lecture 6: microecon ~ct’d. cost of production cost of production includes all the opportunity...
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Lecture 6: MicroEcon ~ct’d
Cost of Production
Cost of production includes all the opportunity costs of making the output of goods and services.
– Explicit costs: input costs that require a direct outlay of money by the firm.
– Implicit costs: input costs that do not require an outlay of money by the firm.
Profits
The firm’s objective is to maximize profits
Profit = Total revenue - Total costProfit = Total revenue - Total cost
Economic Profit: total revenue minus total cost, including both explicit and implicit costs.
Accounting Profit: total revenue minus only the firm’s explicit costs.
Explicit vs. Implicit Costs: An ExampleYou need $100,000 to start your business.
The interest rate is 5%. Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings, borrow the other $60,000– explicit cost = $3000 (5%) interest on the loan– implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.In both cases, total (exp + imp) costs are $5000.
Profits
Copyright © 2004 South-Western
Revenue
Totalopportunitycosts
How an EconomistViews a Firm
How an AccountantViews a Firm
Revenue
Economicprofit
Implicitcosts
Explicitcosts
Explicitcosts
Accountingprofit
Article 6a: The Painful Truth About ProfitsBusiness Week; by: Michael Mandel
Without profits there’s no incentive for innovation or creating new companies.
Today the biggest problem is that most companies are shooting for a return to the highest profit levels of the late 1990s.
>> HIGH WAGES– Despite the recession and a year of slow growth, corporate labor
costs are nearly $1 trillion higher now than in 1997.– Real wages and benefits continue to climb, growing at 2% rate
during the past year >> SLOW GLOBAL GROWTH
– Weak economies overseas have kept exports flat at best– Most major industrial countries are expected to grow more slowly
than the US in the coming year >> OVERBUILT
– There’s already an excess of US industrial capacity– This makes it almost impossible for corporations to raise prices
Article6b: Economic Profit vs. Accounting ProfitWSJ; by Robert Bartley
Profit is any income to a proprietor—Marxist Labor View—which is fallacious
The economist is interested in the dynamic forces of production while: The accountant is interested in proprietorship….cost as a deduction from the owner’s income
Economic profit is the unimputable income i.e. “the residium of product remaining after payment is made at rates established in competition with all comers for all services of men or things for which competition exists”
The highest uses depend on economic profit-rate of return on assets-not on accounting profits.
The issue of interest on equity has tended to constitute an issue between accountants and economic theorists
EPS measures the corporate profit and is called the accounting profit Peter Drucker: EPS represents taxable earnings i.e. after all deductions, is
purely arbitrary concept and has nothing to do with business performance NET-NET: Takes skill to convert EPS into meaningful economic profit
concept.
Marginal Product Marginal Product: for any input, it is the increase in output
that arises from an additional unit of that input. Diminishing Marginal Product: the marginal product of an
input declines as the quantity of the input increases.
0
0.5
1
1.5
2
2.5
3
3.5
0 2 4 6 8 10
Y = Y = √I√II Y MP0 0
1.01 1
0.42 1.4
0.33 1.7
0.34 2
0.25 2.2
Diminishing Marginal ProductQuantity of
Output(cookiesper hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired0 1 2 3 4 5
Production function
I Y MP0 0
501 50
402 90
303 120
204 140
105 150
Fixed & Variable Costs
Fixed costs: those costs that do not vary with the quantity of output produced.
Variable costs: those costs that do vary with the quantity of output produced.
TCTC = = TFCTFC + + TVCTVC Total Costs
– Total Fixed Costs (TFC)– Total Variable Costs (TVC)– Total Costs (TC) – TC = TFC + TVC
Total Cost Curve Shows the relationship between the quantity
a firm can produce and its costs.
Total Cost CurveTotalCost
$80
70
60
50
40
30
20
10
Quantity of Output(cookies per hour)
0 10 20 30 15013011090705040 1401201008060
Total-costcurve
Marginal Cost
Marginal Cost (MC): measures the increase in total cost that arises from an extra unit of production.
M CTCQ
( ch an g e in to ta l co st)
(ch an g e in q u an tity )
EMBA Tavern
M CTCQ
( ch an g e in to ta l co st)
(ch an g e in q u an tity )
Tavern’s Total-Cost CurveTotal Cost
$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
Quantity of Output(pints of beer per hour)
0 1 432 765 98 10
Total-cost curve
Average Costs
Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.
The average cost is the cost of each typical unit of product. – ATC – AFC – AVC
Tavern’s Various Cost CurvesCosts
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity of Output(pints of beer per hour)
0 1 432 765 98 10
MC
ATC
AVC
AFC
Returns/Economies of Scale
Economies of Scale: long-run average total cost falls as the quantity of output increases (implies Increasing Returns to Scale - IRS)
Diseconomies of Scale: long-run average total cost rises as the quantity of output increases (implies Decreasing Returns to Scale – DRS)
Minimum Efficient Scale: smallest quantity a firm can produce such that its long-run average total cost is minimized.
Returns/Economies of Scale
Increasing Returns to Scale (IRS): if a 1% increase in all inputs results in a greater than 1% increase in output
Decreasing Returns to Scale (DRS): if a 1% increase in all inputs results in a less than 1% increase in output
Constant returns to scale (CRS): if a 1% increase in all inputs results in an exactly1% increase in output
Economies of Scale
Quantity ofCars per Day
0
AverageTotalCost
1,200
$12,000
1,000
10,000
ATC in long run
Constantreturns to
scale
Economies
Scale(IRS)
ofDiseconomies
Scale(DRS)
of
Competitive Firms
Total Revenue
Total Revenue: for a firm, is the selling price times the quantity sold.
TR = (P TR = (P Q) Q)
Total revenue is proportional to the amount of output.
Average Revenue Average Revenue: how much revenue a
firm receives for the typical unit sold.
A v erag e R ev en u e =T o ta l rev en u e
Q u an tity
P rice Q u an tity
Q u an tity
P rice
Marginal Revenue Marginal Revenue: the change in total
revenue from an additional unit sold.
MR =MR =TR/ TR/ QQ For competitive firms, marginal revenue
equals the price of the good.
Profit Maximization Firms will produce where TR-TC is greatest
MR=MC
Profit Maximization
Quantity0
Costsand
Revenue
MC
ATC
AVC
MC1
Q1
MC2
Q2
The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.
QMAX
P = MR = MC P = AR = MR
Measuring Profits Graphically
Quantity0
Price
P = AR = MR
ATCMC
P
ATC
Q(profit-maximizing quantity)
Firm withProfits
Decision to Shut Down Shut Down: a short term decision to stop
production (not to exit the market)– Sunk fixed costs are ignored
Shut down if TR < TVC Shut down if TR/Q < TVC/Q
– TR/Q = Average Revenue– TVC/Q = Average Variable Cost
Shut down if P < AVC
In equilibriumP = MR
Decision to Shut Down
MC
Quantity
ATC
AVC
0
Costs
Firmshutsdown ifP< AVC
Firm’s short-runsupply curve
If P > AVC, firm will continue to produce in the short run.
If P > ATC, the firm will continue to produce at a profit.
Decision to Exit
Exit: a long run decision to leave the market The firm exits if the revenue it would get
from producing is less than its total cost.
Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC
Decision to Exit
MC = long-run S
Firmexits ifP < ATC
Quantity
ATC
0
CostsFirm’s long-runsupply curve
Firmenters ifP > ATC
Measuring Profits Graphically
Quantity0
Price
ATCMC
(loss-minimizing quantity)
P = AR = MRP
ATC
Q
Loss
Cost & Profits
Airline Industry
2003199819931988198319781973
50
40
30
20
10
0
% Major Costs as Shares of Operating Expenses
Labor FuelAircraft Ownership Non-Aircraft Ownership
US Airline Cost Index Report 2003
US Airline Cost Index Report 2004
ATA 2004 Economic Report
2003199819931988198319781973
12
10
8
6
4
2
0
% Major Costs as Shares of Operating Expenses
Passenger commissions Advertising and promotionUtilities and Office Supplies Food and Beverages
US Airline Cost Index Report 2003
Article 6c: One Airline’s MagicTime Magazine by: Sally Donnelly
How does Southwest (SW) soar above its money losing rivals?
ProductivityIts employees work harder and are smarter, in return, they get job security and a share of profits– Pilots fly as many as 83 hours a month, compared with about 53
hours in a busy month at United Airlines– Flight attendants work almost twice as many hours as their
counterparts at other airlines– Mechanics change airplane tires faster (like a NASCAR pit) and thus
get higher wages than their counterparts at other airlines
Flexibility– SW pilots also pitch in to help ground crews move luggage
In return, SW compensates it workers in ways other than the base pay– It contributes 15% of its pre-tax income to a profit-sharing plan– It has assured all its workers and unions that there would be no lay-offs– SW doesn’t use the word “employee”, and gives them enough room to grow
and learn– SW has enjoyed big savings by never having the type of defined-benefit
pension plans which has proved so costly for other airlines
Other advantages of SW:– Last year, SW selected 6,000 people out of 2 million resumes received on
the basis of attitudes and not necessarily skills– SW flies point-to-point domestic routes, as opposed to the complex and
expensive hub-and-spoke international networks– No meals served onboard, no bulky drink carts and no entertainment– SW uses less expensive, less crowded secondary airports– Flies only one type of aircraft – Boeing 737 to reduce maintenance costs– Employees own more than 10% of SW outstanding shares, thus they work
more productively and more creatively to increase their own pay checks– Lowest cost per seat mile: 7.5 cents– Highest aircraft hours per day: 10.9 hrs/day
WSJ Article 2002
So What is the Solution?
Do the legacy airlines have any comparative advantage that they can use in competing with their low cost rivals for domestic travelers?
– The honest answer is NO.The time has come for some of the airlines to either merge or liquidate so that excess capacity in the market can be reduced to profitability manage the new demand frontier. (permanent downward shift in demand curve esp. domestic flying)But will the mergers or liquidations save the big boys? Maybe…The only way out is a radical shift in thinking by the big airlines: outsource to low-cost airlines and allow them to bring passengers to your legacy hubs! Then fly these travelers to international destinations on your planes at premium prices where there is no competition from South-West and upstart airlines.