WU Managerial Economics Foundations of Business Analysis and Strategy Questions Be sure to show all your calculations for Question 2 in the Complete sectio

WU Managerial Economics Foundations of Business Analysis and Strategy Questions Be sure to show all your calculations for Question 2 in the Complete section examples of the calculations are in the text. 4 Scholarly sources. Chapter 10
Technology, Production, and
Costs
A C T I V E L E A R N I N G 1:
Brainstorming
You run Starbucks.
• List 3 different costs you have.
• List 3 different
business decisions
that are affected
by your costs.
2
In this chapter, look for the
answers to these questions:
• What is a production function? What is
marginal product? How are they related?
• What are the various costs, and how are
they related to each other and to output?
• How are costs different in the short run vs.
the long run?
• What are “economies of scale”?
Costs: Explicit vs. Implicit
• Explicit costs – require an outlay of money,
e.g. paying wages to workers
• Implicit costs – do not require a cash outlay,
e.g. the opportunity cost of the owner’s time
• Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
• This is true whether the costs are implicit or
explicit. Both matter for firms’ decisions.
Explicit vs. Implicit Costs: An
Example
You 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.
Economic Profit vs. Accounting
Profit
• Accounting profit
= total revenue minus total explicit costs
• Economic profit
= total revenue minus total costs (including
explicit and implicit costs)
• Accounting profit ignores implicit costs,
so it’s higher than economic profit.
Total Revenue, Total Cost, Profit
• We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output
the market
value of the
inputs a firm
uses in
production
A C T I V E L E A R N I N G 2:
Economic profit vs. accounting
profit
The equilibrium rent on office space has just
increased by $500/month.
Compare the effects on accounting profit
and economic profit if
a. you rent your office space
b. you own your office space
A C T I V E L E A R N I N G 2:
Answers
The rent on office space increases
$500/month.
a.You rent your office space.
Explicit costs increase $500/month.
Accounting profit & economic profit each
fall $500/month.
b. You own your office space.
Explicit costs do not change,
so accounting profit does not change.
Implicit costs increase $500/month (opp.
The Production Function
• A production function shows the
relationship between the quantity of inputs
used to produce a good, and the quantity
of output of that good.
• It can be represented by a table, equation,
or graph.
• Example 1:
– Farmer Jack grows wheat.
– He has 5 acres of land.
– He can hire as many workers as he wants.
Example 1: Farmer Jack’s Production
Function
Q
(no. of (bushels
workers) of wheat)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
2,000
1,500
1,000
0
1
2
3
4
No. of workers
5
Marginal Product
• If Jack hires one more worker, his output
rises by the marginal product of labor.
• The marginal product of any input is the
increase in output arising from an
additional unit of that input, holding all
other inputs constant.
• Notation:
∆Q
∆ (delta) = “change in…”
∆L
Examples:
∆Q = change in output, ∆L = change in
labor
EXAMPLE 1: Total & Marginal
Product
L
Q
(no. of (bushels
workers) of wheat)
∆L = 1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
MPL
∆Q = 800
100
0
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
∆Q = 1000
EXAMPLE 1: MPL = Slope of Prod
Function
0
0
1000
1
2
3
4
5
1000
1800
2400
2800
3000
800
600
400
200
MPL
3,000
Quantity of output
L
Q
(no. of (bushels MPL
workers) of wheat)
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why
500 production
the
function
gets flatter
0
as L0 increases.
1
2
3
4
No. of workers
5
Why MPL Is Important
• Recall one of the Ten Principles:
Rational people think at the margin.
• When Farmer Jack hires an extra worker,
– his costs rise by the wage he pays the worker
– his output rises by MPL
• Comparing them helps Jack decide
whether he would benefit from hiring the
worker.
Why MPL Diminishes
• Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
• As Jack adds workers, the average worker has
less land to work with and will be less productive.
• In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
• Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
EXAMPLE 1: Farmer Jack’s Costs
• Farmer Jack must pay $1000 per month
for the land, regardless of how much
wheat he grows.
• The market wage for a farm worker is
$2000 per month.
• So Farmer Jack’s costs are related to how
much wheat he produces….
EXAMPLE 1: Farmer Jack’s Costs
L
Q
cost of
(no. of (bushels
workers) of wheat) land
$1,000
cost of
labor
Total
Cost
0
0
$0 $1,000
1
1000
$1,000 $2,000 $3,000
2
1800
$1,000 $4,000 $5,000
3
2400
$1,000 $6,000 $7,000
4
2800
5
3000
$1,000 $8,000 $9,000
$10,00 $11,00
$1,000
0
0
EXAMPLE 1: Farmer Jack’s Total Cost
Curve
0
$12,000
Total
Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
$10,000
Total cost
Q
(bushels
of wheat)
$8,000
$6,000
$4,000
$2,000
$0
0
1000
2000
3000
Quantity of wheat
Marginal Cost
• Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q
EXAMPLE 1: Total and Marginal
∆Q = 1000
∆Q = 800
∆Q = 600
∆Q = 400
∆Q = 200
Q
Cost
(bushel
Total
s
Cost
of
wheat)
0 $1,000
1000 $3,000
1800 $5,000
2400 $7,000
2800 $9,000
$11,00
3000
0
Marginal
Cost
(MC)
∆TC = $2000
$2.00
∆TC = $2000
$2.50
∆TC = $2000
$3.33
∆TC = $2000
$5.00
∆TC = $2000
$10.00
EXAMPLE 1: The Marginal Cost Curve
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$12
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
2800
$9,000
3000
$11,000
$10.00
$0
0
1,000
2,000
Q
3,000
Why MC Is Important
• Farmer Jack is rational and wants to
maximize
his profit. To increase profit, should he
produce more wheat, or less?
• To find the answer, Farmer Jack
needs to “think at the margin.”
• If the cost of additional wheat (MC) is less
than
the revenue he would get from selling it,
then Jack’s profits rise if he produces
more.
Fixed and Variable Costs
• Fixed costs (FC) – do not vary with the
quantity of output produced.
– For Farmer Jack, FC = $1000 for his land
– Other examples:
cost of equipment, loan payments, rent
• Variable costs (VC) – vary with the
quantity produced.
– For Farmer Jack, VC = wages he pays
workers
– Other example: cost of materials
• Total cost (TC) = FC + VC
EXAMPLE 2
• Our second example is more general,
applies to any type of firm,
producing any good with any types of
inputs.
EXAMPLE 2: Costs
FC
VC
TC
0
$100
$0
$100
1
100
70
170
2
100
120
220
3
100
160
260
4
100
210
310
FC
$700
VC
TC
$600
$500
Costs
Q
$800
$400
$300
$200
5
100
280
380
$100
6
100
380
480
$0
7
100
520
620
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Marginal Cost
TC
0 $100
1 170
2 220
3 260
4 310
5 380
6 480
7 620
MC
$70
50
40
50
70
100
140
$200 Marginal Cost (MC)
Recall,
is $175
the change in total cost from
producing
one more unit:
$150
∆TC
MC =
∆Q
$100
Usually,
MC rises as Q rises, due
$75
to diminishing marginal product.
Costs
Q
$125
$50
Sometimes (as here), MC falls
$25
before rising.
$0
(In other0 examples,
1 2 3 MC
4 may
5 6be 7
constant.)
Q
EXAMPLE 2: Average
Fixed Cost
FC
0 $100
AFC
n.a.
1 100 $100
2 100
50
3 100 33.3
4 100
25
5 100
20
6 100 16.6
7 100 14.3
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
Costs
Q
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The firm is spreading its fixed
$50
costs over a larger and larger
$25
number
of units.
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Average Variable Cost
0
1
2
VC
$0
70
120
AVC
n.a.
Average
$200 variable cost (AVC)
is variable cost divided by the quantity of
output:
$175
AVC = VC/Q
$150
$70
60
3
160
53.33
4
210
52.50
5
280
56.00
6
380
63.33
7
520
74.29
Costs
Q
$125
$100
As Q rises, AVC may fall initially. In most
$75AVC will eventually rise as output rises.
cases,
$50
$25
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Average Total
Cost
Q TC ATC AFC AVC
0
100 n.a.
n.a.
n.a.
1 170 $170 $100 $70
2 220 110
50
60
3 260 86.6 33.3 53.3
4 310 77.5
25
52.5
5 380
76
20
56.0
6 480
80
16.6 63.3
7 620 88.5 14.2 74.2
Average total cost
(ATC) equals total
cost divided by the
quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
EXAMPLE 2: Average Total Cost
Q
0
1
TC
$100
170
ATC
$200
Usually, as in this example, the ATC curve
$175
is
U-shaped.
n.a.
$150
$170
2
220
110
Costs
$125
$100
3
260
86.67
4
310
77.50
5
380
76
$25
6
480
80
$0
7
620
88.57
$75
$50
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
A C T I V E L E A R N I N G 3:
Costs
Fill in the blank spaces of this table.
Q
0
1
2
3
4
5
6
VC
10
30
100
150
210
TC
$50
AFC
n.a.
AVC
ATC
MC
n.a.
n.a.
$10
$10 $60.00
80
150
260
16.67
12.50
8.33
20
30
35
36.67
37.50
43.33
30
60
A C T I V E L E A R N I N G 3:
Answers
AFC =
Use relationship
ATC
between MC
AVC
FC/Q
TC/Q
and
TC
VC/Q
First,
deduce
$50 and
use FCATC
+ VC
Q VC
TCFC =AFC
AVC
= TC.
0
$0
$50
n.a.
n.a.
n.a.
1
10
60 $50.00 $10 $60.00
2
30
80
25.00
15
40.00
3
60
110 16.67
20
36.67
4 100 150 12.50
25
37.50
5 150 200 10.00
30
40.00
6 210 260
8.33
35
43.33
MC
$10
20
30
40
50
60
34
EXAMPLE 2: Why ATC Is Usually UShaped
As Q rises:
$200
Initially,
falling AFC
pulls ATC down.
$175
Costs
Eventually,
rising AVC
pulls ATC up.
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: ATC and MC
When MC < ATC, ATC is falling. $175 $150 ATC is rising. $125 Costs When MC > ATC,
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
ATC
MC
$200
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
Costs in the Short Run & Long
Run
• Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
• Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones)
• In the long run, ATC at any Q is cost per unit using the
most efficient mix of inputs for that Q (e.g., the factory
size with the lowest ATC).
EXAMPLE 3: LRATC with 3 factory
Firm can choose
from 3 factory
sizes: S, M, L.
Each size has its
own SRATC curve.
The firm can
change to a
different factory
size in the long
run, but not in the
short run.
Sizes
Avg
Total
Cost
ATCS
ATCM
ATCL
Q
EXAMPLE 3: LRATC with 3 factory
To produce less
than QA, firm will
choose size S
in the long run.
To produce
between QA
and QB, firm will
choose size M
in the long run.
To produce more
than QB, firm will
choose size L
in the long run.
Sizes
Avg
Total
Cost
ATCS
ATCM
ATCL
LRATC
QA
QB
Q
A Typical LRATC Curve
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
ATC
LRATC
So a typical
LRATC curve
looks like this:
Q
How ATC Changes As
the Scale of Production Changes
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
Q
How ATC Changes As
the Scale of Production Changes
• Economies of scale occur when increasing production
allows greater specialization:
workers more efficient when focusing on a narrow task.
– More common when Q is low.
• Diseconomies of scale are due to coordination problems
in large organizations.
E.g., management becomes stretched, can’t control
costs.
– More common when Q is high.
CONCLUSION
• Costs are critically important to many
business decisions, including production,
pricing, and hiring.
• This chapter has introduced the various
cost concepts.
• The following chapters will show how firms
use these concepts to maximize profits in
various market structures.
CHAPTER SUMMARY
• Implicit costs do not involve a cash outlay,
yet are just as important as explicit costs
to firms’ decisions.
• Accounting profit is revenue minus explicit
costs. Economic profit is revenue minus
total (explicit + implicit) costs.
• The production function shows the
relationship between output and inputs.
CHAPTER SUMMARY
• The marginal product of labor is the increase in output
from a one-unit increase in labor, holding other inputs
constant. The marginal products of other inputs are
defined similarly.
• Marginal product usually diminishes as the input
increases. Thus, as output rises, the production function
becomes flatter, and the total cost curve becomes
steeper.
• Variable costs vary with output; fixed costs do not.
CHAPTER SUMMARY
• Marginal cost is the increase in total cost
from an extra unit of production. The MC
curve is usually upward-sloping.
• Average variable cost is variable cost
divided by output.
• Average fixed cost is fixed cost divided by
output. AFC always falls as output
increases.
• Average total cost (sometimes called “cost
per unit”) is total cost divided by the
quantity of output. The ATC curve is
CHAPTER SUMMARY
• The MC curve intersects the ATC curve
at minimum average total cost.
When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises.
• In the long run, all costs are variable.
• Economies of scale: ATC falls as Q rises.
Diseconomies of scale: ATC rises as Q
rises. Constant returns to scale: ATC
remains constant as Q rises.
Chapter
8
C
A
L
V
E
R
After reading this chapter, you will be able to:
T
8.1 Explain general concepts of production
and cost analysis.
,
8.2 Examine the structure of short-run production based on the relation among
Production and Cost
in the Short Run
total, average, and marginal products.
8.3 Examine the structure of short-run costs using graphs of the total cost curves,
T
average cost curves, and the short-run marginal cost curve.
E
8.4 Relate short-run costs to the production function using the relations between
(i) average variable cost and average
product, and (ii) short-run marginal cost
R
and marginal product.
R
E
N
o doubt almost all managers know that profit is determined not only by
C but also by the costs associated with producthe revenue a firm generates
tion of the firm’s good or
E service. Many managers, however, find man-
N
aging the revenue portion of the profit equation more interesting and exciting
than dealing with issues concerning the costs of production. After all, revenueoriented decisions may involve such
1 tasks as choosing the optimal level and mix
of advertising media, determining the price of the product, and making decisions
8
to expand into new geographic markets
or new product lines. Even the decision to
buy or merge with other firms may
5 be largely motivated by the desire to increase
revenues. When revenue-oriented tasks are compared with those involved in pro9 production engineers discussing productivity
duction issues—spending time with
levels of workers or the need for T
more and better capital equipment, searching for
lower-cost suppliers of production inputs, adopting new technologies to reduce
S
production costs, and perhaps even engaging in a downsizing plan—it is not surprising that managers may enjoy time spent on revenue decisions more than time
spent on production and cost decisions.
274
tho21901_ch08_274-310.indd 274
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C H A P T E R 8   Production and Cost in the Short Run   275
As barriers to trade weakened or vanished in the 1990s, the resulting globalization of markets and heightened competition made it much more difficult to
increase profits by charging higher prices. Global competition has intensified
the need for managers to increase productivity and reduce costs in order to satisfy stockholders’ desire for greater profitability. As one management consultant
recently interviewed in The Wall Street Journal put it, “Cost-cutting has become
the holy-grail of corporate management.” Managers must understand the fundamental principles of production and cost to reduce costs successfully. Many costly
Cmanagers seeking to “reengineer” or “restructure” proerrors have been made by
duction. Most of these errors
A could have been avoided had the managers possessed an understanding of the fundamentals of production and cost that we will
L and the next show how the structure of a firm’s costs
now set forth. This chapter
is determined by the nature
V of the production process that transforms inputs into
goods and services and by the prices of the inputs used in producing the goods or
E
services. In Chapter 10, we show you how to employ regression analysis to estimate the production andR
cost functions for a firm.
Managers make production decisions in two different decision-making time
T
frames: short-run production decisions and long-run production decisions. In
, situations, a manager must produce with some inputs
short-run decision-making
that are fixed in quantity. In a typical short-run situation, the manager has a fixed
amount of plant and equipment with which to produce the firm’s output. The
T
manager can change production
levels by hiring more or less labor and purchasing more or less raw material,
E but the size of the plant is viewed by the manager
as essentially unchangeable or fixed for the purposes of making production decisions in the short run. R
Long-run decision making
R concerns the same types of decisions as the short
run with one important distinction: A manager can choose to operate in any size
plant with any amount E
of capital equipment. Once a firm builds a new plant
or changes the size of an
N existing plant, the manager is once more in a shortrun ­decision-making framework. Sometimes economists think of the short run
C
as the time period during which production actually takes place and the long
run as the planning horizon
E during which future production will take place. As
you will see, the structure of costs differs in rather crucial ways depending on
whether ­production is taking place in the short run or whether the manager is
planning for a particular1level of production in the long run. This chapter presents the ­fundamentals of8the theory of production and the theory of cost in the
short run.
5
9 AND COST
8.1 SOME GENERAL CONCEPTS IN PRODUCTION
T of goods and services from inputs or resources, such
production
Production is the creation
The creation of goods
as labor, machinery and S
other capital equipment, land, raw materials, and so on.
and services from inputs
or resources.
tho21901_ch08_274-310.indd 275
Obviously, when a company such as Ford makes a truck or car or when ExxonMobil refines a gallon of gasoline, the activity is production. But production goes
much further than that. A doctor produces medical services, a teacher produces
8/10/15 6:51 PM
276  C H A P T E R 8   Production and Cost in the Short Run
e­ ducation, and a singer produces entertainment. So production involves services
as well as making the goods people buy. Production is also undertaken by governments and nonprofit organizations. A city police department produces protection,
a public …
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