[Title will be auto-generated] by Drew Grime

Chapter 6 The Theory and Estimation of Production

The Theory and Estimation of Production The Production Function Short-Run Analysis of Total, Average, and Marginal Product Long-Run Production Function Estimation of Production Functions Importance of Production Functions in Managerial Decision Making

Learning Objectives  Define production function and explain difference between short-run and long-run production function  Explain “law of diminishing returns” and how it relates to the Three Stages of Production  Define the Three Stages of Production and explain why a rational firm always tries to operate in Stage II

Learning Objectives  Provide examples of types of inputs that might go into a production function for a manufacturing or service company  Describe various forms of a production function that are used in statistical estimation of these functions  Briefly describe the Cobb-Douglas function and cite a few statistical studies that used this particular functional form in their analysis

The Production Function  Production function: defines the relationship between inputs and the maximum amount that can be produced within a given period of time with a given level of technology.  Mathematically, the production function can be expressed as Q=f(X1, X2, ..., Xk)  Q: level of output  X1, X2, ..., Xk: inputs used in the production process

The Production Function Key assumptions  Some given “state of the art” in the production technology.  Whatever input or input combinations are included in a particular function, the output resulting from their utilization is at the maximum level.

The Production Function For simplicity we will often consider a production function of two inputs: Q=f(X, Y) Q: output X: Labor Y: Capital

The Production Function  The short-run production function shows the maximum quantity of good or service that can be produced by a set of inputs, assuming the amount of at least one of the inputs used remains unchanged.  The long-run production function shows the maximum quantity of good or service that can be produced by a set of inputs, assuming the firm is free to vary the amount of all the inputs being used.

Short-Run and Long-Run Production In the short run some inputs are fixed and some variable  e.g. the firm may be able to vary the amount of labor, but cannot change the amount of capital  in the short run we can talk about factor productivity

Short-Run and Long-Run Production In the long run all inputs become variable  e.g. the long run is the period in which a firm can adjust all inputs to changed conditions  in the long run we can talk about returns to scale (compare latter with economies of scale, which is a cost related concept)

Short-Run Changes in Production (Factor Productivity) Units of K Employed 8 7 6 5 4 3 2 1

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

Output Quantity (Q) 83 96 107 117 127 78 90 101 110 119 64 73 82 90 97 58 67 75 82 89 52 60 67 73 79 41 52 58 64 69 29 39 47 52 56 14 20 27 24 21 3 4 5 6 7 Units of L Employed

How much does the quantity of Q change, when the quantity of L is increased?

128 120 104 95 85 73 52 17 8

Short-Run Analysis of Total, Average, and Marginal Product  Alternative terms in reference to inputs  Inputs  Factors  Factors of production  Resources

 Alternative terms in reference to outputs  Output  Quantity (Q)  Total product (TP)  Product

Short-Run Analysis of Total, Average, and Marginal Product Marginal product (MP): change in output (or Total Product) resulting from a unit change in a variable input. ∆Q MPX = ∆X

Average Product (AP): Total Product per unit of input used. Q APX = X

Short-Run Analysis of Total, Average, and Marginal Product  If MP > AP then AP is rising.  If MP < AP then AP is falling.  MP=AP when AP is maximized.

Short-Run Analysis of Total, Average, and Marginal Product Units of Output 196 184 161

Total Product ∆Q from hiring fourth worker

130

∆Q from hiring third worker 90 ∆Q from hiring second worker 30

∆Q from hiring first worker 1

increasing marginal returns

diminishing marginal returns

Number of Workers

Short-Run Analysis of Total, Average, and Marginal Product  Law of Diminishing Returns: As additional units of a variable input are combined with a fixed input, at some point the additional output (i.e., marginal product) starts to diminish.  Nothing says when diminishing returns will start to take effect, only that it will happen at some point.  All inputs added to the production process are exactly the same in individual productivity

Short-Run Analysis of Total, Average, and Marginal Product The Three Stages of Production in the Short Run  Stage I: From zero units of the variable input to where AP is maximized (where MP=AP)  Stage II: From the maximum AP to where MP=0  Stage III: From where MP=0 on

Short-Run Analysis of Total, Average, and Marginal Product AP,MP

Stage I

Stage II

Stage III

APX Fixed input grossly underutilized; specialization and teamwork cause AP to increase when additional X is used

Specialization and teamwork continue to result in greater output when additional X is used; fixed input being properly utilized

MPX Fixed input capacity is reached; additional X causes output to fall

Short-Run Analysis of Total, Average, and Marginal Product  In the short run, rational firms should only be operating in Stage II.  Why not Stage III?  Firm uses more variable inputs to produce less output

 Why not Stage I?  Underutilizing fixed capacity  Can increase output per unit by increasing the amount of the variable input

Short-Run Analysis of Total, Average, and Marginal Product What level of input usage within Stage II is best for the firm? The answer depends upon how many units of output the firm can sell, the price of the product, and the monetary costs of employing the variable input.

Short-Run Analysis of Total, Average, and Marginal Product  Total Revenue Product (TRP): market value of the firm’s output, computed by multiplying the total product by the market price.  TRP = Q · P

 Marginal Revenue Product (MRP): change in the firm’s TRP resulting from a unit change in the number of inputs used. TRP  MRP = =∆MP ·P ∆X

Short-Run Analysis of Total, Average, and Marginal Product  Total Labor Cost (TLC): total cost of using the variable input, labor, computed by multiplying the wage rate by the number of variable inputs employed.  TLC = w · X

 Marginal Labor Cost (MLC): change in total labor cost resulting from a unit change in the number of variable inputs used. Because the wage rate is assumed to be constant regardless of the number of inputs used, MLC is the same as the wage rate (w).

Short-Run Analysis of Total, Average, and Marginal Product  Summary of relationship between demand for output and demand for input  A profit-maximizing firm operating in perfectly competitive output and input markets will be using the optimal amount of an input at the point at which the monetary value of the input’s marginal product is equal to the additional cost of using that input.  MRP = MLC

Example 1

Note: P = Product Price = $2 W = Cost per unit of labor = $10000 TRP = TP x P, MRP = MP x P TLC = X x W MLC = ∆TLC / ∆X

Table 7.6 Combining Marginal Revenue Product (MRP) with Marginal Labor Cost (MLC) Total Marginal Total Marginal Labor Total Average Marginal Revenue Revenue Labor Labor Unit Product Product Product Product Product Cost Cost (X) (Q or TP) (AP) (MP) (TRP) (MRP) (TLC) (MLC) TRP-TLC MRP-MLC 0 0 0 0 0 0 0 1 10000 10000 10000 20000 20000 10000 10000 10000 10000 2 25000 12500 15000 50000 30000 20000 10000 30000 20000 3 45000 15000 20000 90000 40000 30000 10000 60000 30000 4 60000 15000 15000 120000 30000 40000 10000 80000 20000 5 70000 14000 10000 140000 20000 50000 10000 90000 10000 6 75000 12500 5000 150000 10000 60000 10000 90000 0 7 78000 11143 3000 156000 6000 70000 10000 86000 -4000 8 80000 10000 2000 160000 4000 80000 10000 80000 -6000

Short-Run Analysis of Total, Average, and Marginal Product  Multiple variable inputs  Consider the relationship between the ratio of the marginal product of one input and its cost to the ratio of the marginal product of the other input(s) and their cost.

MP1 MP2 MPk = = w1 w2 wk e.g., country 1 w=$2 MP(L)=2 country 2 w=$4 MP(L)=6 Then, where to produce a product?  Other factors may outweigh this relationship Political/Economic risk factors`

The Long-Run Production Function In the long run, a firm has enough time to change the amount of all its inputs.  Effectively, all inputs are variable.

The long run production process is described by the concept of returns to scale.

The Long-Run Production Function If all inputs into the production process are doubled, three things can happen:  output can more than double increasing returns to scale (IRTS)

 output can exactly double constant returns to scale (CRTS)

 output can less than double decreasing returns to scale (DRTS)

The Long-Run Production Function  One way to measure returns to scale is to use a coefficient of output elasticity:

Percentage change in Q EQ = Percentage change in all inputs  If EQ > 1 then IRTS  If EQ = 1 then CRTS  If EQ < 1 then DRTS

The Long-Run Production Function Returns to scale can also be described using the following equation hQ = f(kX, kY) If h > k then IRTS If h = k then CRTS If h < k then DRTS

Long-Run Changes in Production (Returns to Scale) Units of K Employed 8 7 6 5 4 3 2 1

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

Output Quantity (Q) 83 96 107 117 127 78 90 101 110 119 64 73 82 90 97 58 67 75 82 89 52 60 67 73 79 41 52 58 64 69 29 39 47 52 56 14 20 27 24 21 3 4 5 6 7 Units of L Employed

128 120 104 95 85 73 52 17 8

How much does the quantity of Q change, when the quantity of both L and K is increased?

The Long-Run Production Function Graphically, the returns to scale concept can be illustrated using the following graphs.

IRTS

X,Y

DRTS

CRTS

X,Y

Estimation of Production Functions  Forms of Production Functions  Short run: existence of a fixed factor to which is added a variable factor One variable, one fixed factor Q = f(L)K  Increasing marginal returns followed by decreasing marginal returns Cubic function Q = a + bL + cL2 – dL3  Diminishing marginal returns, but no Stage I Quadratic function Q = a + bL - cL2

Estimation of Production Functions Forms of Production Functions  Power function Q = aLb If b > 1, MP increasing If b = 1, MP constant If b < 1, MP decreasing Can be transformed into a linear equation when expressed in logarithmic terms  logQ = loga + bLogL

Estimation of Production Functions  Forms of Production Functions  Cobb-Douglas Production Function: Q = aLbKc Both capital and labor inputs must exist for Q to be a positive number Can be increasing, decreasing, or constant returns to scale  b + c > 1, IRTS  b + c = 1, CRTS  b + c < 1, DRTS

Permits us to investigate MP for any factor while holding all others constant Elasticities of factors are equal to their exponents

Estimation of Production Functions  Forms of Production Functions  Cobb-Douglas Production Function Can be estimated by linear regression analysis Can accommodate any number of independent variables Does not require that technology be held constant Shortcomings:  Cannot show MP going through all three stages in one specification  Cannot show a firm or industry passing through increasing, constant, and decreasing returns to scale  Specification of data to be used in empirical estimates`

Estimation of Production Functions Statistical Estimation of Production Functions  Inputs should be measured as “flow” rather than “stock” variables, which is not always possible.  Usually, the most important input is labor.  Most difficult input variable is capital.  Must choose between time series and crosssectional analysis.

Estimation of Production Functions  Aggregate Production Functions  Many studies using Cobb-Douglas did not deal with individual firms, rather with aggregations of industries or an economy.  Gathering data for aggregate functions can be difficult. For an economy: GDP could be used For an industry: data from Census of Manufactures or production index from Federal Reserve Board For labor: data from Bureau of Labor Statistics

Importance of Production Functions in Managerial Decision Making  Production levels do not depend on how much a company wants to produce, but on how much its customers want to buy.  Capacity Planning: planning the amount of fixed inputs that will be used along with the variable inputs. Good capacity planning requires:  Accurate forecasts of demand  Effective communication between the production and marketing functions

How to determine optimal combination of inputs in the long-run • To illustrate this case, use “production isoquants” An isoquant is a curve showing all possible combinations of inputs physically capable of producing a given fixed level of output

Example 2 Production Table Units K Units of of K Employed Employed 8 7 6 5 4 3 2 1

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

Output Quantity (Q) Isoquant 83 96 107 117 127 128 78 90 101 110 119 120 64 73 82 90 97 104 58 67 75 82 89 95 52 60 67 73 79 85 41 52 58 64 69 73 29 39 47 52 56 52 14 20 27 24 21 17 3 4 5 6 7 8 Units of of K L Employed

An Isoquant Curve Graph of Isoquant Y

7 6

Q=52

5 4 3 2 1 0 1

Substituting Inputs There exists some degree of substitutability between inputs. Different degrees of substitution: Natural flavoring

Capital

Sugar a) Perfect substitution

All other ingredients b) Perfect complementarity

K1 K2 K3 K4

Corn syrup

L 1 L2

Labor

c) Imperfect substitution

Substituting Inputs (continued) In case the two inputs are imperfectly substitutable, the optimal combination of inputs depends on the degree of substitutability and on the relative prices of the inputs

Substituting Inputs (continued) • The degree of imperfection in substitutability is measured with marginal rate of technical substitution (MRTS): MRTS = ∆Y/∆X (in this MRTS some of L is removed from the production and substituted by K to maintain the same level of output)

Law of Diminishing Marginal Rate of Technical Substitution: Table Input Combinations for Isoquant Q = 52 Combination Y X A 6 2 B 4 3 C 3 4 D 2 6 E 2 8

∆ Y ∆ X MRTS 2 1 2 1 1 1 1 2 1/2 0 2

Law of Diminishing Marginal Rate of Technical Substitution (continued) Y 7

6 5

∆Y =- 2

∆X = 1 ∆Y = -1

∆X = 1

∆Y = -1

∆X = 2

1 0 2

MRTS = ∆Y/∆X = MPX /MPY Units of Y Employed 8 7 6 5 4 3 2 1

37 42 37 31 24 17 8 4 1

60 64 52 47 39 29 18 8 2

Output Quantity (Q) 83 96 107 117 127 78 90 101 110 119 64 73 82 90 97 58 67 75 82 89 52 60 67 73 79 41 52 58 64 69 29 39 47 52 56 14 20 27 24 21 3 4 5 6 7 Units of of K X Employed

128 120 104 95 85 73 52 17 8

MRTS = ∆Y/∆X = MPX /MPY MPX / MPY in Relation to MRTS (X for Y) Combination Q A 52 B 52 C 52 D 52

Y MPx X Mpy MRTS (L for K) MPL / MPK 6 2 4 13 3 6.5 2 2 3 11 4 11 1 1 2 6.5 6 13 1/2 1/2

Importance of production functions in managerial decision making • Example: cell phones • Asian consumers want new phone every 6 months • demand for 3G products • Nokia, Samsung, SonyEricsson must be speedy and flexible (lean manufacturing)

Importance of production functions in managerial decision making • Example: Zara • Spanish fashion retailer • factories located close to stores • quick response time to suggestion in 2-4 weeks (competitors’ responding time in 4 to 12 months)

Importance of production functions in managerial decision making • Application: call centers • service activity • production function is Q = f(X,Y) where Q = number of calls X = variable inputs Y = fixed input

Importance of production functions in managerial decision making • Application: China’s workers • is China running out of workers? • industrial boom • e.g., bicycle factory in Guangdong Province

Chapter 7 The Theory and Estimation Of Cost

The Theory and Estimation of Cost  The Importance of Cost in Managerial Decisions  The Definition and Use of Cost in Economic Analysis  The Relationship Between Production and Cost  The Short Run Cost Function  The Long Run Cost Function  The Learning Curve  Economies of Scope  Economies of Scale: the Short Run Versus the Long Run  Supply Chain Management  Ways Companies Have Cut Costs to Remain Competitive

Learning Objectives  Define the cost function and explain the difference between a short-run and a long-run cost function.  Explain the linkages between the production function and the cost function.  Distinguish between economic cost and accounting cost.  Explain how the concept of relevant cost is used in the economic analysis of cost.  Define short-run total cost, short-run variable cost, and total fixed cost and explain their relationship to each other.

Learning Objectives  Define average cost, average variable cost, and average fixed cost and explain their relationship to each other in the short run. Do the same for average cost and average variable cost in the long run.  Compare and contrast the short-run cost function and the long-run cost function and explain why economies of scale is considered to be a long-run phenomenon.  Provide at least four reasons for the existence of economies of scale.

The Importance of Cost in Managerial Decisions Ways to contain or cut costs over the past decade  Most common: reduce number of people on the payroll  Outsourcing components of the business  Merge, consolidate, then reduce headcount

The 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. vs. Replacement cost  Opportunity cost: amount or subjective value that is forgone in choosing one activity over the next best alternative. vs. Out-of-pocket cost  Incremental cost: varies with the range of options available in the decision.  Sunk cost: does not vary in accordance with decision alternatives.

Cost as an Opportunity Cost • A firm’s cost of production includes all the opportunity costs of making its output of goods and services. • Explicit and Implicit Costs – A firm’s cost of production include explicit costs and implicit costs. • Explicit costs are input costs that require a direct outlay of money by the firm. • Implicit costs are input costs that do not require an outlay of money by the firm.

Cost as an Opportunity Cost • Example: • Helen uses $300 000 of her savings to buy her cookie factory from the previous owner. • If she had left her money in a savings account that pays an interest at a rate of 5 percent, she would have earned $15 000 a year. • Helen by buying a cookie factory has foregone $15 000 a year in interest income. • This foregone $15 000 is an implicit opportunity cost of Helen’s business. • The accountant will not show this cost.

Economic Profit versus Accounting Profit • Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. • Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

Economic Profit Versus Accounting Profit • When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. – Economic profit is smaller than accounting profit.

Economists versus Accountants

How an Economist Views a Firm

Economic profit

How an Accountant Views a Firm Accounting profit

Revenue

Implicit costs

Revenue Total Opportunity Costs

Explicit costs

The Relationship Between Production and Cost  Cost function is simply the production function expressed in monetary rather than physical units.  All assumptions used in the short-run production function applied to the short-run cost function  Costs are determined by the production technology and input prices.  Assume the firm is a “price taker” in the input market (only additional assumption needed to the cost function.

The Relationship Between Production and Cost  Total Variable Cost (TVC): the cost associated with the variable input, determined by multiplying the number of units by the unit price.  Marginal Cost (MC): the rate of change in total variable cost. ∆TVC W MC = = ∆Q that MP MC will  The law of diminishing returns implies eventually increase

Relationship Between Production and Cost • Total variable cost (TVC) is associated with the variable input

Total Input TVC (L) Q (TP) MP (wL) 0 0 0 – Assume w=$500 per unit 1 1,000 1,000 500 (price-taker) 2 3,000 2,000 1,000 3 6,000 3,000 1,500 4 8,000 2,000 2,000 5 9,000 1,000 2,500 6 9,500 500 3,000 7 9,850 350 3,500 8 10,000 150 4,000 9 9,850 -150 4,500

The 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.

Relationship Between Production and Cost Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC.  TC=TFC+TVC Marginal Costs Average Costs

Relationship Between Production and Cost Marginal cost (MC) is the change in total cost associated a change in output. ∆TC MC = ∆Q ∆TC ∆(TFC + TVC ) ∆TFC ∆TVC ∆TVC MC = = = + = 0+ ∆Q ∆Q ∆Q ∆Q ∆Q

Relationship Between Production and Cost • Observe that:

Total TVC – When MP is increasing, Input (L) Q MP (wL) MC is decreasing. 0 0 0 – When MP is decreasing, 1 1,000 1,000 500 MC is increasing. 2 3,000 2,000 1,000 3 6,000 3,000 1,500 4 8,000 2,000 2,000 5 9,000 1,000 2,500 6 9,500 500 3,000 7 9,850 350 3,500 8 10,000 150 4,000 9 9,850 -150 4,500

MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

Relationship Between Production and Cost The relationship between MP and MC is ∆TVC w • ∆L ∆L 1 w MC = = = w• = w• = ∆Q ∆Q ∆Q MP MP

Law of diminishing returns implies that MC will eventually increase!

The Short Run Cost Function Average total cost (ATC) is the average per-unit cost of using all of the firm’s inputs (TC/Q)

 Average variable cost (AVC) is the average per-unit cost of using the firm’s variable inputs (TVC/Q)

 Average fixed cost (AFC) is the average perunit cost of using the firm’s fixed inputs (TFC/Q)

The Short Run Cost Function ATC = AFC + AVC

The Short Run Cost Function Production cost graph or map is

The Short Run Cost Function Important Map Observations  AFC declines steadily over the range of production. Why?  In general, AC is u-shaped. Why?  MC intersects the minimum point on AC. Why?

The Short-Run Cost Function Important Observations  AFC declines steadily over the range of production.  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.

The 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.

The Short-Run Cost Function  For simplicity the following assumptions are made:  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 uses the inputs to produce a single product.  The firm operates with 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” in the input markets.  The short-run production function is affected by the law of diminishing returns.

The Short-Run Cost Function  Standard variables in the short-run cost function:  Quantity (Q): the amount of output that a firm can produce in the short run.  Total fixed cost (TFC): the total cost of using the fixed input, capital (K)  Total variable cost (TVC): the total cost of using the variable input, labor (L)  Total cost (TC): the total cost of using all the firm’s inputs, L and K. TC = TFC + TVC

The Short-Run Cost Function  Alternative specifications of the Total Cost function  Most commonly: specified as a cubic relationship between total cost and output As output increases, total cost first increases at a decreasing rate, then increases at an increasing rate.  Quadratic relationship As output increases, total cost increases at an increasing rate.  Linear relationship As output increases, total cost increases at a constant rate.

The Short-Run Cost Function • Example – TC=100+60Q-5Q2+0.7Q3 • TFC=? 100 • AFC=? TFC/Q=100/Q • AC=? TC/Q=100/Q+60-5Q+0.7Q2 • AVC=? TVC/Q=60-5Q+0.7Q2 • MC=? dTC/dQ=60-10Q+2.1Q2

The 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.  First, increasing returns to scale.  As firms mature, they achieve constant returns, then ultimately decreasing returns to scale.

The LR Relationship Between Production and Cost  In the long run, all inputs are variable.  What makes up LRAC?

The 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.

The 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.

The Long-Run Cost Function  Reasons for long-run economies  Specialization in the use of labor and capital.  Prices of inputs may fall as the firm realizes volume discounts in its 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 than smaller firms.  Larger firms may be able to spread out promotional costs.

The 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. Handling expenses, insurance, security, and inventory costs affect transportation costs.

The 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.

The Long-Run Cost Function Dollars ATC1

$4.00

ATC0

LRATC

ATC3

ATC2

3.00

2.00

B A

D E

1.00

30 Use 0 automated lines

130

161 184 175 196

Use 1 automated lines 90

250

Use 2 automated lines

300

Use 3 automated lines

Units of Output

The 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.  Measured in terms of percentage decrease in additional labor cost as output doubles.  The Learning Curve effect shifts the SRAC curve down Yx = Kxn

 Yx = Units of factor or cost to produce the xth unit  K = Factor units or cost to produce the Kth (usually first) unit  x = Product unit (the xth unit)  n = log S/log 2  S = Slope parameter

Sources of Learning • The experience of the workforce tends to increase with cumulative output—thus workers are more familiar with the production process and have their movements/activities become routinized or a matter of habit. • There are usually several ways to do a task, and it takes time and experimentation to find the best way. • Quality control for inputs and outputs needs time to identify potential problem areas. • Input suppliers have their owning learning process

The Learning Curve • Measures the percentage decrease in additional labor cost each time output doubles. – An “80 percent” learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.

Economies of Scope  If a single firm can jointly produce goods X and Y more cheaply that any combination of firms could produce them separately, then the production of X and Y is characterized by economies of scope Closely related to economies of scale.

Real world examples • Economies of scope between cable TV and high speed internet service. • Production of timber and particle board. • Corn and ethanol production • Production of beef and hides. • Power generation and distribution • Joint cargo and passenger transportation in airlines reduces excess capacity. • Global wholesale distribution of cheese, salad dressing, and cigarettes (example: Phillip-Morris-Kraft). • Computer aided design of (CAD) of aircraft components.

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

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.  The main goal: to increase its profit by cost reduction  Includes all internal and external activities required to fulfill a customer’s demand.  Transaction costs are incurred by using resources outside the firm.  Coordination costs arise because of uncertainty and complexity of tasks.  Information costs arise because information is essential to the proper coordination of activities between the firm and its suppliers.

Supply Chain Management

Raw Materials purchases from Supplier (procurement)

Manufacturing /Production Efficiencies

Transportation efficiencies

Distribution And Warehouse efficiencies

Retail Distribution Efficiencies And need forecasting

Customer order fulfillment and satisfaction

Ways Companies Have Cut Costs to Remain Competitive  The Strategic Use of Cost – cost leadership as the core of its strategy e.g., Wal-Mart and Southwest Airlines (low cost provider);Southwest Airlines cost reduction by (1)payroll (hiring nonunion personnel), (2) food service, and (3) depreciation (old model airplanes)  Reduction in Cost of Materials – material substitution or modification (e.g., deer park bottled water container saving material and protecting the environment )  Using Information Technology to Reduce Costs – e.g., using IT to reduce costs with ERP (enterprise resource planning)  ERP: software that enables companies to integrate their planning, scheduling, synchronization, and tacking of the entire chain of production process  SAP, a German company is an this industry leader

Ways Companies Have Cut Costs to Remain Competitive • Reduction of Process Costs – e.g., employees using software packages to file traveling and expense reports electronically • Relocation to Lower-Wage Countries or Regions • Mergers, Consolidation, and Subsequent Downsizing • Layoffs and Plant Closings (downsizing or restructuring) • Reduction in Fixed Assets – e.g., property, plant, equipment, intellectual property, and etc.

Global application • Example: manufacturing chemicals in China • labor content relatively low (capital intensive industry) • high use of equipment and raw materials • noncost reasons for outsourcing (production over company’s capacity, lack of necessary expertise, regulatory permits required, and etc.,)

Chapter 8 Pricing and Output Decisions: Perfect Competition and Monopoly

Pricing and Output Decisions: Perfect Competition and Monopoly  Competition and Market Types in Economic Analysis  Pricing and Output Decisions in Perfect Competition  Pricing and Output Decisions in Monopoly Markets  The Implications of Perfect Competition and Monopoly for Managerial Decision Making

Learning Objectives  Describe the key characteristics of the four basic market types used in economic analysis.  Compare and contrast the degree of price competition among the four market types.  Provide specific actual examples of the four types of markets.  Explain why the P=MC rule leads firms to the optimal level of production.

Learning Objectives  Describe what happens in the long run in markets where firms that are either incurring economic losses or are making economic profits. Explain why this happens with particular attention to the key assumptions used in this analysis.  Explain how and why the MR=MC rule helps a monopoly to determine the optimal level of price and output.  Explain the relationship between the MR=MC rule and the P=MC rule.

Socially Optimal Resource Allocation

To say that the scheme of resource allocation is “socially optimal” means that a re-allocation of resources could not make any one person better off without making at least one other person worse off.

Socially Optimal Resource Allocation We can trust market forces to allocate resources in a socially optimal way—that is, if markets are “competitive” in structure. If markets are “imperfectly” competitive in structure, then all bets are off.

Four Basic Market Types • How do firms establish their prices and output levels in order to achieve their business objective of profit maximizing? – The pricing and output decisions normally made within the frame work of four basic types of markets

Four Basic Market Types  Perfect Competition (no market power)  Large number of relatively small buyers and sellers  Standardized product (no differentiation of products)  Very easy market entry and exit  Nonprice competition not possible (e.g., marketing)

 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

Four Basic Market Types  Monopolistic Competition (market power based on product differentiation)  Large number of relatively small firms acting independently  Differentiated product  Market entry and exit relatively easy  Nonprice competition very important

 Oligopoly (market power based on product differentiation and/or the firm’s dominance of the market)  Small number of relatively large firms that are mutually interdependent  Differentiated or standardized product  Market entry and exit difficult  Nonprice competition very important among firms selling differentiated products

Four market types • Examples: perfect competition – agricultural products (e.g., corn, wheat , coffee, pork bellies) – financial instruments (e.g., stock, bonds, foreign exchange) – precious metals (e.g., gold, silver, platinum) – Petroleum (exception, OPEC (cartel))

Four market types • Examples: monopoly – Pharmaceuticals (temporary monopoly protected by patent) – Microsoft (pc operating system) – gas station on edge of desert (particular surrounding) – only one in the region

Four market types • Examples: monopolistic competition – boutiques – restaurants – repair shops

Four market types • Examples: oligopoly – oil refining – tobacco – airlines – internet access

Four Basic Market Types by Characteristics Affecting the Degree of Competition

Competition And Market Types of Economic Analysis •

•

In economic analysis, the most important indicator of the degree of competition: the ability of firms to control the price and use it as a competitive weapon A second key measure of competition: the ability of firms to earn an above normal or economic profit in the long run – Market entry and exit most directly affecting the ability of firms to earn economic profit A secondary role in determining the degree of competition – Nonprice competition – product differentiation through advertisement, promotion, new product development, introduction of new features in the current products, and customer service – The extend to which buyer and seller have information about the price of the product and the product itself (quality, reliability, and integrity)

Pricing and Output Decisions in Perfect Competition  The Basic Business Decision: firms considering to enter into a perfectly competitive market on the basis of 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?

Pricing and Output Decisions in Perfect Competition • Although the market price does not vary with an individual firm’s level of output, the unit cost (AC) of production most certainly does in a perfectly competitive market. – why? • Once a law of diminishing returns sets in, then an extra cost per unit will exceed the selling price of the product

Pricing and Output Decisions in Perfect Competition  Key assumptions of the perfectly competitive market  The firm operates in a perfectly competitive market and therefore 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 in the short run. If it cannot earn a profit, then it seeks to minimize its loss.  The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.

Pricing and Output Decisions in Perfect Competition • Suppose the manager of a “stop and shop” convenience store manager wants to own and operate a store of her own. She will have to leave a job and use her savings to own and operate her own shop. – Her current salary: $45,000 – Her savings (yielding 10% return): $50,000

A statement of the projected cost of

operating in the first year Cost of goods sold $300,000 General and administrative expenses $150,000 Total accounting costs $450,000 Forgone Salary $45,000 Forgone returns (10% yield) $5,000 Total opportunity costs $50,000 Total economic cost $500,000

Normal Profit, Economic Profit, and Economic Profit Normal Profit

Economic Profit

Economic Loss

Revenue

$500,000

$550,000

$480,000

Accounting Cost

-$450,000

Opportunity Cost

-$50,000

$50,000

-$20,000

Note: Accounting Profit

Accounting profit of

for $50,000 equals the

$100,000 exceeds the

$30,000 is less than

opportunity cost of

opportunity cost

the opportunity cost

$50,000

of $50,000.

of $50,000

Profit

Pricing and Output Decisions in Perfect Competition • •

•

As a price taker, the firm facing a perfectly elastic demand curve 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.

Pricing and Output Decisions in Perfect Competition 1. The intersection of the market supply and the market demand curve…

Price per Ounce

Market

3. The typical firm can sell all it wants at the market price…

Price per Ounce

Firm

$400

Demand Curve Facing the Firm

Ounces of Gold per Day 2. determine the equilibrium market price

Ounces of Gold per Day 4. so it faces a horizontal demand curve

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.  Marginal Revenue – Marginal Cost Approach  A firm that wants to maximize its profit (or minimize its loss) should 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. In short, MR=MC.  For the perfectly competitive firm, the MR=MC rule may be restated as P=MC.  This is because P=MR in perfectly competitive markets.

Selecting the Optimal Output Level 1. TR – TC Approach

Selecting the Optimal Output Level 1. TR – TC Approach  Graphically, find the output level that maximizes the distance between the total revenue curve and the total cost curve.

Selecting the Optimal Output Level 2. MR – MC Approach

Selecting the Optimal Output Level 2. MR – MC Approach • The optimal level of output level determined at MR=MC – A firm that wants to maximize it profit (or minimize its loss) should produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing the unit.

Pricing and Output Decisions in Perfect Competition • The point where P=MR=MC is the optimal output (Q*) • Profit = TR – TC =(P - AC) · Q* • The firm: one of many price taking sellers in the market, so the market can be beneficial, neutral, and malignant

Pricing and Output Decisions in Perfect Competition • The firm incurs a loss. At the optimum output level price is below average cost. • However, since price is greater than average variable cost, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss.

Pricing and Output Decisions in Perfect Competition • Contribution Margin (CM): the amount by which total revenue exceeds total variable cost. • CM = TR – TVC • If the contribution margin is positive, the firm should continue to produce in the short run in order to defray some of the fixed cost.

Economic Profit, Normal Profit, Loss, and Shutdown What are the firm’s profits in the graph at the right?  Normal Profits  TR = TC

Economic Profit, Normal Profit, Loss, and Shutdown  Should the firm always operate at a loss in the short run?  If the price falls to $50 then how much output should the firm produce?  Why?

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. This is where selling at the price results in zero contribution margin.  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.

Perfect Competition Individual Demand Curve

Quantity Demanded at Different Prices

Quantity Supplied at Different Prices

Added together Market Demand Curve

Individual Supply Curve

Added together

Quantity Demanded by All Consumers at Different Prices

Quantity Supplied by All Firms at Different Prices

Market Supply Curve

Market Equilibrium P

Quantity Demanded by Each Consumer

S D Q

Quantity Supplied by Each Firm

Short-Run Equilibrium in Perfect Competition 2. the typical firm operates here, earning economic profit in the short run.

1. When the demand curve is D1 and market equilibrium is here . . .

Price per Bushel

Market Dollars

Firm

MC AC

$3.50

2.00

$3.50 Loss per Bushel at p = $2 2.00

d2 Profit per Bushel at p = $3.50

D2 Bushels 400,000 700,000 per Year 3.If the demand curve shifts to D2 and the market equilibrium moves here . . .

4,000

7,000

Bushels per Year

4. the typical firm operates here and suffers a short-run loss.

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

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 (assuming a strong demand in the market).  As new firms enter the market, firms that want to survive and perhaps thrive 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.

The Competitive Market in the Long Run

Pricing and Output Decisions in Monopoly Markets A monopoly market consists of one firm. The firm is the market. Has the power to establish 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.

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*.

Pricing and Output Decisions in Monopoly Markets

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

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.  Monopoly market  Most important lesson is not to be complacent or 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.

Global application • Example: Bluefin tuna • sushi restaurants operate in monopolistic

competition • bluefin tuna price determined by perfect competition • low profit margin

Chapter9 Pricing and Output Decisions: Monopolistic Competition & Oligopoly

Pricing and Output Decisions: Monopolistic Competition and Oligopoly

 Introduction  Monopolistic Competition  Oligopoly  Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence  Competing in Imperfectly Competitive Markets  Strategy: The Fundamental Challenge for Firms in Imperfect Competition

Learning Objectives  Cite the main differences between monopolistic competition and oligopoly  Describe the role that mutual interdependence plays in setting prices in oligopolistic markets  Illustrate price rigidity in oligopoly markets using the “kinked demand curve”  Elaborate on how non-price factors help firms in monopolistic competition and oligopoly to differentiate their products and services  Cite and briefly describe the five forces in Porter’s model of competition

Review of Monopoly • A “pure” monopoly is a market structure in which a single seller accounts for 100 percent of market sales. • Pure monopolies are hard to find in the real world. Economists and judges as a rule believe a 90 percent market share is sufficient to constitute an “effective” monopoly.

Review of Monopoly • Barriers to entry into a monopoly market – “[A]nything which creates a disadvantage for potential entrants vis à vis established firms. The height of the barriers is measured by the extent to which, in the long run, established firms can elevate their selling prices above minimal average cost . . . without inducing potential entrants to enter” [Joe Bain, Industrial Organization, 2nd ed., p. 252]. – Barriers to entry into a market . . . can be defined to be socially undesirable limitations to entry of resources which are due to protection of resource owners already in the market” [Christian von Weizsäcker, Barriers to Entry, p. 13].

Review of Monopoly • Examples of barriers to entry – Absolute advantages • Examples: Alcoa had access to low cost hydroelectric power in Pacific NW; Weyerhauser procured extraction rights to tracts of Douglas fir in 1901; International petroleum majors (Texaco, SOCAL, BP, et al) formed a pipeline consortium in California.

– Economies of Scale • Dominant firm may enjoy cost advantages due to realization of scale economies in production, distribution, capital raising, or sales promotion.

Examples of barriers to entry – Barriers due to control of wholesale, retail distribution systems (continued) • Examples: Control of wholesale diamond distribution by DeBeers; Control of advantageous retail shelf space by Proctor and Gamble, Kellogs.

– Barriers due to patents, copyrights, trademarks, and other legal barriers • Examples: Xerox’s patent on xerography; Polaroid’s patent on instamatic photography

– Barriers due to product differentiation/brand power • Examples: Cigarettes, pain relievers, designer jeans, athletic wear, batteries, soft drinks

Introduction Imperfect Competition (monopolistic competition and oligopoly)  Some market power but not absolute market power  Have the ability to set prices within the limits of certain constraints  Mutual Interdependence: interaction among competitors when making decisions

Introduction Perfect Competition Market Power?

Mutual interdependence among competing firms? Non-price competition? Easy market entry or exit ?

Monopoly

No Yes

Monopolistic Competition Oligopoly

Yes, subject to Yes government regulation No

Optional No

Yes

Yes, relatively

Yes No, relatively

easy

difficult

Monopolistic Competition  Characteristics  Many firms  Relatively easy entry  Product differentiation  Can set price at a level higher than the price established by perfect competition

 Use MR = MC rule to maximize profit  If earning above-normal profits, newcomers will enter the market  Market supply curve shifts out and to the right  Firm’s demand curve shifts down and to the left

 Ultimately, in the long run, firms earn only normal profit  E.g., Perdue and Tyson (produced chicken producers)

Monopolistic Competition • Profit Maximization – MR=MC rule – What will happen in the long run? Why?

Monopolistic Competition • In the long run, normal profits invite entry. Why? – Entry of additional firms causes the demand curve for each existing firm to shift. – Monopolistically competitive firms earn normal profits.

Oligopoly • Oligopoly is derived from the Greek work “olig” meaning “few” or “a small number.” • Oligopoly is a market dominated by a relatively small number of large firms • Products are either standardized or differentiated

Oligopoly  Measures of Market Concentration  Herfindahl-Hirschman index (HH): measure of market concentration (max HH = 10,000) n

HH =∑ S i2 i= 1

n: number of firms in the industry Si: firm’s market share Unconcentrated markets have HH < 1,000

Oligopoly Market Concentration

Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence Mutual Interdependence: relatively few sellers create a situation where each is carefully watching the others as it sets its price. Kinked Demand Curve Model  Basic Assumption: competitor will follow a price decrease but will not make a change in reaction to a price increase.

Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence • Seller interdependence – If Kroger offers deep discounts on soft drinks, will Wal-Mart follow suit? – Northwest Airlines “perks” miles do not expire— how did United, Delta, et al react? – Verizon carries unused minutes over the to next month—implications for Cingular, et. al.? – Alcoa’s decision to add production capacity is conditioned upon the investment plans of rival aluminum producers.

Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence •

Original price and quantity at point A. – If reduce price and competitors match the price cut then move along more inelastic demand segment Di. – If increase price and competitors do not follow then move along the more elastic segment Df. – Marginal Revenue curve will be discontinuous where the kink occurs (at point A).

•

Accounting for the behavior of the other firms causes the demand curve to be kinked

Competitors do not match price increases Competitors match price cuts

Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence • In order to maximize profits, apply MR=MC rule. – The MR curve for the kinked demand curve is discontinuous at the kink.

• This leads the firm to charge the same price even if costs change. – Price rigidities – Little empirical support

Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence

Price Leader: one firm in the industry takes the lead in changing prices.  The price leader assumes that firms will follow a price increase. It assumes that firms may follow a reduction in price, but will not go even lower in order not to trigger a price war.

Non-Price Leader: firm that leads the differentiation of products on other, non-price attributes.

Pricing in an Oligopolistic Market: Rivalry and Mutual Interdependence

• Dominant firm price leadership – This is a system of price-output determination we sometimes see in oligopolistic market structures in which there is one firm that is clearly dominant. – General Motors was once the price leader in the U.S. auto industry. – Other “dominant” firms include Du Pont in chemicals, US Steel (now USX), Phillip Morris, Fedex, Boeing, General Electric, AT&T, and Hewlett Packard.

Competing in Imperfectly Competitive Markets  Non-Price Competition: any effort made by firms other than a change in the price of the product in question in order to change the demand for their product.  Efforts intended to influence the non-price determinants of demand  Tastes and preferences  Income  Prices of substitutes and complements  Number of buyers  Future expectations of buyers about the product price

Competing in Imperfectly Competitive Markets  Non-price variables: any factor that managers can control, influence, or explicitly consider in making decisions affecting the demand for their goods and services.  Advertising (tastes and preferences)  Promotion (tastes and preferences)  Location and distribution channels  Market segmentation (income, and tastes and preferences)  Loyalty programs  Product extensions and new product development  Special customer services  Product “lock-in” or “tie-in” (price of sub and comp)  Pre-emptive new product announcements

Competing in Imperfectly Competitive Markets  Equalizing at the margin: general economic concept which managers can use to help make an optimal decision.  Can be used to decide the optimal expenditure level of a nonprice factor that influences a firm’s demand.  MR = MC is an example of equalizing at the margin.

 Revenue and costs may be realized over a long period of time.  Firm must adjust MR, MC for the time value of money.

Competing in imperfectly competitive markets • Examples: the reality of ‘imperfect competition’ •

auto industry

•

small retailers

•

global credit card issuers

Oligopoly Game Theory and Pricing Behavior  Game theory can be used to explain and predict behavior when there is mutual interdependence.  Game theory is concerned with “how individuals make decisions when they are aware that their actions affect each other and when each individual takes this into account.” (Bierman and Fernandez, 1998)  Prisoner’s Dilemma  Two-person  Non-zero-sum  Non-cooperative  Has a dominant strategy

Oligopoly Game Theory and Pricing Behavior  Prisoner’s dilemma  Two individuals commit a serious crime together and are apprehended by police  They know there is insufficient evidence to convict them of the serious crime.  There is enough evidence to convict them of loitering which carries a lesser prison sentence.  Each prisoner is interrogated separately with no communication between them.

Oligopoly Game Theory and Pricing Behavior  Prisoner’s dilemma, continued:  Police tell them that if one of them confesses he will receive a suspended sentence while the other will receive the maximum sentence.  If both talk then they will each receive a moderate sentence.  What will each suspect do?

Oligopoly Game Theory and Pricing Behavior  Prisoner’s dilemma, continued:  Payoff Matrix

Oligopoly Game Theory and Pricing Behavior  Confessing is a dominant strategy for each player.  This is the best strategy no matter what the other player chooses  Each player have no incentive to unilaterally change their strategy.

Oligopoly Game Theory and Pricing Behavior 

Consider the game between two firms, A and B, described below.

 What is the equilibrium?

Oligopoly Game Theory and Pricing Behavior  (Low/Low) is a stable equilibrium. No incentive for either firm to deviate.  Better off at (High/High) but it is not stable. Each firm has an incentive to deviate.

Oligopoly Game Theory and Pricing Behavior  Efficiency implies that there is no other strategy pair that would make one player better off and no player worse off.  (High/High) would be an equilibrium if the firms were allowed to cooperate.