Week 4 managerial economics

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HOMEWORK

Problem 1

Consider a firm that has just built a plant, which cost $

20,000

. Each worker costs $

.00 per hour. Based on this information, fill in the table below.

—

Number of Worker Hours		Output	Marginal Product	Fixed Cost	Variable Cost	Total Cost	Marginal Cost	Average Variable Cost	Average Total Cost
			0				—	20,000
	50	400	20, 250
10 0	9 00	20,500
150	1 3 00	20, 7 50
200	1600	21,000
250	1 8 00	21,250
	300	1900	21,500
350	1950	21,750

Problem 2

Output

300

Number Of Workers
1
2	110
3
4	450
5	590
6	665
7	700
8	725
9	710
10	705

The table above shows the weekly relationship between output and number of workers for a factory with a fixed size of plant.

a. Calculate the marginal product of labor.

b. At what point does diminishing returns set in?

c. Calculate the average product of labor.

d. Find the three stages of production.

Problem 3

Mr. Lee operates a green grocery in a building he owns in one of the outer boroughs of New York City. Recently, a large chemical firm offered him a position as a senior engineer designing plants for its Asian operations. (Mr. Lee has a master’s degree in chemical engineering.) His salary plus benefits would be $95,000 per year. A recent annual financial statement of his store’s operations indicates the following:

____________________________________________

Revenue

$625,000

Cost of goods sold

325,000

Wages of workers

75,000

Taxes, insurance, maintenance, and

depreciation on building
30,000

Interest on business loan (10 %)
5,000

Other miscellaneous expenses
15,000

Profit before taxes

$175,000

____________________________________________

If Mr. Lee decides to take the job, he knows that he can sell the store for $350,000 because of the goodwill built with a steady clientele of neighborhood customers and the excellent location of the building. If he would still hold onto the building, he knows he could earn a rent of $50,000 on this asset. If he did sell the business, assume he would use some of the proceeds from the sale to pay off his business loan of $50,000. He could then invest the difference of $300,000 (i.e., $350,000 – $50,000) and expect to receive an annual return of 9 percent. Should Mr. Lee sell the business and go to work for the chemical company?

In answering this question, also consider the following information:

a. In his own business, Mr. Lee works between 16 and 18 hours a day, 6 days a week. He can expect to work between 10 and 12 hours a day, 5 days a week, in the chemical company.

b. Currently, Mr. Lee is assisted by his wife and his brother, both of whom receive no salary but share in the profits of the business.

c. Mr. Lee expects his salary and the profits of his business to increase at roughly the same rate over the next 5 years.

Problem 4

A perfectly competitive firm has total revenue and total cost curves given by:

TR = 100Q

TC = 5,000 + 2Q + 0.2 Q2

a. Find the profit-maximizing output for this firm.

b. What profit does the firm make?

Problem 5

Suppose three firms face the same total market demand for their product. This demand is

$80

20,000

70 25,000

60 30,000

35,000

Suppose further that all three firms are selling their product for $60 and each has about one third of the total market. One of the firms, in an attempt to gain market share at the expense of the others, drops the price to $50. The other two quickly follow suit.

a. What impact would this move have on the profits of all three firms? Explain your reasoning.

b. Would these firms have been better off in terms of profit if they all had raised the price to $70? Explain.

Problem 6

Because credit card companies and banks must charge the same interest rate on credit cards to all borrowers, there is an adverse selection problem with credit cards. How does a credit card company or firm know whether a person will be a high-quality borrower (i.e., one who pays the debts) or a lower-quality borrower (i.e., one who does not pay debts)?

Describe

a. how the restrictions of a single rate leads to an adverse selection problem, and

b. at least two potential means that credit card companies can use to try to lessen this problem.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Chapter 7
The Theory and
Estimation of Cost
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
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*
Overview
Definition and use of cost
Relating production and cost
Short run and long run cost
Economies of scope and scale
Supply chain management
Ways companies have cut costs to remain competitive

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Learning objectives

define the cost function
distinguish between economic cost and accounting cost
explain how the concept of relevant cost is used

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Learning objectives

understand total, variable, average and fixed cost

distinguish between short-run and long-run cost
provide reasons for the existence of economies of scale

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Importance of cost
in managerial decisions
Ways to contain or cut costs popular during the past decade
most common: reduce number of people on the payroll
outsourcing components of the business
merge, consolidate, then reduce headcount

Chapter Seven
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*
Definition and use of
cost in economic analysis
Relevant cost: a cost that is affected by a management decision
Historical cost: cost incurred at the time of procurement
Opportunity cost: amount or subjective value that is forgone in choosing one activity over the next best alternative
Incremental cost: varies with the range of options available in the decision
Sunk cost: does not vary in accordance with decision alternatives

Chapter Seven
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Relationship between
production and cost

Cost function is simply the production function expressed in monetary rather than physical units

We assume the firm is a ‘price taker’ in the input market
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
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*
Relationship between
production and cost
Total variable cost (TVC) = the cost associated with the variable input, found by multiplying the number of units by the unit price
Marginal cost (MC) = the rate of change in total variable cost

The law of diminishing returns (Chapter 6) implies that MC will eventually increase
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Relationship between
production and cost

Plotting TP and TVC illustrates that they are mirror images of each other
When TP increases at an increasing rate, TVC increases at a decreasing rate
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
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Short-run cost function
For simplicity use the following assumptions:
the firm employs two inputs, labor and capital
the firm operates in a short-run production period where labor is variable, capital is fixed
the firm produces a single product
the firm employs a fixed level of technology
the firm operates at every level of output in the most efficient way
the firm operates in perfectly competitive input markets and must pay for its inputs at a given market rate (it is a ‘price taker’)
the short-run production function is affected by the law of diminishing returns

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Standard variables in the short-run cost function:

Quantity (Q) is the amount of output that a firm can produce in the short run

Total fixed cost (TFC) is the total cost of using the fixed input, capital (K)
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Standard variables in the short-run cost function:

Total variable cost (TVC) is the total cost of using the variable input, labor (L)

Total cost (TC) is the total cost of using all the firm’s inputs,
TC = TFC + TVC
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Standard variables in the short-run cost function:

Average fixed cost (AFC) is the average per-unit cost of using the fixed input K
AFC = TFC/Q
Average variable cost (AVC) is the average per-unit cost of using the variable input L
AVC = TVC/Q
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Standard variables in the short-run cost function:

Average total cost (AC) is the average per-unit cost of all the firm’s inputs
AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a firm’s total cost (or total variable cost) resulting from a unit change in output
MC = DTC/DQ = DTVC/DQ
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Graphical example of the cost variables

Chapter Seven
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*
Short-run cost function
Important observations
AFC declines steadily
when MC = AVC, AVC is at a minimum
when MC < AVC, AVC is falling when MC > AVC, AVC is rising

The same three rules apply for average cost (AC) as for AVC
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
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Short-run cost function
A reduction in the firm’s fixed cost would cause the average cost line to shift downward

A reduction in the firm’s variable cost would cause all three cost lines (AC, AVC, MC) to shift
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Alternative specifications of the Total Cost function (relating total cost and output)
cubic relationship
as output increases, total cost first increases at a decreasing rate, then increases at an increasing rate

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Short-run cost function
Alternative specifications of the Total Cost function (relating total cost and output)
quadratic relationship
as output increases, total cost increases at an increasing rate
linear relationship
as output increases, total cost increases at a constant rate

Chapter Seven
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*
Long-run cost function
In the long run, all inputs to a firm’s production function may be changed

 because there are no fixed inputs, there are no fixed costs
 the firm’s long run marginal cost pertains to returns to scale
 at first increasing returns to scale, then as firms mature they achieve constant returns, then ultimately decreasing returns to scale
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Long-run cost function
When a firm experiences increasing returns to scale:
a proportional increase in all inputs increases output by a greater proportion
as output increases by some percentage, total cost of production increases by some lesser percentage

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Long-run cost function
Economies of scale: situation where a firm’s long-run average cost (LRAC) declines as output increases
Diseconomies of scale: situation where a firm’s LRAC increases as output increases
In general, the LRAC curve is u-shaped.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Long-run cost function
Reasons for long-run economies
specialization of labor and capital
prices of inputs may fall with volume discounts in firm’s purchasing
use of capital equipment with better price-performance ratios
larger firms may be able to raise funds in capital markets at a lower cost
larger firms may be able to spread out promotional costs

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Long-run cost function
Reasons for diseconomies of scale
scale of production becomes so large that it affects the total market demand for inputs, so input prices rise
transportation costs tend to rise as production grows, due to handling expenses, insurance, security, and inventory costs

Chapter Seven
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*
Long-run cost function
In long run, the firm can choose any level of capacity

Once it commits to a level of capacity, at least one of the inputs must be fixed. This then becomes a short-run problem

The LRAC curve is an envelope of SRAC curves, and outlines the lowest per-unit costs the firm will incur over a range of output
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
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Learning curve
Learning curve: line showing the relationship between labor cost and additional units of output

downward slope indicates additional cost per unit declines as the level of output increases because workers improve with practice
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Chapter Seven
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*
Economies of scope
Economies of scope: reduction of a firm’s unit cost by producing two or more goods or services jointly rather than separately

Closely related to economies of scale
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Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Supply chain management
Supply chain management (SCM): efforts by a firm to improve efficiencies through each link of a firm’s supply chain from supplier to customer

transaction costs are incurred by using resources outside the firm
coordination costs arise because of uncertainty and complexity of tasks
information costs arise to properly coordinate activities between the firm and its suppliers
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Supply chain management
Ways to develop better supplier relationships
strategic alliance: firm and outside supplier join together in some sharing of resources
competitive tension: firm uses two or more suppliers, thereby helping the firm keep its purchase prices under control

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Ways companies cut
costs to remain competitive
the strategic use of cost
reduction in cost of materials
using information technology to reduce costs
reduction of process costs
relocation to lower-wage countries or regions
mergers, consolidation, and subsequent downsizing
layoffs and plant closings

Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Global application
Example: manufacturing chemicals in China

labor content relatively low
high use of equipment and raw materials
noncost reasons for outsourcing

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Chapter 8
Pricing and Output Decisions:
Perfect Competition
and Monopoly
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Overview
Competition and market types
Pricing and output decisions in perfect competition
Pricing and output decisions in monopoly markets
Implications for managerial decisions

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Learning objectives
understand the four market types
compare the degree of price competition among the four market types
explain why the P=MC rule leads firms to the optimal level of production
explain how the MR=MC rule helps a monopoly to determine its optimum
explain the relationship between the MR=MC rule and the P=MC rule
describe what happens in the long run

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Four market types
Perfect competition (no market power)

large number of relatively small buyers and sellers
standardized product
very easy market entry and exit
nonprice competition not possible

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Four market types
Monopoly (absolute market power, subject to government regulation)
one firm, firm is the industry
unique product or no close substitutes
market entry and exit difficult or legally impossible
nonprice competition not necessary

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Four market types
Monopolistic competition (market power based on product differentiation)
large number of small firms acting independently
differentiated product
market entry and exit relatively easy
nonprice competition very important

Chapter Eight
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*
Four market types
Oligopoly (product differentiation and/or the firm’s dominance of the market)
small number of large mutually interdependent firms
differentiated or standardized product
market entry and exit difficult
nonprice competition important

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Four market types
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types
Examples: perfect competition
agricultural products
financial instruments
precious metals
petroleum

Chapter Eight
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*
Four market types
Examples: monopoly
pharmaceuticals
Microsoft
gas station on edge of desert

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Four market types
Examples: monopolistic competition
boutiques
restaurants
repair shops

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Four market types
Examples: oligopoly
oil refining
processed foods
airlines
internet access

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Basic business decision: entering a market using the following questions:
how much should we produce?
if we produce such an amount, how much profit will we earn?
if a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit?

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Key assumptions of the perfectly competitive market:
the firm is a price taker
the firm makes the distinction between the short run and the long run
the firm’s objective is to maximize its profit (or minimize loss) in the short run
the firm includes its opportunity cost of operating in a particular market as part of its total cost of production

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Perfectly elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price
 firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product
 no limit to the total revenue that the firm can gain in a perfectly competitive market

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Total revenue/Total cost approach:
compare the total revenue and total cost schedules and find the level of output that either maximizes the firm’s profits or minimizes its loss

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Marginal revenue/Marginal cost approach
produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit (ie. MR=MC)

Note: for the perfectly competitive firm, the MR=MC rule may be restated as P=MC because P=MR in perfectly competitive market
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Case A: economic profit
The point where P=MR=MC is the optimal output (Q*)
 profit = TR – TC
=(P – AC) · Q*

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Case B: economic loss

The firm incurs a loss.
At optimum output, price is below AC
 however, since P > AVC, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Contribution margin: the amount by which total revenue exceeds total variable cost

CM = TR – TVC

 if CM > 0, the firm should continue to produce in the short run in order to defray some of the fixed cost

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Shutdown point: the lowest price at which the firm would still produce

At the shutdown point, the price is equal to the minimum point on the AVC

If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
In the long run, the price in the competitive market will settle at the point where firms earn a normal profit
economic profit invites entry of new firms  shifts the supply curve to the right  puts downward pressure on price and reduces profits
economic loss causes exit of firms  shifts the supply curve to the left  puts upward pressure on price and increases profits

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions
in perfect competition
Observations in perfectly competitive markets:
the earlier the firm enters a market, the better its chances of earning above-normal profit
as new firms enter the market, firms must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors
firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions in monopoly markets
A monopoly market consists of one firm
(the firm is the market)
firm has the power to set any price it wants
however, the firm’s ability to set price is limited by the demand curve for its product, and in particular, the price elasticity of demand
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions in monopoly markets
Assume demand is linear: it is downward sloping because the firm is a price setter
Assume MC is constant
 choose output where MR=MC, set price at P*

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Pricing and output decisions in monopoly markets
Demand is the same as before, as is MR
MC is upward sloping, which shows diminishing returns
 set output where MR=MC

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Implications of perfect competition and monopoly for decision making
Perfectly competitive market
most important lesson is that it is extremely difficult to make money
must be as cost efficient as possible
it might pay for a firm to move into a market before others start to enter

Chapter Eight
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Implications of perfect competition and monopoly for decision making
Monopoly market
most important lesson is not to be arrogant and assume their ability to earn economic profit can never be diminished
changes in economics of a business eventually break down a dominating company’s monopolistic power

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