1. Managerial Economics Jack Wu
Costs
Managerial Economics
Jack Wu

2. Introduction Cost and economies of scale Cost and economies of scope
Experience Curve
Relevant / Opportunity costs
Transfer Pricing
Irrelevant Costs/ Sunk costs

3. Economies of scale
Fixed cost: cost of inputs that do not change with production rate
Variable cost: cost of inputs that change with the production rate
Fixed/variable costs concepts apply in
Short run
Long run

4. Expense Statement

5. Fixed and Variable Costs

6. Economies of scale
Economies of scale (increasing returns to scale): average cost decreases with scale of production
Marginal and average variable costs are identical and do not change with the scale of production.
Average cost decreases with the scale of production.
Distinguish economies of scale from
experience curve = costs fall with increases in cumulative production over time: economies of scale considers rate of production/operation at particular point of time;
economies of scope

7. Scale Economies: Sources
large fixed costs
research, development, and design
information technology
falling average variable costs
distribution of gas and water
container ships

8. Diseconomies of scale
Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

9. Economies of scale: Strategic implications
Either produce on large scale or outsource
Seller side – monopoly/oligopoly
Buyer side – monopsony/oligopsony
Industries with large scale economies:
semiconductor manufacturing
automobile manufacturing
conventional wisdom: manufacturing scale of at least 4 million vehicles/year (“Honda Motor Plans to Stay Small But Nearly Double Its Efficiency”, Wall Street Journal Interactive Edition, July 9, 1999)
increasing scale economies --> mergers and acquisitions: Daimler acquired Chrysler
civil aircraft manufacturing -- industry is duopoly -- Boeing and Airbus
banking services – in U.S., after state governments rescinded laws against inter-state banking, many institutions merged into super-regionals

10. Economies of scale: Google vis-à-vis library
Which link(s) in service chain are scaleable?
Compilation of information
Providing service: servers and network
Responding to enquiries
Google compiles information by machine
cost of compilation may have low marginal cost (maintenance of machines, bandwidth)
once compiled, information is a fixed cost  scaleable
Providing service involves some fixed costs
basic system
but other parts – number of servers, bandwidth -- must be scaled up with number of users
Responding to enquiries:
human response is not scaleable
so Web services try to steer users to FAQs and other automated responses

11. Economies of scope
Economies of scope: total cost of production is lower with joint than with separate production
Diseconomies of scope: total cost of production is higher with joint than with separate production

12. Expenses for two products

13. Economies of Scope
source -- joint cost: cost of inputs that do not change with scope of production
examples:
cable television + telephone
banking + insurance
manufacturing: refrigerator + air-conditioner
strategic implication -- produce/deliver multiple products

14. Economies of scope: Core competence
Technology – apply common technology to multiple products
LCDs – watches, PDAs
Manufacturing – apply same process to multiple products
LCDs, semiconductors
Marketing – brand extensions
spread promotional costs over multiple products/businesses
Example: Casio applied small LCDs to
watches
pocket calculators
handheld computers
Other examples:
laser engine – printer, fax, copier
compressor – refrigerator, air-conditioner

15. HORIZONTAL BOUNDARIES
Economies of scale
Should bank merge with competitor?
Should trucking company acquire smaller rivals?
Economies of scope
Should airline run catering service?
Should bank sell insurance?
Should university open a medical school?

16. Experience curve
Incremental cost falls with cumulative production run over time
Unit cost falls with cumulative production run
Distinguish from economies of scale within one production period

17. Experience curve
Figure: unit cost is indexed at 100 for production of 1 unit.

18. Relevance consider only relevant costs and ignore all other costs
which costs are relevant depends on course of action
relevant costs may be hidden
irrelevant costs may be shown in accounts

19. Opportunity Cost show alternatives report opportunity costs
definition -- net revenue from best alternative course of action
two approaches
show alternatives
report opportunity costs

20. Example
Williams bought a warehouse and paid $300,000 for it. She used her own money $200,000 and made a bank loan of $100,000.
A developer were willing to buy warehouse for 2 million.
If Williams sells warehouse, she could invest proceeds in government bonds and get a secure income $160,000 (2 million*8%).
She could work elsewhere for salary $400,000.

21. INCOME STATEMENT SHOWING ALTERNATIVES
Income statement reporting opportunity costs

22. Transfer pricing
Generally, for internal economic efficiency, set transfer price = marginal cost
Special cases
Perfectly competitive market: transfer price = market price
Production subject to full capacity: transfer price = highest marginal benefit from internal use
Compare marginal benefit across internal users
First mentioned transfer pricing in Chapter 6: Economic Efficiency
With perfectly competitive market, marginal cost = market price, hence set transfer price = market price;
Full capacity: marginal cost not defined, so set transfer price = marginal benefit of input

23. Transfer pricing
Production subject to full capacity: transfer price = highest marginal benefit from internal use
Compare marginal benefit across internal users

24. Sunk Cost
definition -- cost that has been committed and cannot be avoided
alternative courses of action
prior commitments
planning horizon
Fewer commitments  fewer sunk costs;
longer planning horizon  fewer sunk costs.

25. Example
Jupiter Athletic is about to launch a line of new athletic shoes. Some month ago, management prepared an ad campaign with total budget of $310,000.
They forecast the ad would generate sales of 20,000 units. Each sale’s unit contribution margin (price- average variable cost) is $20. The total contribution margin is $20*20000=$400,000. Their expected profit generated from ad is $400, ,000=$90,000.

26. Example: continued
Recently, a major competitor launch a new shoe. Jupiter estimates sales fall to 15,000 units. The contribution margin becomes $20*15,000=$300,000.
Should Jupiter cancel the launch?

27. INCOME STATEMENT SHOWING ALTERNATIVES
Income statement omitting sunk costs

28. Sunk vis-à-vis Fixed Costs
Not all sunk costs are fixed
Not all fixed costs are sunk

29. DISCUSSION QUESTIONS
Qantas operates a fleet of over 100 Boeing jet aircraft. Commercial passenger jets must be operated by a pilot and co-pilot. Many jets carry cargo in their "bellies", under the passenger seating areas. Consider each of the following costs. Identify which are joint costs of passenger and belly cargo services, which are fixed costs of passenger service, and which are both.

30. DISCUSSION QUESTIONS
(A)Cockpit personnel: All jets, large and small, require a pilot and co-pilot. Belly cargo service requires no additional officers in the cockpit.
(B)Airport landing fees: Some airports charge landing fees by weight of the aircraft, while others levy a fixed fee, regardless of weight.
(C)Fuel: Larger aircraft and those carrying heavier loads will consume relatively more fuel.