Managerial Economics MEC 290 Lecture Notes - Lecture 2: Average Variable Cost, Marginal Revenue, Marginal Cost
13 Dec 2016
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Exam 2 Study Guide
I. Cost Theory and Industry Concentration
A. Costs Theory
1. Basics
a. Profit is maximized when marginal cost = marginal revenue
b. Average variable cost (AVC) and average total cost (ATC) are important in determining
operating/profit capacity of a company
c. 4 Areas of profit: (relating price and average costs for effects on profit)
• P > AC, then π > 0
• P = AC, breaking even
• AC > P > AVC, π < 0 but still in business
• P < AVC, π << 0 and shutdown
2. Accounting vs. Economic Costs
a. Accountants for financial reporting purposes typically define/measure cost by some
known historical standard (ie price of a commodity or service)
• Accounting profits = Total Revenues – explicit costs
b. Economists measure costs for decision-making purposes, namely to determine the present
and future costs of resource associated with various alternative courses of action, which
requires an assessment of opportunities foregone (opportunity costs)
• Economic profits = Total Revenue – (Explicit + implicit costs), where implicit costs
are opportunity costs
c. Both accounting and economic costs will include such explicit costs as labor, raw
materials, supplies, rent, interest, and utilities
• Economists will also include the implicit opportunity costs of time and capital that the
owner-manager has invested in the enterprise
• Owner’s opportunity cost of time = best salary offers they could have received
elsewhere
• Opportunity cost of capital = the profit/return possibly earned if the owner had chosen
to employ capital in another investment opportunity of equal risk
d. Nonpecuniary benefits = non-monetary reasons that impact our decisions
3. Production and Cost
a. There is a mirror image relationship between production and cost
b. When MP labor rises, workers at the margin are becoming more productive and so the
MC of the output they produce will fall (and vice-versa)
c. App 8.1 Walmart and productivity
• Walmart was responsible for large increases in productivity per labor hour
• Higher MP and AP imply lower AC and MC at each level of production, which have
partly passed onto consumers in lower prices (and boosting consumer surplus)
• Improvements stemmed from connecting delivery trucks through radios/satellite
(better communication) and using computers to track store sales and inventory and
share with suppliers
• Collaborative planning, forecasting, and replenishment reduces inventory costs for
Walmart and suppliers
d. Profit Maximization
• Golden rule of profit maximization: MR = MC as long as P > AVC
B. Short Run (SR) Costs
1. Basics
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a. Total cost = total fixed costs + total variable costs (TC = TFC + TVC)
b. Average cost = average fixed + average variable (AC = AFC + AVC)
c. Marginal cost (change in cost as we produce one more unit) = ∆TC/∆Q = ∆TVC/∆Q
(since fixed costs are the same)
d. Fixed costs will be a given constant, variable costs = labor input * cost of labor
2. Graphical Analysis
a. SR Cost Curves (left)
• TC = TVC + TFC
• TFC is horizontal because it is fixed
• Shape of the TVC curve is determined by the shape of the TC curve
• TC and TVC both have an inflection point, before that there is increasing cost at a
decreasing rate (increasing MP and decreasing MC), after this diminishing marginal
productivity sets in
• MC = ∆TVC/∆q = (wage rate, w * labor)/∆q = wage rate / marginal productivity of
labor
• AVC = TVC/q = wL/q = w/APL
• On data tables: produce at the level where AVC is at a minimum (anything below this
price is shut down), equilibrium price in a perfectly competitive market can be found
by finding the minimum point of the ATC
b. SR Average and Marginal Cost Curves
• AFC declines because it gets smaller and smaller compared to overall TC (due to
“spreading your overhead”)
• ATC and AVC are “U-shaped” because of diminishing marginal productivity
• MC intersects ATC and AVC at their minima
c. For Data Tables:
• ATC = TC/Q, AFC = TFC/Q, AVC = TVC/Q = ATC – AFC, MC = ∆P/∆Q
C. Long Run (LR) Costs
1. Basics
a. Optimal capacity utilization for the manager may entail
• What is the optimal production level at a given plant size, which would be the output
level that results in the lowest ATC at a given plant site
• Eventually assessing if the current plant size it optimal, or whether
expansion/contraction is warranted, determining where the optimal plant size to
achieve minimum long run ATC
b. In the LR, all inputs can vary so the question becomes what is the cost minimizing
combination of inputs so that MRP = MC (MPL/PL = MPK/PK)
c. App 8.2 American Airlines and cost minimization
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• Huge cost cutting measures and efficiency for operations (ie removing one olive from
airplane salads), CEO Robert Crandall fired a dog
d. App 8.3 Privatization Boosting the Chinese Economy
• Agriculture growth increased to 8.2% annually vs. 2.7% in pre-reform China
• Economist estimate over 40% of China’s 10-fold increase in GDP since 1978 due to
privatization
• Huge private sector industry growth with de-collectivized agriculture, allowed for
increased output and increased overall productivity (boosting GDP) because of higher
incentives to be cost effective
2. Input Substitution Effect
a. When input prices change, the isoquant/isocost equilibrium gets thrown out of whack
(slope of isocost changes with input prices)
b. Input prices change sometimes as the true value of select inputs becomes better known
c. App 8.4 The Economics of Raising and Razing Buildings
• Taller buildings in city (b/c real estate requires building up) vs. suburbs with more
spread out buildings
• Amount of concrete usually depends on the type of environment urban (vertical) vs.
rural (sprawl)
• In Hong Kong used pick axes and cheap labor to bring building down (from top level
on) since that was cheaper than dynamite
d. App 8.5 Moneyball and the Oakland A’s
• Learned the rate of return per dollar spent was lower for sluggers than guys who get
on base
• Used analytics for the first time in this field to be most cost effective
• Billy Bean led this change, shift to higher % of players that could get on base (better
return per $), using applied cost minimization, increased the status of the team while
reducing cost of inputs (players)
• Increased profit with public interest and playoffs in 2000-2003, then other teams
began to catch on with analytics and salaries began to balance out
• In time, guys with higher on base percentages became in greater demand, driving up
their price
3. Long Run Cost Curves
a. Economies of scale = increasing returns to scale, occurs when average costs are falling as
you expand production
b. Different short run average total costs (SRATC) associated with each plant side/output
will combine to get a LRAC curve
D. Economies of Scale and Scope
1. Economies of Scale
a. Occurs when LR average cost falls as output/production/scale rises
b. Consistent with increasing returns to scale in production
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Improvements stemmed from connecting delivery trucks through radios/satellite (better communication) and using computers to track store sales and inventory and share with suppliers: collaborative planning, forecasting, and replenishment reduces inventory costs for. Increased profit with public interest and playoffs in 2000-2003, then other teams began to catch on with analytics and salaries began to balance out. If input prices change, underlying cost curves change, and thus the equilibrium point where mr = mc will change, and thus change production levels. wholesale, then market up another to the msrp: app 11. 3 march madness monopoly, used to have healthy competition between the ncaa and nit tournaments until the. Ie de beers consolidated mines owned or controlled most of the diamond production in south africa and often obtains exclusive marketing agreements with other major diamond-producing countries: legally established and/or regulatory barriers. If mr > mc, then profits will increase if output is increased.
