cost analysis: lecture video

rahuldumpa89

Chapter-6-Production-Cost-LectureNote.ppt

Home >Business & Finance homework help >Economics homework help >cost analysis: lecture video

Chapter 6

Costs

6-*

Table of Contents

6.1 The Nature of Costs
6.2 Short-Run Costs
6.3 Long-Run Costs
6.4 The Learning Curve
6.5 Costs of Producing Multiple Goods

6-*

Introduction

Managerial Problem
Technology choice at home versus abroad: In the United States, firms use relatively capital-intensive technology
Will that same technology be cost minimizing if they move their production abroad?
Solution Approach
First, a firm must determine which production processes are technically efficient so that it can produce the desired level of output without waste. Second, a firm should pick from these technically efficient processes the one that is also economically efficient (minimum cost). By minimizing costs, a firm can increase its profit.
Empirical Methods
When considering costs, a good manager includes opportunity costs or foregone alternatives.
To minimize costs, a manager should distinguish short-run costs from long-run costs.
Firms may reduce costs overtime based on experience or its learning curve.
If a firm produces several goods, individual cost may depend on the cost of producing multiple goods.

6-*

6.1 The Nature of Costs

Explicit and Implicit Costs
Explicit costs are direct, out-of-pocket payments for labor, capital, energy, and materials.
Implicit costs reflect only a foregone opportunity rather than explicit, current expenditure.
Opportunity Costs
The opportunity cost of a resource is the value of the best alternative use of that resource.
Value of Manager’s Time example: Maoyong owns and manages a firm. He pays himself only $1k per month but could work for another firm and make $11k per month. Working for another firm is the best alternative use of his time, so his opportunity cost of time is $11k.
Relevance of Considering Opportunity Cost
Maoyong example: Assume monthly revenue is $49k and explicit costs are $40k, including Maoyong’s monthly wage. The accounting profit is $9k and Maoyong collects $10k per month (profit + wage). However, his opportunity cost is $11k. So, he incurs an economic loss of $1k.

6-*

6.1 The Nature of Costs

Costs of Durable Inputs
Durable inputs are usable for a long period, perhaps for many years.
Capital such as land, buildings, or equipment are durable inputs.
Costs of Durable Inputs (truck example)
There are two problems. First, how to allocate the initial purchase cost over time. Second, what to do if the value of the capital changes over time.
Solution if there is a rental market: The accountant may expense the truck’s purchase price or may amortize it over the life of the truck, following IRS rules. The firm’s opportunity cost of using the truck is the amount that the firm would earn if it rented the truck to others.
Solution if there is no rental market: The opportunity cost of capital of using the truck a year would be the interest forgone in a year.

6-*

6.1 The Nature of Costs

Sunk Costs
Sunk cost is a past expenditure that cannot be recovered.
If an expenditure is sunk, it is not an opportunity cost. So we should not consider it for managerial decisions.
However, sunk costs appear in financial accounts.
Managers Should Ignore Sunk Costs
A firm paid $300k for a parcel of land but the market value is now $200k. If the firm builds a plant on this land, the value for the firm becomes $240k.
Is it worth carrying out production on this land or should the land be sold for its market value of $200k?
The land’s opportunity cost is $200k and the market value loss of $100k is a sunk cost. The sunk cost cannot be recovered and should not be considered in the decision. The values to compare are $240 versus $200. Certainly, the firm should carry out production on this land.

6-*

6.2 Short-Run Costs

Fixed Cost (F) does not vary with the level of output; includes expenditures on land, office space, production facilities, and other overhead expenses; are often sunk costs, but not always.
Variable Cost(VC) changes as the quantity of output changes; refers to the costs of variable inputs.
Total Cost (C) is the sum of fixed and variable costs.
F and VC should be based on inputs’ opportunity costs.

Common Measures of Cost

6-*

6.2 Short-Run Costs

Average Fixed Cost (AFC) falls as output rises because the fixed cost is spread over more units.
Average Variable Cost (AVC) or variable cost per unit of output may either increase or decrease as output rises.
Average Cost (AC) or average total cost may either increase or decrease as output rises.

6-*

6.2 Short-Run Costs

Marginal Cost: MC = ΔC/Δq
Marginal cost (MC) is the amount by which a firm’s cost changes if the firm produces one more unit of output; ∆C is the change in cost when the change in output, ∆q, is 1 unit.
Marginal Cost: MC = ΔVC/Δq
Marginal cost also equals the change in variable cost from a one-unit increase in output.
Marginal Cost using Calculus: MC = dC/dq = dVC/dq
Marginal cost is the rate of change of cost as we make an infinitesimally small change in output. MC=dVC/dq because dF/q=0.

6-*

6.2 Short-Run Costs

Cost Curves: Total Values
Panel a of Figure 6.1 shows the variable cost (VC), fixed cost (F), and total cost (C) curves that correspond to Table 6.1
Graphs: Total, Variable and Fixed Costs
The fixed cost curve, F, is a horizontal line at $48.
The variable cost curve, VC, is zero at zero units of output and rises with output.
The total cost curve, C, is the vertical sum of the VC and F curves, so it is $48 higher than the VC curve at every output level. VC and C curves are parallel.

6-*

6.2 Short-Run Costs

Figure 6.1 Cost Curves

6-*

Table 6.1 How Cost Varies with Output

6-*

6.2 Short-Run Costs

Cost Curves: Average and Marginal Values
Panel b of Figure 6.1 shows the average fixed cost, average variable cost, average cost, and marginal cost curves.
Graphs: Average Costs and Marginal Cost
The marginal cost curve, MC, cuts the average variable cost, AVC, and average cost, AC, curves at their minimums.
The height of the AC curve at point a equals the slope of the line from the origin to the cost curve at A.
The height of the AVC at b equals the slope of the line from the origin to the variable cost curve at B.
The height of the marginal cost is the slope of either the C or VC curve at that quantity.

6-*

6.2 Short-Run Costs

In the short run, the firm increases output by using more labor. However, each extra worker increases output by a smaller amount. Diminishing marginal returns to labor determine the shape of the production function.

The production function determines the shape of the variable cost curve. As output increases, variable cost increases more than proportionally because of diminishing marginal returns.

The production function determines the shape of the marginal cost, average variable cost, and average cost curves.

Production Functions and the Shapes of Short-Run Costs Curves

6-*

6.2 Short-Run Costs

Production Functions & Shapes of Cost Curves: Graph Analysis
If input prices are constant, the firm’s production function determines the shape of the variable cost curve.
The Variable Cost Curve
The VC and the total product curve have the same shape, Figure 6.2.
The total product curve uses the horizontal axis measuring hours of work.
The variable cost curve uses the horizontal axis measuring labor cost: VC = wL.
The VC of 6 units of output is $240 ($10*24).

6-*

6.2 Short-Run Costs

Figure 6.2 Variable Cost and Total Product