managerial economics

In a Nutshell

In this part, you are going to jot down what you have learned BELOW. The said statement of yours could be in a form of concluding statements, arguments, or perspective you have drawn from this lesson. The first three is done for you.

1.Costs refer to the expenses incurred in the production activity. There are different types of cost that a firm encounter as it proceeds in its production activity. Short-run and long-run costs are time period in cost analysis where a firm is using a fixed cost and variable cost respectively.

2.Under long-run condition, the firm will encounter economies of scale or diseconomies of scale conditions that would reflect cost advantages of the firm in its production.

3.Cost-Volume-Profit Analysis examines the relationship of firm's output, cost, revenue, and profit. This tool helps the firm in identifying break-even output that would serve as benchmark in its production where it earns normal profit. Once determined, the firm can then add more to realize an economic profit.

Now it's your turn!

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Cost and its Types Again costs are merely expenses of the firm incurred during its production activity. In the context of business and economics, managers faced different kinds of costs. To name a few, the following costs are being encountered by firms: a. Explicit Costs or out-of-pocket costs are expenses which involves an actual cash outlay. This includes rent, wages, cost of raw materials, and etc. b. Implicit Costs or opportunity cost that involves non-cash outlay. The owner of the resource which uses it for personal gain without any considerations to its revenue alternatives are form of implicit costs. c. Historical Costs refers to the price paid for a resource originally at the time of purchase. A machine that is bought three years ago and is accounted during the time it is purchased is an example of this cost. d. Current Costs refers to the amount that would be paid for an item under present market conditions. e. Sunk Costs are costs which cannot be altered in any way and have already been incurred. Constructed building or invested machines are examples of sunk costs. f . Incremental Costs are the added costs of a change in the level of production or the nature of activity. It may be an additional cost in adding a machine or labor or other inputs and production/distribution or pricing strategies. g. Short-run Costs are the costs over a period during which some factors of production are fixed. h. Long-run Costs are the costs over a period long enough to permit changes in all factors of production. i. Private Costs or internal costs refer to costs that accrue directly to the individuals performing a particular activity. All cost directly related to business (unless there are ethical considerations) are part of this cost. j. Social Costs or external costs are costs that are incurred that give social or environmental degradation. These costs are computed using the cost-benefit analysis. It is just to note that even though there are different types of costs that a firm. encounters, the determination of cost is not purely objective. Hence, managers should be careful in using the available cost information when conducting cost estimation analysis. Production and Cost The relationship between production and cost can be illustrated with the use of cost function. The said function indicates the input prices and gives information on the level of output produced and the price to be charge on the outputs. Cost function, generally, is expressed mathematically as:C = f(X.T.Pt etc) where : X is Output; T is Technology; and Pf is Prices of Inputs The "etc" or others that may be included as a factor in the function could be: Size of Plant, State of Technology, Management and Administrative Efficiency, Process and Range of Products, Supply Chains and Logistics. Short-Run Cost Behavior As mentioned earlier, short-run is a time period where a firm is using at least a fixed unit of input. This may entail that the firm is also experiencing a fixed cost which is the main determinants under this condition. Fored cost reflects the cost incurred by using a fixed input. Other costs under short-run period are: Variable Costs which are costs incurred by using variable inputs, Total Cost is the sum of Fixed and variable costs, Average Cost is the cost per unit of output (could also be the sum of Average Fixed Cost and Average Variable Costs), and Marginal Cost which is the additional cost per additional unit of output. It is the partial derivative of the cost function with respect to output (). To understand the relationship between the aforementioned short-run costs, consider the following table: Table 5. Short-Run Costs Output Fixed Cost Variable Total Cost Average Marginal (Q) (FC) Cost (VC) (TC) Cost (AC) Cost (MC) P5.00 P10.00 P15.00 P15.00 5.00 20.00 25.00 12.50 P10.00 5.00 25.00 30.00 10.00 5.00 5.00 35.00 40.00 10.00 10.00 5.00 50.00 55.00 11.00 15.00 5.00 70.00 75.00 12.50 20.00 5.00 100.00 105.00 15.00 30.00 5.00 140.00 145.00 18.13 40.00 To have a clear picture, a constructed graphical illustration of the short-run cost is presented below. As can be seen on the graph, the orientation of the fixed cost curve is horizontal, parallel to the output axis since the value of the cost is fixed However, as to the case of variable cost curve it is upward sloping due to fact that this cost is dependent on the level of output, that is, as output increases so as the variable cost. The structure of the total cost curve follows on that of the variable cost since total cost is comprised of variable cost but lies above on it for it has another component which is fixed cost that adds up on its value. Lastly, average cost and marginal cost have same structure of the curve, that is, a typical U-shaped. The downward portion of the curve is mainly due to the increasing returns of the firm (stage 1 of the production) while the upward portion is due to diminishing return (stage 2 of the production). The point of intersection of AC and MC indicates that the firm reaches the maximum portion of its average product.Short-Run Cost Curves Cost 160 140 120 +Fixed Cost 100 "Variable Cost 80 Total Cost 60 *Average Cost 40 Marginal Cost 20 Output/TP 1 2 3 Figure 9. Short Run Costs Curves Long-Run Cost Behavior Under long-run condition, the firm has complete flexibility thus all costs are held variable. Notable discussion under this condition is the appearance or structure of the curve which is U-Shaped which envelops all short-run average cost (SAC) curves, as shown on the graph below. The long-run cost curve determines the adjustment of the short-run average cost curves that is triggered by the expansion of the firm. It also reveals if the firm is in the condition of economies or diseconomies of scale and the optimal plant sizes. In the graph, initially at O, total cost is determined by C1, when firm expands (say it adds machines), short run cost adjusts to SAC, and determines another cost, C2. In this condition the firm is experiencing economies of scale since average cost decrease while output increases. However, as firm adds more machine its short-run cost curve adjust to SAC, and determines an increasing cost which is Ca. In this condition the firm is experiencing diseconomies of scale, that is output increase but average cost also increase. Among the three SAC determined, the firm is in its optimal plant size at SACz Cost SAC1 SACT SACS LAC Outout 02Firm may also get cost advantage by undertaking product diversification using the same scale of plant. This refers to economies of scope which occur when changing the mix of operations has cost benefits. Say producing 100 units of product A alone may cost a firm P1 million. If it produces same quantity, 100 units, but a combination of product A and other product, say B, it may reduce its cost by certain amount. This is what economies of scope all about. The reason for this is that the products may use common processing facilities or there may be cost complementarity, especially when there are joint products or by-products. Cost-Volume-Profit (CVP) Analysis CVP Analysis, also known as Break-Even Analysis, examines relationships between costs, revenues and profit on the one hand and volume of output on the other. To understand this concept, the following two (2) assumptions are commonly adopted to simplify its mathematical analysis: 1. MC is constant at all levels of output. This implies that the total cost function is linear. 2. Firms are price-takers, meaning that they are operating under conditions of perfect competition. Below is a graphical approach in analyzing the break-even condition of a firm considering the assumptions given: Cost, Revenue Revenue Cost Profit Break-Even Condition LOSS Output Figure 11. Break-Even ConditionMathematically, the Break-Even (BE) Output can be derived using the linear revenue and cost functions. Revenue Function: R = PQ where P is Price and Q is Output, and R is Revenue Cost Function: C = a + bQ. where a is Fixed Cost, b is Average Variable Cost (AVC), Q is Output, and C is Cost As a rule of thumb, BE is attained when R = C, and by substituting the function for R and C this yields: PQ = a + bQ (combine like terms) Q(b - P) = a (dividing both sides by b - P) Q = a / (b - P) where: Q is Break-Even Outout and (b - Plis the profit contribution Example: Suppose the Cost and Revenue of Firm C is given as follows: R = 50Q C = 20 + 100 Determine: a. BE Output b. Total Revenue at BE Output; C. Total Cost at BE Output; d. Profit Contribution; e . Profit at Q = 25 Solutions: BE Output: 50Q = 20 + 100 (Solve for Q) Q = 0.5 b. Total Revenue at BE Output R = 50Q R = 50(0.5) R = 25 c. Total Cost at BE Output C = 20 + 10Q C = 20 + 10(0.5) C = 25 d. Profit Contribution ne =b-P ne = 10 -50 nc = 40 e. Profit at Q = 25 n = R-C n = 50(25) - (20 + 10(25)) 1 = 1250 -270 II = 980