Managerial economics economic tools for todays decision makers 7th edtion by keat young and erfle chapter 07

7-2 Chapter Outline • Importance of cost in managerial decisions • Definition and use of costs in economic analysis • Relationship between production and cost • Short-run cost function •

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Chapter 7

The Theory and Estimation

of Cost

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Chapter Outline

• Importance of cost in managerial decisions

• Definition and use of costs in economic analysis

• Relationship between production and cost

• Short-run cost function

• Long-run cost function

• Learning curve

• Economies of scope and scale

• Supply chain management

• Ways companies have cut costs to remain

competitive

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• Define total, variable, average and fixed cost

• Explain the linkage between the production and

cost function

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– Consolidation of shared services

– Outsourcing components of the business

– Mergers and consolidation (usually with a

reduction in employees)

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Definition and Use of

Cost in Economic Analysis

• Relevant cost: a cost that is affected by a

management decision

• Historical cost: cost incurred at the time of procurement

• Opportunity cost: amount or subjective

value that is forgone in choosing one activity

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Definition and Use of

Cost in Economic Analysis

• Incremental cost: varies with the range of options available in the decision

• Sunk cost: does not vary in accordance with decision alternatives

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Relationship Between

Production and Cost

• Cost function is simply the production

function expressed in monetary rather than physical units

• We assume the firm is a ‘price taker’ in the input market

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• Total variable cost (TVC) = the cost

associated with the variable input, found by multiplying the number of units by the unit price

• Marginal cost (MC) = the rate of change

in total variable cost

– The law of diminishing returns implies that MC will eventually increase

MP

W Q

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Plotting TP and TVC

illustrates that they

are mirror images of

each other

When TP increases

at an increasing

rate, TVC increases

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Short-run Cost Function

• Short-run cost function assumptions:

– the firm employs two inputs, labor and capital

– the firm operates in a short-run production

period where labor is variable, capital is fixed– the firm produces a single product

– the firm employs a fixed level of technology

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• More short run cost function assumptions.

– the firm operates at every level of output in the most efficient way

– the firm operates in perfectly competitive input markets and must pay for its inputs at a given market rate (it is a ‘price taker’)

– the short-run production function is affected by the law of diminishing returns

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• Standard variables in the short-run cost

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function:

– Average total cost (AC) is the average per-unit cost of all the firm’s inputs

AC = AFC + AVC = TC/Q– Marginal cost (MC) is the change in a firm’s total cost (or total variable cost) resulting from a unit

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• Graphical example of the cost variables

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• Important observations

– AFC declines steadily

– when MC = AVC, AVC is at a minimum

– when MC < AVC, AVC is falling

– when MC > AVC, AVC is rising

The same three rules apply for average cost (AC)

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Two critical relationships:

• Productivity and cost are inversely related.

• The marginal cost pulls average either up or down depending on if it is above or below

average.

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• A reduction in the firm’s fixed cost would

cause the average cost line to shift

downward

• A reduction in the firm’s variable cost would cause all three cost lines (AC, AVC, MC) to shift downward.

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• Alternative specifications of the Total Cost function (relating total cost and output)

– cubic relationship:

as output increases, total cost first increases at a decreasing rate, then increases at an increasing rate

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• Alternative specifications of the Total Cost

function (relating total cost and output)

– quadratic relationship: as output increases, total cost increases at an increasing rate

– linear relationship: as output increases, total cost increases at a constant rate

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Long-run Cost Function

• In the long run, all inputs to a firm’s

production function may be changed

– Because there are no fixed inputs, there are no fixed costs

– The firm’s long run marginal cost pertains to

returns to scale– In general, at first firms achieve increasing

returns to scale, then as they mature they have

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• When a firm experiences increasing returns

to scale:

– a proportional increase in all inputs increases

output by a greater proportion

– as output increases by some percentage, total cost of production increases by some lesser percentage

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• Economies of scale: situation where a

firm’s long-run average cost (LRAC) declines

as output increases

• Diseconomies of scale: situation where a

firm’s LRAC increases as output increases

• In general, the LRAC curve is u-shaped.

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• Reasons for long-run economies of scale:

– specialization of labor and capital

– prices of inputs may fall with volume discounts in firm’s purchasing

– use of capital equipment with better

price-performance ratios– larger firms may be able to raise funds in capital markets at a lower cost

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• Reasons for diseconomies of scale:

– Scale of production is not optimal for the total

market demand

– Transportation costs tend to rise as production grows, due to handling expenses, insurance, security, and inventory costs

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• In long run, the firm can choose any level of

capacity

• Once it commits to a level of capacity, at least one

of the inputs must be fixed This then becomes a

short-run problem

• The LRAC curve is an envelope of SRAC curves, and outlines the lowest per-unit costs the firm will incur

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Learning Curve

• Learning curve: line showing the

relationship between labor cost and

additional units of output

– A downward slope indicates additional cost per unit declines as the level of output increases because workers improve with practice

– The production process also improves as

engineers and other development personnel gain

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Learning Curve

• Learning curve: measured in terms of percentage

decrease in additional labor cost as output increases

Yx = Kxn

Yx = units of factor or cost to produce the xth unit

K = factor units or cost to produce the Kth

(usually first) unit

x = product unit (the xth unit)

n = log S/log 2

S = slope parameter

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Economies of Scope

• Economies of scope: reduction of a firm’s

unit cost by producing two or more goods or services jointly rather than separately

– Closely related to economies of scale

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Supply Chain Management

• Supply chain management (SCM):

efforts by a firm to improve efficiencies

through each link of a firm’s supply chain

from supplier to customer

– transaction costs are incurred by using resources outside the firm

– coordination costs arise because of uncertainty and complexity of tasks

– information costs arise to properly coordinate

activities between the firm and its suppliers

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• Ways to develop better supplier

relationships

– strategic alliance: firm and outside supplier join together in some sharing of resources

– competitive tension: firm uses two or more

suppliers, thereby helping the firm keep its purchase prices under control

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Ways Companies Cut

Costs to Remain Competitive

• the strategic use of cost

• reduction in cost of materials

• using information technology to reduce costs

• reduction of process costs

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Ways Companies Cut

Costs to Remain Competitive

• relocation to lower-wage countries or

regions

• mergers, consolidation, and subsequent downsizing

• layoffs and plant closings

• reductions in fixed assets

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Global Application

• Discussion example: Li & Fung

Is this the model of a global business?

– Operating in 40 countries around the world

– Outsourcing the entire supply chain

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Summary

• Virtually all management decisions must

consider the impact on costs.

• The short run cost function has fixed costs,

in the long run, all costs are variable.

• The law of diminishing returns also affects costs.

• Firms may experience economies of scope and scale and benefit by the learning curve.

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