COSTS OF PRODUCTION AND THE THEORY OF SUPPLY

Managerial Economics, Lecture 5

Dr. YANG, Nan

Partly Based on the Notes Prepared by Fernando Quijano

Outline• 7.1 Measuring Cost: Which Costs Matter?• 7.2 Costs in the Short Run• 7.3 Costs in the Long Run• 7.4 Long-Run versus Short-Run Cost Curves

• 8.3 Marginal Revenue, Marginal Cost, and Profit Maximization• 8.4 Choosing Output in the Short Run• 8.5 The Competitive Firm’s Short-Run Supply Curve• 8.6 The Short-Run Market Supply Curve• 8.7 Choosing Output in the Long-Run• 8.8 The Industry’s Long-Run Supply Curve

Measuring Cost: Which Costs Matter?7.1

• Economic Cost versus Accounting Cost

● accounting cost Actual expenses plus depreciation charges for capital equipment.

Economic cost = Opportunity cost + accounting cost

● economic cost Cost to a firm of utilizing economic resources in production.

Opportunity Cost

● opportunity cost Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use.

• Sunk Costs, Fixed Costs and Variable Costs

● total cost (TC or C) Total economic cost of production, consistingof fixed and variable costs.

● fixed cost (FC) Cost that does not vary with the level of output and that can be eliminated only by shutting down.

● variable cost (VC) Cost that varies as output varies.

● sunk cost Expenditure that has been made and cannot be recovered.

Because a sunk cost cannot be recovered, it should not influence the firm’s decisions.

MARGINAL COST (MC)● marginal cost (MC) Increase in cost resulting from the production of one (marginally) extra unit of output.

• Fixed cost does not change as the firm’s level of output changes.• Hence, marginal cost is equal to the increase in variable cost or the

increase in total cost that results from an extra unit of output.

AVERAGE TOTAL COST (ATC)

● average total cost (ATC) Firm’s total cost divided by its level of output.

● average fixed cost (AFC) Fixed cost divided by the level of output.

● average variable cost (AVC) Variable cost divided by the level of output.

MC VC TC⁄⁄

Example: Sunk Cost, Fixed Cost, Variable Cost, and Marginal Cost

• Sunk costs: license fee, sanitation approval, “WESTERN FOOD” lampbox, the menu board, etc.

• Fixed costs: rent, cook’s wage, owner’s outside option, etc.

• Variable costs: utilities, food ingredients, second/third cook’s wage, etc.

• Marginal costs for a fish n’ chips: the fish, the chips, the tartar sauce, the gas for cooking the dish, etc.

• Average costs: divide the relevant costs by the total number of dishes sold.

Costs in the Short Run7.2• The Determinants of Short-Run Cost

Suppose labor is changeable in the short-run. The change in variable cost is the per-unit cost of the extra labor w times the amount of extra labor needed to produce the extra output dL.

The extra labor needed to obtain an extra unit of output is dL/dq = 1/MPL. As a result,

(7.1)

DIMINISHING MARGINAL RETURNS AND MARGINAL COSTDiminishing marginal returns means that the marginal product of labor declines as the quantity of labor employed increases.

As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.

MC VC ⁄⁄

MC MP⁄

• The Shapes of the Cost Curves

COST CURVES FOR A FIRMFIGURE 7.1

• In (a) total cost TC is the vertical sum of fixed cost FC and variable cost VC.

• In (b) average total cost ATC is the sum of average variable cost AVC and average fixed cost AFC.

• Minimum ATC and AVC is achieved when ATC=MC, AVC=MC.

• When ATC>MC, producing one unit more incurs MC and reduces ATC.

• When ATC<MC, producing one unit less saves MC and reduces ATC.

The Cost-Minimizing Input Choice: how to select inputs to produce a given output at minimum cost. (With the example of two inputs: capital and labor)

Please note the analogs to the consumers’ problem!

THE PRICE OF CAPITAL AND LABORThe price of capital is its user cost, given by r = Depreciation rate + Interest rate.The price of labor is the wage w.

Cost in the Long Run7.3

• The Isocost Line (budget line)

All combinations of labor and capital that can be purchased for a given cost.

• The Production function (utility function), Isoquant Line (indifference curve)

All combinations of labor and capital that can be purchased for a given cost.

,

with slope dK/dL = −(w/r)

PRODUCING A GIVEN OUTPUT AT MINIMUM COST

FIGURE 7.3

• Isocost (budget) line C1 is tangent to isoquant (indifference) curve q1 at A.

• Input price change? Total cost change?

• marginal rate of technical substitution of labor for capital (MRTS) (MRS)

satisfies

Choosing Inputs (Determine a optimal consumption bundle)

MRTS// MP MP⁄

MRTS MP MP⁄ ⁄

Cost Minimization with Varying Output Levels

● expansion path (income-consumption curve) Curve passing through points of tangency between a firm’s isocost lines and its isoquants.

To move from the expansion path to the cost curve, we follow three steps:

1. Choose an output level represented by an isoquant. Then find the point of tangency of that isoquant with an isocost line.

2. From the chosen isocost line, determine the minimum cost of producing the output level that has been selected.

3. Graph the output-cost combination.

The Expansion Path and Long-Run Costs

A FIRM’S EXPANSION PATH AND LONG-RUN TOTAL COST CURVE

FIGURE 7.6

• expansion path (income-consumption curve)

• In (a), the expansion path illustrates the lowest-cost combinations of labor and capital that can be used to produce each level of output in the long run

• In (b), the corresponding long-run total cost curve measures the least cost of producing each level of output.

The Expansion Path and Long-Run Costs

Long-Run versus Short-Run Cost Curves7.4• The Inflexibility of Short-Run Production

THE INFLEXIBILITY OF SHORT-RUN PRODUCTION

FIGURE 7.8

In the short run, a firm’s cost of production may not be minimized because of inflexibility of capital inputs. 1. Output is initially at level q1,

(using L1, K1). 2. In the short run, output q2

can be produced only by increasing labor from L1 to L3 because capital is fixed at K1.

3. In the long run, the same output can be produced more cheaply by increasing labor from L1 to L2 and capital from K1 to K2.

LONG-RUN AVERAGE AND MARGINAL COST

FIGURE 7.9

• Minimum LAC is achieved when LAC =LMC, LAC =LMC.

• When LAC>LMC, producing one unit more incurs LMC and reduces LAC.

• When LAC<LMC, producing one unit less saves LMC and reduces LAC.

• There is no such thing as “long run fixed/variable costs”

• Economies and Diseconomies of Scale

As output increases, the firm’s average cost of producing that output islikely to decline, at least to a point. This can happen for the following reasons:

1. Workers can specialize in the activities at which they are most productive.

2. Scale can provide flexibility.

3. Bigger purchasing power when buying input in large quantities

● economies of scale Situation in which output can be doubled forless than a doubling of cost.

“Wal-Mart, the US retailer taking over the world by stealth”, The Guardian, 2010.

Wal-Mart's founder, Sam Walton, opened a discount store … in 1951. … a retail empire that spans 8,100 stores in 15 countries generating $401bn of revenue annually. … Four of America's 10 richest individuals are from Wal-Mart's low-profile Walton family.

Wal-Mart's executives say the company is "saving people money so they can live better”….

"With the scale the company has, the economies of scale it can command, it basically extracts every last nickel out of its suppliers."

“The Diffusion of Wal-Mart and Economies of Density.” Thomas Holmes (Univ. of Minnesota)

At some point, however, it is likely that the average cost of productionwill begin to increase with output. This can happen for the following reasons:

1. Managing a larger firm may become complex and inefficient.

2. The advantages of buying in bulk may be disappearing. At some point, available supplies of key inputs may be limited, pushing their costs up.

3. Financing costs-liquidity.

● diseconomies of scale Situation in which a doubling of output requires more than a doubling of cost.

• On the one hand, on the other…

“Expansion pushed Digital Domain from ‘Titanic’ to bankruptcy”, Rueters, 2011

Digital Domain Media's filing for bankruptcy protection on Tuesday… (DDM) started when James Cameron launched the special effects powerhouse for his film "Titanic”. The company, which created special effects for this summer's blockbuster "The Avengers" and the "Transformers"… (in two years) agreed to finance a Hollywood film, open an animation studio, help run studios in Abu Dhabi and China, and to create a college in Florida to award four-year animation degrees.

"The problem is that the investments were costing more than they were able to bring in."

● economies of scope Situation in which joint output of a single firmis greater than output that could be achieved by two different firms when each produces a single product.

● diseconomies of scope Situation in which joint output of a single firm is less than could be achieved by separate firms when each produces a single product.

“Bundling and Nonlinear Pricing in Telecommunications”, LUO Yao (UToronto)

• Bundling land line telephone and ADSL internet saves costs for the service provider (signals transmitted in a same cable).

• Using data from the China Telecom, Luo estimates the cost saving for bundling1Mbps internet with phone to be 2.60 CNY/month, for 2 Mbps 3.27 CNY/month.

Such cost complementarity also appears in cable TV (production technology), financial services (synergy of human resources), etc..

Production with Two Outputs—Economies of Scope7.5

Marginal Revenue, Marginal Cost, and Profit Maximization8.3

● profit Difference between total revenue and total cost.

π(q) = R(q) − C(q)

● marginal revenue Change in revenue resulting from a one-unit increase in output.

A firm chooses output q*, so that profit, the difference AB between revenue R and cost C, is maximized. At that output, marginal revenue (the slope of the revenue curve) is equal to marginal cost (the slope of the cost curve).

dπ/dq = dR/dq − dC/dq = 0MR(q) = MC(q)

PROFIT MAXIMIZATON IN THE SHORT RUN

FIGURE 8.1

Demand and Marginal Revenue for a Competitive Firm

A competitive firm takes the market price of the product as given, choosing its output on the assumption that the price will be unaffected by the output choice.

In (a) the demand curve facing the firm is perfectly elastic, even though the market demand curve in (b) is downward sloping.

DEMAND CURVE FACED BY A COMPETITIVE FIRMFIGURE 8.2

The demand curve d facing an individual firm in a competitive market isboth its average revenue curve and its marginal revenue curve. Along thisdemand curve, marginal revenue, average revenue, and price are all equal.

Profit Maximization by a Competitive Firm

MC(q) = MR = P

A perfectly competitive firm should choose its output so that marginal cost equals price:

When MC<MR, producing one more unit costs MC more but leads to an increase of MR on revenue. So, further production increases profit.

When MC>MR, producing one less unit saves MC on costs and leads to a loss of MR on revenue. So, refraining from production increases profit.

12, 10, 2 4 , 12 ∗ 3, ∗ 8

Open for thanksgiving?

“Holiday shopping marathon starts as consumer sentiment shaky”, Rueters, 2012

This year, Target Corp has joined Wal-Mart and Gap Inc in being open at least part of the day, and some retailers will be open throughout the day, a trend that began to take hold in 2011.

"It's a finite pie - if you can get a bit more by being open, then do it," O'Shea (a Moody’s senior analyst) said.

But crowds were thin at the flagship Lord & Taylor on 5th Avenue, where workers voluntarily signed up for holiday shifts for an extra compensation day and holiday pay.

Short-Run Profit Maximization by a Competitive Firm

A COMPETITIVE FIRM MAKING A POSITIVE PROFIT

FIGURE 8.3

• In the short run, the competitive firm maximizes its profit by choosing q* at which marginal cost MC is equal to the price P (or marginal revenue MR).

• The profit of the firm is measured by the rectangle ABCD.

• Any change in output, whether lower at q1 or higher at q2, will lead to lower profit. Output Rule: MC = MR

Choosing Output in the Short Run8.4

The Competitive Firm’s Short-run Supply Curve8.5

THE SHORT-RUN SUPPLY CURVE FOR A COMPETITIVE FIRM

FIGURE 8.6

The firm’s supply curve is the portion of the marginal cost curve for which marginal cost is greater than average variable cost.

In the short run, the firm chooses its output so that marginal cost MC is equal to price as long as the firm covers its average variable cost. The short-run supply curve is given by the crosshatched portion of the marginal cost curve.

The Short-Run Market Supply Curve8.6

INDUSTRY SUPPLY IN THE SHORT RUN

FIGURE 8.9

The short-run industry supply curve is the sum of the supply curves of individual firms.• The third firm has a lower

average variable cost curve than the first two firms.

• The market supply curve Sbegins at price P1 and follows the marginal cost curve of the third firm MC3until price equals P2, when the other two join.

• For P2 and all prices above it, the industry quantity supplied is the sum of the quantities supplied by each of the three firms.

Long-Run Profit Maximization

OUTPUT CHOICE IN THE LONG RUN

FIGURE 8.13

The firm maximizes its profit by choosing the output at which price equals long-run marginal cost LMC. In the diagram, the firm increases its profit from ABCD to EFGD by increasing its output in the long run.

The long-run output of a profit-maximizing competitive firm is the point at which long-run marginal cost equals the price.

Choosing Output in the Long Run8.7

Long-Run Competitive Equilibrium

ACCOUNTING PROFIT AND ECONOMIC PROFIT

π = R − wL − rK

ZERO ECONOMIC PROFIT

● zero economic profit A firm is earning a normal return on its investment—i.e., it is doing as well as it could by investing its money elsewhere.

ENTRY AND EXIT

In a market with entry and exit, a firm enters when it can earn a positive long-run profit and exits when it faces the prospect of a long-run loss.

Economic profit takes into account opportunity costs. One such opportunity cost is the return to the firm’s owners if their capital were used elsewhere. Accounting profit equals revenues R minus labor cost wL, which is positive. Economic profit

, however, equals revenues R minus labor cost wL minus the capital cost, rk.

● long-run competitive equilibrium All firms in an industry are maximizing profit, no firm has an incentive to enter or exit, and price is such that quantity supplied equals quantity demanded.

When a firm earns zero economic profit, it has no incentive to exit the industry.Likewise, other firms have no special incentive to enter.

A long-run competitive equilibrium occurs when three conditions hold:

1. All firms in the industry are maximizing profit.

2. No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit.

3. The price of the product is such that the quantity supplied by theindustry is equal to the quantity demanded by consumers.

LONG-RUN COMPETITIVE EQUILIBRIUM

FIGURE 8.14

• Initially the long-run equilibrium price of a product is $40 per unit (Figure (b)).

• In (a) we see that firms earn positive profits because long-run average cost reaches a minimum of $30 (at q2).

• Positive profit encourages entry of new firms and causes a shift to the right in the supply curve to S2, as shown in (b).

• The long-run equilibrium occurs at a price of $30, as shown in (a), where each firm earns zero profit and there is no incentive to enter or exit the industry.

Easy money… or not?

“Casino competition hots up, can S'pore IRs take the heat?”, ChannelNewsAsia, 2007

…luxury casino complexes coming up in Tokyo and the southern island region of Okinawa by 2012, as Japan moves closer to an overhaul of its strict gambling laws.

Taiwan is also considering lifting its ban on casinos, while Thailand is also seen as likely to relax its gaming laws in the coming years… Closer to home, there’s Gentingin Malaysia and sister company’s Star Cruises vessels with casinos on board which ply to Singapore. Goa, too, has a number of gambling ships…

“Singapore set to become second largest Asia-Pacific casino market”, CNA, 2011

(PricewaterhouseCoopers) predicted that Singapore would overtake South Korea and Australia this year to become the second-largest Asia-Pacific casino market behind traditional leader Macau.

“Singapore’s Casinos Lose Luster as Gaming Revenue Decline”, Bloomberg, 2012

Genting Singapore Plc and Las Vegas Sands Corp. reported the lowest gaming revenue in at least 18 months at their Singapore casinos…

The Industry’s Long-Run Supply Curve8.8Constant-Cost Industry● constant-cost industry Industry whose long-run supply curve is horizontal.

In (b), the long-run supply curve in a constant-cost industry is a horizontal line SL. • When demand increases,

initially causing a price rise, the firm initially increases its output from q1 to q2 (a).

• But the entry of new firms causes a shift to the right in industry supply.

• Because input prices are unaffected by the increased output of the industry, entry occurs until the original price is obtained (at point Bin (b)).

The long-run supply curve for a constant-cost industry is, therefore, a horizontal line at a price that is equal to the long-run minimum average cost of production.

LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY

FIGURE 8.16

Increasing-Cost Industry● increasing-cost industry Industry whose long-run supply curve is upward sloping.

LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY

FIGURE 8.17

In (b), the long-run supply curve in an increasing-cost industry is an upward-sloping curve SL. • When demand increases,

initially causing a price rise, the firms increase their output from q1 to q2 in (a).

• The entry of new firms causes a shift to the right in supply from S1 to S2.

• Because input prices increase as a result, the new long-run equilibrium occurs at a higher price than the initial equilibrium.

In an increasing-cost industry, the long-run industry supply curve is upward sloping.

Decreasing-Cost Industry

● decreasing-cost industry Industry whose long-run supply curve is downward sloping.

Intel co-founder Gordon Moore’s “Moore's Law”, states that the number of transistors on a chip will double approximately every two years.