ECONOMIC EFFICIENCY & COST
IMBA NCCU
Managerial Economics
Jack Wu
ECONOMIC EFFICIENCY
CASE: AIRPORTS IN NEW YORK AREA,
2008
Newark , Continental Airlines (72% of takeoff
and landing slots), 35.4 million passengers
 Kennedy , Delta Airline (31% of takeoff and
landing slots), 47.8 million passengers
 LaGuardia, US Airways (32% of takeoff and
landing slots), 23.1 million passengers

OUTCOMES OF LANDING FEE POLICY





The Port Authority charges airlines landing fees based on
aircraft weight. The fees are on average of $6 per passenger
and do not vary with the time of day.
During peak hours, the demand for takeoffs and landings
at Newark exceeds capacity.
FAA presented a 10-year plan limiting scheduled takeoffs
and landings to 81 per hour and establishing an auction for
landing and takeoff slots.
However, the Port Authority, major airlines resisted the
FAA plan.
FAA abandoned the plan and sought other ways to relieve
congestion at Newark.
APPLICATION OF MANAGERIAL
ECONOMICS
Takeoff and landing slots at an airport with
limited runway capacity are a scarce resource.
 However, if the slots are allocated by
administrative rule, the allocation of resources
might not be economically efficient.

ECON EFFICIENCY: CONDITIONS
for all users, same marginal benefit
 for all suppliers, same marginal cost
 marginal benefit = marginal cost

ECONOMIC EFFICIENCY V.S. TECHNICAL
EFFICIENCY
Contrast economic efficiency vis-à-vis technical
efficiency
 Technical efficiency

producing at lowest possible cost
 doesn’t consider how much benefit the item provides

ADAM SMITH’S INVISIBLE HAND: PRICE
Competitive market achieves three sufficient
condition for economic efficiency:
 buyers and sellers in a market system act
independently and selfishly, yet the overall
outcome is efficient

i) users buy until marginal benefit equals price;
 ii) producers supply until marginal cost equals prices;
 iii) users and producers face same price.

INVISIBLE HAND
 Outcome
of price
competition in market
 Marginal
benefit = price
 Marginal cost = price
 Single price in market
EXAMPLE OF INVISIBLE HAND






Major policy issue: how to allocate licenses for 3G
wireless telecommunications;
“beauty contest” -- France
auction – Germany, UK, US
pioneer: in early 1990s, US Federal
Communications Commission showed that
spectrum licenses were worth billions;
created pressure on other governments to allocate
by auction and not favoritism.
Auction ensures that item goes to user with highest
marginal benefit.
UCLA ANDERSON SCHOOL, 1989
Half an invisible hand is worse than none
 priced photocopying paper
 free bond paper
PRICE CEILING
Upper limit that sellers can charge and buyers can
pay
 rent control
 regulated price for electricity
Price ($ per month)
RENT CONTROL: EQUILIBRIUM
1100
b
1000
900
0
supply
equilibrium
excess demand
290
300
demand
310
Quantity (Thousand units a month)
Price ($ per month)
RENT CONTROL: SURPLUSES
buyer surplus gain = cfeg
buyer surplus loss = dgb
seller surplus loss = cfeg + geb
d
1100
1000 c
900
f
b
g
supply
e
demand
0
290
300
310
Quantity (Thousand units a month)
RENT CONTROL: LOSSES
deadweight losses -- sellers willing to provide
item at price that buyers willing to pay, but
provision doesn’t occur
 price elasticities of demand and supply
_demand more inelastic --> larger loss
_ supply more elastic --> larger loss

PRICE FLOOR
Lower limit that sellers can charge and buyers can
pay
 minimum wage
 agricultural price supports
Wage ($ per hour)
MINIMUM WAGE: EQUILIBRIUM
a
excess supply
supply
4.20
b
4.00
equilibrium
c
0
demand
8
10
11
Quantity (Billion worker-hours a week)
Wage ($ per hour)
MINIMUM WAGE: SURPLUSES
seller surplus gain = fdge
seller surplus loss = ghb
buyer surplus loss = fdge + egb
a
4.20
4.00
f
d
supply
e
b
g
h
c
0
demand
8
10
11
Quantity (Billion worker-hours a week)
MINIMUM WAGE: LOSSES
deadweight losses -- sellers willing to provide
item at price that buyers willing to pay, but
provision doesn’t occur
 price elasticities of demand and supply
_supply more inelastic --> larger loss
_demand more elastic --> larger loss

TAX: COMMODITY TAX
“the only two sure things in life are death and
taxes”
 buyer’s price - tax = seller’s price
 payment vis-à-vis incidence
US: airlines pay tax
 Asia: passengers pay

Price ($ per ticket)
TAX: EQUILIBRIUM
804
$10
e
800
794
0
supply
b
h
900
demand
920
Quantity (Thousand tickets a year)
TAX: SURPLUSES
Price ($ per ticket)
buyer surplus loss = fdge + egb
seller surplus loss = djhg + ghb
revenue gain = fdge + djhg
804 f
800 d
794
0
j
$10
e
g
b
h
900
supply
demand
920
Quantity (Thousand tickets a year)
INCIDENCE
incidence and deadweight loss depend on price
elasticities of demand and supply
 ideal tax (no deadweight loss): inelastic
demand/supply
 who pays the tax not relevant

COSTS
INTRODUCTION
Cost and economies of scale
 Cost and economies of scope
 Relevant / Opportunity costs
 Irrelevant Costs/ Sunk costs

ECONOMIES OF SCALE
Fixed cost: cost of inputs that do not change with
production rate
 Variable cost: cost of inputs that change with the
production rate


Fixed/variable costs concepts apply in
Short run
 Long run

EXPENSE STATEMENT
D aily
Production
(thousands)
0
10
20
30
40
50
60
70
80
90
Labor
$5000
$5000
$5000
$5000
$5000
$5000
$5000
$5000
$5000
$5000
Printing
Press
$1000
$1500
$2000
$2500
$3000
$3500
$4000
$4500
$5000
$5500
Ink
and
Paper
$0
$1200
$2400
$3600
$4800
$6000
$7200
$8400
$9600
$10800
Electric
pow er
$200
$300
$400
$500
$600
$700
$800
$900
$1000
$1100
Total
$6200
$8000
$9800
$11600
$13400
$15200
$17000
$18800
$20600
$22400
FIXED AND VARIABLE COSTS
Daily
Production
(thousands)
0
10
20
30
40
50
60
70
80
90
Fixed
Cost
$6200
$6200
$6200
$6200
$6200
$6200
$6200
$6200
$6200
$6200
Variable
Cost
$0
$1800
$3600
$5400
$7200
$9000
$10800
$12600
$14400
$16200
Total
Cost
$6200
$8000
$9800
$11600
$13400
$15200
$17000
$18800
$20600
$22400
Marginal
Cost
Average
Fixed
Cost
Average
Variable
Cost
Average
Cost
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.62
$0.31
$0.21
$0.16
$0.12
$0.10
$0.09
$0.08
$0.07
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.18
$0.80
$0.49
$0.39
$0.34
$0.30
$0.28
$0.27
$0.26
$0.25
ECONOMIES OF SCALE

Economies of scale (increasing
returns to scale): average cost
decreases with scale of
production
SCALE ECONOMIES: SOURCES

large fixed costs
research, development, and design
 information technology


falling average variable costs
distribution of gas and water
 container ships

DISECONOMIES OF SCALE

Definition: Diseconomies of scale (decreasing
returns to scale) – average cost increases with
scale of production
ECONOMIES OF SCALE:
STRATEGIC IMPLICATIONS

Either produce on large scale or outsource
Seller side – monopoly/oligopoly
 Buyer side – monopsony/oligopsony

ECONOMIES OF SCOPE
Economies of scope: total cost of production is
lower with joint than with separate production
 Diseconomies of scope: total cost of production is
higher with joint than with separate production

EXPENSES FOR TWO PRODUCTS
Organization
Output
Labor Printing Ink etc. Total
Press
Cost
Separate production
Daily Globe
50,000 $5,000 $3,500 $6,700 $15,200
Afternoon Globe 50,000 $5,000 $3,500 $6,700 $15,200
Two papers
$30,400
Combined production
Two papers
100,000$10,000 $3,500 $13,400 $26,900
ECONOMIES OF SCOPE
source -- joint cost: cost of inputs that do not
change with scope of production
 examples:

•

cable television + telephone
banking + insurance
manufacturing: refrigerator + air-conditioner
strategic implication -- produce/deliver multiple
products
RELEVANCE

consider only relevant costs and ignore all other
costs

which costs are relevant depends on course of action
relevant costs may be hidden
 irrelevant costs may be shown in accounts

OPPORTUNITY COST
definition -- net revenue from best alternative
course of action
 two approaches

•
•
show alternatives
report opportunity costs
EXAMPLE
Williams bought a warehouse and paid $300,000
for it. She used her own money $200,000 and
made a bank loan of $100,000.
 A developer were willing to buy warehouse for 2
million.
 If Williams sells warehouse, she could invest
proceeds in government bonds and get a secure
income $160,000 (2 million*8%).
 She could work elsewhere for salary $400,000.

INCOME STATEMENT SHOWING
ALTERNATIVES
Revenue
Expenses
Profit
Continue
Warehouse
Operations
$700,000
$220,000
$480,000
Shutdown
$560,000
$0
$560,000
Income statement reporting opportunity costs
Revenue
$700,000
Cost
$780,000
Profit
($80,000)
SUNK COST
 definition
-- cost that has been committed
and cannot be avoided
 alternative courses of action
•
•
prior commitments
planning horizon
 Fewer
commitments  fewer sunk costs;
 longer planning horizon  fewer sunk
costs.
EXAMPLE
Jupiter Athletic is about to launch a line of new
athletic shoes. Some month ago, management
prepared an ad campaign with total budget of
$310,000.
 They forecast the ad would generate sales of
20,000 units. Each sale’s unit contribution
margin (price- average variable cost) is $20. The
total contribution margin is $20*20000=$400,000.
Their expected profit generated from ad is
$400,000-310,000=$90,000.

EXAMPLE: CONTINUED
Recently, a major competitor launch a new shoe.
Jupiter estimates sales fall to 15,000 units. The
contribution margin becomes
$20*15,000=$300,000.
 Should Jupiter cancel the launch?

INCOME STATEMENT SHOWING
ALTERNATIVES
Contribution margin
Graphic arts
consultant fee
Road Runner charge
Daily Globe charge
Profit
Continue
Product Launch
$300,000
$50,000
Cancel
Launch
$0
$50,000
$60,000
$200,000
($10,000)
$30,000
$20,000
($100,000)
Income statement omitting sunk costs
Contribution margin
Graphic arts cost
Road Runner charge
Daily Globe charge
Profit
$300,000
$0
$30,000
$180,000
$90,000
DISCUSSION QUESTION

Suppose that MM system operates two call
centers: A and B. Table reports the total costs at
the two centers for various rates of customer
service. To serve a total of 5000 calls per day in
the cheapest way, how many calls should the
company serve from A center and how many from
B center? Explain why.
DISCUSSION QUESTION
Service Rate(calls/day)
Total costs from A center
Total costs from B center
1000
$5000
$8000
2000
$11000
$16000
3000
$18000
$24000
4000
$26000
$32000
5000
$35000
$40000