Transcript File

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