Managerial Economics: Economic Tools for Today’s Decision Makers, 4/e By Paul Keat and Philip Young

1. Managerial Economics: Economic Tools for Today’s Decision Makers, 4/e By Paul Keat and Philip Young

2. Before We Start…Group Presentation • So popular? Q = aLbK1-b or c • b+c > 1 IRTS • b+c = 1 CRTS • b+c < 1 DRTS • Short Run Analysis: MPK = c Q/K & MPL = b Q/L • b & c are elasticities of K & L factors • LogQ=loga+blogL+clogK + dlogT where T  technology

3. The Theory and Estimation of Cost • Definition of Cost • The Short Run Relationship Between Production and Cost • The Short Run Cost Function • The Long Run Relationship Between Production and Cost • The Long Run Cost Function • The Learning Curve

4. Definition of Cost • A cost is relevant if it is affected by a management decision. • Historical cost is incurred at the time of procurement • Replacement cost is necessary to replace inventory • Are historical costs relevant?

5. Definition of Cost • There are two types of cost associated with economic analysis • Opportunity cost is the value that is forgone in choosing one activity over the next best alternative • Out-of-pocket cost is actual transfer of value that occur • Which cost is relevant?

6. Definition of Cost • There are two types of cost associated with time • Incremental cost varies with the range of options available in the decision making process. • Sunk cost does not vary with decision options. • Is sunk cost relevant?

7. SR Relationship Between Production and Cost • A firm’s cost structure is related to its production process. • Costs are determined by the production technology and input prices. • Assuming that the firm is a “price taker” in the input market.

8. SR Relationship Between Production and Cost • Total variable cost (TVC) is associated with the variable input • Assume w=$500 per unit (price-taker)

9. SR Relationship Between Production and Cost • TP and TVC are mirror images of each other Kings Dominion Example

10. SR Relationship Between Production and Cost • Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC. • TC=TFC+TVC • Marginal Costs • Average Costs Tool Set for Production Cost Analysis vs. Production Process Analysis

11. SR Relationship Between Production and Cost • Marginal cost (MC) is the change in total cost associated a change in output.

12. SR Relationship Between Production and Cost • Add marginal cost to the table

13. SR Relationship Between Production and Cost • Observe that: • When MP is increasing, MC is decreasing. • When MP is decreasing, MC is increasing.

14. SR Relationship Between Production and Cost • The relationship between MP and MC is Law of diminishing returns implies that MC will eventually increase! Why?

15. The Short Run Cost Function • Average total cost (ATC) is the average per-unit cost of using all of the firm’s inputs (TC/Q) • Average variable cost (AVC) is the average per-unit cost of using the firm’s variable inputs (TVC/Q) • Average fixed cost (AFC) is the average per-unit cost of using the firm’s fixed inputs (TFC/Q)

16. The Short Run Cost Function • Add ATC = AFC + AVC to the table

17. The Short Run Cost Function • ATC = AFC + AVC

18. The Short Run Cost Function • Production cost graph or map is

19. The Short Run Cost Function • Important Map Observations • AFC declines steadily over the range of production. Why? • In general, ATC is u-shaped. Why? • MC intersects the minimum point (q*) on ATC. Why?

20. The Short Run Cost Function • Important Map Observations • What is the economic significance of q*?

21. The Short Run Cost Function • Average total cost (ATC) is the average per-unit cost of using all of the firm’s inputs (TC/Q) • At Q* - ATC is minimized or inputs are used most efficiently given the production function Going at 55 MPH

22. The Short Run Cost Function • A change in input prices will shift the cost curves. • If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip Case

23. The Short Run Cost Function • A change in input prices will shift the cost curves. • If variable input costs are reduced then MC, AVC, and AC will all shift downward. Airline Industry Case

24. The Short Run Cost Function • Yahoo Group Discussion • What is different about dot.com businesses? Irrational Exuberance

25. The LR Relationship Between Production and Cost • In the long run, all inputs are variable. • What makes up LRAC?

26. The Long-Run Cost Function • LRAC is made up for SRACs • SRAC curves represent various plant sizes • Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve

27. The Long-Run Cost Function • The LRAC is the lower envelope of all of the SRAC curves. • Minimum efficient scale is the lowest output level for which LRAC is minimized Is LRAC a function of market size? What are implications?

28. The Long-Run Cost Function • Reasons for Economies of Scale… • Increasing returns to scale • Specialization in the use of labor and capital • Economies in maintaining inventory • Discounts from bulk purchases • Lower cost of raising capital funds • Spreading promotional and R&D costs • Management efficiencies

29. The Long-Run Cost Function • Reasons for Diseconomies of Scale… • Decreasing returns to scale • Input market imperfections • Management coordination and control problems

30. The Learning Curve • Measures the percentage decrease in additional labor cost each time output doubles. • An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.

31. The Learning Curve • A downward slope in the learning curve indicates the presence of the learning curve effect • Why? Workers improve their productivity with practice • The learning curve effect shifts the SRAC downward

32. Production Cost Homework • Page 378 • Problem 10