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TUMAINI UNIVERSITY FACULTY OF BUSINESS ADM Managerial Economics G. Loth Theory of Firms Costs, Revenues and Objectives Theory of Firms Profit: Difference between Revenue and Cost Π = TR - TC Theory of Firms Revenue = amount received from the sale of goods or services TR = P x Q Theory of Firms Total Cost is the sum of all costs – fixed, variable and semi-fixed Fixed Costs – do NOT depend on quantity produced- Rent, Rates, Insurance, etc. Variable Costs –vary directly with the amount produced – raw materials Semi–Fixed Costs - may vary with output but not directly – some types of labour, energy costs Theory of Firms Factor Costs: Labour – wages/salaries Land – rent Capital – interest Enterprise - profit Theory of Firms Average Cost = Total cost divided by the number of units produced AC = TC/Q AVC = TVC/Q AFC = TFC/Q Theory of Firms Marginal Cost The cost of producing one extra or one less unit of output MC = TCn units – TCn-1 / Q If TC of 100 units = £500 and TC of producing 101 units is £505, MC = £5.00 Important concept Theory of Firms Short and Long run: Short run – some factors fixed and cannot be increased/reduced Long Run – time taken to vary all factors of production Short and long run vary in all industries: Theory of Firms Railways – short run –’easy’ to increase labour, long lead times for new rolling stock – 5 years? Supermarkets – short run – can buy new shelving, hire staff, etc but opening of new stores takes several years Local Builder – short run buys new tools, hires assistant; long run – purchasing a new van – a couple of months? Theory of Firms Diminishing Marginal Returns Assumptions – some factors fixed (e.g. capital and land) Adding variable factor – (labour) Total Product Average Product – TP / Q variable factor (Qv) Marginal Product ΔTP/ΔQv Theory of Firms Increasing the variable factor: TP rises at first, slows then falls AP rises at first then starts to fall MP rises, then falls, cuts AP at highest point of AP, cuts horizontal axis at point where TP starts to fall Theory of Firms Objectives of firms: Profit maximisation Profit satisficing Long term survival Share price maximisation Revenue maximisation Brand loyalty Expansion and market dominance The Theory and Estimation of Cost Definition of Cost The Short Run Relationship Between Production and Cost The Long Run Relationship Between Production and Cost The Short Run Cost Function The Long Run Cost Function The Learning Curve Definition of Cost A cost is relevant if it is affected by a management decision. Historical cost is incurred at the time of procurement Replacement cost is necessary to replace inventory Are historical costs relevant? Definition of Cost There are two types of cost associated with time Incremental cost varies with the range of options available in the decision making process. Sunk cost does not vary with decision options. Is sunk cost relevant? Definition of Cost There are two types of cost associated with economic analysis Opportunity cost is the value that is forgone in choosing one activity over the next best alternative Out-of-pocket cost is actual transfer of value that occur Which cost is relevant? SR Relationship Between Production and Cost A firm’s cost structure is related to its production process. Costs are determined by the production technology and input prices. Assuming that the firm is a “price taker” in the input market. SR Relationship Between Production and Cost Total Total variable cost (TVC) is associated with the variable input Assume w=$500 per unit (price-taker) Input (L) 0 1 2 3 4 5 6 7 8 9 Q (TP) 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850 MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 SR Relationship Between Production and Cost TP and TVC are mirror images of each other Kings Dominion Example SR Relationship Between Production and Cost Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC. TC=TFC+TVC Marginal Costs Average Costs Tool Set for Production Cost Analysis vs. Production Process Analysis SR Relationship Between Production and Cost Marginal cost (MC) is the change in total cost associated a change in output. TC MC Q TC (TFC TVC ) TFC TVC TVC MC 0 Q Q Q Q Q SR Relationship Between Production and Cost Add marginal cost to the table Total Input (L) 0 1 2 3 4 5 6 7 8 9 Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850 MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33 SR Relationship Between Production and Cost Total Input Observe that: (L) When MP is increasing, MC 0 1 is decreasing. 2 When MP is 3 decreasing, 4 MC is 5 increasing. 6 7 8 9 Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850 MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33 SR Relationship Between Production and Cost The relationship between MP and MC is TVC w L L 1 w MC w w Q Q Q MP MP Law of diminishing returns implies that MC will eventually increase! Why? The Short Run Cost Function Average total cost (ATC) is the average perunit cost of using all of the firm’s inputs (TC/Q) Average variable cost (AVC) is the average perunit cost of using the firm’s variable inputs (TVC/Q) Average fixed cost (AFC) is the average per-unit cost of using the firm’s fixed inputs (TFC/Q) The Short Run Cost Function Add ATC = AFC + AVC to the table The Short Run Cost Function ATC = AFC + AVC The Short Run Cost Function Production cost graph or map is The Short Run Cost Function Important Map Observations AFC declines steadily over the range of production. Why? In general, ATC is u-shaped. Why? MC intersects the minimum point (q*) on ATC. Why? The Short Run Cost Function Important Map Observations What is the economic significance of q*? The Short Run Cost Function Average total cost (ATC) is the average perunit cost of using all of the firm’s inputs (TC/Q) At Q* - ATC is minimized or inputs are used most efficiently given the production function The Short Run Cost Function A change in input prices will shift the cost curves. If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip Case The Short Run Cost Function A change in input prices will shift the cost curves. If variable input costs are reduced then MC, AVC, and AC will all shift downward. Airline Industry Case The Short Run Cost Function Yahoo Group Discussion What is different about dot.com businesses? Irrational Exuberance The LR Relationship Between Production and Cost In the long run, all inputs are variable. What makes up LRAC? The Long-Run Cost Function LRAC is made up for SRACs SRAC curves represent various plant sizes Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve The Long-Run Cost Function The LRAC is the lower envelope of all of the SRAC curves. Minimum efficient scale is the lowest output level for which LRAC is minimized Is LRAC a function of market size? What are implications? The Long-Run Cost Function Reasons for Economies of Scale… Increasing returns to scale Specialization in the use of labor and capital Economies in maintaining inventory Discounts from bulk purchases Lower cost of raising capital funds Spreading promotional and R&D costs Management efficiencies The Long-Run Cost Function Reasons for Diseconomies of Scale… Decreasing returns to scale Input market imperfections Management coordination and control problems The Learning Curve Measures the percentage decrease in additional labor cost each time output doubles. An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level. The Learning Curve A downward slope in the learning curve indicates the presence of the learning curve effect Why? Workers improve their productivity with practice The learning curve effect shifts the SRAC downward