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Supply, Elasticity and Costs
Assistant Professor Chanin Yoopetch
Learning outcomes
By studying this chapter students will be able to:
 understand and utilize the concept of elasticity of supply
 identify the factors of production
 distinguish between fixed and variable factors of production
 analyse the relationship between costs and output in the short
run and long run
 understand the reasons for economies of scale
Price elasticity of supply

Elasticity of supply measures


the responsiveness of supply to a change in price.
This relationship may be expressed as a formula:
 Percentage change in quantity supplied ÷ Percentage
change in price

Where supply is inelastic it means

that supply cannot easily be changed, whereas elastic
supply is more flexible.

Ways to increase supply
 Expanding your factories?
 Outsourcing ?
Factors affecting price elasticity of
supply




time period
availability of stocks
spare capacity
flexibility of capacity / resource mobility
Factors affecting price elasticity of
supply

time period

The longer the
period of time,
the easier it is
for supply to
be changed.

Build more
hotel rooms
or invest in
more
capacity
Factors affecting price elasticity of
supply

availability of stocks


in the warehouse, enabling supply to be flexible
and more elastic
However, some leisure services, such as theatres
and hotels, can’t be kept in stock, so supply is
inelastic in the short run
Factors affecting price elasticity of
supply

spare capacity

Some hotels generally utilize only 90% of
capacity to provide services.


Some airlines have spare aircraft available for
deployment
Making supply more elastic
Factors affecting price elasticity of
supply

flexibility of capacity / resource mobility

Flexibility of capacity





Resources can easily be shifted from provision of one
good or service to another.
Flexibility of the labour force is one of the key factors.
Many organizations train staff to be multiskilled to
enable them to shift from one task to another.
Job rotation
Organizations have to deal with training several skills
Supply and costs

Leisure and tourism inputs

Land


Labour


This includes skilled and unskilled human effort.
Capital


This includes natural resources such as minerals, and land
itself.
This includes buildings, machines and tools.
Enterprise

This is the factor which brings together the other factors of
production to produce goods and services.
Supply and costs

Leisure and tourism inputs

We can also categorize factors of production into;


Fixed and variable factors
Fixed factors
 Those factors which cannot be easily varied in the short run
 E.g. Actual building of hotels, airports

Variable factors
 Can be changed in the short run and include unskilled
labour, energy and readily available raw materials
The Costs of Production
Supply
The Law of Supply:
Firms are willing to
produce and sell a
greater quantity of a
good when the price of
a good is high, this
results in a supply
curve that slopes
upward.
Why Study Behavior of Firms?
 Gain
a better
understanding of the
decisions made by
producers.
 Study
how the behavior of
a firm depends on the
structure of the market.
Purpose Facing The Typical
Firm
The economic purpose of the firm
is to maximize profits!
Profit: The firm’s revenues minus its costs.
An Individual Firm’s Profit:
Revenue minus Cost

Revenues: The amount that the firm receives for
the sale of its product.
(Market Price x Amount Sold)= Revenues

Costs: The amount that the firm pays to buy
inputs.

Profit is often referred to as Producer Surplus: the
amount a seller is paid minus the cost of
production. A measure of the benefits to sellers.
Producer Surplus: Graphical
S
Producer
Surplus
PE
Production
Costs
D
QE
Costs of Production

In general, three costs are often considered
when making business strategy or supply
decisions.
Explicit Costs
Implicit Costs
Sunk Costs
Costs as Opportunity Costs

The firm’s costs include Explicit Costs and
Implicit Costs:

Explicit Costs: costs that involve a direct money
outlay for factors of production. (cost for wages,materials)

Implicit Costs: costs that do not involve direct money
outlay. (e.g. opportunity costs)


Both can include opportunity costs.
Especially, for self-employed or self-owned business; one’s
time or one’s opportunity to do something else.
Costs as Opportunity Costs

Economists include all opportunity costs
when measuring costs.

Accountants measure the explicit costs but
often ignore the implicit costs.

When revenues exceed both explicit and
implicit costs the firm earns economic
profits.
Costs as Opportunity Costs

A third, not so obvious implicit cost includes
sunk costs.

Sunk costs are costs that have already
been committed and cannot be recovered.
Sunk Costs are . . .

an opportunity cost

often ignored when making decisions about
business strategy

Cost for market research
The Various Measures of Cost
Costs of production may be divided into two
specific categories:
 Fixed Costs:


Those costs that do not vary with the amount of
output produced.(Security services, full-time worker salary)
Variable Costs:

Those costs that do vary with the amount of output
produced.(cost of flour for producing cake)
Fixed versus Variable Costs

The division of costs between fixed and
variable often depends on the time horizon
being considered.

Over a period of weeks, i.e. short-run, some
costs are fixed (e.g. plant size.)

Over a period of years, i.e. long-run, many fixed
costs become variable costs.

Allows greater ability to respond to changing
circumstances in the long run.
Family of Total Costs...
 Total
Fixed Costs (TFC)- costs that do
not vary with the quantity of output produced
 Total
Variable Costs- (TVC)- Costs
that do vary with the quantity of output produced
 Total
Costs (TC):
TC = TFC + TVC
Family of Average Costs. . .
 Average
Costs:
Specific Cost / Output Level

Average Fixed Costs (AFC)- fixed costs divided
by the quantity of output

Average Variable Costs (AVC)- variable costs
divided by the quantity of output

Average Total Costs (ATC)- total costs divided by
the quantity of output
Marginal Cost:
“How much does it cost to produce an additional unit of
output?”
 Marginal
Cost (MC):
“The extra or additional cost of producing one more
unit of output.”

MC is the addition to the cost of production that must be
covered by additional revenue for profit maximization
Mathematical Definitions of
Costs

Average Total Cost:
ATC = TC / Q

Marginal Cost:
MC =
TC /
Q
Long run costs
Long run

Economies of scale- Economies of scale arises from
increases in the size of an organization.

Financial
 Large firms tend to have bigger assets.
 Large firms tend to get lower borrowing rates from banks??

buying and selling
 Buying and selling economies arise from buying and selling in bulk.
 Buying , leading to large purchase discounts
 Selling, costs of advertising are spread out over a large number of sales

Managerial / specialization
 Large travel agency chains, comparing to a small travel agency, will have the
scope for employing experts in functional areas, such as accounting,
marketing, and personnel.
Long run costs
Long run
 Economies of scale- Economies of scale arises from
increases in the size of an organization.

Technical
 Relating to utilization of complex and expensive technology and
machinery. Cost per guest per year will be relatively insignificant for
large hotels when they buy an expensive accounting system software.

economies of increased dimensions
 Cost of buying one big bus for 50 people is cheaper than cost of buying
5 vans( also for 50 people).
Long run costs
Long run

Economies of scale- Economies of scale arises from
increases in the size of an organization.
 risk-bearing
 The ability of large organizations to stay viable in hard time.
 Two factors
 Diversified interests (demand falls in one area can be
compensated for by business elsewhere.
 Large organizations with more assets are able to sustain
short-term losses from reserves.
Long run costs
Long run costs
 Diseconomies of scale
 are the forces that cause larger firms to produce goods and services
at increased per-unit costs.
Long run costs

Two types of diseconomies of scale

Internal diseconomies
 For some firms, it is difficult to manage efficiently beyond a
certain size and problems of control, delegation, and
communications arise.
 It may arise from the growth due to M&A.

External diseconomies
 Can result from activities in a particular area which can be from
high pollution costs.
 External diseconomies can be restricted by prohibiting some
polluting activities and taxing others
How firms grow
1.
internal growth

A slow process,

2.
Firms slowly accumulate assets to grow.
mergers and take-overs


A faster process of growth
Including vertical and horizontal integration,
and diversification
Vertical integration


The degree to which a firm owns its upstream
suppliers and its downstream buyers
The concept of vertical integration can be
visualized using the value chain.
Vertical Integration
Benefits of Vertical Integration
Vertical integration potentially offers the following
advantages:
•Reduce transportation costs if common
ownership results in closer geographic
proximity.
•Improve supply chain coordination.
•Provide more opportunities to differentiate by
means of increased control over inputs.
•Capture upstream or downstream profit
margins.
Horizontal integration


Horizontal growth can be achieved by internal expansion or by
external expansion through mergers and acquisitions of firms
offering similar products and services. A firm may diversify by
growing horizontally into unrelated businesses.
Some examples of horizontal integration include:
 The Standard Oil Company's acquisition of 40
refineries.
 An automobile manufacturer's acquisition of a sport
utility vehicle manufacturer.
 A media company's ownership of radio, television,
newspapers, books, and magazines.
Benefits of Horizontal Integration




Economies of scale - achieved by selling more of the
same product, for example, by geographic expansion.
Economies of scope - achieved by sharing resources
common to different products. Commonly referred to as
"synergies."
Increased market power (over suppliers and
downstream channel members)
Reduction in the cost of international trade by operating
factories in foreign markets.
Social and private costs

Private costs of production are those costs
which an organization has to pay for its
inputs.


They are also known as accounting costs since
they appear in an organization’s accounts.
Social costs do not appear in an
organization’s accounts and do not affect its
profitability, although they may well affect
the well-being of society at large.
Group assignment
- Short and long run costs



What happens to
average short run
costs of a hotel as
occupancy falls?
How will the hotel
respond to a long run
fall in occupancy?
How do hotels benefit
from economies of
scale?
The End