Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 1 Managerial Economics.

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Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 1 Managerial Economics in a Global Economy, 5th Edition by Dominick Salvatore Chapter 7 Cost Theory and Estimation

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 2 The Nature of Costs Explicit Costs –Accounting Costs Economic Costs –Implicit Costs –Alternative or Opportunity Costs Relevant Costs –Incremental Costs –Sunk Costs are Irrelevant

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 3 Short-Run Cost Functions Total Cost = TC = f(Q) Total Fixed Cost = TFC Total Variable Cost = TVC TC = TFC + TVC

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 4 Short-Run Cost Functions Average Total Cost = ATC = TC/Q Average Fixed Cost = AFC = TFC/Q Average Variable Cost = AVC = TVC/Q ATC = AFC + AVC Marginal Cost =  TC/  Q =  TVC/  Q

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 5 Short-Run Cost Functions

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 6

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 7 Short-Run Cost Functions Average Variable Cost AVC = TVC/Q = w/AP L Marginal Cost  TC/  Q =  TVC/  Q = w/MP L

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 8 Long-Run Cost Curves Long-Run Total Cost = LTC = f(Q) Long-Run Average Cost = LAC = LTC/Q Long-Run Marginal Cost = LMC =  LTC/  Q

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 9 Derivation of Long-Run Cost Curves

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 10 Relationship Between Long-Run and Short-Run Average Cost Curves

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 11 Possible Shapes of the LAC Curve

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 12 Learning Curves Average Cost of Unit Q = C = aQ b Estimation Form: log C = log a + b Log Q

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 13 Minimizing Costs Internationally Foreign Sourcing of Inputs New International Economies of Scale Immigration of Skilled Labor Brain Drain

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 14 Logistics or Supply Chain Management Merges and integrates functions –Purchasing –Transportation –Warehousing –Distribution –Customer Services Source of competitive advantage

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 15 Logistics or Supply Chain Management Reasons for the growth of logistics –Advances in computer technology Decreased cost of logistical problem solving –Growth of just-in-time inventory management Increased need to monitor and manage input and output flows –Globalization of production and distribution Increased complexity of input and output flows

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 16 Cost-Volume-Profit Analysis Total Revenue = TR = (P)(Q) Total Cost = TC = TFC + (AVC)(Q) Breakeven Volume TR = TC (P)(Q) = TFC + (AVC)(Q) Q BE = TFC/(P - AVC)

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 17 Cost-Volume-Profit Analysis P = 40 TFC = 200 AVC = 5 Q BE = 40

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 18 Operating Leverage Operating Leverage = TFC/TVC Degree of Operating Leverage = DOL

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 19 Operating Leverage TC’ has a higher DOL than TC and therefore a higher Q BE

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 20 Empirical Estimation Data Collection Issues Opportunity Costs Must be Extracted from Accounting Cost Data Costs Must be Apportioned Among Products Costs Must be Matched to Output Over Time Costs Must be Corrected for Inflation

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 21 Empirical Estimation Functional Form for Short-Run Cost Functions Theoretical FormLinear Approximation

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 22 Empirical Estimation Theoretical FormLinear Approximation

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 23 Empirical Estimation Long-Run Cost Curves Cross-Sectional Regression Analysis Engineering Method Survival Technique

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved.Slide 24 Empirical Estimation Actual LAC versus empirically estimated LAC’