session 2 cost analysis and supply managerial economics professor changqi wu

Session 2

Cost Analysis and Supply

Cost Analysis and Supply

Managerial Economics

Professor Changqi Wu

Cost analysis Slide 2

Topics for Today

Production and Cost

Cost Concepts

Cost Analysis

Firm’s Production Decision

Supply Curve

Market Mechanism


1. Production and Cost

Production process utilizes productive inputs to produce useful output for buyers

Categories of production inputs labor (skilled and unskilled)

capital

technology

Management skills


Production Function

Production Function indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology.

The production function for two inputs:

Q = F(K,L)

Q = Output, K = Capital, L = Labor

Production with One Variable Input

Laborper Month

Outputper

Month

60

112

0 2 3 4 5 6 7 8 9 101

A

B

C

D

8

10

20E

0 2 3 4 5 6 7 9 101

30

Outputper

Month

Laborper Month

AP = slope of line from origin to a point on TP, lines B, & C.MP = slope of a tangent to any point on the TP line, lines A, C, D.

Average product

Marginal product

Total product


As the use of an input increases in equal increments, a point will be reached at which the resulting additions to output decreases (i.e. Marginal Product declines).

Diminishing Marginal Returns


From Production to Cost

A production function measures the relationship between inputs and output.

To determine the optimal level of output, we must translate the production technology to dollar value of costs.


Cost is not Waste

A cost curve depicts the relationship between output and the most efficient way of producing that output.

A cost curve is the mirror image of the production functionInput price change moves cost curve

Technology change moves cost curve


Economic and Accounting Concepts of Cost

Accounting CostActual expenses plus depreciation charges

for capital equipmentHistorical records

Economic CostCost of utilizing economic resources in

production, including opportunity costForward looking


Opportunity Cost

Business decision making requires information on future alternative courses of action

Opportunity cost measures the forgone net revenue from the best alternative course of action

Example of opportunity cost: Shanghai Petrochemicals


Shanghai Petrochemicals

Shanghai Petrochemicals is a listed company at the Stock Exchanges of both New York and Hong Kong.

Its 1994 Annual Report shows that the company made a profit of RMB 1.77 billion.

In that year Shanghai Petrochemicals bought 4.5 million ton of crude oil at the subsidized price of RMB670/ton while the crude oil price in the international market was at average RMB1100/ton.

Indirect cost savings due to the government subsidies amounted to RMB 1.93 billion.

The company actually lost RMB 150 million in that year.


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)

VC FC TC

2. Concepts of Cost


Total Cost Curves of a Firm

Output

Cost($ peryear)

100

200

300

400

0 1 2 3 4 5 6 7 8 9 10 11 12 13

VCVariable cost

increases with production and

the rate varies withincreasing &

decreasing returns.

TCTotal cost

is the verticalsum of FC

and VC.

FC50

Fixed cost does notvary with output


Average Total Cost

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:

Q

TCor AVC AFC ATC


Marginal Cost

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:

Q

TC

Q

VC MC


Unit Cost Curves

Output (units/yr.)

Cost($ per

unit)

25

50

75

100

0 1 2 3 4 5 6 7 8 9 10 11

MC

ATC

AVC

AFC


Fixed Cost and Sunk Cost

Expenditure that has been made and cannot be recovered.

Sunk cost should not influence a firm’s decision.

An example

A firm pays $500,000 of deposit for an option to buy a building.

The cost of the building is $5 million or a total of $5.5 million.

The firm finds another building for $5.25 million.

Which building should the firm buy?


3. Cost Analysis

Economy of scale

Economy of scope

Economy of experience

Economy of time


3.1 Economy of Scale

Economy of scale means…

Average cost declines when the scale of production expands

Economy of scale may arise at different levels of productionproduct level, plant level, firm level

Economy of scale may arise at different aspects of business operationsproduction, marketing, R&D

Cost analysis

AnnualSales Volume(units per year)

LAC (includingcost of capital)

Unit Costs ($/unit)

4000

$10

$5

MESYour current sales volume.

5000

Small firm’s current sales volume.

1000

Economy of Scale


Sources of Economy of Scale

Production requires significant fixed inputs indivisibility

Physical laws: the two third rule

construction cost = k (throughput)2/3

Economy of mass reserves

Specialized labor

Economy of scales in purchasing


Minimum Efficient Scale is ...

the smallest production scale at which minimum unit cost is attained

Methods to assess MES in an industry Statistical estimation of cost function

The survivor principle

Profitability and firm size

Engineering approach

MES may change when technology advances


Economy of Scale in Action

Take advantages of economy of scaleBuilding inventory

Contracting out

Developing backlog

Strategic implications of economy of scale

Cost analysis

3.2 Economy of Experiences

Cumulative ProductionVolume (total number ofunits produced to date)

Unit Cost

ExperienceCurve with 80% Slope

100 200

$1.00/unit

$0.80/unit

•Experience curves are characterized by their slope (also called BCG slope or progress ratio)

•Slope = by how much do unit costs fall --- as a percentage of a baseline level --- when cumulative output doubles.


Sources of Experience Effect

Labor efficiency

New processes and improved methods

Product redesign

Product standardization


Economy of Experience in Action

We can use experience curve to forecast cost changes Forward pricing: pricing based on future cost strategic effect: moving down quickly along experience

curve to gain competitive advantage

Using pre-launch announcement to prevent rivals from taking advantage of economy of learning

A firms enjoying a experience based low cost should take measures to reduce employee turnovers


Economy of Experience in Action

Earlier-mover advantage refers to the idea that "the rich get richer”

Because your business unit has entered a market early (either by happenstance or superior foresight), your past success in the market sustains a dynamics whereby your cost or benefit advantage becomes more pronounced over time.


Economies of Scale Versus Learning

Production capacity

Time span


Economies ofScale Versus Learning

Output

Cost($ per unitof output)

AC1999

B

Economies of Scale

A

AC2000

LearningC


3.3 Economy of Scope

Economy of scope exists when the total cost of a single firm with multiple products is lower than the sum of the total costs of two independent firms with each producing the a single product.

Examples: Chicken farm--poultry and eggs Automobile company--cars and trucks Universal banking


The degree of economies of scope measures the savings in cost and can be written:

If SC > 0 -- Economies of scope

If SC < 0 -- Diseconomies of scope

)(

)()()C( SC

2,1

2,121

QQC

QQCQCQ

Degree of Economies of Scope


3.4 Economy of Time

The Case of PC MarketMoore’s Law dominates

Highly competitive with modulization

Product life cycle is only 3 months

Price of components falls 50 % a year. One percent a week.


Pri

ce

Time

V

UA

BB1

V1

W

X

X1

Y1

Y

Sales Line (price now fixed)

Time Line

Rate of Price Decline

Rate of Price Decline

What is Dell doing?


Implications

Can we apply the Dell model to other businesses?

Toyota introduced the build-to-order system in 1999Costs were lowed

Client satisfaction rose.


C - R

4. Output Decision and Supply

q

R MR

q

CMC


Choosing Output in the Short Run

A competitive firm acts as a price-taker, its marginal revenue is a horizontal lineP = D = MR = AR

Observations:P = MRMR = MCP = MC


q0

Lost profit forqq < q*

Lost profit forq2 > q*

q1 q2

A Competitive FirmMaking a Positive Profit

10

20

30

40

Price($ per

unit)

0 1 2 3 4 5 6 7 8 9 10 11

50

60MC

AVC

ATCAR=MR=P

Outputq*

At q*: MR = MCand P > ATC

ABCDor

qx AC) -(P *

D A

BC

q1 : MR > MC andq2: MC > MR andq0: MC = MR but

MC falling


Would this producercontinue to produce with a loss?

A Competitive FirmIncurring Losses

Price($ per

unit)

Output

AVC

ATCMC

q*

P = MR

B

F

C

A

E

DAt q*: MR = MCand P < ATCLosses = P- AC) x q* or ABCD


Summary of Production Decisions

Profit is maximized when MC = MR

If P > ATC the firm is making profits.

If AVC < P < ATC the firm should produce at a loss.

If P < AVC < ATC the firm should shut-down.


Supply Curve

Supply curve depicts the relationship between price and quantity supplied

Supply curve depend on the time needed for production adjustment

Short-run supply curve replicates part of a firm’s marginal cost curve

Industry supply curve is horizontal add-up of individual firms’ supply curves


Price($ per

unit)

MC

Output

AVC

ATC

P = AVC

P1

P2

q1 q2

S = MC above AVC

A Firm’s Supply Curve

Shut-down


Observations

Supply is upward sloping due to diminishing returns.

Higher price compensates the firm for higher cost of additional output and increases total profit because it applies to all units.


MC3

Industry Supply

$ perunit

0 2 4 8 105 7 15 21

MC1

SSThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Quantity

MC2

P1

P3

P2

Question: If increasingoutput raises inputcosts, what impactwould it have on market supply?


Supply Elasticity

Supply elasticity is Responsiveness of supply of a good to changes in

price

measured as % change of the supply for an item if the price changes by 1%

Property

Price elasticity of supply > 0


Producer Surplus

Firms earn a surplus on all but the last unit of output.

The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production.

Producer surplus is very sensitive to price changes


AA

DD

BB

CC

ProducerProducerSurplusSurplus

Alternatively, VC is thesum of MC or ODCq* .R is P x q* or OABq*.Producer surplus =

R - VC or ABCD.

Producer Surplus of a Firm

Price($ per

unit ofoutput)

Output

AVCAVCMCMC

00

PP

qq**

At q* MC = MR.Between 0 and q ,

MR > MC for all units.


5. The Market Mechanism

Characteristics of a competitive marketMany buyers and sellers in the

marketplace.

All sellers sell identical products.

Free entry and exit.

Perfect information


The Market Mechanism

A market is at equilibrium when market demand equals market supply

When demand or supply conditions change, market equilibrium will change.

Price may deviate from market equilibrium. When that happens, market participants react to the new market conditions. That restores the market equilibrium.


The Market Equilibrium

Quantity

D

S

The curves intersect atequilibrium, or market-

clearing, price. At P0 thequantity supplied is equalto the quantity demanded

at Q0 .

P0

Q0

Price($ per unit)



D

S

Q2

Assume the price is P1 , then:1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2.3) Producers lower price.4) Quantity supplied decreases

and quantity demanded increases.

5) Equilibrium at P2Q3

P1

Surplus

Q1 Quantity

Price($ per unit)

P2

Q3



D

S

Q2 Q1

P2

Shortage

Quantity

Price($ per unit)

Assume the price is P2 , then:1) Qd : Q2 > Qs : Q1

2) Shortage is Q1:Q2.3) Producers raise price.

4) Quantity supplied increases and quantity demanded decreases.

5) Equilibrium at P3, Q3

Q3

P3


S’

Q2

Raw material prices fall

S shifts to S’

Surplus @ P1 of Q1, Q2

Equilibrium @ P3, Q3

P

Q

SD

P3

Q3Q1

P1

Changes In Market Equilibrium


D’ SD

Q3

P3

Q2

Income Increases

Demand shifts to D’

Shortage @ P1 of Q1, Q2

Equilibrium @ P3, Q3

P

QQ1

P1

Changes In Market Equilibrium


Intervention in the Marketplace

Price control creates shortages/surplus

To solve the shortage problemRationing

Queuing and searching: non-price competition

Black market solution


Key Learning Points

Cost is not waste, it reflects the technical aspects of production and input prices.

Opportunity cost is vital for decision-making, but is hardly reflected in financial statements.

A profit seeker sets his marginal cost equal to his marginal revenue

Market mechanism can lead to efficient allocation of resources.

session 2 cost analysis and supply managerial economics professor changqi wu

Documents

cost analysisslide

fixed cost

total cost of production

cost production process

concepts of cost slide

total cost curves

indirect cost savings

production technology