Chapter 5 (cont’d)
Costs
(Long-Run)
Sony
Cost per unit
• Morita: Came to U.S. in 1955 hoping to sell his
new radio. His story is illustrated in this
diagram.
5
10
50
100
Sony
• Notice that Morita’s curve is U-shaped
• Why?
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5b–3
Production
• An entrepreneur must put together
resources -- land, labor, capital -- and
produce a product people will be willing
and able to purchase.
• In the planning period -- long run -- the
entrepreneur has the option of choosing
any combination of inputs.
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5b–4
Combining Resources
• There are many combinations of
resources that could be used.
• Consider the following table showing
different quantities of mechanics and
different quantities of airplanes that the
hypothetical airlines PWA might use:
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5b–5
Alternative Quantities of Output that
Can Be Produced by Different
Combinations of Resources
Number
of Mechanics
Capital -- Number of Airplanes
5
10
15
0
0
0
0
1
30
100
250
2
3
4
5
6
7
8
60
100
130
130
110
100
80
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250
360
440
500
540
550
540
360
480
580
650
700
720
680
20
0
25
0
30
0
35
0
40
0
340
450
570
640
710
760
790
800
410
520
610
690
760
800
820
830
400
530
620
700
770
820
850
860
400
520
620
700
780
830
870
880
390
500
610
690
770
840
890
900
5b–6
Long Run
• What is the difference between the
short run and the long run?
• The long run is a period of time just long
enough that all resources (inputs) are
variable.
• So, in terms of the manufacturing table,
we have . . .
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5b–7
Alternative Quantities of Output that
Can Be Produced by Different
Combinations of ALL Resources
Number
of Mechanics
Capital -- Number of Airplanes
5
10
15
0
0
0
0
1
30
100
250
2
3
4
5
6
7
8
60
100
130
130
110
100
80
Copyright © Houghton Mifflin Company.All rights reserved.
250
360
440
500
540
550
540
360
480
580
650
700
720
680
20
0
25
0
30
0
35
0
40
0
340
450
570
640
710
760
790
800
410
520
610
690
760
800
820
830
400
530
620
700
770
820
850
860
400
520
620
700
780
830
870
880
390
500
610
690
770
840
890
900
5b–8
Long Run
• All resources are variable.
• This means that the firm can choose
any combination on the manufacturing
table, not just those along column
labeled “10.”
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5b–9
Production to Costs
• If either of the resources is fixed, then
we get diminishing marginal returns as
we increase the other resource.
• For instance, we could fix the number of
airplanes at any level, say 10, 20, or 40.
• And vary the number of mechanics.
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5b–10
Notice what occurs as the number of
mechanics is increased at any of the
levels of airplanes:
Number
of Mechanics
Capital -- Number of Airplanes
15
10
5
0
0
0
0
250
100
30
1
2
3
4
5
6
7
8
60
100
130
130
110
100
80
Copyright © Houghton Mifflin Company.All rights reserved.
250
360
440
500
540
550
540
360
480
580
650
700
720
680
20
0
25
0
30
0
35
0
40
0
340
450
570
640
710
760
790
800
410
520
610
690
760
800
820
830
400
530
620
700
770
820
850
860
400
520
620
700
780
830
870
880
390
500
610
690
770
840
890
900
5b–11
Production to Costs
• Or we could fix the number of
mechanics and vary the number of
airplanes.
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5b–12
Notice what occurs to output as the
number of airplanes is increased at
any of the levels of mechanics:
Number
of Mechanics
Capital -- Number of Airplanes
5
10
15
0
0
0
0
1
30
100
250
2
3
4
5
6
7
8
60
100
130
130
110
100
80
Copyright © Houghton Mifflin Company.All rights reserved.
250
360
440
500
540
550
540
360
480
580
650
700
720
680
20
0
25
0
30
0
35
0
40
0
340
450
570
640
710
760
790
800
410
520
610
690
760
800
820
830
400
530
620
700
770
820
850
860
400
520
620
700
780
830
870
880
390
500
610
690
770
840
890
900
5b–13
Production to Costs
• If we fix either of the resources, then we
get diminishing marginal returns as we
increase the other resource.
• However, in the long run, both
resources are variable.
• So what happens to output as we vary
both resources?
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5b–14
The Long Run or Planning Period: As
we double both resources, what
happens to output?
Number
of Mechanics
Capital -- Number of Airplanes
5
10
15
0
0
0
0
1
30
100
250
2
3
4
5
6
7
8
60
100
130
130
110
100
80
Copyright © Houghton Mifflin Company.All rights reserved.
250
360
440
500
540
550
540
360
480
580
650
700
720
680
20
0
25
0
30
0
35
0
40
0
340
450
570
640
710
760
790
800
410
520
610
690
760
800
820
830
400
530
620
700
770
820
850
860
400
520
620
700
780
830
870
880
390
500
610
690
770
840
890
900
5b–15
Scale : Size of Firm
• As the scale or size of the firm is increased,
that is, as all resources are increased, what
happens to output --- to per-unit costs?
• Since at each fixed level of resources, there
are diminishing marginal returns as we vary
one of the resources, then there are
• U-shaped cost curves for each scale.
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5b–16
Notice what happens to output as resources are
doubled -- it initially more than doubles and then
increases less quickly. What does this mean for
costs?
Number
of Mechanics
Capital -- Number of Airplanes
5
10
15
0
0
0
0
1
30
100
250
2
3
4
5
6
7
8
60
100
130
130
110
100
80
Copyright © Houghton Mifflin Company.All rights reserved.
250
360
440
500
540
550
540
360
480
580
650
700
720
680
20
0
25
0
30
0
35
0
40
0
340
450
570
640
710
760
790
800
410
520
610
690
760
800
820
830
400
530
620
700
770
820
850
860
400
520
620
700
780
830
870
880
390
500
610
690
770
840
890
900
5b–17
Costs
Economies of Scale
• As output rises and the scale of the firm
increases, costs per unit of output:
• Decrease---called economies of scale.
• Increase---called diseconomies of scale.
• Remain constant---called constant
returns to scale.
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5b–19
Costs
This is referred to
as economies of scale
or size.
Costs
This is referred to as
diseconomies of scale
or size.
Economies of Scale
• Not all firms or industries have a Ushaped long run cost curve.
• Economies or diseconomies do not
come about because of a law like the
law of diminishing marginal returns.
• Thus, some industries may have only
economies, others only diseconomies,
and others constant returns to scale.
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5b–22
Costs
What if ATC in the
long run looks like
this?
LRATC
Output
Costs
What if long run
ATC and demand
look like this?
Demand
LRATC
Output
What if long
run ATC looks
like this?
Costs
LRATC
Output
What if long
run ATC looks
like this
Costs
LRATC
and demand
like this?
Demand
Output
What if long
run ATC looks
like this?
Costs
LRATC
Output
What if long run
ATC and demand
look like this?
Costs
LRATC
Demand
Output
What if long
run ATC looks
like this?
Costs
LRATC
and demand
looks like this?
Demand
Output
Economies of Scope
• Are there per-unit changes in cost resulting
from diversifying or expanding the scope of
business?
• If cost increases, then there are
diseconomies of scope.
• If cost decreases: then there are economies
of scope.
Cases: Bayer, BASF, Hoechst
Cases: Advertising agencies
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5b–30
Cost per Unit
The Experience Curve
Aircraft
Chickens
Cumulative Output
The Experience Curve
Cost per Unit
NOTICE THIS!!!
Aircraft
Chickens
Cumulative Output
The Experience Curve
Monsanto vs. Holland Sweetener
• NutraSweet brand -- Monsanto spent 7
years “marching down the learning
curve.”
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5b–33
Measuring Costs
Historic Cost
• measuring costs on the basis of what the asset
originally cost the firm.
Current Cost
• measuring costs on the basis of what a current
replacement of the asset would cost.
The historic costs look back; the current costs
look at the present; and the stock market
value looks forward.
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5b–34
Measuring Costs
• None of these measures tells us much of use.
• What we really want to know is what the
return would be to funds used to purchase
assets for this firm if those funds were used in
another investment.
• The firm’s performance must be compared to
what else the investor’s money could be used
for -- the alternatives.
• This is called opportunity cost.
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5b–35
Measuring Costs
• Accountants do not provide information about
opportunity costs because it is too subjective
and hard to measure.
• There is a move to try to capture opportunity
costs: Measuring economic profit has been
proposed and adopted by some firms.
• Economic profit =
operating profit - (cost of capital)(amount of capital)
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5b–36
Measuring Costs
• Coca-Cola has adopted economic profit
for planning and a basis for managerial
compensation.
• In economics, all costs are opportunity
costs.
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5b–37
Measuring Costs
• In economics, all costs are opportunity costs.
• The cost curves measure opportunity costs -account for what else the funds could be
used for.
• It is reasonably straightforward to move from
accounting costs for labor, land, and
materials to opportunity costs (in fact, their
accounting costs are probably good
measures of opportunity costs).
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5b–38
Measuring Costs
• Capital (and non compensated time of the
owner) is more difficult.
• If an asset were purchased 5 years ago,
historic costs would measure only the original
cost and current costs would only measure
replacement costs.
• What about the lost returns from not investing
in other alternatives?
• This is not closely approximated by either
original cost or current cost.
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5b–39
Measuring Costs
• Thus, you might compare the returns to what
a marginal firm would have to pay to acquire
the asset.
• A marginal firm is a firm that is neither adding
value nor subtracting it.
• It is typically the firm in the industry that is at
the bottom of the rung---without going out of
business,
• Consider the following situations:
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5b–40
What is the situation depicted here?
What is the green line?
ATC
$
AVC
Demand1
output
And here, with demand2,
what is the situation?
ATC
$
AVC
Demand2
output
Now, at demand3 , what is the
situation? What is the green line?
ATC
$
AVC
Demand3
output
Summary Review of Costs
• Scale -- Long Run
•
•
•
•
•
Economies of Scale
Diseconomies of Scale
Returns to Scale
Constant Returns to Scale
Minimum Efficient Scale
• Returns or Product -- Short Term
• Diminishing Marginal Returns
• Diminishing Marginal Product
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5b–44
Application: Downsizing could
result in a shift of cost curves.
ATC1
$
Or a move along
one cost curve.
ATC2
Demand1
output
Outsourcing and Joint Ventures
• Outsourcing would be illustrated not much
differently than the previous case of
downsizing.
• The size of the firm would decrease in the
case of outsourcing – efficiency should
increase.
• In the case of a joint venture, many
alternative things might happen: reduced
costs, decreased size, increased demand, or
increased size and increased efficiency.
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5b–46