ECNE 610 Managerial Economics APRIL 2014 Chapter7 1

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ECNE 610 Managerial Economics APRIL 2014 Chapter-7 1 Dr. Mazharul Islam

ECNE 610 Managerial Economics APRIL 2014 Chapter-7 1 Dr. Mazharul Islam

2 7 5 Theory and Estimation of Cost Dr. Mazharul Islam

2 7 5 Theory and Estimation of Cost Dr. Mazharul Islam

3 Lesson Objectives q define the cost function. q distinguish between economic cost and

3 Lesson Objectives q define the cost function. q distinguish between economic cost and accounting cost. q explain how the concept of relevant cost is used. q understand total, variable, average and fixed cost. q distinguish between short-run and long-run cost. q provide reasons for the existence of economies of scale. Dr. Mazharul Islam

4 Definition and use of cost in economic analysis: Economic Costs: A firm’s economic

4 Definition and use of cost in economic analysis: Economic Costs: A firm’s economic costs are the opportunity costs of the resources used, whether those resources are owned by others or by the firm. Explicit costs (Accounting Costs) Refer to the firm’s actual cash payments for resources wages, rent, interest, insurance, taxes, etc. Such money payments are for the use of resources owned by others. Dr. Mazharul Islam

5 Definition and use of cost in economic analysis: Implicit costs Refer to the

5 Definition and use of cost in economic analysis: Implicit costs Refer to the opportunity costs of using its selfowned, self-employed resources. Implicit costs are the money payments that self-employed resources could have earn in their best alternative use. Dr. Mazharul Islam

6 ECONOMIC PROFITS Total Revenue: It is the amount received from the sale of

6 ECONOMIC PROFITS Total Revenue: It is the amount received from the sale of the product; it is equal to the number of units sold (Q) times the price received per unit (P). TR = Qx. P Economic Profit (Actual profit) Total Revenue Economic Cost

7 Economic (opportunity) Costs Profits to an Economist Economic Profit Implicit costs Explicit Costs

7 Economic (opportunity) Costs Profits to an Economist Economic Profit Implicit costs Explicit Costs Profits to an Accountant T O T A L R E V E N U E Accounting Profit Accounting costs (explicit costs only)

8 A particular example to clarify the distinction between explicit and implicit costs. Khalid

8 A particular example to clarify the distinction between explicit and implicit costs. Khalid Al Ghamdi runs a small furniture firm. He hires one assistant at SAR 21, 000 per year, pays annual rent of SAR 5000 a year for his shop, an invested SAR 20, 000 from his savings on materials that could have earn him SAR 1000 per year as interest rate. He has been offered SAR 24, 000 per year to work as a manager for competitor. He estimates his entrepreneurial talents are worth SAR 3000 per year. Total annual revenue from furniture sales is SAR 100, 000.

9 Total revenue explicit costs: Assistant's salary Material and equipment Shop rent Equals accounting

9 Total revenue explicit costs: Assistant's salary Material and equipment Shop rent Equals accounting profit $100, 000 21, 000 20, 000 5, 000 implicit costs: Adnan's forgone salary 24, 000 Forgone interest on savings 1, 000 Entrepreneurial profit 3, 000 Equals economic profit ______ $26, 000 Accounting profit equals total revenue minus explicit costs used to determine a firm’s taxable income However, this ignores the opportunity cost of Ghamdi’s own resources $54, 000 His forgone salary of $24, 000 Annual interest of $1, 000 from the savings used to start the business Entrepreneurial profit $5, 000 Economic profit equals total revenue minus all costs, both explicit and implicit Accounting profit of $54, 000 less implicit costs of $28, 000 economic profit of $26, 000

10 When the demand for a firm’s product changes, the firm’s profitability depends on

10 When the demand for a firm’s product changes, the firm’s profitability depends on how quickly it can adjust the amount of the various resources that it employed. Some resources can easily and quickly adjust such as labor, raw material, fuel and power but some resources need much more time to adjust such as building, machinery and equipment. Because of this differences in adjustment time, economists consider everything into two conceptual periods: the short run and the long run.

 Short run at least one resource (Capital) is fixed. Long run all resources

Short run at least one resource (Capital) is fixed. Long run all resources are variable. Resources can be divided into two categories Variable resources can be varied quickly to change the output rate. Fixed resources are those resources which cannot be easily changed.

12 Relationship between production and cost Cost function is simply the production function expressed

12 Relationship between production and cost Cost function is simply the production function expressed in monetary rather than physical units. We assume the firm is a ‘price taker’ in the input market Dr. Mazharul Islam

SHORT-RUN PRODUCTION COSTS Total Fixed Costs = Total Variable Costs = Total Costs =

SHORT-RUN PRODUCTION COSTS Total Fixed Costs = Total Variable Costs = Total Costs = Average Fixed Costs = Average Variable Costs = Average Total Costs = Marginal Cost = TFC TVC TC AFC AVC ATC MC

14 Total, fixed, and variable costs Costs of production usually divided into two sections

14 Total, fixed, and variable costs Costs of production usually divided into two sections such as fixed costs and variable costs Fixed costs are those costs that do not vary with the quantity of output produced, e. g. the cost of the factory. Variable costs are those costs that do vary with the quantity of output produced, e. g. the cost of workers. Dr. Mazharul Islam

15 Chapter Seven Short-run cost function For simplicity use the following assumptions: the firm

15 Chapter Seven Short-run cost function For simplicity use the following assumptions: the firm employs two inputs, labor and capital the firm operates in a short-run production period where labor is variable, capital is fixed the firm produces a single product the firm employs a fixed level of technology the firm operates at every level of output in the most efficient way the firm operates in perfectly competitive input markets and must pay for its inputs at a given market rate (it is a ‘price taker’) the short-run production function is affected by the law of diminishing returns

Short-run cost function Fixed Costs: Total cost of using the fixed input (K). Total

Short-run cost function Fixed Costs: Total cost of using the fixed input (K). Total Fixed Costs = Total costs – Total Variable costs. This costs also be found by multiplying the number of fixed inputs by the price of the input. Total Fixed Costs Average Fixed Costs = Quantity Variable Costs: total cost of using the variable input, labor (L). Total Variable Costs = Total costs – Total Fixed costs. This costs also be found by multiplying the number of variable inputs by the input price. Total Variable Average Variable Costs = Quantity

Total Cost = Total Fixed + Variable Cos Average Total Costs = Quantity So

Total Cost = Total Fixed + Variable Cos Average Total Costs = Quantity So Average Cost (AC) = AFC + AVC = TC/Q Marginal Cost: the rate of change in total variable cost. Marginal Change in Total Costs = Change in Quantity = DTC/DQ

Costs (dollars) SHORT-RUN COSTS GRAPHICALLY Combining TVC With TFC to get Total Cost TC

Costs (dollars) SHORT-RUN COSTS GRAPHICALLY Combining TVC With TFC to get Total Cost TC TVC Fixed Cost Variable Cost TFC Quantity

The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand Copyright© 2004 South-Western

The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand Copyright© 2004 South-Western

 Graphical example of the cost variables 20

Graphical example of the cost variables 20

Explaining Cost Curves and Their Shapes The average total-cost curve is U-shaped. average total-cost

Explaining Cost Curves and Their Shapes The average total-cost curve is U-shaped. average total-cost At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially. The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than

Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. Whenever marginal cost is equal to average total cost, ATC is minimum. The same three rules apply for average variable cost (AVC) as for ATC

23 Chapter Seven

23 Chapter Seven

24 Chapter Seven

24 Chapter Seven

25 Chapter Seven Long-run cost function In the long run, all inputs to a

25 Chapter Seven Long-run cost function In the long run, all inputs to a firm’s production function may be changed because there are no fixed inputs, there are no fixed costs. at first increasing returns to scale, then as firms mature they achieve constant returns, then ultimately decreasing returns to scale

26 Economies Chapter Seven of scale: situation where a firm’s long-run average cost (LRAC)

26 Economies Chapter Seven of scale: situation where a firm’s long-run average cost (LRAC) declines as output increases Diseconomies of scale: situation where a firm’s LRAC increases as output increases In general, the LRAC curve is ushaped.

27 Chapter Seven Reasons for economies of scale specialization of labor and capital prices

27 Chapter Seven Reasons for economies of scale specialization of labor and capital prices of inputs may fall with volume discounts in firm’s purchasing use of capital equipment with better priceperformance ratios larger firms may be able to raise funds in capital markets at a lower cost larger firms may be able to spread out promotional costs

28 Chapter Seven Reasons for diseconomies of scale of production becomes so large that

28 Chapter Seven Reasons for diseconomies of scale of production becomes so large that it affects the total market demand for inputs, so input prices rise transportation costs tend to rise as production grows, due to handling expenses, insurance, security, and inventory costs

29 Chapter Seven Economies of scope: reduction of a firm’s unit cost by producing

29 Chapter Seven Economies of scope: reduction of a firm’s unit cost by producing two or more goods or services jointly rather than separately.

30 Chapter Seven Supply chain management (SCM): efforts by a firm to improve efficiencies

30 Chapter Seven Supply chain management (SCM): efforts by a firm to improve efficiencies through each link of a firm’s supply chain from supplier to customer. • • • transaction costs are incurred by using resources outside the firm. coordination costs arise because of uncertainty and complexity of tasks. information costs arise to properly coordinate activities between the firm and its suppliers.

31 Chapter Seven Supply chain management Ways to develop better supplier relationships strategic alliance:

31 Chapter Seven Supply chain management Ways to develop better supplier relationships strategic alliance: firm and outside supplier join together in some sharing of resources competitive tension: firm uses two or more suppliers, thereby helping the firm keep its purchase prices under control

32 Chapter Seven Ways companies cut costs to remain competitive the strategic use of

32 Chapter Seven Ways companies cut costs to remain competitive the strategic use of cost reduction in cost of materials using information technology to reduce costs reduction of process costs relocation to lower-wage countries or regions mergers, consolidation, and subsequent downsizing layoffs and plant closings

33 Do you have any question? Dr. Mazharul Islam

33 Do you have any question? Dr. Mazharul Islam