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Lecture objectives
SEEG 5013 Managerial Economics
o To examine the nature of costs of production. o To derive the firms short-run and long-run total, average and marginal cost curves. o To examine plant size and economies of scale, economies of scope and learning curve. o Discuss international trade in inputs and immigration of skilled labor. o Discuss logistics or supply chain management. o Discuss breakeven analysis.
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Chapter 7: Cost Theory and Estimation

Dr. Hj. Mohd Razani Hj. Mohd Jali FE 0.55 (Economics Building) College of Arts and Sciences razani@uum.edu.my 04-928 3524

The Nature of Costs

Explicit Costs
Actual expenditures of firm to hire, rent or purchase inputs. Also known as accounting costs.

The Nature of Costs

Incremental Cost
Incremental cost is the change in cost tied to a managerial decision. Incremental cost can involve multiple units of output. Marginal cost involves a single unit of output.

Implicit Costs
Value of inputs owned and used by firm in its own production activity. Include highest salary that entrepreneur could earn in his/her best alternative employment. Or highest return for capital investment elsewhere. Alternative or opportunity costs. Also known as economic costs.
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Sunk Cost
Irreversible expenses incurred previously. Sunk costs are irrelevant to present decisions.
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Cost Functions operating period

Short Run Versus Long Run
At least one input is fixed in the short run. All inputs are variable in the long run.

Short-Run Cost Functions

Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC

Fixed and Variable Costs

Fixed cost is a short-run concept. All costs are variable in the long run.

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Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost = TC/Q = TVC/Q

Hypothetical short-run & per-unit cost schedules of a firm

AVC curve is U shaped. With labor as variable input, TVC for any outpuit level (Q) equals wage rate,(w which is fixed) times quantity of labor (L). AVC = TVC/Q = w/APL

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Since average physical product of labor (APL) usually rises first, reaches maximum then falls, it follows that AVC curve first falls, reaches a minumum then rises. ATC curve continues to fall after AVC curve begins to rise as long as the decline in AFC exceeds the rise in AVC. MC curve is also U shaped. MC = TC/Q = TVC/Q = w/MPL

Long-Run Cost Curves

Long-run total cost curves show minimum total cost in an ideal environment. Economies of Scale
Increasing returns to scale imply falling average costs. Constant returns to scale implies constant average costs. Decreasing returns to scale implies rising average costs.
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Long-Run Cost Curves

Long-Run Total Cost, LTC = f(Q) Long-Run Average Cost, LAC = LTC/Q Long-Run Marginal Cost, LMC = LTC/Q

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Long-Run Average Cost Curves LAC curve shows the lowest average cost of producing each level of output when firm can build the most appropriate plant to produce each level of output.

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Plant size and economies of scale

Multi-plant Economies and Diseconomies of Scale
Multi-plant economies are cost advantages from operating several plants. Multi-plant diseconomies are coordination costs from operating several plants.

Economies of Scope
Economies of Scope Concept
Scope economies are cost advantages that stem from producing multiple outputs. Big scope economies explain the popularity of multi-product firms. Without scope economies, firms specialize.

Plant Size and Flexibility

Big plants can offer lower AC. Smaller plants can make it easier to add and /or subtract capacity.

Exploiting Scope Economies

Scope economics often shape competitive strategy for new products.
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Learning Curves
Learning Curve Concept
Learning causes an inward shift in the LRAC curve due to better production knowledge. Learning is often mistaken for scale economies.

Learning Curves

Strategic Implications of the Learning Curve Concept

If learning results in 20% to 30% cost savings, it becomes a key part of competitive strategy.

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Minimizing Costs Internationally

Foreign Sourcing of Inputs New International Economies of Scale Immigration of Skilled Labor Brain Drain

Logistics or Supply Chain Management

Merges and integrates functions
Purchasing Transportation Warehousing Distribution Customer Services

Source of competitive advantage

Logistics or Supply Chain Management

Reasons for the growth of logistics
Advances in computer technology
Decreased cost of logistical problem solving

Cost-Volume-Profit Analysis
Total Revenue, TR = (P)(Q) Total Cost, TC = TFC + (AVC)(Q) Breakeven Volume, TR = TC (P)(Q) = TFC + (AVC)(Q) QBE = TFC/(P AVC)

Growth of just-in-time inventory management

Increased need to monitor and manage input and output flows

Globalization of production and distribution

Increased complexity of input and output flows

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Cost-Volume-Profit Analysis
P = 10

Cost-volume-profit Charts Cost-volume-profit analysis shows effects of varying scale. Breakeven analysis shows zero profit points of cost coverage. Degree of Operating Leverage DOL is the elasticity of profit with respect to output. DOL=Q(P-AVC)/[Q(P-AVC)-TFC].

TFC = 200 AVC = 5 QBE = 40

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Questions or comments?

Reference: Salvatore (2008), Ch. 7

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