Managerial economics strategy by m perloff and brander chapter 6 costs

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Managerial economics  strategy by m perloff and brander  chapter 6 costs

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Chapter Costs Table of Contents • 6.1 The Nature of Costs • 6.2 Short-Run Costs • 6.3 Long-Run Costs • 6.4 The Learning Curve • 6.5 Costs of Producing Multiple Goods 6-2 © 2014 Pearson Education, Inc All rights reserved Introduction • Managerial Problem – Technology choice at home versus abroad: In the United States, firms use relatively capital-intensive technology – Will that same technology be cost minimizing if they move their production abroad? • Solution Approach – First, a firm must determine which production processes are technically efficient so that it can produce the desired level of output without waste Second, a firm should pick from these technically efficient processes the one that is also economically efficient (minimum cost) By minimizing costs, a firm can increase its profit • Empirical Methods – When considering costs, a good manager includes opportunity costs or foregone alternatives – To minimize costs, a manager should distinguish short-run costs from long-run costs – Firms may reduce costs overtime based on experience or its learning curve – If a firm produces several goods, individual cost may depend on the cost of producing multiple goods 6-3 © 2014 Pearson Education, Inc All rights reserved 6.1 The Nature of Costs • Explicit and Implicit Costs – Explicit costs are direct, out-of-pocket payments for labor, capital, energy, and materials – Implicit costs reflect only a foregone opportunity rather than explicit, current expenditure • Opportunity Costs – The opportunity cost of a resource is the value of the best alternative use of that resource – Value of Manager’s Time example: Maoyong owns and manages a firm He pays himself only $1k per month but could work for another firm and make $11k per month Working for another firm is the best alternative use of his time, so his opportunity cost of time is $11k • Relevance of Considering Opportunity Cost – Maoyong example: Assume monthly revenue is $49k and explicit costs are $40k, including Maoyong’s monthly wage The accounting profit is $9k and Maoyong collects $10k per month (profit + wage) However, his opportunity cost is $11k So, he incurs an economic loss of $1k 6-4 © 2014 Pearson Education, Inc All rights reserved 6.1 The Nature of CostsCosts of Durable Inputs – Durable inputs are usable for a long period, perhaps for many years – Capital such as land, buildings, or equipment are durable inputs • Costs of Durable Inputs (truck example) – There are two problems First, how to allocate the initial purchase cost over time Second, what to if the value of the capital changes over time – Solution if there is a rental market: The accountant may expense the truck’s purchase price or may amortize it over the life of the truck, following IRS rules The firm’s opportunity cost of using the truck is the amount that the firm would earn if it rented the truck to others – Solution if there is no rental market: The opportunity cost of capital of using the truck a year would be the interest forgone in a year 6-5 © 2014 Pearson Education, Inc All rights reserved 6.1 The Nature of Costs • Sunk Costs – Sunk cost is a past expenditure that cannot be recovered – If an expenditure is sunk, it is not an opportunity cost So we should not consider it for managerial decisions – However, sunk costs appear in financial accounts • Managers Should Ignore Sunk Costs – A firm paid $300k for a parcel of land but the market value is now $200k If the firm builds a plant on this land, the value for the firm becomes $240k – Is it worth carrying out production on this land or should the land be sold for its market value of $200k? – The land’s opportunity cost is $200k and the market value loss of $100k is a sunk cost The sunk cost cannot be recovered and should not be considered in the decision The values to compare are $240 versus $200 Certainly, the firm should carry out production on this land 6-6 © 2014 Pearson Education, Inc All rights reserved 6.2 Short-Run Costs Common Measures of Cost • Fixed Cost (F) does not vary with the level of output; includes expenditures on land, office space, production facilities, and other overhead expenses; are often sunk costs, but not always • Variable Cost(VC) changes as the quantity of output changes; refers to the costs of variable inputs • Total Cost (C) is the sum of fixed and variable costs • F and VC should be based on inputs’ opportunity costs 6-7 © 2014 Pearson Education, Inc All rights reserved 6.2 Short-Run Costs • Average Fixed Cost (AFC) falls as output rises because the fixed cost is spread over more units • Average Variable Cost (AVC) or variable cost per unit of output may either increase or decrease as output rises • Average Cost (AC) or average total cost may either increase or decrease as output rises 6-8 © 2014 Pearson Education, Inc All rights reserved 6.2 Short-Run Costs • Marginal Cost: MC = ΔC/Δq – Marginal cost (MC) is the amount by which a firm’s cost changes if the firm produces one more unit of output; ∆C is the change in cost when the change in output, ∆q, is unit • Marginal Cost: MC = ΔVC/Δq – Marginal cost also equals the change in variable cost from a one-unit increase in output • Marginal Cost using Calculus: MC = dC/dq = dVC/dq – Marginal cost is the rate of change of cost as we make an infinitesimally small change in output MC=dVC/dq because dF/q=0 6-9 © 2014 Pearson Education, Inc All rights reserved 6.2 Short-Run Costs • Cost Curves: Total Values – Panel a of Figure 6.1 shows the variable cost (VC), fixed cost (F), and total cost (C) curves that correspond to Table 6.1 • Graphs: Total, Variable and Fixed Costs – The fixed cost curve, F, is a horizontal line at $48 – The variable cost curve, VC, is zero at zero units of output and rises with output – The total cost curve, C, is the vertical sum of the VC and F curves, so it is $48 higher than the VC curve at every output level VC and C curves are parallel 6-10 © 2014 Pearson Education, Inc All rights reserved 6.3 Long Run Costs Three Equivalent Rules to Minimize Costs in the Long-Run • The Lowest Isocost Rule – The firm minimizes its cost by using the combination of inputs on the isoquant that is on the lowest isocost line that touches the isoquant • The Tangency Rule: MRTS = - w/r – At the minimum-cost bundle, x, the isoquant is tangent to the isocost line The slope of the isoquant (MRTS) and the slope of the isocost are equal • The Last-Dollar Rule: (MPL/w) = (MPK/r) – Cost is minimized if inputs are chosen so that the last dollar spent on labor adds as much extra output as the last dollar spent on capital Thus, spending one more dollar on labor at x gets the firm as much extra output as spending the same amount on capital 6-25 © 2014 Pearson Education, Inc All rights reserved 6.3 Long Run Costs • Factor Price Changes – How should the firm change its behavior if the cost of one of the factors changes? – If one factor becomes relatively cheaper, the firm should substitute factors considering the slopes of the isoquant and isocost curves • Factor Price Changes: Graph Analysis – In Figure 6.5, the initial wage = $24 and the rental rate of capital = $8 The lowest isocost line ($2,000) is tangent to the q = 100 isoquant at x(L = 50, K = 100) – When the wage falls from $24 to $8, the isocost lines become flatter: Labor is relatively less expensive than capital now – The slope of the isocost lines falls from –w/r = –24/8 = –3 to –8/8 = –1 – The new lowest isocost line ($1,032) is tangent at v (L = 77, K = 52) – Thus, when the wage falls, the firm uses more labor and less capital to produce a given level of output, and the cost of production falls from $2,000 to $1,032 6-26 © 2014 Pearson Education, Inc All rights reserved 6.3 Long Run Costs Figure 6.5 Effect of a Change in Factor Price 6-27 © 2014 Pearson Education, Inc All rights reserved 6.3 Long-Run Costs Production Functions and the Shapes of Long-Run Costs Curves • In the long run, returns to scale determine the shape of the production function, and the production function, in turn, determines the shape of the AC curve and other cost curves • If a production function has increasing returns to scale at low levels of output, constant returns to scale at intermediate levels of output, and decreasing returns to scale at high levels of output, the LRAC curve must be U-shaped • LRAC curves can have many different shapes depending whether the production process has economies or diseconomies of scale • Perfectly competitive firms typically have U-shaped AC curves Noncompetitive markets may be U-shaped, L-shaped, everywhere downward sloping, everywhere upward sloping or have other shapes 6-28 © 2014 Pearson Education, Inc All rights reserved 6.3 Long Run Costs • LRAC as the Envelope of SRAC Curves – The long-run average cost is always equal to or below the short-run average cost Any input combination in the short run is also available in the long run However, changing capital levels to reduce costs are only available in the long run – In the long run, the firm chooses the plant size that minimizes its cost of production, so it picks the plant size that has the lowest average cost for each possible output level • LRAC as the Envelope of SRAC Curves: Graph Analysis – At q1, in Figure 6.7, the firm opts for the small plant size, whereas at q2, it uses the medium plant size – If there are only three possible plant sizes, with short-run average costs SRAC1, SRAC2, and SRAC3, the long-run average cost curve is the solid, scalloped portion of the three short-run curves (envelope curve) – LRAC is the smooth and U-shaped long-run average cost curve 6-29 © 2014 Pearson Education, Inc All rights reserved 6.3 Long Run Costs Figure 6.7 Long-Run Average Cost as the Envelope of Short-Run Average Cost Curves 6-30 © 2014 Pearson Education, Inc All rights reserved 6.4 The Learning Curve • Learning by Doing – Learning by doing refers to the productive skills and knowledge that workers and managers gain from experience – Workers add speed with practice Managers learn how to organize production more efficiently, assign tasks based on worker’s skills, and reduce inventory costs Engineers optimize product designs with experimentation – For these and other reasons, the average cost of production tends to fall over time, and the effect is particularly strong with new products • Learning Curve and Costs – The learning curve is the relationship between average costs and cumulative output – The cumulative output is the total number of units of output produced since the product was introduced – If a firm is operating in the economies of scale section of its average cost curve, expanding output lowers its cost for two reasons Its average cost falls today because of economies of scale, and also because of learning by doing 6-31 © 2014 Pearson Education, Inc All rights reserved 6.5 Costs of Producing Multiple Goods • Joint Production is Less Costly – – – If a firm produces two or more goods that are linked by a single input, the cost of one good may depend on the output level of another For example, cattle provide beef and hides A firm enjoys economies of scope if it is less expensive to produce goods jointly than separately It is less expensive to produce beef and hides together than separately, so there are economies of scope • Economies of Scope: SC = [C(q1,0) + C(0,q2) - C(q1, q2)]/C(q1, q2) – C(q1, 0) is the cost of producing q1 of the first good, C(0, q2) is the cost of producing q2 of the second good, and C(q1, q2) is the cost of producing both goods together – If SC is zero, the cost of producing the two goods separately, C(q1,0) + C(0,q2), is the same as producing them together, C(q1, q2) There are no economies of scope – If SC is positive, it is less expensive to produce goods jointly than separately There are economies of scope If SC is negative, there are diseconomies of scope, and the two goods should be produced separately – 6-32 © 2014 Pearson Education, Inc All rights reserved Managerial Solution • Managerial Problem – Technology choice at home versus abroad: In the United States, firms use a relatively capital-intensive technology – Will that same technology be cost minimizing if they move their production abroad? • Solution – The answer depends on relative factor prices and whether the firm’s isoquant is smooth – If the isoquant is smooth, even a slight difference in relative factor prices will induce the firm to shift along the isoquant and use a different technology with a different capital-labor ratio – If the isoquant has kinks, the firm will use a different technology only if the relative factor prices differ substantially 6-33 © 2014 Pearson Education, Inc All rights reserved Table 6.2 Bundles of Labor and Capital That Cost the Firm $200 6-34 © 2014 Pearson Education, Inc All rights reserved Figure 6.6 Long-Run Cost Curves 6-35 © 2014 Pearson Education, Inc All rights reserved Table 6.3 Returns to Scale and Long-Run Costs 6-36 © 2014 Pearson Education, Inc All rights reserved Table 6.4 Shape of Average Cost Curves in Canadian Manufacturing 6-37 © 2014 Pearson Education, Inc All rights reserved Figure 6.8 Learning by Doing 6-38 © 2014 Pearson Education, Inc All rights reserved Figure 6.9 Technology Choice 6-39 © 2014 Pearson Education, Inc All rights reserved ... is also economically efficient (minimum cost) By minimizing costs, a firm can increase its profit • Empirical Methods – When considering costs, a good manager includes opportunity costs or foregone... – Value of Manager’s Time example: Maoyong owns and manages a firm He pays himself only $1k per month but could work for another firm and make $11k per month Working for another firm is the best... reserved MC = w/MPL • Remember MPL = Δq/ΔL • So, ΔL/Δq is just the inverse of MPL • Marginal cost equals wage divided by marginal product of labor • Marginal product of labor and marginal cost move

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  • Slide 1

  • Table of Contents

  • Introduction

  • 6.1 The Nature of Costs

  • Slide 5

  • Slide 6

  • 6.2 Short-Run Costs

  • Slide 8

  • Slide 9

  • Slide 10

  • Slide 11

  • Table 6.1 How Cost Varies with Output

  • Slide 13

  • Slide 14

  • Slide 15

  • Slide 16

  • Slide 17

  • Slide 18

  • 6.2 Short Run Costs

  • 6.3 Long Run Costs

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