Review of Economics Lecture 3 COSTS
COSTS TWO BASIC TYPES • Production costs • Organisation/co-ordination costs (Transaction costs)
Costs Keeping costs under control is vital for good business performance. Keeping costs down at the “state of the art” frontier is a tactical matter. Achieving lower costs than your competitors, on a sustainable basis, is a strategic matter (and much more difficult!)
Costs ‘Cost drivers’ are those factors that determine the level of costs a firm achieves. Four of these cost drivers are of particular importance: • Capacity utilisation: the intensity of utilisation of a firm’s resources. • Economies of scale. • Learning and/or experience effects. • Economies and/or diseconomies of scope.
PRODUCTION COSTS (A business unit level concept)
THE PRODUCTION FUNCTION Q = f (K, L) K = “capital”, L = labour
Production time periods • An input is fixed if it does not vary with the quantity of output. • An input is variable if the quantity employed varies with the firm’s output. e.g. a blast furnace; electricity consumption. Note: fixity is not primarily a physical property; it is a matter of contracts.
Two production time periods • The Short Run is that period during which at least one input is fixed. • The Long Run is that period during which all factors are considered to be variable. Aspects: • Think about the short run and the long run as different types of planning periods: • The long run: a hypothetical state in which decisions are not hemmed in by any input constraints. • Choices constrained in the short run by legacies of past choices: fixed inputs (and so fixed costs).
Production and costs in the short run How do production costs vary with the level of output? Two counteracting forces: • Spreading of fixed costs; • Diminishing returns at the margin. A set of cost measures for use in subsequent analysis: Let C = Total Cost and Q = Total Output Average Cost (AC) = C/Q Marginal Cost (MC) = C/Q
100 90 80 70 60 AVC, AFC 50 40 30 20 10 0 0 5 10 15 20 25 30 35 40 OUTPUT, Q AFC and AVC in relation to output Q AFC AVC
60 50 40 AC & MC 30 20 10 0 0 50 100 150 200 250 OUTPUT, Q AC and MC in relation to output Q MC AC
Costs in the long run In the long run, nothing is “fixed”. This is a planning period rather than real time. The firm is in a position where it can make strategic choices about • its scale of output rate; • the length of its production run over time; • its output mix (its scope of output); • the locations of its production units.
Production and costs in the long run But even though no input is fixed, there are two types of costs that are special in some sense: • Costs that have some minimum, irreducible magnitude due to indivisibilities (2) Overheads: costs incurred whatever the scale of output Overhead are of particular interest because: (a) They may be spread over a range of products (b) The resources that generate these costs may have the property of public goods: can be used without being depleted
Economies of Scale A fall in the average (unit) cost as the scale of production is increased. Two types: (a) Technical (b) Financial The latter arises from: • Indivisibilities • Overhead spreading • Financial muscle/bargaining power • Marketing advantages
CUMULATIVE SCALE ECONOMIES An ex-post fall in average costs when bringing initial development costs into consideration. e.g. The development of a jet aircraft
200 x Index of unit cost (1970=100) x x 150 x x x 100 x 1940 x2 x4 Cumulative volume of refinery runs US refining cost (for refinery of given capacity and complexity, 1940 - 1973)
10 $ 000 1909 1915 1912 85% slope 1918 1923 1 10000 100000 1000000 10000000 Price of model T, 1909 - 1923 (average list price in 1958 dollars) 0.1 The experience effect at Ford
Other production cost advantages LEARNING OR EXPERIENCE EFFECTS Time-based competition First-mover advantages Electronics, Sony
Organisational costs These apply at the corporate level of the firm
The nature and structure of firms Why do firms exist? What determines their boundaries? Two extreme forms of arranging production: • pure market exchange • hierarchy/ administrative decision (firms) These are two extreme points on a spectrum of possibilities. What we see is usually something between these two extremes. The existence of firms depends on firms having cost advantages over market-based exchange.
Costs and market transactions The process of exchange involves “transactions costs”: Think of buying a house; hiring the services of an advertising agency; arranging the supply of complex components; contracting to have a house built. Costs involved in using markets: • The costs involved in searching for information about prices and suppliers. • The costs involved in negotiating, drawing up, monitoring, renegotiating and enforcing contracts.
What factors give rise to transactional costs? • Opportunism • Bounded rationality • Asset-specificity • Asymmetric information • 1. Hidden information. • 2. Hidden actions. • Team production
Costs and firms • Implications: • Firms develop whenever the costs of transactions through markets exceed the costs of organising and coordinating production within firms. • Their boundaries and structures depend on these relative costs and their changes over time. • We shall see later how this affects: • Horizontal integration • Vertical integration • Diversification/conglomeration • Networks/cooperation • Supply chain relationships • Examples: • Telephone call centres. • UK insurance industry. • UK car industry.
Costs and firms Economic activity within firms also involves costs We may call these organisation costs They are the costs of establishing and operating the organisational hierarchy But, a firm may be able to deal with the problems we mentioned earlier more effectively than can be done through pure market contracting
ECONOMIES OF SCOPE Many firms produce a variety of goods, which suggests that this may bring cost advantages. An Economy of Scope: • Where cost complementarity occurs in the production of two or more goods. • Where a number of related goods are produced using a common process or input e.g. R&D, Reputation, Distribution.
Task 3 THE ORGANISATION AND ITS COSTS . • Select an organisation about which you know something. What, if any, are the major sources in your organisation of: economies of scale diseconomies of scale economies of scope? • Are there other economies of scope you think that could be exploited by your organisation? • Explain how the boundary of the organisation (horizontal and vertical integration, diversification, relationships with suppliers etc.) has been affected, or might be affected in the future, by the relative costs of doing business within the firm and through market exchange