Chapter Four

1. Chapter Four Do you know where your costs are?

2. Cost Quotes “Costs are always higher than expected, even when they are expected to fall. They require scrupulous scrutiny and constant containment.” Theodore Levitt Thinking About Management

3. Cost Quotes “… the task of keeping costs from rising requires constant struggle, absorbing a great part of the energy of the manager. How easy it is for an inefficient manager to dissipate the differential on which profitability rests.” Frederich von Hayek The Use of Knowledge in Society

4. Production Function • In any production process the outputs produced require “resources” or “factors of production” or “inputs” • Outputs = f (Inputs) • Inputs are broadly classified in economics

5. Major Inputs and their Payments • Land (N) • Land is paid rents ( r ) • Labor (L) • Labor is paid wages (w) • Capital (K) • Capital is paid interest (i) • Entrepreneurship (E) • Entrepreneurship is paid profits (p)

6. Time and Production • Economists draw a distinction between the short run (SR) and the long run (LR) • The distinction is this: • In the short run at least one of the factors of production is fixed but in the long run no inputs are fixed (all inputs become variable.)

7. Short Run in Production • Output = f (L,K) • Focus on a simple production function employing capital (K) and labor (L) • Capital is the fixed input in the short run • Labor is the variable input in the short run • Once capital is in place, successive units of the variable input (L) are applied to the fixed capital plant (K)

8. First, costs fall as you increase output • Initially, the K plant is underutilized relative to the quantities of labor being applied to it • As successive unit of L are applied to the fixed K plant, the K plant is used more efficiently • This increased efficiency causes the per unit costs of production, average costs (SRAC) to fall

9. Second, costs reach their minimum • Through some range the plant is being used efficiently • As a result the per unit costs are at their lowest

10. Last, costs begin to rise • Finally, the per unit costs begin to rise again as the fixed K plant becomes over utilized

11. So what? • The fact that cost curves are U-shaped means that there is some range of production where your costs are lowest • Empirically almost all evidence points to either U-shaped or L-shaped cost curves • L-shaped still implies an efficient range of production

12. Costs in the Short Run • Again, the short run in production is defined as a time period in which at least one unit of production is fixed • SRAC curves are U-shaped due to the Law of Diminishing Marginal Returns (LDMR)

13. LDMR • Given a fixed K plant (i.e., we are in the short run,) initial applications of labor will increase productivity however, eventually the productivity of additional (marginal) applications of labor will fall as the K plant becomes over-utilized • From a technical perspective • Initially the K plant is underutilized, then there is some range of production where it is efficiently utilized and eventually it becomes over-utilized • This creates the well known and empirically consistent U-shaped SRATC curve

14. LDMR • Is a consistent aspect of dealing with an existing technology that yields a particular form of K plant • Is a technological consistency which impacts the shape of cost curves • Applies only to the short run • Technologies change • K plant can be changed in the LR

15. Costs in the Long Run • Long Run per unit cost curves are also U-shaped • Because all inputs are variable in the LR, it can’t be due to fixed K plant and LDMR • Introduce Economies of scale and scope

16. Economies of Scale • exist if the firm achieves per unit cost reductions as it increases production levels • leads to U-shaped cost curves in the short run Per Unit Costs SAC minimum per unit cost or minimum efficient scale Production Quantities

17. Economies of scale - declining per unit costsDiseconomies of scale - rising per unit costs Per Unit Costs Economies of Scale Diseconomies of Scale SAC Q increasing returns to scale constant returns to scale decreasing returns to scale

18. Economies of Scope • exist when a firm expands the variety or scope of its activities, e.g., • a lumber company sells chipped bark for lawn decoration • a finance company uses their financial data to produce marketing reports • a group of small firms shares a secretarial pool • a slaughter house invents hot dogs • and

19. Economies of Scope • the relative costs of producing a variety of goods and/or services in conjunction with each other is lower than the costs of producing the same set of goods and/or services in isolation of one another • Management Speak • “leveraging core competencies” • “competing on capabilities” • “mobilizing invisible assets”

20. Economies of Scope • mathematically • English • “producing these products together is cheaper than producing them separately”

21. Major sources of scope and scale economies • Spreading fixed costs and indivisibilities • Increasing variable input productivity • Inventories • Physical properties of production

22. Costs in the Long Run • Long run costs curves are U-shaped due to economies and diseconomies of scale • Economies of scale cause costs to fall • Diseconomies of scale cause costs to rise • The LRAC is a collection of overlapping SRAC curves

23. Costs in the Long Run • Think of the SRAC curve as the manager attempting to operate in a given plant at the lowest possible costs • Think of the LRAC curve as the manager attempting to search out the most efficient plant scale possible

24. Economies of Scale and Scope - Major Sources • Spreading fixed costs and indivisibilities • Increasing variable input productivity • Inventories • Physical properties of production

25. Spreading fixed costs and indivisibilities • fixed, up-front costs usually exist • these fixed, up-front costs are often difficult to divide • as these fixed costs are spread over larger production quantities the per unit production cost falls

26. Spreading fixed costs and indivisibilities • Suppose you have a hotdog stand • Before you produce one hot dog you have to buy the stand • This represents a large, fixed, upfront cost • On a per hotdog basis the cost of the first hot dog includes the entire cost of the stand! • As you produce more and more hotdogs, the price of the stand per hotdog falls (until you hit capacity and then the process begins anew.

27. Increasing variable input productivity • Economies of Scale through Specialization • Opportunities for specialization often exist in the production process • Specialization increases productivity • Increased productivity reduces per unit costs

28. Inventories • Inventories have clear costs but running out of stock does too • Balancing the costs of holding inventory with the costs of “stock out”

29. Inventories • Inventory costs drive up cost of goods sold -- but not equally • firms doing higher volumes of business can hold proportionately less inventories than can firms doing lower volumes of business.

30. Queuing Theory • As arrival rates at the main distribution warehouse increase, the distributor can carry smaller excess inventory in percentage terms to maintain a fixed rate of stock outages • arrival rates - the rate at which stock comes into the main warehouse • service rates - the rate at which stock leaves the warehouse

31. Queuing Theory - Implications • There are economies of scale in inventories held • Note - Inventories are still costly! • but, they are proportionally less costly for large scale distribution systems

32. Physical properties of production • Build a 10X10 block house • suppose that running block is $30 per linear foot • Costs = linear feet X $30 • Costs = 40 X $30 = $1200 • square footage is 10 X 10 = 100 sq. ft. • Cost per square foot is $1200/100 = $12 per square foot

33. Physical properties of production • Build a 20X20 block house • suppose that running block is $30 per linear foot • Costs = linear feet X $30 • Costs = 80 X $30 = $2400 • square footage is 20 X 20 = 400 sq. ft. • Cost per square foot is $2400/400 = $6 per square foot

34. The cube-square rule • the volume of a structure increases with the cube of its linear dimensions whereas its surface area increases with the square of its linear dimension

35. Implications of the cube-square rule • Vessels exhibit economies of scale • brewing • pharmaceuticals • super tankers • Pipelines exhibit economies of scale • Doubling the diameter of the pipeline more than doubles the flow capacity through it

36. Other sources of Economies of Scale and Scope • Purchasing Inputs • Marketing/Advertising • Research and Development

37. Purchasing Economies – Advantages • Bulk Purchases of inputs often available at lower prices • lower negotiation costs • lower packaging costs • lower distribution costs • lower information costs

38. Purchasing Economies – Advantages • Costs to service can be lower • Large production runs • Lower transactions costs, less contracting required • Increased price sensitivity among purchasers • “Big-ticket” price sensitivity

39. Marketing/Advertising AC = Cost of sending a message # of potential customers reached DIVIDED BY # of realized customers # of potential customers reached Numerator is the cost of sending messages per potential customer. Denominator is the proportion of potential customers who become actual costumers.

40. Marketing/Advertising • Ads may have large, up-front fixed costs to construct but low marginal costs to distribute • Campaign Costs • Negotiation with distributor of ads • Wide reach reduces AC

41. Marketing/Advertising • Advertising Reach and Costs • National Ads tend to be more cost effective • Firms with a national presence... • need not worry about consumers being unable to find their product • can reduce the number and cost of negotiations • may be able to exert monopsony pressure on the price of advertising

42. Research and Development • R&D is usually an upfront, fixed expense • R&D carries substantial risk and cost • Exhibit large economies of scope

43. R&D Costs - Pharmaceuticals • Pre-1962 estimated cost for the development of a new drug = $6.5 million • During the 1970s estimated cost for the development of a new drug = $140 million • 1991estimated cost for the development of a new drug = $200 million • In 1991, member firms of the Pharmaceutical Manufacturers Association spent $8.9 billion for R&D

44. Diseconomies of Scale • Bidding up input prices (labor) • Bureaucracy • Over-utilization of specialized resources

45. Table 4.1 – Graphic Version • The following slide uses the data in Table 4.1 of your text • NOTE: There is a misprint in the book. The 1,400 total costs figure associated with output quantity of 40 should be 1,600 rather than 1,400

47. Table 4.2 – Graphic Version • Here we look at the per unit costs of production

49. Table 4.3 – Graphic Version • Here we look at the per unit costs of production including the opportunity costs of the K plant • Maital refers to these as “Average Fully Allocated Costs”