EWMBA201a: Economic Costs

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EWMBA201a Economic Costs Costs of Production
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Opportunity costs

• Payoffs from an action must be judged against the
  best alternative action.
• Make sure you think of all the possible
  alternatives at a decision node,
• and think through the implications of each
  node.
• Acquisition costs are irrelevant to opportunity
  costs.
• Economic costs include opportunity costs.

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Opportunity cost examples

• What are the major costs associated with
  attending Haas for you? For daytime students?
• What is the cost to Hertz of a car that is
  returned late?
• What is the value of your frequent flyer miles?

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Opportunity cost example airline fuel hedges

• A number of the airlines buy hedges on jet fuel
  costs.
• For instance, if jet fuel prices are trading at
  1/gallon, an airline may hedge possible price
  increases by purchasing a financial option that
  allows it to buy 500 million gallons of fuel at
  that price in the future.
• If the jet fuel price falls below 1/gallon, the
  airline is out what they paid for the hedge and
  they buy fuel at the lower spot price.
• If the jet fuel price goes above 1/gallon, they
  can purchase 500 million gallons at 1/gallon.

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Airline jet fuel hedge example

• Southwest Airlines currently holds options
  allowing them to purchase jet fuel at a price of
  1.25/gallon.
• Imagine that it has a route for which its net
  revenue is equivalent to 1.25/gallon. In other
  words, the route is only profitable if the jet
  fuel price is at or below 1.25.
• Should Southwests decision to fly that route
  depend on whether or not it has hedged its fuel
  costs?
• For instance, imagine a route where SWA has
  non-fuel costs of 5,000 per flight. Its planes
  get roughly .25 miles/gallon, so if the route is
  500 miles, its using 4500 2000 gallons of
  fuel at a cost of 1.2520002,500. If it
  usually carries 100 passengers who generate net
  revenue of 75 apiece, its passengers are paying
  7,500. Net revenues on the route are negative
  unless fuel is less than or equal to 1.25/gallon.

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Southwests decision if its un-hedged
Drop route
0
Jet fuel price 1.50 p.5
Buy fuel in spot market, operate route
-.25/gallon
No hedges
Buy spot, operate route
.15/gallon
Jet fuel price 1.10 p.5
Drop route
0
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Southwests decision if its hedged
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Southwests decision if its hedged
Although SWAs acquisition cost for jet fuel
depends on whether it has hedges, its opportunity
cost of using jet fuel reflects the spot price in
either case.
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Fuel hedge positions of major US airlines
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Jet fuel and crude oil prices
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Decision trees and sunk costs
Develop product
-1mm 2.5mm
Movie will be a hit p0.8
Acquire license for new product
Dont develop product
0
-.5mm
Develop product
-1mm .1mm
Movie will be a flop p0.2
Dont develop product
0
Lesson Whats behind you is not important.
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Economic costs versus accounting costs

• There are two things to do with costs
• Keep track of them (RECORD KEEPING).
• Make decisions on the basis of them (DECISION
  MAKING).
• Accounting rules are designed to help firms and
  investors keep track of costs where did the
  money go and where did it come from?
• Accountants are less willing to recognize
  uncertain costs.
• Example opportunity costs.
• Accountants are unwilling to ignore previous
  expenditures.

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Economic cost concepts A firms cost functions

• Economic costs actual expenditures
• sunk costs
• opportunity costs
• Cost functions relate some cost to the quantity a
  firm produces.
• Cost functions represent ideal rather than actual
  costs.
• A firms cost function may change over time.

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We will talk about 6 types of cost functions

• Total cost (C) total cost of inputs the firm
  needs to produce output q. Denoted C(q).
• Fixed cost (FC) the cost that does not depend
  on the output level, C(0) or really C(0.00001)
• Variable cost (VC) that cost which would be
  zero if the output level were zero, C(q) C(0)
  or really C(q) C(0.00001).
• Average total cost (ATC) (aka simply average
  cost (AC)) total cost divided by output level,
  C(q)/q.
• Average variable cost (AVC) variable cost
  divided by output level, VC(q)/q.
• Marginal cost (MC) the unit cost of a small
  increase in output.
• Derivative of cost with respect to output, dC/dq
• Approximated by C(q)-C(q-1), e.g. C(40)-C(39)

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A total cost function graphically
An example C(Q) 10 .5Q
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The average total cost function
ATC(Q) C(Q)/Q 10/Q .5
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Marginal costs
MC(Q) dC(Q)/dQ .5
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T-shirt factory example

• To produce T-shirts
• Lease one machine at 20 / week.
• Machine requires one worker.
• The machine, operated by the worker, produces one
  T-shirt per hour.
• Worker is paid 1/hour on weekdays (up to 40
  hours), 2/hour on Saturdays (up to 8 hours), 3
  on Sundays (up to 8 hours).

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T-shirts costs

• Suppose output level is 40 T-shirts per week.
  Then,
• Fixed cost FC 20.
• Variable cost VC 40 x 1 40.
• Average total cost ATC (2040)/40 1.5
• Average variable cost AVC (40)/40 1
• Marginal cost MC 1.
• (Note that producing an extra T-shirt would imply
  working on Saturday, which costs more MC(41)
  2.)
• Similar calculations can be made for other output
  levels, leading to the cost functions

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T-shirt factory cost functions
Cost ()
MC
3
2
ATC
1.5
1
48
T-shirts
10
20
30
40
50
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Marginal and average cost curves generic shape
Cost ()
MC
p2
ATC
p1
q1
q2
Marginal cost always crosses average cost at its
minimum.
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More average cost and marginal cost in Excel
C(Q) 10 .2Q2 ATC 10/Q .2Q AVC .2Q MC
.4Q
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Economies of scale

• Economies of scale describe how the firms
  average costs change as output increases.
• ATC ? with quantity diseconomies of scale
• ATC ? with quantity economies of scale
• Note a cost function can exhibit economies of
  scale at some output levels and diseconomies of
  scale at other output levels.