Download Cost Analysis and Supply

Managerial Economics
Session 2
Cost Analysis and
Supply
Professor Changqi Wu
Topics for Today

Production and Cost

Cost Concepts

Cost Analysis

Firm’s Production Decision

Supply Curve

Market Mechanism
Cost analysis
Slide 2
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
Cost analysis
Slide 3
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
Cost analysis
Slide 4
Production with One Variable Input
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.
Output
per
Month
112
Output
per
Month
D
Marginal product
30
C
Average product
Total product
60
20
B
10
A
0 1 2 3 4 5 6 7 8 9 10
E
Labor
per Month
Labor
0 1 2 3 4 5 6 7 8 9 10 per Month
Diminishing Marginal Returns

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).
Cost analysis
Slide 6
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 analysis
Slide 7
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 function
 Input
price change moves cost curve
 Technology
Cost analysis
change moves cost curve
Slide 8
Economic and Accounting Concepts of Cost


Accounting Cost

Actual expenses plus depreciation charges
for capital equipment

Historical records
Economic Cost

Cost of utilizing economic resources in
production, including opportunity cost

Forward looking
Cost analysis
Slide 9
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
Cost analysis
Slide 10
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.
Cost analysis
Slide 11
2. Concepts of Cost

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)
TC  FC  VC
Cost analysis
Slide 12
Total Cost Curves of a Firm
Total cost
is the vertical
sum of FC
and VC.
Cost 400
($ per
year)
TC
VC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.
300
200
Fixed cost does not
vary with output
100
FC
50
0
Cost analysis
1
2
3
4
5
6
7
8
9
10
11
12
13
Slide 13
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:
TC
ATC  AFC  AVC or
Q
Cost analysis
Slide 14
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:
VC TC
MC 

Q
Q
Cost analysis
Slide 15
Unit Cost Curves
Cost
($ per
unit)
100
MC
75
50
ATC
AVC
25
AFC
0
Cost analysis
1
2
3
4
5
6
7
8
9
10
11
Output (units/yr.)
Slide 16
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 $5.25 million.

Which building should the firm buy?
Cost analysis
Slide 17
3. Cost Analysis

Economy of scale

Economy of scope

Economy of experience

Economy of time
Cost analysis
Slide 18
3.1 Economy of Scale

Economy of scale means…
Average cost declines when the scale of production
expands

Economy of scale may arise at different levels
of production


product level, plant level, firm level
Economy of scale may arise at different
aspects of business operations

production, marketing, R&D
Cost analysis
Slide 19
Economy of Scale
Unit Costs
($/unit)
$10
$5
LAC (including
cost of capital)
1000
Small firm’s current
sales volume.
Cost analysis
Annual
Sales Volume
(units per year)
4000 5000
MES
Your current sales
volume.
Slide 20
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
Cost analysis
Slide 21
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
Cost analysis
Slide 22
Economy of Scale in Action


Take advantages of economy of scale

Building inventory

Contracting out

Developing backlog
Strategic implications of economy of scale
Cost analysis
Slide 23
3.2 Economy of Experiences
Unit Cost
•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.
$1.00/unit
$0.80/unit
Experience
Curve with 80% Slope
100
Cost analysis
200
Cumulative Production
Volume (total number of
units produced to date)
Slide 24
Sources of Experience Effect

Labor efficiency

New processes and improved methods

Product redesign

Product standardization
Cost analysis
Slide 25
Economy of Experience in Action

We can use experience curve to forecast cost
changes

Forward pricing: pricing based on future cost

strategic effect: moving down quickly along experience curve
to gain competitive advantage

Using pre-launch announcement to prevent rivals
from taking advantage of economy of learning

A firms enjoying a experience based low cost should
take measures to reduce employee turnovers
Cost analysis
Slide 26
Economy of Experience in Action

Earlier-mover advantage refers to the idea
that "the rich get richer”

Because your business unit has entered a
market early (either by happenstance or
superior foresight), your past success in the
market sustains a dynamics whereby your
cost or benefit advantage becomes more
pronounced over time.
Cost analysis
Slide 27
Economies of Scale Versus Learning

Production capacity

Time span
Cost analysis
Slide 28
Economies of
Scale Versus Learning
Cost
($ per unit
of output)
Economies of Scale
A
B
Learning
C
AC1999
AC2000
Output
Cost analysis
Slide 29
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
Cost analysis
Slide 30
Degree of Economies of Scope
The degree of economies of scope
measures the savings in cost and can
be written:
C(Q1)  C (Q 2)  C (Q1, Q 2)
SC 
C (Q1, Q 2)
 If SC > 0 -- Economies of scope


If SC < 0 -- Diseconomies of scope
Cost analysis
Slide 31
3.4 Economy of Time

The Case of PC Market

Moore’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.
Cost analysis
Slide 32
Price
What is Dell doing?
B
B1
V1
Sales Line (price now fixed)
V
Time Line
W
A
U
X
Rate of Price
Decline
X1
Rate of Price
Decline
Cost analysis
Y
Y1
Time
Slide 33
Implications

Can we apply the Dell model to other
businesses?

Toyota introduced the build-to-order
system in 1999
 Costs
were lowed
 Client
satisfaction rose.
Cost analysis
Slide 34
4. Output Decision and Supply
  R-C
R
MR 
q
C
MC 
q
Cost analysis
Slide 35
Choosing Output in the Short Run

A competitive firm acts as a price-taker,
its marginal revenue is a horizontal line
P=

D = MR = AR
Observations:

P = MR

MR = MC

P = MC
Cost analysis
Slide 36
A Competitive Firm
Making a Positive Profit
MC
Price
60
($ per
unit)
50
40
Lost profit for
q q < q*
A
D
Lost profit for
q2 > q*
ATC
C
B
AVC
30
At q*: MR = MC
and P > ATC
q1 : MR > MC and
q2: MC > MR20
and
q0: MC = MR but
MC falling
10
0
  (P - AC) x q*
or ABCD
1
q0
Cost analysis
AR=MR=P
2
3
4
5
6
7
q1
8
q*
9
q2
10
11
Output
Slide 37
A Competitive Firm
Incurring Losses
MC
Price
($ per
unit)
C
D
At q*: MR = MC
and P < ATC
Losses = P- AC) x q*
or ABCD
F
B
A
P = MR
AVC
E
q*
Cost analysis
ATC
Would this producer
continue to produce
with a loss?
Output
Slide 38
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 shutdown.
Cost analysis
Slide 39
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
Cost analysis
Slide 40
A Firm’s Supply Curve
Price
($ per
unit)
S = MC above AVC
MC
P2
ATC
P1
AVC
P = AVC
Shut-down
q1
Cost analysis
q2
Output
Slide 41
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.
Cost analysis
Slide 42
Industry Supply
MC1 MC2
$ per
unit
MC3
The short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
P3
P2
P1
0
Cost analysis
Question: If increasing
output raises input
costs, what impact
would it have on
market supply?
2
4 5
7 8
10
15
Quantity 21
Slide 43
S
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
Cost analysis
Slide 44
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
Cost analysis
Slide 45
Producer Surplus of a Firm
Price
($ per
unit of
output)
At q* MC = MR.
Between 0 and q ,
MR > MC for all units.
Producer
Surplus
MC
AVC
B
A
D
0
Cost analysis
P
C
q*
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
Producer surplus =
R - VC or ABCD.
Output
Slide 46
5. The Market Mechanism
Characteristics of a competitive market
 Many
buyers and sellers in the
marketplace.
 All
sellers sell identical products.
 Free
entry and exit.
 Perfect
Cost analysis
information
Slide 47
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.
Cost analysis
Slide 48
The Market Equilibrium
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Cost analysis
Quantity
Slide 49
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
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
P2
D
Q2
Cost analysis
Q3
Q1 Quantity
Slide 50
The Market Mechanism
Price
($ per unit)
S
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
P3
P2
Shortage
Q2
Cost analysis
Q3
D
Q1 Quantity
Slide 51
Changes In Market Equilibrium

Raw material prices
fall



P
D
S
S’
S shifts to S’
Surplus @ P1 of
Q 1, Q 2
Equilibrium @ P3,
Q3
P1
P3
Q1 Q3 Q2
Cost analysis
Slide 52
Q
Changes In Market Equilibrium

Income Increases
P

Demand shifts to D’

Shortage @ P1 of Q1, Q2 P3

Equilibrium @ P3, Q3
D
D’
S
P1
Q1 Q3 Q2
Cost analysis
Slide 53
Q
Intervention in the Marketplace

Price control creates shortages/surplus

To solve the shortage problem
 Rationing
 Queuing
and searching: non-price
competition
 Black
Cost analysis
market solution
Slide 54
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.
Cost analysis
Slide 55