Download Costs

Lecture 6: MicroEcon ~ct’d
Cost of Production
Cost of production includes all the
opportunity costs of making the output of
goods and services.
– Explicit costs: input costs that require a direct
outlay of money by the firm.
– Implicit costs: input costs that do not require an
outlay of money by the firm.
Profits
 The firm’s objective is to maximize profits
Profit = Total revenue - Total cost
 Economic Profit: total revenue minus total cost,
including both explicit and implicit costs.
 Accounting Profit: total revenue minus only the
firm’s explicit costs.
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = $3000 (5%) interest on the loan
– implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
How an Economist
Views a Firm
Profits
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © 2004 South-Western
Article 6a: The Painful Truth About Profits
Business Week; by: Michael Mandel
 Without profits there’s no incentive for innovation or creating new
companies.
 Today the biggest problem is that most companies are shooting for
a return to the highest profit levels of the late 1990s.
 >> HIGH WAGES
– Despite the recession and a year of slow growth, corporate labor
costs are nearly $1 trillion higher now than in 1997.
– Real wages and benefits continue to climb, growing at 2% rate
during the past year
 >> SLOW GLOBAL GROWTH
– Weak economies overseas have kept exports flat at best
– Most major industrial countries are expected to grow more slowly
than the US in the coming year
 >> OVERBUILT
– There’s already an excess of US industrial capacity
– This makes it almost impossible for corporations to raise prices
Article6b: Economic Profit vs. Accounting Profit
WSJ; by Robert Bartley
 Profit is any income to a proprietor—Marxist Labor View—which is
fallacious
 The economist is interested in the dynamic forces of production while: The
accountant is interested in proprietorship….cost as a deduction from the
owner’s income
 Economic profit is the unimputable income i.e. “the residium of product
remaining after payment is made at rates established in competition with
all comers for all services of men or things for which competition exists”
 The highest uses depend on economic profit-rate of return on assets-not
on accounting profits.
 The issue of interest on equity has tended to constitute an issue between
accountants and economic theorists
 EPS measures the corporate profit and is called the accounting profit
 Peter Drucker: EPS represents taxable earnings i.e. after all deductions, is
purely arbitrary concept and has nothing to do with business performance
 NET-NET: Takes skill to convert EPS into meaningful economic profit
concept.
Marginal Product
 Marginal Product: for any input, it is the increase in output
that arises from an additional unit of that input.
 Diminishing Marginal Product: the marginal product of an
input declines as the quantity of the input increases.
I
0
Y
0
MP
Y = √I
1.0
1
3.5
1
0.4
2
1.4
2.5
0.3
3
1.7
2
2.2
1
0.5
0.2
5
2
1.5
0.3
4
3
0
0
2
4
6
8
10
Diminishing Marginal Product
Quantity of
Output
(cookies
per hour)
Production function
150
I
0
Y
0
50
140
130
1
120
50
40
110
2
100
90
90
30
80
3
70
120
60
20
50
4
40
140
30
10
20
5
10
0
MP
1
2
3
4
5
Number of Workers Hired
150
Fixed & Variable Costs
 Fixed costs: those costs that do not vary with the quantity
of output produced.
 Variable costs: those costs that do vary with the quantity of
output produced.
TC = TFC + TVC
 Total Costs
–
–
–
–
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
Total Cost Curve
Shows the relationship between the quantity
a firm can produce and its costs.
Total Cost Curve
Total
Cost
Total-cost
curve
$80
70
60
50
40
30
20
10
0
10 20 30 40 50 60 70
80 90 100 110 120 130 140 150
Quantity of Output
(cookies per hour)
Marginal Cost
Marginal Cost (MC): measures the increase
in total cost that arises from an extra unit of
production.
(change in total cost) TC
MC 

(change in quantity)
Q
EMBA Tavern
(change in total cost) TC
MC 

(change in quantity)
Q
Tavern’s Total-Cost Curve
Total Cost
$15.00
Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
8
9
10
Quantity of Output
(pints of beer per hour)
Average Costs
Average costs can be determined by
dividing the firm’s costs by the quantity of
output it produces.
The average cost is the cost of each typical
unit of product.
– ATC
– AFC
– AVC
Tavern’s Various Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
9
10
Quantity of Output
(pints of beer per hour)
Returns/Economies of Scale
 Economies of Scale: long-run average total cost
falls as the quantity of output increases (implies
Increasing Returns to Scale - IRS)
 Diseconomies of Scale: long-run average total cost
rises as the quantity of output increases (implies
Decreasing Returns to Scale – DRS)
 Minimum Efficient Scale: smallest quantity a firm
can produce such that its long-run average total
cost is minimized.
Returns/Economies of Scale
 Increasing Returns to Scale (IRS): if a 1% increase
in all inputs results in a greater than 1% increase
in output
 Decreasing Returns to Scale (DRS): if a 1%
increase in all inputs results in a less than 1%
increase in output
 Constant returns to scale (CRS): if a 1% increase
in all inputs results in an exactly1% increase in
output
Economies of Scale
Average
Total
Cost
ATC in long run
$12,000
10,000
Economies
of
Scale
(IRS)
0
Constant
returns to
scale
1,000 1,200
Diseconomies
of
Scale
(DRS)
Quantity of
Cars per Day
Competitive Firms
Total Revenue
Total Revenue: for a firm, is the selling
price times the quantity sold.
TR = (P  Q)
Total revenue is proportional to the amount
of output.
Average Revenue
Average Revenue: how much revenue a
firm receives for the typical unit sold.
Total revenue
Average Revenue =
Quantity
Price  Quantity

Quantity
 Price
Marginal Revenue
Marginal Revenue: the change in total
revenue from an additional unit sold.
MR =TR/ Q
For competitive firms, marginal revenue
equals the price of the good.
Profit Maximization
Firms will produce where TR-TC is greatest
MR=MC
Profit Maximization
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
MC
MC2
ATC
P = MR = MC
P = AR = MR
AVC
MC1
0
Q1
QMAX
Q2
Quantity
Measuring Profits Graphically
Price
Firm with
Profits
MC
ATC
P
ATC
P = AR = MR
0
Quantity
Q
(profit-maximizing quantity)
Decision to Shut Down
Shut Down: a short term decision to stop
production (not to exit the market)
– Sunk fixed costs are ignored
Shut down if TR < TVC
Shut down if TR/Q < TVC/Q
– TR/Q = Average Revenue
In equilibrium
– TVC/Q = Average Variable Cost
P = MR
Shut down if P < AVC
Decision to Shut Down
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
Decision to Exit
Exit: a long run decision to leave the market
The firm exits if the revenue it would get
from producing is less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
Decision to Exit
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
Measuring Profits Graphically
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Q
(loss-minimizing quantity)
Quantity
Cost & Profits
Airline Industry
Major Costs as Shares of Operating Expenses
%
50
40
30
20
10
0
1973
1978
1983
Labor
Aircraft Ow nership
1988
1993
Fuel
Non-Aircraft Ow nership
US Airline Cost Index Report 2003
1998
2003
US Airline Cost Index Report 2004
ATA 2004 Economic Report
Major Costs as Shares of Operating Expenses
%
12
10
8
6
4
2
0
1973
1978
1983
Passenger com m issions
Utilities and Office Supplies
1988
1993
1998
2003
Advertising and prom otion
Food and Beverages
US Airline Cost Index Report 2003
Article 6c: One Airline’s Magic
Time Magazine by: Sally Donnelly
How does Southwest (SW) soar above its money losing rivals?
 Productivity
Its employees work harder and are smarter, in return, they get job
security and a share of profits
– Pilots fly as many as 83 hours a month, compared with about 53
hours in a busy month at United Airlines
– Flight attendants work almost twice as many hours as their
counterparts at other airlines
– Mechanics change airplane tires faster (like a NASCAR pit) and thus
get higher wages than their counterparts at other airlines
 Flexibility
– SW pilots also pitch in to help ground crews move luggage
 In return, SW compensates it workers in ways other than the base pay
– It contributes 15% of its pre-tax income to a profit-sharing plan
– It has assured all its workers and unions that there would be no lay-offs
– SW doesn’t use the word “employee”, and gives them enough room to grow
and learn
– SW has enjoyed big savings by never having the type of defined-benefit
pension plans which has proved so costly for other airlines
 Other advantages of SW:
– Last year, SW selected 6,000 people out of 2 million resumes received on
the basis of attitudes and not necessarily skills
– SW flies point-to-point domestic routes, as opposed to the complex and
expensive hub-and-spoke international networks
– No meals served onboard, no bulky drink carts and no entertainment
– SW uses less expensive, less crowded secondary airports
– Flies only one type of aircraft – Boeing 737 to reduce maintenance costs
– Employees own more than 10% of SW outstanding shares, thus they work
more productively and more creatively to increase their own pay checks
– Lowest cost per seat mile: 7.5 cents
– Highest aircraft hours per day: 10.9 hrs/day
WSJ Article 2002
So What is the Solution?
Do the legacy airlines have any comparative advantage that
they can use in competing with their low cost rivals for
domestic travelers?
– The honest answer is NO.
The time has come for some of the airlines to either merge
or liquidate so that excess capacity in the market can be
reduced to profitability manage the new demand frontier.
(permanent downward shift in demand curve esp. domestic
flying)
But will the mergers or liquidations save the big boys?
Maybe…
The only way out is a radical shift in thinking by the big
airlines: outsource to low-cost airlines and allow them to bring
passengers to your legacy hubs! Then fly these travelers to
international destinations on your planes at premium prices
where there is no competition from South-West and upstart
airlines.