing each alone - C(Q1) + C(Q2). Clearly, SC measures the percentage saving as a result of producing them jointly rather than individually.
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Economies of Scope
Example 1:

Suppose that the Martin Company produces 1,000 milling pp p yp , g machines and 500 lathes per year at a cost of \$15 million, whereas if a firm produced 1,000 milling machines only, the cost would be \$12 million, and if it produced 500 lathes only, the cost would be \$6 million million. In this case, the cost of producing both the milling machines and the lathes is less than the total cost of producing each separately. Th t l Thus, there are economies of scope. th i f In the case of the Martin Company, SC = 0.20, which means p g that there is a 20 percent saving of this sort.

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Economies of Scope
Example 2:

Suppose that a regional airline offers regularly scheduled pp g g y passenger service between midsize city pairs and that there is modest local demand for air parcel and small-package delivery service. A small airline may find that its regularly scheduled passenger service can be profitably supplemented by providing cargo services, since the cost of flying both passengers and cargo is much l h less th than th t of specializing in either passenger or cargo that f i li i i ith services.

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## Exploiting Scope Economies

Economies of scope are important because they permit a firm to translate superior skill in a given product line into unique advantages ad antages in the p od ction of complementa products. production complementary p od cts Effective competitive strategy often emphasizes product lines related to a firms current stars, or areas of recognized strength For example, PepsiCo, Inc., has long been leader in the soft drink market. Over time, the company has gradually broadened its product line to include various brands of regular and soft diet drinks Tropicana, Fritos and Doritos chips, Grandma s drinks, Tropicana chips Grandmas Cookies, and other snack foods. PepsiCo can no longer be considered just a soft drink manufacturer. manufacturer It is a widely diversified beverages and snack food company for whom well over one-half of total current profits come from non-soft drink lines.

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## Exploiting Scope Economies

PepsiCos snack foods and sport drink product line extension strategy is effective because it capitalizes on the distribution network net o k and ma keting e pe tise developed in the fi ms soft marketing expertise de eloped firms drink business. In this case, for PepsiCo, soft drinks, snack foods, and sports p p beverages are a natural fit and a good example of how a firm has been able to take the skills gained in developing one star (soft drinks) and use them to develop others (snack foods, sport drinks) drinks).

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Learning Curve
The learning curve embodies the (inverse) relationship between average production cost and cumulative output, i.e., the total amount of output produced since th introduction of the product. t f t t d d i the i t d ti f th d t The experience of the workforce tends to increase with p cumulative outputthus workers are more familiar with the production process and have their movements/activities become routinized or a matter of habit habit. There are usually several ways to do a task, and it takes time and experimentation to find the best way. p y Quality control for inputs and outputs needs time to identify potential problem areas. For example, there may be a number of d f ti f defective items which makes it possible to identify the it hi h k ibl t id tif th source of a problem and correct it quickly.

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Average Cost LAC (year 1) Learning is manifested by a downward shift of the LAC function

## LAC (year 2) 1,000 1,500 Rate of Output (per Month)

Learning Curve

In the figure, start with an output of 1,000. The firms average cost curve is LAC (year 1). If the firm expands its output to 1,500, its average cost would fall on the same AC curve curve. However, if it continues to produce 1,500, then the average cost curve falls to LAC (year 2) because of the learning by doing effect. Managers, economists, and engineers often use the learning curve to represent the extent to which the average cost of producing an item falls in response to increases in its cumulative total output. The learning curve is expressed as: C = aQb, where C is the input cost of the Qth unit of output produced. If this relationship holds exactly, a is the cost of the first unit produced. The value of b is negative, since increases in cumulative total output reduce total cost. If the absolute value of b is large, cost falls more rapidly with increases in cumulative total output than it would if the absolute value of b were small.

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Application - 4

Many firms have adopted pricing strategies based on the learning curve. Consider the case of Texas Instruments, a major producer of semiconductor chips and other electronic products. When the semiconductor industry was relatively young, Texas Instruments priced its products at less than its then-current average costs in order to increase its output rate and its cumulative total output. Believing that the learning curve was relatively steep, it hoped that this would reduce its average costs to such an extent that its product would be profitable to produce and sell at this low price. This strategy was extremely successful. As Texas Instruments continued to cut price, its rivals began to withdraw from the market, its output continued to grow up its (average) costs were further up, reduced, and its profits rose.
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