Chapter 8 Theory and Estimation of Cost Managerial

Chapter 8 Theory and Estimation of Cost Managerial Economics: Economic Tools for Today’s Decision Makers, 4/e By Paul Keat and Philip Young

Before We Start…Group Presentation • So popular? b 1 -b or c Q = a. L K • 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 • Log. Q=loga+blog. L+clog. K + dlog. T where T technology 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost • Total variable cost (TVC) is associated with the variable input • Assume w=$500 per unit (pricetaker) 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost • TP and TVC are mirror images of each other 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Kings Dominion Example Keat/Young

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 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost • Marginal cost (MC) is the change in total cost associated a change in output. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost • Add marginal cost to the table 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost • Observe that: • When MP is increasing, MC is decreasing. • When MP is decreasing, MC is increasing. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost • The relationship between MP and MC is Law of diminishing returns implies that MC will eventually increase! Why? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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) 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function • Add ATC = AFC + AVC to the table 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function • ATC = AFC + AVC 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function • Production cost graph or map is 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function • Important Map Observations • What is the economic significance of q*? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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 2003 Prentice Hall Business Publishing Case Managerial Economics, 4/e Keat/Young

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. 2003 Prentice Hall Business Publishing Airline Industry Managerial Case Economics, 4/e Keat/Young

The Short Run Cost Function • Yahoo Group Discussion • What is different about dot. com businesses? Irrational Exuberance 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The LR Relationship Between Production and Cost • In the long run, all inputs are variable. • What makes up LRAC? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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? 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Long-Run Cost Function • Reasons for Economies of Scale… üIncreasing returns to scale üSpecialization 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 üManagement efficiencies 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Long-Run Cost Function • Reasons for Diseconomies of Scale… ü Decreasing returns to scale ü Input market imperfections ü Management coordination and control problems 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Production Cost Homework • Page 378 • Problem 10 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young