Cost

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Cost

• ECG 507
• Professor Allen
• 9/8/05

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1. Cost Introduction

• The production function measures the relationship
  between input and output.
• Given the production technology, managers must
  choose how to produce.
• To determine the optimal level of output and the
  input combinations, we must convert from the
  output measurements to dollar measurements or
  costs.

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2. Cost definition

• Cost what you give up
• Examples
• Cost of NC States MBA
• Cost of launching a new product
• Cost of running your own business
• Cost associated with inventory
• Cost associated with equipment

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3. Measuring Cost Which Costs Matter?

• Accounting Cost
• Consider only explicit cost, the out of pocket
  cost for such items as wages, salaries,
  materials, and property rentals

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4. Measuring Cost Which Costs Matter?

• Economic Cost considers explicit and imputed
  cost.
• Imputed cost is the cost associated with
  opportunities that are foregone by not putting
  resources in their highest valued use.
• Applies to all inputs labor, equipment,
  structures, shareholders equity
• Opportunity cost explicit cost imputed cost
• Use cash flow comparisons to estimate

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5. Present Discounted Value (PDV)

• Determining the value today of a future flow of
  income
• The value of a future payment must be discounted
  for the time period and interest rate that could
  be earned.
• Interest rate rate at which one can borrow or
  lend money

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6. Present Discounted Value (PDV)

• Future Value (FV)
• One dollar invested today should yield (1 R)
  dollars a year from now
• (1 R) is the future value of the dollar today
• What is the value today of getting 1 a year from
  now?
• What is the present discounted value of the 1?

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7. Present Discounted Value (PDV)
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8. Present Discounted Value (PDV)

• The interest rate impacts the PDV
• The lower the interest rate, the more you have to
  invest to reach your goal in the future
• We can see how different interest rates will give
  different future values

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9.PDV of 1 Paid in the Future
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10. Sunk cost

• An expenditure that has been made and cannot be
  recovered--they should not influence a firms
  decisions.
• Example Pluto Nash
• Key point do not include an item in explicit
  costs unless it is relevant to decision at hand

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11. Cost in the Short Run

• Fixed costs do not change with changes in output
• Variable costs increase as output increases.
• Total cost of production equals the fixed cost
  plus the variable cost

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12. Cost in the Short Run

• Average Total Cost (ATC) is the cost per unit of
  output, or average fixed cost (AFC) plus average
  variable cost (AVC). This can be written

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13. Cost in the Short Run

• Marginal Cost (MC) is the cost of expanding
  output by one unit. Since fixed cost have no
  impact on marginal cost, it can be written as

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14. Key cost issues

• Economic vs. accounting costs
• Replacement cost
• Depreciation
• Inventory
• Fixed costs not same as sunk costs
• Allocating overhead

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15. Cost exercises

• Leith Honda has six Civics on the lot for which
  it paid 14,500. New models are coming in, and
  with special promotions will cost Leith 13,900.
  A customer offers Leith 14,250 for a Civic in
  stock. Should Leith accept or reject?

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16. Cost exercises

• Shania Twain has a contract that calls for her to
  make one album per year, for which she gets paid
  5 million. She decides to change musical
  directions and sing famous arias from well-known
  operas. It has cost 500,000 to produce and
  market each of her earlier albums. What
  judgments do you have to make before deciding
  whether to release Shanias new material?

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17. Cost exercises
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18.Cost exercises
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19. Cost exercises
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20. Determinants of cost

• Productivity
• Price of inputs
• Overhead

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21. Cost Curves for a Firm

• Unit Costs
• MC must rise with Q eventually
• AFC falls continuously
• When MC
• MC ATC at minimum ATC

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22. Cost Curves for a Firm

• Unit Costs
• When MC
• MC AVC at minimum AVC
• Minimum AVC occurs at a lower output than minimum
  ATC due to FC

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23. Long-run cost curves

• Each set of short-run cost curves is associated
  with a given combination of fixed inputs.
• Long-run relationship between output and costs
  depends on returns to scale
• constant AC stays same
• increasing AC falls with output
• decreasing AC rises with output

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24. Long-Run Cost withConstant Returns to Scale
With many plant sizes with SAC 10 the LAC
LMC and is a straight line
Cost ( per unit of output
SAC1
SAC2
SAC3
SMC1
SMC2
SMC3
LAC LMC
Output
Q1
Q2
Q3
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25. Long-Run Cost with Scale Economies,
Diseconomies
SAC1
LAC
SAC3
Cost ( per unit of output
SAC2
SMC1
SMC3
LMC
SMC2
Output
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26. Economies of scale theory

• Returns to scale holds K/L constant, which in
  long run makes little sense
• Instead look at economies of scale
• EC ?C / ?Q
• Key issue is whether EC
  1 (diseconomies).

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27. Economies of scale

• Sources of economies of scale
• Spreading overhead
• Physical properties of production
• Marketing and purchasing economies
• Sources of diseconomies of scale
• Labor costs
• Bureaucracy
• Spread specialized resources too thin
• Measurement compare ATC at different Q

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28. Production with Two Outputs--Economies of
Scope

• Examples
• Microsoftoperating system and office
  applications (and travel agent at one time)
• General Electric --ranges and refrigerators
• University--Teaching and sports

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29. Production with Two Outputs--Economies of
Scope

• Economies of scope exist when the joint output of
  a single firm is greater than the output that
  could be achieved by two different firms each
  producing a single output.
• Advantages
• Use same capital and labor.
• Share management resources.

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30. Production with Two Outputs--Economies of
Scope

• The degree of economies of scope measures the
  savings in cost can be written
• C(Q1) is the cost of producing Q1
• C(Q2) is the cost of producing Q2
• C(Q1Q2) is the joint cost of producing both
  products

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31. Production with Two Outputs--Economies of
Scope

• Interpretation
• If SC 0 -- Economies of scope
• If SC

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32. Production with Two Outputs--Economies of
Scope

• Observations
• There is no direct relationship between economies
  of scope and economies of scale.
• May experience economies of scope and
  diseconomies of scale
• May have economies of scale and not have
  economies of scope
• Believed to be very important in RD
• Key concept in business today similar to
  leveraging core competencies

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33. The Learning Curve

• The learning curve measures the impact of
  workers experience on the costs of production.
• It describes the relationship between a firms
  cumulative output and amount of inputs needed to
  produce a unit of output.
• Example In aircraft assembly, costs fall by 20
  per plane each time output doubles