PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
Cost Curves
• Want to compare MR to MC.
• So far, we assumed that MC was constant.
• This is OK for small decisions.
• Small enough that MC is not altered much
• Small enough that estimates of any change are not worth
performing.
• But may not be appropriate for larger decisions.
Possibilities include:
• Scale economies
• Scope economies
• Learning-by-doing
Econ 5313
Production Experiment
• Need series of volunteers (one at a time). We are going to
see how many “widgets” can be made with 1 worker, 2
workers, etc. Widget production entails folding a piece of
paper twice and stapling the folds together.
• Q=f(K,L) where Q is the widget, K is capital (stapler) and L
is labor (student volunteers).
• Widgets are fragile and break if the fall to the ground.
• Neatness does not count.
• Our goal is to fill values in this table.
Econ 5313
Production Experiment
• Our goal is to fill values in this table
K
1
1
1
1
1
1
1
L
0
1
2
3
4
5
6
Q
0
Econ 5313
Production Experiment
• Our real goal is to learn about returns to scale. First we
want to fill in some additional columns.
• How do we define Average Product of Labor(APL)?
• APL = Q/L
• How do we define Marginal Product of Labor (MPL)?
• MPL = DQ/DL
K
1
1
1
1
1
1
1
L
0
1
2
3
4
5
6
Q
0
AP
MP
Econ 5313
Production Experiment
• The tabular data can be graphed and usually looks like
this.
7
6
5
4
AP
3
MP
2
1
0
1
2
3
4
5
6
• What do we call it when MP is rising?
• Increasing Returns to Scale (IRS)
• What do we call it when MP is falling?
• Decreasing Returns to Scale (DRS)
Econ 5313
Production Experiment
• What caused the increasing returns to scale in our
experiment?
• Division of Labor (also called Specialization)
• What caused the decreasing returns to scale in our
experiment?
• Congestion: Only one stapler to be shared by all
• Coordination: Had to agree on roles for all participants and had to
hand off work incomplete product to next team member
• Just about all production processes share these
properties.
• Division of Labor in Smith’s Pin Factory
• Congestion from “fixity” of various inputs
• Coordination from communication with ever more participants
Econ 5313
Implications
• Often, this is where a manager add the most firm value
• How do you eke out ever more gains from increased division of
labor without invoking the curse of congestion and coordination?
• This is THE feature behind the industrial revolution
• Ex Ford’s assembly line but also Ford’s extensive vertical
integration
• Precursor of the MBA was the “efficiency expert”
• A dominant feature of the information revolution is
communication
• Reducing the coordination problem implies greater specialization.
• Also, participants in production need not be in one firm but can
be along the supply chain
Econ 5313
Implications
• What does a “hump” shaped marginal product curve
imply for the shape of the marginal cost curve?
• Suppose a unit of K cost $10 and a unit of L cost $10
• Fill in this table from the experiment:
K
1
1
1
1
1
1
L
1
2
3
4
5
6
• AC = TC/Q
• MC = DTC/DQ
Q
AP
MP TC
AC
MC
Econ 5313
Implications
• A “hump” shaped marginal product curve implies a “U”
shaped the marginal cost curve.
6
5
4
AC
MC
3
2
1
0
1
2
3
4
5
6
Econ 5313
Implications
• In the real world, MC are from increments from more
than one input
• Measuring marginal productivity a little trickier
• But general principle still usually generates “U” shaped MC curve
• Costs minimization is at bottom of the “U”
Econ 5313
Sony Transistor Radio
• Akio Morita and the Sony transistor radio way back at the
founding of the company
• He was offered the opportunity to sell 100,000 units but
turned it down
• Because of capacity issues, he estimated his unit costs at,
$20 for 5K, $15 for 10K, and $40 for 100K
• Expansion is not always desirable
Econ 5313
Scale Economies
• For some production processes, MC always below AC
• No “U” shape, increasing returns to scale everywhere
• This is particularly true for “information goods”
• Ex Computer software, music, movies, video games, smart phone
apps, online auctions, social networks
• Now, costs minimization can lead to ever bigger firms
• Role in dotcom bubble of 1999-2000?
• Example: Webvan going to offer online grocery shopping
• Use web interface for ordering like Amazon
• Purchased small pickup trucks specially designed to be
refrigerated for deliveries
• Only makes sense for huge volume
• Company failure meant $1 billion loss on trucks alone
Econ 5313
Scope Economies
• Suppose we redid our production experiment with two
different widget designs.
1.
2.
You make equal numbers of two designs in one process
You make one in one process and the other in a different
process
• Which organizational form leads to the least costly
production?
• If 1, then economies of “scope”
• If 2, then diseconomies of “scope”
• C(Q1, Q2) versus C(Q1) + C(Q2)
Econ 5313
Scope Economies
• Where do economies of scope come from?
•
Usually, economies of scale in some component
• Ex: Auto assembly – Why do they make trucks, sedans,
minivans, sports cars etc.?
•
•
•
•
Typically buy components but make engines (why?)
Hard to contract over due to holdup problems
But design and tooling represents a huge FC
Make just one version of a 4 cylinder (or V6, or V8) and put it
into as many models as possible
Econ 5313
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Breakfast Sausage Producer
Regional - Used 18 trucks in distribution to 21
southern and Midwestern states
But demand is seasonal – peaks in winter
Trucks were idle in summer – not exploiting scale
economies
Possible Solutions:
•
•
Outsource distribution – supplier can “smooth” capacity
utilization over other products from other customers, but
vulnerable to holdup
Vertically integrate – parent uses trucks for other products
during summer, but blunts incentives
Econ 5313
•
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Pet Food Producer
A pet food company has 2,500 products (SKU’s) with
200 different formulas
They receive a lot of pressure from large customers
like Wal-Mart to reduce prices
To respond to Wal-Mart, the company shrinks it
product offerings
•
•
•
70 SKUs w/13 formulas
This led to a 25% savings for the company because of
reduced production costs
How?
Econ 5313
•
•
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Pet Food Producer
Production with each new formula requires that the
production line shut down for setup
Line workers idle during this time
The production line exhibits scale economies
Econ 5313
•
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Learning-By-Doing
Learning curves or Learning-By-Doing (LBD) slightly
different from scale economies
Scale economies from producing 20 units versus 10
units in a period of time
Learning-By-Doing from producing 10 units in a
period of time after producing 10 units in the
previous period
•
•
Not necessarily due to division of labor
Due to ‘tweaking’ the process based on what you
discovered the first time
Econ 5313
•
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Microchip makers stamp out increasingly complicated
chips onto silicon wafers
Test each chip to check for defects
Also test to correct design or production defects
First batch has whopping 90% defect rate
•
•
Fix most glaring mistakes
Next batch has 80% defect rate
•
•
•
Microchip Makers
Just doubled the yield per unit of effort!
Fix a few more mistakes
Continued tweaking typically ultimately yields 15%
defect rate at end of product lifecycle
•
One reason why prices of consumer electronics falls
Econ 5313
•
Airplane Manufacturer
Every time an airplane manufacturer doubles
production, marginal costs decrease by 20%
•
Number produced in time period may not change
Q
1
2
3
4
5
6
7
8
9
10
MC
$100.00
$80.00
$70.21
$64.00
$59.56
$56.17
$53.45
$51.20
$49.29
$47.65
TC
$100.00
$180.00
$250.21
$314.21
$373.77
$429.94
$483.39
$534.59
$583.89
$631.54
AC
$100.00
$90.00
$83.40
$78.55
$74.75
$71.66
$69.06
$66.82
$64.88
$63.15
Econ 5313
•
Airplane Manufacturer
Same information graphically
$120
$100
$80
$60
MC
$40
AC
$20
$0
0
2
4
6
8
10
Econ 5313
•
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Airplane Manufacturer
Am Air is considering a large airframe purchase from
a Boeing. Because of this order, Boeing’s unit costs
will be lower in the future. Boeing will be able to
charge lower prices to future customers, airlines in
competition with Am Air. Am Air could be providing a
competitive advantage to its competitors!
What are possible contracting solutions?
•
•
•
Am Air gets kickbacks on future orders (probably violates
antitrust laws)
Am Air gets a percent of increase in Boeing’s stock market
value when the deal is announced or buy calls (probably
violates security laws)
Exclusive contract for airframe and favorable prices
Econ 5313
•
•
Anticipating Learning-by-Doing
Every time you double production, your costs
decrease by 50%. The first unit costs you $64 to
produce
On a project for 4 units, what is your break-even
price?
Econ 5313
•
•
Anticipating Learning-by-Doing
On a project for 4 units, what is your break-even
price?
You can win another project for 2 more units. What is
your break-even price for those units?
Q
1
2
3
4
5
6
MC
$64
$32
$21
$16
$13
$11
TC
$64
$96
$117
$133
$146
$157
AC
$64
$48
$39
$33
$29
$26
Econ 5313
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From the Blog
Chapter 7
Nissan-Renault Alliance
Thoreau was a polluter
Joe Fresh at JCP
Airline Operations
Auto Alliance
Rental Car Formats
Learning-by-doing is Embodied in the Manager
Econ 5313
Main Points
• Increasing Returns – Usually from division of labor
• Diminishing Returns – Usually from congestion and
coordination problems
• Efficient firms balance the two
• Solving some congestion issues allows for more specialization
• Scale economies means that costs fall as you produce more
• Scope economies means that the costs of producing one
good are lower because you produce another good
• Often from scale economies in a common component
• Learning-by-Doing means that current production will
lower future costs
• Anticipate this when planning over the product lifecycle