1. ECNE610 Managerial Economics APRIL 2014 1 Dr. Mazharul Islam Chapter-7

2. Dr. Mazharul Islam 2 5 7 The Theory and Estimation of Cost

3. Lesson Objectives  define the cost function.  distinguish between economic cost and accounting cost.  explain how the concept of relevant cost is used.  understand total, variable, average and fixed cost.  distinguish between short-run and long-run cost.  provide reasons for the existence of economies of scale. 3 Dr. Mazharul Islam

4. Definition and use of cost in economic analysis: 4 Dr. Mazharul Islam Economic Costs: A firm’s economic costs are the opportunity costs of the resources used, whether those resources are owned by others or by the firm. Explicit costs (Accounting Costs)  Refer to the firm’s actual cash payments for resources  wages, rent, interest, insurance, taxes, etc. Such money payments are for the use of resources owned by others.

5. Definition and use of cost in economic analysis: Implicit costs  Refer to the opportunity costs of using its self- owned, self-employed resources. Implicit costs are the money payments that self- employed resources could have earn in their best alternative use. 5 Dr. Mazharul Islam

6. Economic Profit (Actual profit) Total Revenue Economic Cost ECONOMIC PROFITS Total Revenue: It is the amount received from the sale of the product; it is equal to the number of units sold (Q) times the price received per unit (P). TR = QxP 6

7. Economic Profit Implicit costs Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs TOTALREVENUETOTALREVENUE Profits to an Economist Profits to an Accountant 7

8. A particular example to clarify the distinction between explicit and implicit costs.  Khalid Al Ghamdi runs a small furniture firm. He hires one assistant at SAR21,000 per year, pays annual rent of SAR5000 a year for his shop, an invested SAR20,000 from his savings on materials that could have earn him SAR1000 per year as interest rate. He has been offered SAR24,000 per year to work as a manager for competitor. He estimates his entrepreneurial talents are worth SAR 3000 per year. Total annual revenue from furniture sales is SAR 100,000. 8

9. Total revenue$100,000 explicit costs: Assistant's salary 21,000 Material and equipment20,000 Shop rent5,000 Equals accounting profit $54,000 implicit costs: Adnan's forgone salary24,000 Forgone interest on savings1,000 Entrepreneurial profit3,000 Equals economic profit ___________ $26,000  Accounting profit equals total revenue minus explicit costs  used to determine a firm’s taxable income  However, this ignores the opportunity cost of Ghamdi’s own resources  His forgone salary of $24,000  Annual interest of $1,000 from the savings used to start the business  Entrepreneurial profit $5,000  Economic profit equals total revenue minus all costs, both explicit and implicit  Accounting profit of $54,000 less implicit costs of $28,000  economic profit of $26,000 9

10.  When the demand for a firm’s product changes, the firm’s profitability depends on how quickly it can adjust the amount of the various resources that it employed. Some resources can easily and quickly adjust such as labor, raw material, fuel and power but some resources need much more time to adjust such as building, machinery and equipment. Because of this differences in adjustment time, economists consider everything into two conceptual periods: the short run and the long run. 10

11.  Short run  at least one resource (Capital) is fixed.  Long run  all resources are variable. Resources can be divided into two categories  Variable resources can be varied quickly to change the output rate.  Fixed resources are those resources which cannot be easily changed.

12. 12  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 Dr. Mazharul Islam Relationship between production and cost

13. Marginal Cost = MC Total Fixed Costs = TFC Total Variable Costs = TVC Average Variable Costs = AVC Total Costs = TC Average Total Costs = ATC Average Fixed Costs = AFC SHORT-RUN PRODUCTION COSTS

14. 14 fixed costs variable costs Costs of production usually divided into two sections such as fixed costs and variable costs.  Fixed costs are those costs that do not vary with the quantity of output produced, e.g. the cost of the factory.  Variable costs are those costs that do vary with the quantity of output produced, e.g. the cost of workers. Dr. Mazharul Islam Total, fixed, and variable costs

15. Chapter Seven15 Short-run cost function For simplicity use the following 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  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

16. Fixed Costs: Total cost of using the fixed input (K). Total Fixed Costs = Total costs – Total Variable costs. This costs also be found by multiplying the number of fixed inputs by the price of the input. Average Fixed Costs = Total Fixed Costs Quantity Variable Costs: total cost of using the variable input, labor (L). Total Variable Costs = Total costs – Total Fixed costs. This costs also be found by multiplying the number of variable inputs by the input price. Average Variable Costs = Total Variable Costs Quantity Short-run cost function

17. Total Cost = Total Fixed + Variable Costs Average Total Cost = Total Costs Quantity Marginal Cost: the rate of change in total variable cost. Marginal Cost = Change in Total Costs Change in Quantity So Average Cost (AC) = AFC + AVC = TC/Q   TC/  Q

18. Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost SHORT-RUN COSTS GRAPHICALLY

19. The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand Copyright©2004 South-Western

20. 20  Graphical example of the cost variables

21. average total-cost  The average total-cost curve is U-shaped.  At very low levels of output average total cost is high because fixed cost is spread over only a few units.  Average total cost declines as output increases.  Average total cost starts rising because average variable cost rises substantially. efficient scale  The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. Explaining Cost Curves and Their Shapes

22.  Whenever marginal cost is less than average total cost, average total cost is falling.  Whenever marginal cost is greater than average total cost, average total cost is rising.  Whenever marginal cost is equal to average total cost, ATC is minimum. The same three rules apply for average variable cost (AVC) as for ATC Relationship between Marginal Cost and Average Total Cost

23. Chapter Seven23 

24. Chapter Seven24 

25. Chapter Seven25 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.  at first increasing returns to scale, then as firms mature they achieve constant returns, then ultimately decreasing returns to scale

26. Chapter Seven26  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.

27. Chapter Seven27 Reasons for 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  larger firms may be able to spread out promotional costs

28. Chapter Seven28 Reasons for diseconomies of scale  scale of production becomes so large that it affects the total market demand for inputs, so input prices rise  transportation costs tend to rise as production grows, due to handling expenses, insurance, security, and inventory costs

29. Chapter Seven29 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.

30. Chapter Seven30 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.

31. Chapter Seven31 Supply chain management 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

32. Chapter Seven32 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  relocation to lower-wage countries or regions  mergers, consolidation, and subsequent downsizing  layoffs and plant closings

33. Do you have any question? 33 Dr. Mazharul Islam