Ch 5 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 down 2) how much to produce

Also, this chapter supports the theory of supply.

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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 lowwage countries mergers, consolidations, and

Choosing Output:
COSTS
Technology
& costs of hiring factors of production TC curves (short & long run)

REVENUES
Demand curve

AC (short & long run)

AR

CHECK: produce in SR? close down in LR?

MC

MR
3

Choose output level

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 firms decisions
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Costs 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
costs that do vary with output levels

Variable costs
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Costs in the Short Run

continued
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:

VC TC MC Q Q
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Costs in the Short Run continued

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:

TFC TVC TC ATC Q Q Q

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The Determinants of Short-Run Cost

The relationship between the production function and cost can be detected by looking at the relationship between either increasing returns (to a factor) and cost, or decreasing returns (i.e. when the law of diminishing returns takes effect) and cost:
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The relationship between the production function 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 With decreasing returns, output is decreasing relative to input and variable cost and total cost will rise relative to output
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Decreasing returns and cost

SR Cost Curves for a Firm

Unit Costs

AFC falls continuously and MC equals AVC and ATC at their minimum Minimum AVC occurs at a lower output than minimum ATC due to FC
P 100 75 50 25 AFC
0

MC

ATC AVC

1 2 3 4 5 6 7 8 9 10 11

Output

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 1 subject to checking the average condition:

The Firms Short-Run Output Decision Firm sets output at Q , where SRMC=MR
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

SRMC

SRATC
SRATC1 SRAVC1

SRAVC SMC = MR

MR Q1
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Output

 The decision:

The firms long-run output 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

LMC

always passes through the minimum point of LAC.

AC1

LMC
LAC

LMC = MR

MR Q1
Output (goods per week)
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The firms output decisions a summary

Marginal condition
Short-run Choose the output decision level at which MR = SRMC Long-run decision Choose the output level at which MR = LRMC

Check whether to produce

Produce this output unless price lower than SRAVC. If it is, produce zero. Produce this output unless price is lower than LRAC. If it is, produce zero.

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Long-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 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

Output

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

LRAC
Output
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Economies of Scale
continued
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 17a production concept!

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

$
LRAC

MC increasing

Q
Economies of scale Diseconomies of scale
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Economies of scale can be classified as

a) External economies of scale

advantages that a firm gains from the expansion and size of the industry as whole industrial clusters b) Internal economies of scale advantages that a firm gains from increasing the scale of its own operation
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Why can a firm become more efficient as the scale of production rises?
Technical economies Marketing economies Financial economies Managerial economies Risk-bearing economies Administrative economies

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Why can a firm become more inefficient as the scale of production 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 (diseconomies) is the underlying pattern of returns to scale in the firms long-run production function
Increasing returns to scale lead to economies of scale and decreasing returns to scale leads to diseconomies of scale

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Using LRAC as DecisionMaking Tool

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 LRAC: an envelope of short-run

cost curves
SRATC2
SRATC1

SRATC4
SRATC3

Output

Each plant size LRAC is designed for a given output level So there is a sequence of SRATC curves, each corresponding to a different optimal output level.

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
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Average cost

The existence of economies of scale means that in the long run, as the firms increases its scale of operation, the LRAC of production falls. Each individual scale of
SRMC Costs per unit ($)

SRAC

the firm will still be subject to diminishing returns and have a Ushaped SRAC curve.

SRMC SRAC SRMC SRAC

LRAC
Units of output

Minimum 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
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Increasing LRAC: Diseconomies of Scale

SRMC SRAC Costs per unit ($) SRMC SRAC

LRAC

SRMC
SRAC

Units of output

Constant 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 as well as its costs

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

Economies of scope exist when the unit cost of producing two or more products/services jointly is lower than producing them separately
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 Exist

For example: 1) Both products use same inputs (capital and labor) 2) The firms share management resources 3) Both products use the same labor skills and type of machinery
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Economies of Scope
continued
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 continued

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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P&G acquires The Gillette Company (29.1.2005)

Both companies have complementary expertise in health and personal care The companies also share complementary technology platforms in skin care and particularly in oral care Same distribution channels (Wal-Mart etc.)

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Degree of Economies of Scope

The degree of economies of scope measures the savings in cost:
C(Q 1) C(Q 2) C(Q 1, Q2) SC C(Q 1, Q2)

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

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Dynamic Changes in CostsThe Learning Curve

The learning curve measures the impact of workers experience on the costs of production It describes the relationship between a firms cumulative output and amount of inputs needed to produce a unit of output The learning curve implies:

1) The labor requirement per unit falls

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The Learning Curve

Hours of labor per machine lot 10

8 6 4 2 0 10 20 30 40 50
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Cumulative number of machine lots produced

The Learning Curve

Hours of labor per machine lot

10 8 6 4 2 0 10 20 30 40 50
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Cumulative number of machine lots produced

The Learning Curve

Hours of labor per machine lot

10
8

The horizontal axis measures the cumulative number of hours of machine lots the firm has produced The vertical axis measures the number of hours of labor needed to produce each lot
10 20 30 40 50
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6
4 2 0

Cumulative # of machine lots produced

Economies of Scale Versus Learning

Cost ($ per unit of output)

A AC1

Output

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Economies of Scale Versus Learning

continued
Cost ($ per unit of output)

Economies of Scale A

AC1

Output

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Economies of Scale Versus Learning continued

Cost
($ per unit of output)

Economies of Scale

A B Learning C AC1
AC2 Output
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