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MZUMBE UNIVERSITY (CHUO KIKUU MZUMBE) ECO 5011: MANAGERIAL ECONOMICS HANDOUTS FOR GRADUATE STUDENTS Honest Prosper Ngowi 1 [email protected] 1 The author is a senior lecturer, researcher and consultant in Economics and Business at Mzumbe University Dar Es Salaam Business School, Tanzania. He has researched, consulted, lectured and published widely (over 40 academic works and 60 newspaper and magazine articles). Among the areas he has written on include the Current Global Financial and Economic Crisis (GFEC); Research and Development (R&D); Project Management; Foreign Direct Investments (FDIs); The New Economy; Entrepreneurship; Public Private Partnerships (PPP); Informal Sector; Privatization; Executive Agencies in Service Delivery; Economic Growth; University-Industry Linkages; Funding Civil Societies; Mainstreaming HIV/AIDS in Curricula and Workplaces; Economic Impacts of HIV/AIDS; Biofuel production; Kilimo Kwanza; Programs/projects Evaluations and Reviews among others. Some of the works can be accessed by googling Honest Prosper Ngowi 1

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MZUMBE UNIVERSITY(CHUO KIKUU MZUMBE)

ECO 5011: MANAGERIAL ECONOMICS HANDOUTS

FOR GRADUATE STUDENTS

Honest Prosper Ngowi 1

[email protected]

+255 754653740

Mzumbe University Business School, Box 20266 Dar Es salaam, Tanzania

TOPIC ONE1 The author is a senior lecturer, researcher and consultant in Economics and Business at Mzumbe University Dar Es Salaam Business School, Tanzania. He has researched, consulted, lectured and published widely (over 40 academic works and 60 newspaper and magazine articles). Among the areas he has written on include the Current Global Financial and Economic Crisis (GFEC); Research and Development (R&D); Project Management; Foreign Direct Investments (FDIs); The New Economy; Entrepreneurship; Public Private Partnerships (PPP); Informal Sector; Privatization; Executive Agencies in Service Delivery; Economic Growth; University-Industry Linkages; Funding Civil Societies; Mainstreaming HIV/AIDS in Curricula and Workplaces; Economic Impacts of HIV/AIDS; Biofuel production; Kilimo Kwanza; Programs/projects Evaluations and Reviews among others. Some of the works can be accessed by googling Honest Prosper Ngowi

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INTRODUCTION

Managerial economics (also called business economics), is a branch of economics that applies microeconomic analysis to specific business decisions. It bridges economic theory and economics in practice. The unifying theme that runs through most of managerial economics is the attempt to optimize business decisions given the firm's objectives and given constraints imposed by scarcity. Almost any business decision can be analysed with managerial economics techniques, but it is most commonly applied to:

Risk analysis - various uncertainty models, decision rules, and risk quantification techniques are used to assess the riskness of a decision.

Production analysis - microeconomic techniques are used to analyse production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function.

Pricing analysis - microeconomic techniques are used to analyse various pricing decisions including joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method.

Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.

Managerial economics is the application of economic principles to decision-making in

business firms or of other management units. The basic concepts are derived mainly from

microeconomic theory, which studies the behaviour of individual consumers, firms, and

industries. It is concerned with the application of economic principles and methodologies

to business decision problems.

Managerial DecisionsManagers are faced with the challenge of making various and often difficult decisions. These include decisions related to factor inputs (their sources, quantity, quality, price etc), production process (optimal production methods taking into account both economic and non-economic dimensions) and decisions related to factor outputs (quantity, quality, timing, packaging, marketing etc) and many other decisions. Making these decisions involve choices. Managerial economics focuses on choices that managers have to make. It deals with:

i) Identifying problems and opportunitiesii) Analyzing alternatives from which choices can be madeiii) Making choices that are best from the standpoint of the firm or organization in

questionManagerial economics provides a set of tools for analyzing decision problems and developing criteria for choosing the best possible solution to such problems. Some of the key tools will be discussed in the sessions.

Factors Influencing Managerial Decisions

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Many factors contribute to making managerial decisions difficult. These include competition, uncertainty and ongoing changes. Others include human resource issues, technology, environment, political parties, pressure groups (for example Civil Society Organizations). These factors may have serious consequences, both in terms of people and economics.

Firms and Management Objectives

A firm (a company) is a transformation unit concerned with converting factor input into higher-valued intermediate and/or final goods and services. A firm is the basic producing unit in an economy.

Management (of firms) Objectives

The objective of management of firms is profit maximization.

Profit maximization

Profit is the difference that arises when a firm’s total revenue is greater that its total cost. This is the economic definition of profit. It differs from the accounting definition of profit which takes into account only explicit (as opposed to implicit) costs.Economic profit can be viewed in terms of:

a) The return accruing to enterprise owners (entrepreneurs) after the payment of all explicit costs (payment such as wages to outside factor-input suppliers) and all implicit costs (payments for the use of factor inputs like capital, labour etc supplied by owners themselves).

b) A residual return to the owners of a firm for providing capital and for risk-bearing/taking

c) The ‘reward’ to entrepreneurs for organizing productivity activity, for innovating new products, etc and risk taking;

d) Prime mover of a private enterprise (market) economy serving to allocate resources between competing end uses in line with consumer demands;

e) In aggregate terms, a source of income and thus included as part of National Income

Profit = Revenue – Cost. (P = R – C

Profit maximization is the objective of the firm in traditional theory of the firm and the theory of the markets. Firms seek to establish that price-output combination which yields the maximum amount of profit. This can be depicted in two waysFirstly, where the total revenue exceeds total cost by the greatest amount.Secondly, where marginal revenue equals marginal cost (MR = MC). In this case firm maximizes its profit where/when the marginal revenue curve interacts with marginal cost curve.Optimization Using Marginal Analysis

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Net benefits (profit) are maximized or net losses are minimized when the decision maker follows a simple rule. Continue engaging in an activity as long as the marginal benefit is greater than or equal to the marginal cost. Generally, the optimal decision occurs when the marginal benefit equals the marginal cost as long as this equality exists. Marginal analysis enables people to get the greatest value from resources when they make decisions.

Marginal Analysis

A technique used in microeconomics by which very small changes in specific variables are studied in terms of the effect on related variables and the system as a whole. It is an examination of the effects of adding one extra unit to, or taking away one unit from, some economic variable. This leads to related terms like marginal: cost, profit, revenue, utility, product, propensity to save/consume, etc. Marginal analysis is an approach in economic decision making.

Time Value of MoneyMany economic decisions involve benefits and costs that are expected to occur at different future points in time. To determine if the expected future cash inflows are sufficient to justify the initial outlay, we must have a way to compare cash flows occurring at different points in time. The value of a firm is equal to the discounted (or present) value of all expected returns. These future returns are discounted at a rate of return that is consistent with the risk of the expected future returns. When future returns are more certain, the discount rate used is lower resulting into a high present value of a firm ceteris paribus. When future returns are riskier or more uncertain, they are discounted at a higher rate resulting into a lower present value of the firm ceteris paribus. In making a decision on the problem of comparing the benefits and costs of an economic transaction that occur at different points in time requires answer to the following questions: Is 1 shilling to be received one year from today worth less than 1 shilling in hand today? If so why is it worth less? How much less worth is it? The answer to the questions depend on the alternative uses of the shilling that are available between now and one year from now.

TOPIC TWO: DEMAND ANALYSIS

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Demand: Demand (effective demand) is the want, need or desire for a product backed the money to purchase it (purchasing power). Demand is always based on “willingness and ability to pay” for a product, not merely want or need for the product. Consumers’ total demand for a product is reflected in the demand curve.

Demand curve: Is a line showing the relationship between the price of a product or factor of production and the quantity demanded per time period. The demand curve is usually downward sloping, since consumers will want to buy more as price decreases.

Demand function: Is a form of notation that links the dependent variable, quantity demanded (Qd) with various independent variables that determine quantity demanded such as product price (P), income (Y), prices of substitute products (Ps), advertising (A) etc. Changes in any of these independent variables will affect quantity demanded differently. Change in P, Y, Ps, A etc will affect Qd differently depending on many other aspects like elasticity of demand etc.

Mathematical expression of the demand function

Qd = f(P, Y, Ps, A, etc

i.e. Demand is a function of: P, Y, Ps, A etc

Types of demand

There are various types of demand. These include demand for:

Consumer and Producer Goods: Consumer goods are also called final goods. These are goods that are ultimately consumed rather than used in the production of another good. Producer or intermediate goods are used as inputs to make the final good.

Manufactured goods are goods that have been processed in any way. They are the opposite of raw materials, but include intermediate goods as well as final goods.

For Perishable and Durable Goods: Perishable – as opposed to durable goods are goods that do not last “long”. They include such farm products like some vegetables and fruits. Durable goods include things like machines.

Discussion Question

With examples, discuss how durability and perishability of a good affects its demand.

Derived Demand: Occurs where demand for one good or service occurs as a result of demand for another. This may occur as the former is a part of production of the second. For example, demand for coal leads to derived demand for mining, as coal must be mined for coal to be consumed.

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Derived demand applies to both consumers and producers. Producers have a derived demand for employees, the employees themselves are not demanded, rather the skills and productivity that they bring.

Autonomous Demand: Is the opposite of derived demand. Goods and services in this case, are demanded not because they are related.

Determinants of Demand

Demand for a good or service is determined by many different factors other than price, such as the price of substitute goods and complementary goods. In extreme cases, demand may be completely unrelated to price, or nearly infinite at a given price. The key determinants of demand include the following:

Number of Consumers: If more buyers enter a market, the demand for the product will increase, shifting the demand curve to the right, ceteris paribus.

Consumer Tastes and Preferences: As consumers' tastes or preferences change, the demand for products will also change.

Consumer Income: As consumers' incomes change, the demand for goods and services will change. For most products, demand increase when consumers have larger incomes.

Prices of Related Goods: When the prices of related goods change, demand may increase or decrease. If products can replace one another, they are called substitutes. A change in the price of one good will change the demand for its substitutes. For example, if the price of chicken increases, people will substitute away from chicken to its substitute, beef. The demand for beef will increase.

When products are used with one another, they are called complements. When the price of a product changes, the demand for its complement will also change. For example, sugar and tea are usually used with one another. If the price of sugar increase, people will purchase less tea.

Consumer Expectations: Changes in consumer expectations about the future (consumer sentiments) can cause changes in the current demand for products.

Other determinants of demand include consumers’ choice/taste and preference, price of the commodity in question etc.

Demand Elasticities

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Elasticity is the ratio of the proportional change in one variable with respect to proportional change in another variable (derived from the word elastic = relatively responsive to change). Price elasticity, for example, is the sensitivity of quantity demanded or supplied to changes in prices. Elasticity is usually expressed as a negative number but shown as a positive percentage value.

Elasticity of demand/demand elasticity

Is a measure of the degree of responsiveness of quantity demanded of a particular product to a give change in one of the independent variables that affect demand for that product. The responsiveness of demand to a change in income is known as income elasticity of demand. The responsiveness of demand for a particular product to changes in the prices of other related products is called cross-elasticity of demand.

Elasticity of supply

Is the degree of responsiveness of quantity supplied of a particular product to changes in the product’s price.

Mathematical expression for elasticity of demand

E = % change in quantity demanded/% change in price

i.e. Q2 – Q1/Q1 /P2 – P1/P1 = delta Q/Q1 x P1/delta P

Where:

Q2 = new quantity demanded; Q1 = original quantity demanded

P2 = new price level; P1 = original price level

(Percentage change in quantity demanded divide by percentage change in price). Similar expression is used for supply elasticity.

Applications of the elasticity concept

One typical application of the concept of elasticity is to consider what happens to consumer demand for a good when prices increase. As the price of a good rises, consumers will usually demand a lower quantity of that good, perhaps by consuming less, or substituting other goods. The greater the extent to which demand falls as price rises, the greater the price elasticity of demand. However, there may be some goods that consumers require, cannot consume less of, and cannot find substitutes for even if prices rise (for example, certain prescription drugs and oil and its derivatives such as gasoline). For such goods, the price elasticity of demand might be considered inelastic.

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Elasticity will normally be different in the short term and the long term. For example, for many goods the supply can be increased over time by locating alternative sources, investing in an expansion of production capacity, or developing competitive products which can substitute. One might therefore expect that the price elasticity of supply will be greater in the long term than the short term for such a good, that is, that supply can adjust to price changes to a greater degree over a longer time.

This applies to the demand side as well. For example, if the price of petrol rises, consumers will find ways to conserve their use of the resource. However, some of these ways, like finding a more fuel-efficient car, take time. So consumers as well may be less able to adapt to price shocks in the short term than in the long term.

The concept of elasticity has an extraordinarily wide range of applications in economics. In particular, an understanding of elasticity is useful to understand the dynamic response of supply and demand in a market, in order to achieve an intended result or avoid unintended results. For example, a business considering a price increase might find that doing so lowers profits if demand is highly elastic, as sales would fall sharply. Similarly, a business considering a price cut might find that it does not increase sales, if demand for the product is price inelastic.

More/Alternative Description of Demand Analysis

Demand:The theory of demand is the body of theory concerned with the determinants of the market demand for goods and services and the effects of market demand (together with market supply) on the prices and quantities transacted of particular goods ans services.

Demand or effective demand is the want, need or desire for a product backed by the money to purchase it. In economics, demand is always based on ”willingness and ability to pay” for a product, not merely want or need for the product. Consumer’s total demand for a product is reflected in the demand curve.

Demand curve Is a line showing the relationship between the price of a product or factor of production and the quantity demanded per time period.

Figure: Demand curve

Price

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Demand curve P1 P2

0 q1 q2 quantity

Consider the figure above. Demand is the total quantity of a good or service that buyers are prepared to purchase at a given price. The typical market curve slopes downwards from left to right, indicating that as price falls more is demanded (that is movement along the existing demand curve). Thus if price falls from OP1 to OP2, the quantity demanded will increase from Oq1 to Oq2.

The slope of the demand curve reflects the degree of responsiveness of quantity demanded to changes in the products price.

Shift in demand curve

Is a movement of the demand curve from one position to another (left or right) as a result of some economic change other than price. A given demand curve is always drawn on the ceteris paribus assumption that all other factors affecting demand (income, tastes, etc) are held constant. If any of these change, however, then this will bring about a shift in the demand curve. For example if income increases, the demand curve will shift to the right, so that more is now demanded at each price than formerly.

Figure: Shift in demand curve

Price D1 D2 P

D1 D2

O q1 q2 quantity

Consider the above diagram. An increase in income shifts the demand curve D1D1 to D2D2, increasing the quantity demanded from Oq1 to O q2. The magnitude of this shift depends upon the income elasticity of demand for the product.

Demand function

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Is a form of notation that links the dependent variable, quantity demanded (Qd), with various independent variables that determine quantity demanded such as product price (P), income (Y), prices of substitute products (Ps), advertising (A), etc: Qd = f(P, Y, Ps, A, etc). Changes in any of these independent variables will affect quantity demanded, and if we wish to investigate the particular effect of any one of these variables upon quantity demanded, then we could hold the influence of the other independent variable.

Demand schedule

This is a table listing various prices of a product and the specific quantities demanded at each of these prices. The information provided by a demand schedule can be used to construct a demand curve showing the price-quantity demanded relationship in graphical form.

SupplySupply is the amount of a product made available for sale by firms. In economic analysis, the total supply of a product is reflected in the supply curve.

Supply curve

Is a line showing the relationship between the price of a product or factor of production and the quantity supplied per time period. ”Supply” means the total quantity of a product or factor that firms or factor owners are prepared to sell at a given price.The typical market supply curve for a product slopes upwards from left to right, indicating that as price rises more is supplied (that is, a movement along the existing supply curve). Thus, if price rise from OP1 to OP2 in the figure below, the quantity supplied will increase from OQ1 to OQ2.

Figure: Supply curve Price S P2

P1 S 0 Q1 Q2 quantity

The figure above shows the supply curve for the market as a whole. This curve is derived by aggregating the individual supply curves of all the producers of the good, which in turn are derived from the producers’ cost curves.Most supply curves slope upwards because, as the price of the product rises, producers will find it more profitable to manufacture, using their existing production facilities, and

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because any increase in short-run marginal costs associated with increasing output will be covered by the higher price obtained.The slope of the supply curve reflects the degree of responsiveness of quantity supllied to changes in the product’s price. The supply curve interacts with the demand curve to determine the equilibrium market price.

Shift in supply curve

Is a movement of the supply curve from one position to another (left or right). As a result of some economic change, other than price. A given supply curve is always drawn on the ceteris paribus assumption that all other factors affecting supply (cost in particular) are held constant. If any of these change, however, then this will bring about a shift in the supply curve. For example if the cost of production fall, the supply curve wll shift to the right so that more is now supplied at each price than formerly.

Figure: Shift in supply curve.price

S1 S2P S1 S2 0 Q1 Q2 quantity

The curve above shows that a fall in production costs shifts the supply curve S1S1 to S2S2, increasing the quantity supplied at price OP from OQ1 to OQ2. The magnitude of this shift depends on the sensitivity of product supply to changes in costs.

Supply schedule

Is a schedule (table) listing the various prices of a product and the specific quantities supplied at each of these prices. The information provided by a supply schedule can be used to construct a supply curve showing the price/quantity-supplied relationship in graphical form.

Supply function

Is a form of notation that links the dependent variable, quantity supplied (Qs), with various independent variables that determine quantity supplied such as product price (P), prices of factor inputs (P1 and P2), the state of technology (T), and business goals (G). The supply equation states: Changes in any of these independent variables will affect

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quantity supplied, and if we wish to investigate the particular effect of any one of these variables upon quantity supplied then we could hold the influence of the other independent variables constant (ceteris paribus), whilst we focus upon the particular effect of that independent variable

Equilibrium of the MarketEquilibrium is a state of balance with no tendency to change.Equilibrium of the market is a state where supply equals demand, and the prevailing price is the equilibrium market price.

Equilibrium market price

Is the price at which the quantity demanded of a good is exactly equal to the quantity supplied. This quantity is referred to as equilibrium market quantity. S price D

Ep E

S D Eq quantity

Consider the graph above. E = Equilibrium point; Ep = Equilibrium price and Eq = Equilibrium quantity. At E, S = D. All that is supplied is demanded and there is no surplus (S > D) or deficit (S<D). At this point the market is therefore clearing.

Change in equilibrium market price

Is an increase or decrease in price resulting from a shift in the demand curve or supply curve.

Analysis of Elasticity and its usefulness in economic analysisElasticity is a relative responsive to change.

Elasticity of demand or demand elasticity

Is a measure of the degree of responsiveness of quantity demanded of a particular product to a given change in one of the independent variables that affect demand for that product. The responsiveness of demand to a change in price is referred to as price elasticity of demand; the responsiveness of demand to a change in income is known as income

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elasticity of demand; and the responsiveness of demand for a particular product to changes in the prices of other related products (complementary or substitute) is called cross-elasticity of demand.

Arc Elasticity: Is a rough measure of the responsiveness of demand or supply to changes in price, income etc. In the case of price elasticity of demand, it is the ratio of the percentage change in quantity demanded (Q) to the percentage change in price (P) over a price range.

Mathematical expression of arc elasticity of demand

e= Q1 – Qo/P1 – Po X P1 + Po/Q1 + Qo

Where Po = original price; Qo = original quantity; P1 = new price; Q1 = new quantity.

Because arch elasticity measures the elasticity of demand over a price range or arc of the demand curve, it is only an approximation of demand elasticity at a particular price (point elasticity).

Discussion question: Assume that you have been engaged as a consultant by firm that produces various goods and services. The firm does not know how the concept and theory of elasticity of demand can be used to predict (or determine) its revenues. With examples, give the needed explanation to the firm.

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TOPIC THREE: PRODUCTION ANALYSIS

Introduction

Demand analysis deals with the demand side of the economy. Production (and cost) analysis deals with the supply side of the economy. Production Analysis relates physical inputs to physical outputs. It studies, inter alia, the least cost combination of factor inputs, factor productivities and returns to scale. This is a technological relationship between the output of a commodity and its inputs.

Example: One adult pair of trousers (factor output) may require 1½ metres of cloth, 300 metres of thread and 2 hrs of machine time (factor inputs). Factor inputs are usually classified as: land, labour, capital, entrepreneurship and technology.

Production is the act of combining factors of production by firms to produce outputs of goods and services. The relationship between inputs and outputs in physical terms is shown by production function and in cost terms by cost function.

Production Function: Is a notation that shows for a given state of technological knowledge the relationship between physical quantities of factor inputs and the physical quantities of output involved in producing a good or service. It is the specification of the minimum input requirements needed to produce designated quantities of output, given available technology and other factor inputs. It is usually presumed that unique production functions can be constructed for every production technology.

Since the quantity of output depends on the quantity of inputs used, the relationship can be depicted in the form of functional notation below

Qx= f(Ld, L, K, M, T)

Where:

Qx =Output of X

Ld = Land employed

L =Labor

K = Capital,

M = Entrepreneurship and T = Technology

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For analytical purposes, only L and K will be used. It is accepted that both L and K are necessary for production of a commodity and they are substitutes to each other. However, they are not perfect substitutes. Given the substitutability of L and K, production techniques can either be capital intensive or labour intensive.

Production function can be alternatively presented as Q = f(I1, I2…In),

Where: Q = output of a product and I1, I2 etc are quantities of the various factor inputs 1, 2, etc used in producing that output.

Purpose of Production Function

The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production.

Production function in the short- and long-run

In the short run a firm can try to alter demand by changing the price of the output or adjusting the level of promotional (adverts) expenditure. In the long run the firm has more options available to it, most notably, adjusting its production processes so they better match the characteristics of demand. This usually involves changing the scale of operations by adjusting the level of fixed inputs. Example: Twiga Cement Wazo Hill extension to meet increased demand for cement in the country.NB: It has to be noted that short – or long run time period is relative and contextual.

Statistical Production Functions

Most commonly used statistical production function is the Cob-Douglas Production Function. This is a particular physical relationship between output of products and factor inputs used to produce these outputs. The Cob-Douglas production function suggests that where there is effective competition in factor markets the elasticity of technical substitution between labour and capital will be equal to one (unit elasticity). This means that labour can be substituted for capital in any given proportions and vice versa without affecting output. It suggests that the share of capital and share of labour inputs are relative constants in an economy, so that although labour and capital inputs may change in absolute terms, the relative share between the two inputs remains constant.

Aggregate production functions

These are production functions for whole nation(s). In theory they are the summation of all the production functions of individual producers (firms).

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Production Techniques: Capital and labour intensive

Factor inputs can be combined in a number of different ways to produce the same amount of output. One method may employ large amounts of capital and only small amounts of labour (capital intensive production) or vice versa (labour-intensive production). In physical terms, the method that is technically the most efficient is the one that uses the fewest inputs. The most economical way of producing outputs is through the least cost way of producing. Such relationships can be analyzed using isoquant curves and isocost lines.

Isoquant curves

Are curves that show the varying combination of factors of production that can be used to produce a given quantity of a product with a given state of technology (where factor inputs can be substituted for one another in the production process).

An isoquant reflects the units of production per period, say 100 units. Anywhere along the isoquant curve it is possible to determine the combination of factor inputs required to produce 100 units. The slope of the isoquant reflects substitutability of one factor for the other in the production process.

Isoquants slope downward to the right because the two inputs can be substituted for one another in the production process. They are convex to the origin because although the inputs can be substituted for one another, they are not perfect substitutes.

NB: Students should be able to draw an isoquant curve: K on Y axis, L on X axis and show how K and L may be substituted without affecting the production level

Isocost line

Shows the combinations of the two factor inputs which can be purchased for the same total money outlay (budget). Its slope reflects the relative prices of the two factors of production. Where the isoquant is tangential to the isocost line, is the least cost combination of inputs for producing a given number of outputs.

NB: Students should be able to draw an isoquant curve tangent to an isocost line: capital in the vertical and labour in the horizontal axis)

Least-cost combination of inputs

Firms have various possible levels of combination of factor inputs to get a given level of output. Each input combination however has a different cost. The supply theory in economics assumes that profit maximizing firms will always employ that combination of factor inputs that minimizes the total cost of producing a given output. This is the least cost combination of factor inputs. Firms therefore will/should strive to identify and operate at that least cost combination of inputs and produce at that level of output.

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This can be achieved in two major ways/approaches. These are arithmetic and geometric approaches.

Arithmetic approach to determine least cost combination of inputs

This consists of listing the different alternative combinations of inputs producing the same outputs. The total cost of each combination is then calculated. These costs are then compared and the alternative with the minimum total cost is chosen as the least cost combination.

Discussion/review question

Consider the table below for a firm with two-input combination for production of 100 units of a certain output using a linear production function. Assume that the unit price of capital (K) is 10 and that of labour (L) is 7. Help the firm to arithmetically determine the least cost combination of inputs.

Table

L K4 105 86 67 510 4

Geometric approach to determine least cost combination of inputs

This is achieved by drawing isoquant curves and isocost lines. The least cost combination of inputs is achieved where the isoquant curve is tangential to the isocost line.

Example: If price of labour (PL) = 5 and price of capital (PK) = 10 and amount of money available (budget outlay) is 100/=; the cost equation is

C = L.PL + K.PK = 5L + 10K = 100

- Maximum L (without K) is 20 units and Maximum K (without L) is 10 units. Given the maximum values of L and K we can draw a line joining these values and call it an isocost line.

NB: Students should be able to plot the above equation geometrically.

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Factor productivities and return to scale

Factor Productivity is the relationship between the output of an economic unit and the factor inputs that have gone into producing that output. It is usually measured in terms of output per man-hour. Factor productivity theory/concept can be used to facilitate inter-firm, inter-industry, and inter-country comparisons. An increase in productivity occurs when output per man-hour is raised2. The main source of productivity increases is the use of more and better capital stock (capital widening and capital deepening).

Capital widening is an increase in the capital input in the economy at the same rate as the increase in the labour input so that the proportion in which capital and labour are combined to produce national output remains unchanged.

Capital deepening is an increase in the capital input in the economy at a faster rate than the increase in the labour input so that proportionally more capital to labour is used to produce national output (capital intensive mode of production). Increased productivity makes an important contribution to the achievement of higher rates of economic growth.

Total factor Productivity of labour

Total Factor Productivity of Labour, or TFPL = Total physical product of labour.

Average Physical Product of Labour = APPL

APPL = TPPL

L

Marginal Physical Product of labor

Marginal Physical Product of labor MPPL = APPL

L

Law of Diminishing Returns

As more and more units of a variable factor are used together with constant amounts of other factors, the TPP of the variable factor increases, but the increment goes on diminishing after a certain point. It increases at a decreasing rate before starting declining (falling).

NB: The APP and MPP also first increase and reach their maximum values before they start falling

2 Students should be able to identify and discuss factors that may contribute into an increase or decrease in labour and capital productivity

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Discussion questions: What are the factors that influence factor productivity in your organization in particular and in a country like Tanzania in general?

Returns to scale

Is the relationship between output of a product and the quantities of factor inputs used to produce it in the long run (as opposed to short run). Where doubling the quantity of factor inputs used results in a doubling of output, then returns to scale is experienced. Where economies of scale are present, a doubling of factor inputs results in a more than proportionate increase in output. Where diseconomies of scale are encountered, a doubling of factor inputs results in a less than proportionate increase in output.

Economies of scale

Are the advantages associated with large scale production. It is the long-run reduction in average (or unit) costs that occurs as the scale of the firm’s output is increased (all factor inputs being variable).

NB: Students should read more about economies of scale, including why and how they arise including managerial, commercial, marketing and financial economies of scale.

Diseconomies of scale

These are the disadvantages of large scale production. Is the possible increase in long-run or average cost that may occur as the scale of the firms’ output is increased beyond some critical points. Initially, as output is increased, long-run average costs may at first decline, reflecting the presence of economies of scale, but after a certain point, long-run average costs may start to rise. The main sources of the diseconomies of scale are the managerial and administration problems of controlling large-scale operations and labour relations problems in large firms.

Discussion questions

1. Assume that you are a manager in an organization that is producing some goods and services. How can you use the knowledge of production functions in your work? Give examples.

2. Despite of lacking the various economies of scale as predicted in the economic theory, we see successful small companies/businesses and even businesses that have a ‘not to become big’ as part of their strategy. Give a reasoned economic account for such a paradox.

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COST ANALYSIS

The concept of cost is central in economics in general and in a number of managerial decision-making in particular. This is particularly so for managerial decisions undertaken in a bid to maximize profit. It is to be remembered that mathematically:

Profit = Revenue – Cost or

Cost = Revenue - Profit.

Cost is the payment incurred by a firm in producing its outputs of goods and services. There are however, different types of costs. In making any managerial decision involving cost therefore, one has to use a relevant cost concept. In what follows some types of costs (different cost concepts) are briefly introduced. The list is not exhaustive though.

Types of Costs

Explicit cost is the payment made by a firm for use of factor inputs not owned by the firm. Explicit cost involves the firm in purchasing inputs from outside factor markets. For example hiring machines, outsourcing personnel etc.

Implicit cost represents payments for the use of factor inputs owned by the firm itself. For example using own personnel and machines.

Private and external: When a transaction takes place, it typically involves both private costs and external costs as outline below.

Private costs are the costs that the buyer of a good or service pays the seller. This can also be described as the costs internal to the firm's production function.

External costs (also called externalities) are the costs (or benefits) that people other than the buyers are forced to pay as a result of the transaction. The bearers of such costs can be either particular individuals or society at large. External costs are often both non-monetary and problematic to quantify for comparison with monetary values. They include things like pollution, things that society will likely have to pay for in some way or at some time in the future (environmental destruction), but that are not included in transaction prices.

Social costs are the sum of private costs and external costs.

Example: The manufacturing cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of running the plant and labour costs) reflects the private cost for the manufacturer. The polluted waters or polluted air also created as part of the process of producing the car is an external cost borne by those who are affected by the pollution or who value unpolluted air or water. Because the manufacturer does not pay

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for this external cost and does not include this cost in the price of the car, they are said to be external to the market pricing mechanism. The air pollution from driving the car is also an externality produced by the car user in the process of using his good. The driver does not compensate for the environmental damage caused by using the car.

NB: Various taxes have been introduces in some places to (partly) compensate for environmental destruction (green/environmental taxes).

Some other cost concepts

Total cost

Is the cost of all factors of production used by a firm in producing a particular level of output. In the short run, a firm’s total cost consists of total fixed cost ( which are independent of quantity produced such as expenses for assets like buildings, insurance etc) and total variable cost (varies according to quantity produced such as raw materials). Total cost interacts with total revenue in determining the optimal level of production where profit is maximized and costs minimized. In the long run, a firm must earn enough total revenue to cover total variable and total fixed costs (including a normal profit margin). Otherwise it will have to leave the market.

Total cost = total variable costs + total fixed cost

TC = TVC + TFC

The rate at which total cost changes as the amount produced changes is called marginal cost.

Average cost: Is the unit cost of producing a particular volume of output in a firm. Mathematically, it is equal to total cost divided by the number of goods produced.

Average cost = TC/Q, where TC is total cost and Q are the total number of outputs produced

Marginal Costs: is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.

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A typical Marginal Cost Curve

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.

It is a general principle of economics that a (rational) producer should always produce (and sell) the last unit if the marginal cost is less than the market price. As the market price will be dictated by supply and demand, it leads to the conclusion that marginal cost equals marginal revenue (at optimal point of production)

Out-of-pocket costs: The out of pocket cost is the total of all costs you must pay for service. They are direct outlays of cash which are not reimbursed.

Example: In operating a vehicle: fuel, parking fees and road tolls are considered out-of-pocket expenses for the trip. Insurance, oil changes, and interest are not, because the outlay of cash covers expenses accrued over a longer period of time.

Book Costs: Are historical/past costs. For example, a book cost of $10,000 is a historical fact; it is not a measure of current value or of r replacement cost, either of which may be greater or less than $10,000.

Separable: Costs that are identifiable with specific products, for example university’s cost of running a specific campus or course may be easily separated from the total costs

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of running the whole university. This can be easily achieved if organizations have cost and profit centres.

Common Costs: A common cost is a cost that is common to a number of costing objects but cannot be traced to them individually. For example, the wage cost of a pilot is a common cost of all of the passengers on the aircraft. Without the pilot, there would be no flight and no passengers. But no part of the pilot's wage is caused by any one passenger taking the flight.

Short-run and long-run Costs (See variable and fixed cost)

Short-run cost is that cost that varies with output when plant and equipment remain the same (constant, unaltered). Long-run cost: is that cost which varies with output when all factor inputs change. As said earlier (in production analysis), in the short run firms are constrained in various ways, they have very little flexibility and options. In making production decisions with a given plant size, managers have to make use of short-run costs for analysis, but when thinking of increasing plant size, long-run cost analysis should be employed.

Opportunity cost (as opposed to actual cost)

Opportunity cost, or economic cost, is the cost of something in terms of an opportunity forgone (and the benefits which could be received from that opportunity). It is a measure of the economic cost of using scarce resources to produce one particular good or service in terms of the alternatives thereby forgone.

Opportunity cost need not be assessed in monetary terms, but rather can be assessed in terms of anything which is of value to the person or persons doing the assessing (or those affected by the outcome). It is therefore subjective, not objective. When making decisions therefore, one needs to ask “what is the opportunity cost of choosing A instead of B?”

Opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the one's decision to build a school on a vacant land is the loss of the land for, say, a sporting center, or (not and) the inability to use the land for a parking lot, or the money which could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate, because the land cannot be used for more than one of these purposes. Scarcity necessitates trade-offs, and trade-offs result in an opportunity cost.

Relative Price and Opportunity Cost

Opportunity cost is expressed in relative price, that is, the price of one choice relative to the price of another.

Example: If a cake 4000 Tshs and a loaf of bread costs 2000 Tshs, then the relative price of cake is 2 loaves of bread. This is because if one goes to a shop with only 4000 Tsh and

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buys a cake with it, then one can say that the opportunity cost of that cake was 2 loaves of bread (assuming that bread was the next best alternative).

Applications of Opportunity Cost

The concept of opportunity cost has a wide range of applications including:

Consumer choice: See the example above Production possibilities: If commodity A is produced instead of B, how much of

B is forgone? (assuming only one commodity can be produced) Cost of capital: Between source (say bank) A and B Time management: Reading versus relaxation time…work-leisure trade-off. Career choice: What does one forgo/sacrifice when choosing one and not the

other carrier or carrier path? Analysis of comparative advantage: In which product does a country/firm have

comparative advantage in production?

Actual Cost (as opposed to opportunity cost)

These are costs actually incurred in acquiring or producing a good or a service. These costs are real cash outflows and are generally recorded in accounting books. Therefore, they are also called acquisition or accounting costs.

Cost Function

Is a function that depicts the general relationship between the cost of factor inputs and the cost of output in a firm. In order to determine the cost of producing a particular output it is necessary to know not only the required quantities of the various inputs but also their prices. The cost function can be derived from the production function by adding the information about factor prices. It would take the general form shown below:

Qc = f (p1 1l, p2 l2….pn ln) where

Qc is the cost of producing a particular output, Q, and p1, p2, etc, are the prices of the various factors used, while l1, l2 are the quantities of factors needed. The factor prices p1, p2, etc which a firm must pay in order to attract units of these factors will depend upon the interaction of and free interplay of market forces of supply and demand.

Determinants of Costs (cost drivers, cost items)

There are various factors that determine (influence) firms’ costs of producing goods and services. They include

Prices of factor inputs (factor prices) like price of labour, land, capital, entrepreneurship and technology. The higher the factor price, the higher the production and output cost.

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Output level (the higher the level, the higher the total cost but the lower the average cost);

Factor productivities (the higher the productivity the lower the cost of output because the same output can be produced using smaller quantities of factor inputs which have higher productivity

Technological advancement (technological advancement improves the efficiency or productivity of a factor of production. The cost of production is inversely related to technological advancement.

NB: It is to be noted that the relationships above have to be qualified by a ceteris paribus condition (other factors/things remaining constant). Students should understand what are these “other factors” in a specific production context and situation. It should also be understood that the more costly are some of the cost determinants above, the more efficient is the production process likely to be, ceteris paribus.

Short-run Cost-output Relationship

In the short-run fixed cost do not vary with the level of output. Variable cost and total cost however do change.

Long-run Cost-output Relationship

In the long-run both fixed and variable costs are subject to change, together with the total cost.

Some managerial implications of the above: In the short-run, never worry about fixed costs (permanent staff salaries, insurance, business premise rent etc…do so when thinking and planning for the long-run. In the long run managers/decision makers have to think of what are currently fixed and variable costs because they will all be variable when that long-term ‘comes’.

Break-even Analysis

Break-even is the short-run rate of output and sales at which a supplier generates just enough revenue to cover fixed and variable costs, earning neither profit nor loss. At the Break Even Point:

Revenue = Total Cost

If the selling price of a product exceeds its unit variable cost, then each unit of product sold will earn a contribution3 towards fixed cost and profits. Once sufficient units are

3 Contribution is the difference between a product’s sales revenue and its variable cost. If total contributions are just large enough to cover fixed costs, then the producer breaks-even, if less he makes loss. If it exceeds fixed costs, he makes a profit

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being sold so that their total contributions cover the supplier’s fixed costs, then the firm breaks-even. If less than the break-even sales volume is achieved, then total contributions will not meet fixed costs and the supplier will make a loss. If the sales volume achieved exceeds the break-even volume, total contributions will cover the fixed costs and leave a surplus that constitutes profit.

Introduction

Demand analysis deals with the demand side of the economy. Production (and cost) analysis deals with the supply side of the economy. Production Analysis relates physical inputs to physical outputs. It studies, inter alia, the least cost combination of factor inputs, factor productivities and returns to scale. This is a technological relationship between the output of a commodity and its inputs.

Eg. One adult pair of trousers (factor output) may require 1½ metres of cloth, 300 metres of thread and 2 hrs of machine time (factor inputs). Factor inputs are usually classified as: land, labour, capital, entrepreneurship and technology.

Production is the act of combining factors of production by firms to produce outputs of goods and services. The relationship between inputs and outputs in physical terms is shown by production function and in cost terms by cost function.

Production Function: Is a function that shows for a given state of technological knowledge the relationship between physical quantities of factor inputs and the physical quantities of output involved in producing a good or service. It is the specification of the minimum input requirements needed to produce designated quantities of output, given available technology and other factor inputs. It is usually presumed that unique production functions can be constructed for every production technology.

Since the quantity of output depends on the quantity of inputs used, the relationship can be depicted in the form of functional notation below

Qx= f(Ld, L, K, M, T)

Where:

Qx =Output of X

Ld = Land employed

L =Labor

K = Capital,

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M = Entrepreneurship and

T = Technology

For analytical purposes, only L and K will be used. It is accepted that both L and K are necessary for production of a commodity and they are substitutes to each other. However, they are not perfect substitutes. Given the substitutability of L and K, production techniques can either be capital intensive or labour intensive.

Production function can be alternatively presented as Q = f(I1, I2…In),

Where: Q = output of a product and I1, I2 etc are quantities of the various factor inputs 1,2, etc used in producing that output.

Purpose of Production Function

The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production.

Production function in the short- and long-run

In the short run a firm can try to alter demand by changing the price of the output or adjusting the level of promotional (adverts) expenditure. In the long run the firm has more options available to it, most notably, adjusting its production processes so they better match the characteristics of demand. This usually involves changing the scale of operations by adjusting the level of fixed inputs. Example: Twiga Cement Wazo Hill extension to meet increased demand for cement in the country.

Statistical Production Functions

Most commonly used statistical production function is the Cob-Douglas Production Function. This is a particular physical relationship between output of products and factor inputs used to produce these outputs. The Cob-Douglas production function suggests that where there effective competition in factor markets the elasticity of technical substitution between labour and capital will be equal to one (unit elasticity). This means that labour can be substituted for capital in any given proportions and vice versa without affecting output. It suggests that the share of capital and share of labour inputs are relative constants in an economy, so that although labour and capital inputs may change in absolute terms, the relative share between the two inputs remains constant.

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Aggregate production functions

These are production functions for whole nation(s). In theory they are the summation of all the production functions of individual producers (firms).

Production Techniques: Capital and labour intensive

Factor inputs can be combined in a number of different ways to produce the same amount of output. One method may employ large amounts of capital and only small amounts of labour (capital intensive production) or vice versa (labour-intensive production). In physical terms, the method that is technically the most efficient is the one that uses the fewest inputs. The most economical way of producing outputs is through the least cost way of producing. Such relationships can be analyzed using isoquant curves, isoquant maps and process rays.

Isoquant curves

Are curves that show the varying combination of factors of production that can be used to produce a given quantity of a product with a given state of technology (where factor inputs can be substituted for one another in the production process).

An isoquant reflects the units of production per period, say 100 units. Anywhere along the isoquant curve it is possible to determine the combination of factor inputs required to produce 100 units. The slope of the isoquant reflects substitutability of one factor for the other in the production process.

Isoquants slope downward to the right because the two inputs can be substituted for one another in the production process. They are convex to the origin because although the inputs can be substituted for one another, they are not perfect substitutes.

NB: Students should be able to draw an isoquant curve: K on Y axis, L on X axis and show how K and L may be substituted without affecting the production level

Isocost line

Shows the combinations of the two factor inputs which can be purchased for the same total money outlay (budget). Its slope reflects the relative prices of the two factors of production. Where the isoquant is tangential to the isocost line, is the least cost combination of inputs for producing a given number of outputs.

NB: Students should be able to draw an isoquant curve tangent to an isocost line: capital in the vertical and labour in the horizontal axis)

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Least-cost combination of inputs

Firms have various possible levels of combination of factor inputs to get a given level of output. Each input combination however has a different cost. The supply theory in economics assumes that profit maximizing firms will always employ that combination of factor inputs that minimizes the total cost of producing a given output. This is the least cost combination of factor inputs. Firms therefore will/should strive to identify and operate at that least cost combination of inputs and produce at that level of output. This can be achieved in two major ways/approaches. These are arithmetic and geometric approaches.

Arithmetic approach to determine least cost combination of inputs

This consists of listing the different alternative combinations of inputs producing the same outputs. The total cost of each combination is then calculated. These cost are then compared and the alternative with the minimum total cost is chosen as the least cost combination.

Discussion/review question:

Consider the table below for a firm with two-input combination for production of 100 units of a certain output. Assume that the unit price of capital (K) is 10 and that of labour (L) is 7. Help the firm to arithmetically determine the least cost combination of inputs.

Table

L K4 105 86 67 510 4

Geometric approach to determine least cost combination of inputs

This is achieved where the isoquant curve is tangential to the isocost line (refer above).

Example: If price of labour (PL) = 5 and price of capital (PK) = 10 and amount of money available (budget outlay) is 100/=; the cost equation is

C = L.PL + K.PK = 5L + 10K = 100

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- Maximum L (without K) is 20 units and Maximum K (without L) is 10 units. Given the maximum values of L and K we can draw a line joining these values and call it an isocost line.

NB: Students should be able to plot the above equation geometrically.

Factor productivities and return to scale

Factor Productivity is the relationship between the output of an economic unit and the factor inputs that have gone into producing that output. It is usually measured in terms of output per man hour. Factor productivity theory/concept can be used to facilitate inter-firm, inter-industry, and inter-country comparisons. An increase in productivity occurs when output per man hour is raised. The main source of productivity increases is the use of more and better capital stock (capital widening and capital deepening).

Capital widening is an increase in the capital input in the economy at the same rate as the increase in the labour input so that the proportion in which capital and labour are combined to produce national output remains unchanged.

Capital deepening is an increase in the capital input in the economy at a faster rate than the increase in the labour input so that proportionally more capital to labour is used to produce national output (capital intensive mode of production). Increased productivity makes an important contribution to the achievement of higher rates of economic growth.

Total factor Productivity of labour

Total factor Productivity of labour, or TTPL= Total physical product of labour.

Average Physical Product of Labour = APPL

APPL = TPPL

L

Marginal Physical Product of labor

Marginal Physical Product of labor MPPL = APPL

L

Law of Diminishing Returns

As more and more units of a variable factor are used together with constant amounts of other factors, the TPP of the variable factor increases, but the increment goes on diminishing after a certain point. It increases at a decreasing rate before starting declining (falling).

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NB: The APP and MPP also first increase and reach their maximum values before they start falling

Discussion questions: What are the factors that influence factor productivity in your organization in particular and in a country like Tanzania in general?

Returns to scale

Is the relationship between output of a product and the quantities of factor inputs used to produce it in the long run (as opposed to short run). Where doubling the quantity of factor inputs used results in a doubling of output, then returns to scale is experienced. Where economies of scale are present, a doubling of factor inputs results in a more than proportionate increase in output. Where diseconomies of scale are encountered, a doubling of factor inputs results in a less than proportionate increase in output.

Economies of scale

Are the advantages associated with large scale production. It is the long-run reduction in average (or unit) costs that occurs as the scale of the firm’s output is increased (all factor inputs being variable).

NB: Students should read more about economies of scale, including why and how they arise including managerial, commercial, marketing and financial economies of scale.

Diseconomies of scale

These are the disadvantages of large scale production. Is the possible increase in long-run or average cost that may occur as the scale of the firms’ output is increased beyond some critical point. Initially, as output is increased, long-run average costs may at first decline, reflecting the presence of economies of scale, but after a certain point, long-run average costs may start to rise. The main sources of the diseconomies of scale are the managerial and administration problems of controlling large-scale operations and labour relations problems in large firms.

Discussion questions

3. Assume that you are a manager in an organization that is producing some goods and services. How can you use the knowledge of production functions in your work? Give examples.

4. Despite of lacking the various economies of scale as predicted in the economic theory, we see successful small companies/businesses and even businesses that have a ‘not to become big’ as part of their strategy. Give a reasoned economic account for such a paradox.

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TOPIC FOUR: COST ANALYSIS

The concept of cost is central in economics in general and in a number of managerial decision-making in particular. This is particularly so for managerial decisions undertaken in a bid to maximize profit. It is to be remembered that mathematically:

Profit = Revenue – Cost or Cost = Revenue - Profit.

Cost is the payment incurred by a firm in producing its outputs of goods and services. There are however, different types of costs. In making any managerial decision involving cost therefore, one has to use a relevant cost concept. In what follows some types of costs (different cost concepts) are briefly introduced. The list is not exhaustive though.

Types of Costs

Explicit cost is the payment made by a firm for use of factor inputs not owned by the firm. Explicit cost involves the firm in purchasing inputs from outside factor markets. For example hiring machines, outsourcing personnel etc.

Implicit cost represents payments for the use of factor inputs owned by the firm itself. For example using own personnel and machines.

Private and external: When a transaction takes place, it typically involves both private costs and external costs as outline below.

Private costs are the costs that the buyer of a good or service pays the seller. This can also be described as the costs internal to the firm's production function.

External costs (also called externalities) are the costs (or benefits) that people other than the buyers are forced to pay as a result of the transaction. The bearers of such costs can be either particular individuals or society at large. External costs are often both non-monetary and problematic to quantify for comparison with monetary values. They include things like pollution, things that society will likely have to pay for in some way or at some time in the future (environmental destruction), but that are not included in transaction prices.

Social costs are the sum of private costs and external costs.

Example: The manufacturing cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of running the plant and labour costs) reflects the private cost for the manufacturer. The polluted waters or polluted air also created as part of the process of producing the car is an external cost borne by those who are affected by the pollution or who value unpolluted air or water. Because the manufacturer does not pay for this external cost and does not include this cost in the price of the car, they are said to be external to the market pricing mechanism. The air pollution from driving the car is

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also an externality produced by the car user in the process of using his good. The driver does not compensate for the environmental damage caused by using the car.

NB: Various taxes have been introduces in some places to (partly) compensate for environmental destruction (green/environmental taxes).

Some other cost concepts

Total cost

Is the cost of all factors of production used by a firm in producing a particular level of output. In the short run, a firm’s total cost consists of total fixed cost ( which are independent of quantity produced such as expenses for assets like buildings, insurance etc) and total variable cost (varies according to quantity produced such as raw materials). Total cost interacts with total revenue in determining the optimal level of production where profit is maximized and costs minimized. In the long run, a firm must earn enough total revenue to cover total variable and total fixed costs (including a normal profit margin). Otherwise it will have to leave the market.

Total cost = total variable costs + total fixed cost

TC = TVC + TFC

The rate at which total cost changes as the amount produced changes is called marginal cost.

Average cost: Is the unit cost of producing a particular volume of output in a firm. Mathematically, it is equal to total cost divided by the number of goods produced.

Average cost = TC/Q, where TC is total cost and Q are the total number of outputs produced

Marginal Costs: is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.

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A typical Marginal Cost Curve

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.

It is a general principle of economics that a (rational) producer should always produce (and sell) the last unit if the marginal cost is less than the market price. As the market price will be dictated by supply and demand, it leads to the conclusion that marginal cost equals marginal revenue (at optimal point of production)

Out-of-pocket costs: The out of pocket cost is the total of all costs you must pay for service. They are direct outlays of cash which are not reimbursed.

Example: In operating a vehicle: fuel, parking fees and road tolls are considered out-of-pocket expenses for the trip. Insurance, oil changes, and interest are not, because the outlay of cash covers expenses accrued over a longer period of time.

Book Costs: Are historical/past costs. For example, a book cost of $10,000 is a historical fact; it is not a measure of current value or of r replacement cost, either of which may be greater or less than $10,000.

Separable: Costs that are identifiable with specific products, for example university’s cost of running a specific campus or course may be easily separated from the total costs

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of running the whole university. This can be easily achieved if organizations have cost and profit centres.

Common Costs: A common cost is a cost that is common to a number of costing objects but cannot be traced to them individually. For example, the wage cost of a pilot is a common cost of all of the passengers on the aircraft. Without the pilot, there would be no flight and no passengers. But no part of the pilot's wage is caused by any one passenger taking the flight.

Short-run and long-run Costs (See variable and fixed cost)

Short-run cost is that cost that varies with output when plant and equipment remain the same (constant, unaltered). Long-run cost: is that cost which varies with output when all factor inputs change. As said earlier (in production analysis), in the short run firms are constrained in various ways, they have very little flexibility and options. In making production decisions with a given plant size, managers have to make use of short-run costs for analysis, but when thinking of increasing plant size, long-run cost analysis should be employed.

Opportunity cost (as opposed to actual cost)

Opportunity cost, or economic cost, is the cost of something in terms of an opportunity forgone (and the benefits which could be received from that opportunity). It is a measure of the economic cost of using scarce resources to produce one particular good or service in terms of the alternatives thereby forgone.

Opportunity cost need not be assessed in monetary terms, but rather can be assessed in terms of anything which is of value to the person or persons doing the assessing (or those affected by the outcome). It is therefore subjective, not objective. When making decisions therefore, one needs to ask “what is the opportunity cost of choosing A instead of B?”

Opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the one's decision to build a school on a vacant land is the loss of the land for, say, a sporting center, or (not and) the inability to use the land for a parking lot, or the money which could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate, because the land cannot be used for more than one of these purposes. Scarcity necessitates trade-offs, and trade-offs result in an opportunity cost.

Relative Price and Opportunity Cost

Opportunity cost is expressed in relative price, that is, the price of one choice relative to the price of another.

Example: If a cake 4000 Tshs and a loaf of bread costs 2000 Tshs, then the relative price of cake is 2 loaves of bread. This is because if one goes to a shop with only 4000 Tsh and

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buys a cake with it, then one can say that the opportunity cost of that cake was 2 loaves of bread (assuming that bread was the next best alternative).

Applications of Opportunity Cost

The concept of opportunity cost has a wide range of applications including:

Consumer choice: See the example above Production possibilities: If commodity A is produced instead of B, how much of

B is forgone? (assuming only one commodity can be produced) Cost of capital: Between source (say bank) A and B Time management: Reading versus relaxation time…work-leisure trade-off. Career choice: What does one forgo/sacrifice when choosing one and not the

other carrier or carrier path? Analysis of comparative advantage: In which product does a country/firm have

comparative advantage in production?

Actual Cost (as opposed to opportunity cost)

These are costs actually incurred in acquiring or producing a good or a service. These costs are real cash outflows and are generally recorded in accounting books. Therefore, they are also called acquisition or accounting costs.

Determinants of Costs (cost drivers, cost items)

There are various factors that determine (influence) firms’ costs of producing goods and services. They include

Prices of factor inputs (factor prices) like price of labour, land, capital, entrepreneurship and technology. The higher the factor price, the higher the production and output cost.

Output level (the higher the level, the higher the total cost but the lower the average cost);

Factor productivities (the higher the productivity the lower the cost of output because the same output can be produced using smaller quantities of factor inputs which have higher productivity

Technological advancement (technological advancement improves the efficiency or productivity of a factor of production. The cost of production is inversely related to technological advancement.

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NB: It is to be noted that the relationships above have to be qualified by a ceteris paribus condition (other factors/things remaining constant). Students should understand what are these “other factors” in a specific production context and situation. It should also be understood that the more costly are some of the cost determinants above, the more efficient is the production process likely to be, ceteris paribus.

Short-run Cost-output Relationship

In the short-run fixed cost do not vary with the level of output. Variable cost and total cost however do change.

Long-run Cost-output Relationship

In the long-run both fixed and variable costs are subject to change, together with the total cost.

Some managerial implications of the above: In the short-run, never worry about fixed costs (permanent staff salaries, insurance, business premise rent etc…do so when thinking and planning for the long-run. In the long run managers/decision makers have to think of what are currently fixed and variable costs because they will all be variable when that long-term ‘comes’.

Break-even Analysis

Break-even is the short-run rate of output and sales at which a supplier generates just enough revenue to cover fixed and variable costs, earning neither profit nor loss. At the Break Even Point:

Revenue = Total Cost

If the selling price of a product exceeds its unit variable cost, then each unit of product sold will earn a contribution4 towards fixed cost and profits. Once sufficient units are being sold so that their total contributions cover the supplier’s fixed costs, then the firm breaks-even. If less than the break-even sales volume is achieved, then total contributions will not meet fixed costs and the supplier will make a loss. If the sales volume achieved exceeds the break-even volume, total contributions will cover the fixed costs and leave a surplus that constitutes profit.

4 Contribution is the difference between a product’s sales revenue and its variable cost. If total contributions are just large enough to cover fixed costs, then the producer breaks-even, if less he makes loss. If it exceeds fixed costs, he makes a profit

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Case study

Students are advised to read the case study below to see the practical side of some of the theoretical aspects covered in this and other topics, with emphasis on production function, revenues, costs, profits etc

The economics of smallholder dairy production in Hai District, Tanzania

By Gilead I. Mlay

Department of Rural Economy, Sokoine University of Agriculture,Morogoro, Tanzania

Abstract

This paper presents a cost-returns analysis of smallholder dairy production in Hai District, Tanzania. The use of gross-margins analysis to assess the economic impact of proposed technologies is demonstrated. The data used were obtained during a 1984 household survey of 150 randomly selected farmers keeping dairy cattle.

The results indicate that dairy production is economically attractive for smallholder farmers in both the short run and long run. The high internal rate of return (over 50%), while suggesting an overestimation of enterprise costs, explains the high demand for dairy cattle by smallholder farmers despite the present critical shortage of feedstuffs.

The comparison of gross margins per cow and per man day with existing feeding technology, and an improved technology that incorporates the use of urea-molasses mixture, shows that productivity can be improved with these inputs. While merely reorganizing resources is unlikely to raise farmers' income substantially, technologies that can make existing resources more productive do have this potential.

Introduction

Smallholder dairy production in Tanzania is concentrated in the highland areas of Kilimanjaro, Arusha and Mbeya. The increased demand for fresh milk in urban centres in recent years has resulted in an expansion of smallholder dairy production around these centres. Until recently, Government policy on dairy development focused mainly on large-scale State-owned farms. The new Tanzania livestock policy gives due emphasis to the development of the smallholder sector through increased supply of upgraded cattle, animal feeds and other production inputs, including extension services (Ministry of Livestock Development 1983).

The emphasis on smallholder dairy production in Tanzania calls for increased efforts towards the development of locally tested technology that will increase productivity given farmers' present resources. Available information about peasant farmers indicates that they are good decision makers, given their experience and resources, and that a mere

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reallocation of their resources will not appreciably increase incomes (Stevens 1977). Assuming that smallholder farmers allocate their resources to maximize profit or expected utility of profit, subject to satisfying their subsistence needs, new technologies will only have a chance of success if they effect an improvement in standard of living. There is, therefore, a need to understand the economics of current smallholder production systems and the potential impact of proposed new technologies before making definite recommendations.

This paper reports on the results of a study of the economies of smallholder dairy production in Hai District. The work is part of an ongoing project on smallholder dairy feeding systems whose main objective is to design innovations that will increase productivity. The data used in this paper are based on a household survey conducted in February/March 1984 on a randomly selected sample of 150 households keeping dairy cattle.

Farming Systems in Hai District

Land use in the District is based on kinship structures which are basically patrilineal as far as patterns of land ownership and inheritance are concerned. Farmers own farms in two distinct zones: the highlands, where they live in permanent homesteads, and the lowland zone.

The highland zone has relatively more rainfall and the cropping pattern is coffee with bananas. The lowland zone is cropped with maize and beans. The survey conducted in 1984 indicated that the median farm size in the highland zone is 1.01 hectares, while in the lowland zone it is 1.2 hectares. The average distances from the homestead to the lowland farms is 18 km (Urio and Mlay 1984). These statistics suggest that land in the District is a critical constraint and that agricultural production can only be increased through intensive land-use measures.

Crop Production

In the highland zone, coffee intercropped with bananas are the main crops. Vegetables are also growing in this zone. Maize and beans are the main crops in the lowland zone, either as pure stands or intercropped. Tractor utilization during land preparation is a common practice in the lowland zone. While coffee is the main cash crop in the District, production has been falling in recent years due to the high incidence of coffee berry disease. Falling production coupled with declining real producer prices have resulted in a growing tendency towards diversification.

Livestock Production

Livestock production is an integral part of the farming system in the District. Land scarcity has contributed significantly to the high degree of dependence between the crop and livestock sub-systems. Stall feeding is the rule, and crop by-products are extensively

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used as feed, while the manure from the livestock is, in turn, used on the banana/coffee plots to maintain soil fertility.

According to the 1978 national census, cattle are the most numerous livestock in the District, followed by sheep, goats and pigs, as shown in Table 1.

Table 1. Numbers of domestic animals in Hai District, 1975

Type Number Average per

household

Cattle 132,000 4.0

Sheep 28,200 0.9

Goats 9,000 0.3

Source: Adapted from M.E. Mlambiti et al 1982.

The rapidly increasing demand for milk as reflected in the parallel market price of Sh. 20 per litre compared with the official price of Sh. 10 per litre coupled with declining income from coffee has seen a rapid growth in commercial milk production by smallholder farmers in the District. The relatively unproductive local Zebu is being replaced by improved breeds.

Land constraints and the scarcity of commercial feeds pose special problems for livestock feeding. The main sources of feed are crop byproducts (mainly banana leaves and pseudostems), maize stover and bean straw. Some farmers have also established pasture leys (Pennisetum purpureum, Tripsacum laxum and Setaria spp.) along farm boundaries, footpaths, and on any patches of land unsuitable for crop production, the use of commercial feeds is limited and erratic, and reflects availability rather than ignorance on the part of farmers. On the basis of the survey conducted in 1984, only 58% of sampled farmers used commercial feeds and all indicated that the levels used were below the recommended rates (Urio and Mlay 1984).

Analytical Procedures

Three main analytical procedures are used. These are gross-margin analysis, production-function analysis and returns to investment. Important measures of technical and economic efficiency of resource utilization can be derived from these three analyses.

Gross-Margin Analysis

Gross margins are widely used in farm planning. They can be used to prepare partial budgets for minor changes in the farm programme, or to prepare completed budgets for major changes in farm programmes (Styrrock 1971). Gross-margin analysis involves

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determining all variable costs and revenue associated with an enterprise. The difference between revenue and total variable costs is the gross margin for the enterprise, and, in essence, this is the return to capital, management and risk.

Several efficiency measures can be calculated from the general analysis and compared with standards to identify areas of potential improvement. Such efficiency measures include gross margin per unit of the enterprise, gross margin per unit of a scarce resource, and gross margin per unit of an investment. In addition, the potential effects of introducing a new technology on the above efficiency measures can be assessed before resources are committed to production.

Production Function Analysis

A production function shows the technical relationship between inputs and output. The general form of the relationship is presented in equation 1.

Y = f (X1, X2 ... Xn) ......... (1)

where X1, to Xn are the production inputs and Y is output.

While several function forms have been used to study the productivity of agricultural inputs, the Cobb-Douglas production function is the most commonly used (Welsch 1965). It has the following form:

Y = A II Xii Bi ......... (2)

where Bi (i = 1, 2..., n) are the partial elasticities of production.

Each measures the degree of responsiveness of output when the corresponding input is changed by 1%. The magnitudes of these coefficients can be used to assess the productivity of the inputs.

The data required for the analysis are cross-sectional, collected across households. Detailed records on outputs and levels of use of the identified inputs are necessary. With appropriate logarithmic transformation and assumptions, estimates of the elasticities can be obtained by the least-squares method. This approach is not used in this paper due to lack of suitable data.

Return to Investment

The returns-to-investment method allows direct comparison with alternative enterprises. This method is particularly useful in cases where loans are to be sought for establishing or expanding an enterprise. The measure proposed here is the internal rate of return

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whose formula is as follows:

......... (3)

where

n = number of years for which the internal rate of return is relevant

Fn = Net cash flow for year n, and

i = an internally calculated rates of interest that makes the discounted present value of the flow of costs equal to the discounted present value of the flow of returns at a point in time.

The observed returns to investment can be used to explain the observed returns to investment can be used to explain the observed investment behaviour by the farmers.

Results and Discussion

Gross Margins

Table 2 presents results of gross margin analysis based on current production organization in the District. The prices used are those that prevailed in the market when the survey was conducted.

Table 2. Gross margins for a smallholder dairy farmer in Hai District

Animal numbers and performance  

  Average herd size excluding calves 4

  Average number of calves 1

  Average number of cows in milk 2

  Average milk yield per cow per day (litres) 7.4

  Average lactation length in months 10

Revenue (TSh)  

  Milk (2,220 x 2) litres @ Sh. 10 44,400a

Variable costs (TSh)  

  Concentrates 1,755.00b

  Mineral supplements 824.20

  Purchase and transport of crop residues 988.50

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  Maintenance of cattle shed 750.00

  Veterinary expenses 320.00

Total variable costsc 4,637.70

  Gross margin (revenue-costs) (TSh) 39,762.30

  Gross margin per cow (TSh) 9,940.58

  Labour in man days per yearc 220.00

  Gross margin per man day (TSh) 180.74

a The revenue on milk sales assume that all milk is sold.

b Accurate data on concentrate feeding rates were not available.

c Only family labour is used, and the figure of 55 man days per cow per year is adapted from Mlambiti 1983.

One of the innovations currently being tested in the District is the use of a molasses-urea mixture. Apart from improving the intake of maize stover, it is intended to improve feed quality by providing nitrogen. Since data are still being collected, the results presented below are based on created data to illustrate the use of gross margins in assessing the potential economic impact of a new technology. It is assumed that 13 man days will be required to collect the molasses-urea mixture from the selling centres and that the feeding rate is 2 kg per animal per day. The milk yield is assumed to increase by 10% when all other factors are maintained at their present levels.

Table 3. Gross margin analysis incorporating molasses-urea mixture

Revenue  

Milk sales (2,442 x 2) litres @ Sh. 10 48,840.00

Variable costs (TSh)  

Original cost (Table 2) in TSh 4,637,70

Molasses urea (2 kg x 4 x 365) kg @ 0.60 (TSh) 1,460.00

Total variable costs 6,097.70

Gross margin (revenue costs) 42,742.20

Original labour in man days 220

Additional labour in man days 13

Total labour in man days 233

Gross margin per cow in TSh 10,685.50

Gross margin per man day in TSh 183.44

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The results in Table 2 indicate that, in the short run, smallholder dairy production under the existing production system is economically viable. The enterprise covers all the variables in costs and has a large positive return to capital, management and risk. The long-run viability of the enterprise is dependent on it being able to cover all production costs. The gross margin per cow and per man day can only be assessed in the presence of other figures for comparison.

The cash-flow results indicate that, with the exception of the first year, the net benefits from the dairy enterprise are positive. The apparently high positive net benefits suggest that costs have been underestimated, in particular the cost of feeds. The exclusion of costs of family labour have also contributed to the under estimation of costs. In computing the internal rate of return, a figure of over 50% was obtained, again suggesting that enterprise costs have been underestimated. However, the high demand for dairy heifers, as reflected by the high parallel market price of Sh. 15,000-18,000 compared with an official price of Sh. 6,000 per heifer, suggests that the enterprise has high returns to investment.

Table 4. Cash-flow analysis of a typical smallholder dairy enterprise in Hai District (TSh)

OUTFLOW

YEAR

1 2 3 4 5 6 7 8 9 10

Capital expenditure

Heifers 45,000.00

0 0 0 0 0 0 0 0 0

Construction of shed

25,000.00

0 0 0 0 0 0 0 0 0

Subtotal 70,000.00

0 0 0 0 0 0 0 0 0

Operating expenses

Maintenance of shed

0 350.00 450.00 550.00 650.00 750.00 750.00 150.00 750.00 750.00

Concentrates

1,755.00

1,755.00

Crop residues

988.50 988.50 988.50 988.50 988.50 988.50 1,755.00

1,755.00

1,755.03

1,755.00

Veterinary costs

320.00 320.00 320.00 320.00 320.00 320.00 988.50 988.50 988.50 988.50

Mineral 824.00 824.00 824.00 824.00 824.00 824.00 320.00 320.00 320.00 320.00

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supplements

Subtotal 3,887.50

4,237.50

4,437.50

4,437.50

4,537.50

4,637.50

824.00 824.00 824.00 824.00

Total outflows

73,887.50

4,237.50

4,437.50

4,437.50

4,537.50

4,637.50

4,637.50

4,637.50

4,637.50

4,637.50

INFLOW

Sales of milk

0 3,120.00

35,400.00

40,200.00

44,400.00

44,400.00

44,400.00

40,200.00

35,400.00

31,200.00

Sales of calves

0 1,500.00

1,500.00

1,500.00

1,500.00

1,500.00

1,500.00

0 0 0

Sales of culls

0 0 0 0 0 0 0 0 0 0

Total inflows

0 0 3,200.00

36,900.00

45,900.00

45,900.00

45,900.00

40,200.00

35,400.00

46,200.00

Net benefit

-73,887.50

28,462.50

32,562.50

37,262.50

41,362.50

41,262.55

41,262.50

35,562.50

30,762.50

41,567.50

Conclusions and recommendations

This paper has demonstrated the application of gross-margins analysis and internal rate of return to assessing the economics of smallholder dairy production in the Hai District. The results indicate that, both in the short and the long run, dairy production is a viable economic activity under smallholder conditions.

Work done by other researchers in the District has shown that a mere reallocation of resources through enterprise reorganization will not increase farmers' income appreciably (Mlambiti 1983; Msechu 1979). This suggests that an increase in farmers' incomes will come from improved technologies that will make the existing resources more productive. As indicated by the results on potential use of molasses-urea mixture, the gross margins per cow and per man day can be changed if livestock are made more productive.

It is recommended that researchers involved in developing or tasting technologies for use by smallholder farmers first obtain detailed base-line data on current farming practices and resource utilization and then use them to assess the economics of those enterprises without improved technologies. Alternative technologies should then be subjected to economic analysis and the results compared with those of the traditional practices. This will allow us to make more rational choices and technology recommendations, which are, therefore, more likely to be adopted by farmers.

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Cost-Output Relation: Students should reflect and revise what has been said on short-run cost-output relationship including fixed cost and output; variable cost and output and total cost and output.

Long-run relationship: Reflect on what has been said on costs and production levels in the long-run.

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TOPIC FIVE: MARKET STRUCTURE

Market structure

Market structure (also known as market form) describes the state of a market with respect to competition. It is the way a market is organized. The theory of markets focuses especially on those aspects of market structure which have an important influence on the behaviour of firms and buyers and on market performance. Structural features having a major strategic importance in relation t market conduct and performance include:

a) The degree of seller concentration and buyer concentration as measured by the number of sellers and buyers (whether there are many sellers/buyers in the market, or a few, or only one), and their relative size distribution;

b) The condition of entry to the market (the extent to which established suppliers have advantages over potential new entrants because of barriers to entry);

c) The nature of the product supplied (whether it is homogeneous product or subject to product differentiation);

d) The extent to which firms produce their own input requirements or own distribution outlets for their products – vertical integration-)

e) The extent to which firms operate in a number of markets rather than just one market – diversification -)

Market structure, in turn, is affected by market conduct and performance.

The major market structure/forms are:

Perfect competition: in which the market consists of a very large number of firms producing a homogeneous product. There is free market entry and exit as there are no barriers; there is perfect knowledge of the market by buyers and sellers.

Monopolistic competition: also called competitive market, imperfect competition or imperfect market is a market situation where there are a large number of independent firms which have a very small proportion of the market share. It is characterized by many firms and buyers; differentiated products; and free market entry and exit.

Oligopoly: A market is dominated by a small number of firms. It is also characterized by few large firms and many small buyers; homogenious or differentiated products (identical products or differentiated from each other in some ways – color, packaging, test etc -); difficulty market entry (high barriers to entry) making it difficult for new firms to enter

Oligopsony: A market dominated by many small sellers and a few large buyers. There is buyer concentration. The buyers confront the sellers.

Monopoly: Only one provider of a product or service. It is characterized by one firm and many buyers; a lack of substitute product; blocked entry (barriers to entry are so severe that it is impossible for new firms to enter the market. Monopolists are price makers and quantity adjusters. Example of monopolists include TANESCO and National Insurance Corporation (NIC) before

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liberalization). Note that regulatory authorities have the role of making sure that monopolists are not abusing their market powers to the disadvantage of consumers. Example EWURA vis a vis TANESCO and DAWASCO and SUMATRA vis a vis transporters in Dar Es Salaam (Daladala owners) – all in relation to increased consumer prices.

Monopsony: Is a form buyer concentration. It is a market situation in which a single buyer confronts many small suppliers. Sometimes there is only one buyer in a market and many sellers. For example crop marketing boards before liberalization in Tanzania). Monopsonists are often able to secure advantageous terms from suppliers in the form of bulk-buying price discounts and extended credit terms.

A Summary of the Basic Market Structures

Market StructureSeller Entry

BarriersSeller

NumberBuyer Entry

BarriersBuyer

Number

Perfect Competition No Many No Many

Monopolistic competition

No Many No Many

Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

Monopoly Yes One No Many

Monopsony No Many Yes One

The correct sequence of the market structure from most to least competitive is perfect competition, imperfect competition, oligopoly, and pure monopoly.

Criteria for Classifying Markets: The main criteria by which one can distinguish between different market structures are: the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. The market form can equally be known to an extent by the barriers on entry and exit. It is to be noted that in the Perfectly Competitive market, there exists free entry and exit; this applies to prospective/existing buyers and sellers.

Importance of market structure: In decision-making analysis, market structure has an important role through its impact on the decision-making environment. The extent and characteristics of competition in the market affect choice behavior among the actors. Markets are classified according to some variables. They include number of buyers and sellers, extent of product substitutability, ease of entry and exit, and the extent of mutual interdependence. Market structure is important in that it affects market outcomes through

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its impact on the motivations, opportunities and decisions of economic actors participating in the market.

TOPIC SIX: THEORY OF PRICING

Price is the assigned numerical monetary value of a good, service or asset. It is the money value of a unit of good, service, asset or factor input. In some markets (for example perfect competition), price will be determined entirely by the free interplay of the market forces of supply and demand. In monopoly market powerful suppliers have considerable discretion over the price that they charge – price maker and quantity adjuster while consumers are price takers. In some circumstances (centrally planned/command economy), prices may be subjected to government price control (price commission) or regulated by means of prices and incomes policy (regulatory authorities).

The concept of price is central to microeconomics where it is one of the most important variables in resource allocation theory (also called price theory). Price is also central to marketing where it is one of variables in the marketing mix that business people use to develop a marketing plan.

Theory of price asserts that the market price reflects interaction between demand considerations based on marginal utility and supply considerations based on marginal cost. An equilibrium price is supposed to be where supply meets demand.

Relative/real and nominal price

Nominal price is the price quoted in money. It is a price of a product measured in terms of current prevailing price levels, making no allowance for the effects of inflation.

Relative or real price is the exchange ratio between real goods regardless of money. It is the price of a product measured in constant price terms to make allowance for the effects of inflation.

The distinction between real and nominal price is made to make sense of inflation. When all prices are quoted in terms of money units, and the prices in money units change more or less proportionately, the ratio of exchange may not change much. In the extreme case, if all prices quoted in money change in the same proportion, the relative price remains the same. A price index can be used in the discussion of real and nominal prices.

Price index

Price index is a weighted average of the prices of selected goods and services measured over time. Among the commonly used price indices is the retail price index (RPI) or consumer price index (CPI). The index measures the average level of the price of a general (representative) basket of goods and service bought by a representative consumer. In constructing the index, a base year is chosen and assigned a value of 100. Price

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changes are then reflected in changes in the index value over time. For example if in the base year 1997 the price was 100 and in the current year (2007) it is 155, it indicates that the retail prices, on average, had risen by 55% between 1997 and 2007. This indicates that for a product that was sold at 100 Shs. in the base year, it is now being sold at 155 Shs.

Determinants of price

There are various factors that determine/influence the price of goods and services. The factors include demand; cost of production; objective of the firm (profit or not for profit…when for profit, is it super profit or normal profit); government policy (socialist- versus capitalist- oriented policies) and nature of market structure (perfect competition, monopoly, oligopoly, monopsony etc – make a reference to the discussion on market structure in topic five above).

Discussion questions

1). Tanzania has experienced several epochs (time periods) in the practices of price-setting for some goods and services. Discuss with relevant examples.

2).With examples, discuss in detail how each of the above price determinants affect price of different goods and services differently.

Price discrimination

Price discrimination is the ability of a supplier to sell the same product in a number of separate markets at different prices. Markets can be separated in a number of ways, including different geographical locations (eg domestic and foreign), the nature of the product itself (eg. Original and used spare parts), and users’ requirement (eg. Industrial and domestic consumption). Price discrimination may be time based (charging different prices at different times of the day / week / year eg. “Happy Hours”/calling at night; on and off season pricing in transport/tourism. Students should relate price discrimination to market segmentation.

Pricing Methods in Practice

There are various methods of setting a price for a product. These include the following:

Cost-plus pricing: Set the price at your production cost, including both variable and fixed costs, plus a certain profit margin. So long as you have your costs calculated correctly and have accurately predicted your sales volume, you will always be operating at a profit.

Value-based pricing: Price your product based on the value it creates for the customer. Let customers determine how much they want to pay depending on the value they attach to a good or service. It may involve some bargaining. As a seller you must make sure that the

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price you accept covers your production costs. This is usually the most profitable form of pricing, if you can achieve it.

Psychological pricing: Hitting price points that are significant e.g. 99.99 sounds better than 100.00. In this case one must take into consideration the consumer's perception of hi/her price, figuring things like:

-Positioning: If you want to be the "low-cost leader", you must be priced lower than your competitors. If you want to signal high quality, you should probably be priced higher than most of your competitors.- Popular price points - There are certain "price points" (specific prices) at which people become much more willing to buy a certain type of product. For example, "under 100" (Tshs, $ etc) is a popular price point. "under 20 with sales tax" is another popular price point. 99.99 or 79.99 "value menu" is another popular price point. Dropping your price to a popular price point might mean a lower margin, but more than enough increase in sales to offset it.- Fair pricing - Sometimes it simply doesn't matter what the value of the product is, even if you don't have any direct competition. There is a limit to what consumers perceive as "fair". If it is obvious that your product only cost 20 Tshs to manufacture, even if it delivered 10,000 Tshs in value, you would have a hard time charging two or three thousand Tshs for it. A little market testing will help you determine the maximum price consumers will perceive as fair.

Penetration pricing: Used for new products wanting to gain market share. The product is priced low so that it is able to get a hold in the market.

Market skimming: When a new innovative product is bought out - during the first few months high prices can be charged as there is little competition and the product is popular because it is new.

Loss leader pricing: Charging below cost price to try and attract customers to other products (normally in supermarkets). When customers come to buy the low priced goods/services they are likely to buy other products too that have normal/higher prices.

Discount pricing: Offering lower prices for a set time period to try and boost sales and sell off unwanted stock.Marginal cost pricing is the principle that the market will, over time, cause goods to be sold at their marginal cost of production. Whether goods are in fact sold at their marginal cost will depend on competition and other factors. In the most general criticism of the theory of marginal cost pricing, it is noted that monopoly power may allow a producer to maintain prices above the marginal cost. For example, if a good has low elasticity of demand (consumers are insensitive to changes in price) and supply of the product is limited (or can be limited), prices may be considerably higher than marginal cost. Since this description applies to most products with established brands, marginal pricing may be relatively rare.

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NB: Some of the methods above are more or less similar. There is no "one right way" to calculate your pricing. One has to consider various factors involved and determine one’s objectives in pricing strategy. Your price must be enough higher than costs. It should not be higher than what most consumers consider "fair".

Discussion question

With relevant examples, discuss the factors you would consider in your managerial decision-making on setting a price for goods and services that you are producing. (You may think of imaginary goods/services)

Assumption behind the theory of the firm

Theory of the Firm

A firm (company or supplier) is a transformation unit concerned with converting factor inputs into higher-valued intermediate and final goods or services. A firm is the basic producing/supplying unit in an economy and is a vital building block in constructing a theory of the market to explain how firms interact and how they price and output decisions influence market supply and price. The aim/objective of firms is profit- maximization. In the context of price-setting therefore, they would set price in such a way that they more than cover their costs and realize a reasonable profit margin.

NB: Students are advised to read a paper by Kuzilwa and Ngowi (1998) on “Pricing Behaviour of Firms Under Liberalized Markets in Tanzania: Theory and Practice”5

5 Published in Economics and Development Papers (1998), Issue No. 1. Institute of Development Management (IDM) Mzumbe. Pg. 75 – 90.

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TOPIC SEVEN: LONG TERM INVESTMENT ANALYSIS

Investment

Investment or investing is a term with several closely-related meanings in business management, finance and economics. It is related to saving or deferring consumption. It is the choice by firms and/or individuals to risk their savings with the hope of gaining in future. Rather than store the good produced, or its money equivalent, the investor chooses to use that good either to create a durable consumer or producer good, or to lend the original saved good to another in exchange for either interest or a share of the profits.

It is to be understood that:

Y = C + S…S leads to I so that at the end Y = C + I where:

Y = income; C = consumption; S = saving and I = investment.

In economics, investment is the production per unit time of goods which are not consumed but are to be used for future production. Examples include tangibles (such as building a railroad or factory) and intangibles (such as a year of schooling or on-the-job training). In measures of national income and output, gross investment (represented by the variable I) is also a component of Gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports (X – M), where X is export and M is import. Thus investment is everything that remains of production after consumption, government spending, and exports are subtracted.

Investment Analysis

NB: It is to be understood that analysis is a fourth phase of a project (investment). See the box below for a full coverage of project cycle and where analysis comes in.

A project is a finite endeavor—having specific start and completion dates—undertaken to create a unique product or service which brings about beneficial change or added value. This finite characteristic of projects stands in sharp contrast to processes, or operations, which are permanent or semi-permanent functional work to repetitively produce the same product or service. A project is a carefully defined set of activities that use resources (money, people, materials, energy, space, provisions, communication,

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motivation, etc.) to achieve the project goals and objectives.

Project Cycle/Phases – Examples of Agricultural (Agro)-projects

Agro-investments, as most other investments have to be looked at as projects. The aim of the firms, companies, enterprises and individuals who own and/or manage these projects should be profit maximization. In order to achieve this goal/objective, the various project phases/cycles have to be very carefully looked at by the investors. In what follows some key issues in the various agricultural project phases/cycle are presented.Project Phases/Cycle. A project cycle is the natural sequence in the way projects are planned and carried out. The cycle may be divided into many various ways or phases as indicated belowProject Conceptualization PhaseAt this phase one thinks and conceptualizes many different possible projects that can be implemented. It is normally a process of thinking very broadly and widely on almost all possible projects that one would like to embark on. This stage/phase is important before one identifies some of the more viable and feasible projects to be given more consideration for implementation. In the context of agro-projects this is the stage where one may be thinking of projects like dairy farm; poultry; piggery; gardening; plantations etc. Only imagination should be the limit of the projects that one can think of at this stage.

Project Identification PhaseAt this phase one identifies few (two or three) projects out of all the projects that were conceptualized in phase one. The identified projects are those that are more feasible and viable. Those that can give profit to the owner. In identifying a project therefore, one sets some criteria to use. For example one may say, a project that will pollute the environment (destroy flora and fauna), or will use child labour or that is too complicated or costly to implement, should be dropped from the conceptualized ones.Project Analysis PhaseWhen one has identifies those few projects, one makes a critical analysis of all the identified projects, one by one. Here the aim is to make sure that all positive and negative sides of a project are critically, clearly and objectively examined before one selects a project to implement. In analysis one looks at various issues like:a) Technical Aspects: Ask yourself: Is the project technically viable? Is the technical

knowledge that is need for the specific project known and available? Who has the technical knowledge? What do we know/don’t we know about the technical aspects?. For example if it is an agricultural produce processing and package project (for example processing and packing of tomatoes, fruits for juices, meat for sausages or groundnuts for oil) do we have the technology to do that? Do we have the needed machines? Can we operate them? Do we know the packaging requirements in terms of materials that are needed? Recommended volume? Storage requirements etc?

ii) Managerial Aspects: Do we have the needed managerial skills to manage the project? Do we have the human resources management skills? Do we have financial management skills etc?iii) Social Aspects: Is the project socially desirable and acceptable? For example, a

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piggery project among Muslim community may not be socially acceptable. What will be the contribution of the project in social development? For example, will it reduce crime due to employment creation for jobless youths? Will it help in bringing water, electricity, roads, schools etc to the community?iv) Economic/Commercial Aspects: Are we going to make profit out of the project? What costs will be involved? How much revenue will be created and when? How much profit will we make and when?v) Financial Aspects: How much money do we need? Where will we get the money from? What will be the repayment conditions and schedule? Do we have security/collateral against the loan we are seeking? EtcProject Selection PhaseWhen you have subjected all the identified projects to the analysis above, you have to determine which one gives you the most satisfactory answer. Remember the aim is to maximize profit, other things being equal/ceteris paribus. Therefore, you are expected to choose only one project that will give you the highest return/greatest profit. Normally one project is chosen or passes the test and is carried to the next stage of implementation.Project Implementation PhaseThis is the phase where actions start taking place. It is the phase where funds are committed to various project activities. For example if a poultry project is chosen, this is the stage when people are hired to clear the site; building materials for huts are bought and actual construction starts taking place. Food and medicine for the chicken are bought and the chicken are bought, fed and ultimately sold.Project Monitoring and Evaluation (M&E)M&E is a very important phase/stage. Here you observe whether things are going the way they were/are supposed to be going. Are the costs of construction, food, medicine, manpower as they were planned? Have they increased/gone down? By how much? Are the chicken growing the way they are supposed? If yes, ok. If no, why and what can be done? Is the sales price, quantity and cost as planned? If yes ok. If no, what is the variation and why? What can be done?M&E should be a continuous activity during the implementation stage. Failure to monitor will lead to project failure. Monitoring and evaluating too late, may not be helpful as it may be too late to reverse some adverse development.

Investment analysis (also known as project/investment appraisal and capital budgeting) includes the acts of examination and assessment of economic and market trends, earnings prospects, earnings ratios, and various other indicators and factors to determine suitable investment strategies. It is to be understood that investment needs capital.

The Nature of Capital Expenditure Decisions

Managers/decision makers are faced with difficulty decisions on capital expenditure. Capital expenditure in this context is the same as investments. Decision makers therefore, have to make strategic and good decisions on investments for their firms. The decisions

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should be informed and helped by various techniques. These techniques include capital budgeting (investment appraisal).

Capital Budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development (R&D) projects are worth pursuing. It is the process in which a business/firm determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark.

Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited/scarce, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Decisions on investment, which takes time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now.

Often, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns). It could be much more profitable putting the planned investment money in the bank and earning interest, or investing in an alternative project. Capital budgeting is very obviously a vital activity in business. Vast sums of money can be easily wasted if the investment turns out to be wrong or uneconomic.

Capital budgeting versus current expenditures

A capital investment project can be distinguished from current expenditures by two features:

a) such projects are relatively largeb) a significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits..

As a result, most medium-sized and large organisations have developed special procedures and methods for dealing with these decisions. A systematic approach to capital budgeting implies:

a) the formulation of long-term goals

b) the creative search for and identification of new investment opportunities

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c) classification of projects and recognition of economically and/or statistically dependent proposals

d) the estimation and forecasting of current and future cash flows

e) a suitable administrative framework capable of transferring the required information to the decision level

f) the controlling of expenditures and careful monitoring of crucial aspects of project execution

g) a set of decision rules which can differentiate acceptable from unacceptable alternatives is required.

Capital Budgeting Methods

Many formal methods are used in capital budgeting. They include Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), Modified Internal Rate of Return, and Equivalent Annuity (EA).

Net present value

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV. (in the context of Time value of money). The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV.

The NPV is greatly affected by the discount rate, so selecting the proper rate is critical to making the right decision. The proper rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the Capital Asset Pricing Model (CAPM) to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected (Students should make reference to their studies in financial management). To understand and use NPV, one should consider the concept of discounted cash flow.

Discounted Cash FlowThis is a cash flow associated with economic projects that are adjusted to allow for the timing of the cash flow and the potential interest on the funds involved. Most projects have their main costs or cash outflows in the first year or so, while their revenue or cash inflows are spread over many future years. The amount of cash in hand today is worth

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less in the future. Firms should only invest if the returns will be bigger than the invested funds.

The Appropriate Rate of Discount

A discount rate is the rate of interest at which the streams of cash inflows and outflows associated with an investment project are to be discounted in order to get discounted cash flow. For private sector projects (profit oriented) the discount rate is frequently based upon the weighted-average cost of capital to the firm, with the interest cost of each form of finance (long term loans, overdrafts, equity etc) being weighted by the proportion that each form of finance contributes to total company finances.

The time value of money

Recall that the interaction of lenders with borrowers sets an equilibrium rate of interest. Borrowing is only worthwhile if the return on the loan exceeds the cost of the borrowed funds. Lending is only worthwhile if the return is at least equal to that which can be obtained from alternative opportunities in the same risk class.

The interest rate received by the lender is made up of:

i) The time value of money: the receipt of money is preferred sooner rather than later. Money can be used to earn more money. The earlier the money is received, the greater the potential for increasing wealth. Thus, to forego the use of money, you must get some compensation.

ii) The risk of the capital sum not being repaid. This uncertainty requires a premium as a hedge against the risk, hence the return must be commensurate with the risk being undertaken.

iii) Inflation: money may lose its purchasing power over time. The lender must be compensated for the declining spending/purchasing power of money. If the lender receives no compensation, he/she will be worse off when the loan is repaid than at the time of lending the money.

Computation of Net present value (NPV)

The NPV method is used for evaluating the desirability of investments or projects.

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where:

Ct = the net cash receipt at the end of year tIo = the initial investment outlayr = the discount rate/the required minimum rate of return on investmentn = the project/investment's duration in years.

The discount factor r can be calculated using:

Examples:

Decision rule:

If NPV is positive (+): accept the projectIf NPV is negative (-): reject the project

Exercise: Net present value

A firm intends to invest $1,000 in a project that generated net receipts of $800, $900 and $600 in the first, second and third years respectively. Should the firm go ahead with the project?

Hints: (Especially for the morning class)

To solve the above problem, compute the NPV for year 1 first, the NPV for year 2, then NPV for year 3 …then add them before deducting the initial capital outlay.

Internal rate of return

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The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate (minimum discount rate) should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues.

Equivalent annuity method

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal lifespan. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.

Ranked Projects

The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

Estimating the Firm’s Cost of Capital

Look at the discussion on determinants of cost in general and cost of capital (interest rate) in particular.

Cost-Benefit Analysis (CBA)

CBA is a process by which business decisions are analyzed. The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted. Some consultants or analysts also build the model to put a

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dollar value on intangible items, such as the benefits and costs associated with living in a certain town. Most analysts will also factor opportunity cost into such equations.

Prior to erecting a new plant or taking on a new project, prudent managers will conduct a cost-benefit analysis as a means of evaluating all of the potential costs and revenues that may be generated if the project is completed. The outcome of the analysis will determine whether the project is financially feasible, or if another project should be pursued.

Cost Benefit Analysis is a relatively simple and widely used technique for deciding whether to make a change. As its name suggests, you simply add up the value of the benefits of a course of action, and subtract the costs associated with it.

Costs are either one-off, or may be ongoing. Benefits are most often received over time. We build this effect of time into our analysis by calculating a payback period. This is the time it takes for the benefits of a change to repay its costs. Many companies look for payback on projects over a specified period of time e.g. three years.

How to Use the Tool:

In its simple form, cost-benefit analysis is carried out using only financial costs and financial benefits. For example, a simple cost benefit ratio for a road scheme would measure the cost of building the road, and subtract this from the economic benefit of improving transport links. It would not measure either the cost of environmental damage or the benefit of quicker and easier travel to work.

A more sophisticated approach to building a cost benefit models is to try to put a financial value on intangible costs and benefits, say cost on environment, cost/benefits of stress-free traveling etc. These are all questions that people have to answer, and answers that people have to defend.

Key points

Cost/Benefit Analysis is a powerful, widely used and relatively easy tool for deciding whether to make a change.

To use the tool, firstly work out how much the change will cost to make. Then calculate the benefit you will from it.

Where costs or benefits are paid or received over time, work out the time it will take for the benefits to repay the costs. Cost/Benefit Analysis can be carried out using only financial costs and financial benefits. Larger projects are evaluated using formal finance/capital budgeting, which takes into account many of the complexities involved with financial Decision Making (make reference to your studies on financial management).

CBA is a term that refers both to:

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a formal discipline used to help appraise, or assess, the case for a project or proposal and

an informal approach to making decisions of any kind.

Under both definitions the process involves, whether explicitly or implicitly, weighing the total expected costs against the total expected benefits of one or more actions in order to choose the best or most profitable option.

All benefits and all costs are expressed in money terms, and are adjusted for the time value of money, so that all flows of benefits and flows of project costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their “present value.” Closely related, but slightly different, formal techniques include Cost-effectiveness analysis, Economic impact analysis, Fiscal impact analysis and Social Return on Investment(SROI) analysis. The latter builds upon the logic of cost-benefit analysis, but differs in that it is explicitly designed to inform the practical decision-making of enterprise managers and investors focused on optimising their social and environmental impacts.

Why and How to Conduct CBA?

A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn out. Although a cost benefit analysis can be used for almost anything, it is most commonly done on financial questions. CBA relies on the addition of positive factors and the subtraction of negative ones to determine a net result. As a result, it is also known as running the numbers.

It finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the costs and all the benefits and properly quantify them.

Example Cost Benefit Analysis

As the Production Manager, you are proposing the purchase of a $1 Million stamping machine to increase output. Before you can present the proposal to the management, you know you need some facts to support your suggestion, so you decide to run the numbers and do a cost benefit analysis.

You itemize the benefits. With the new machine, you can produce 100 more units per hour. The three workers currently doing the stamping by hand can be replaced (moving from labour to capital intensive production technique). The units will be higher quality because they will be more uniform. You are convinced these outweigh the costs.

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There is a cost to purchase the machine and it will consume some electricity. Any other costs would be insignificant.

You calculate the selling price of the 100 additional units per hour multiplied by the number of production hours per month. Add to that two percent for the units that aren't rejected because of the quality of the machine output. You also add the monthly salaries of the three workers. That is good total benefit.

Then you calculate the monthly cost of the machine, by dividing the purchase price by 12 months per year and divide that by the 10 years the machine should last. The manufacturer's specifications tell you what the power consumption of the machine is and you can get power cost numbers from accounting so you figure the cost of electricity to run the machine and add the purchase cost to get a total cost figure.

You subtract your total cost figure from your total benefit value and your analysis shows a healthy profit.

Don't use the selling price of the units to calculate the value. Sales price includes many additional factors that will unnecessarily complicate your analysis if you include them, not the least of which is profit margin. Instead, get the activity based value of the units from accounting and use that. You remembered to add the value of the increased quality by factoring in the average reject rate, but you may want to reduce that a little because even the machine won't always be perfect. Finally, when calculating the value of replacing three employees, in addition to their salaries, be sure to add their overhead costs, the costs of their benefits, etc., which can run 75-100% of their salary. Accounting can give you the exact number for the workers' "fully burdened" labor rates.

In addition to properly quantifying the benefits, make sure you included all of them. For instance, you may be able to buy feed stock for the machine in large rolls instead of the individual sheets needed when the work is done by hand. This should lower the cost of material, another benefit.

As for the cost of the machine, in addition to it's purchase price and any taxes you will have to pay on it, you must add the cost of interest on the money spent to purchase it. The company may purchase it on credit and incur interest charges, or it may buy it outright. However, even if it buys the machine outright, you will have to include interest charges equivalent to what the company could have collected in interest if it had not spent the money.

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REVIEW QUESTIONS

NB: These questions are addition to the various discussion questions given in the handouts.

1. Consider the hypothetical short term data of a given firm as summarized in the table below and answer the questions that follow

Quantity Variable Cost

Fixed Cost

Total Cost

Marginal cost

Unit price

Total Revenue

Profit Marginal Revenue

1 30 50 102 35 103 47 104 53 10

Questions:a) Fill in the blank space clearly showing the procedure you followedb) Is the firm optimizing its production? If so, at what level of production?c) Should the firm keep on producing in the long run? Why?d) What possibilities does the firm has in the long run to make its production more

meaningful?

2. Look at the mathematical expression of the demand function for a given commodity below and make economic sense out of it by answering the questions that follow

Qd = f(P, Y, Ps, Pc, Ad…)Where:Qd = quantity demanded; P = price of the commodity; Y = consumers’ income; Ps = price of substitute goods; Pc = price of complementary goods and Ad = advertisementQuestions: a) With specific examples, discuss how each of the independent variables above

affect the dependent variable differently

3. You have been employed as a consultant for a firm that wants to segment its market. The firm does not clearly understand the concept of market segmentation; requirements for successful market segmentation; and the possible variables that can be used to segment markets. Help the firm to answer the unanswered questions, giving very specific examples.

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4. a) A given firm is considering to change the price of its commodities. As the consultant of that firm, explain to its management why it should consider the concept of elasticity of demand before it implements its price change strategy.

4 b) Think of hypothetical numbers and illustrate to the firm on how it should calculate its price elasticity of demand, clearly interpreting for the firm the economics behind the answer that you are getting in your computation of price elasticity of demand.

4 c) Given the answer that to got in your computation of price elasticity of demand, would you advise the firm to change the price of its commodity? Why?5. As part of management of a given firm, you are charged with the responsibility of making demand forecast for the goods and services that you are producing. In the board meeting you are supposed to advise on the possible techniques that can be used. Give the advise clearly showing the importance of making forecasts.

6. As a seller of goods and services, what factors would you consider as you try to set the prices to charge? What techniques will you use? Give examples.

7. Assume that you are producing some goods and services. You want different consumers to pay different prices for the goods and service. With relevant examples, give a detailed explanation on how you would do that.

8.The different market structures present different power relationships between buyers and sellers. With specific examples, discuss who has power in a given market structure.

9. With relevant examples, discuss how managerial decisions can be informed by economic analytical tools like (i) marginal cost (ii) marginal profit (iii) marginal revenue and (iv) marginal product.

10. Assume that you are a manager in an organization that is producing some goods and services. How can you use the knowledge of managerial economics in your daily work? Give examples.

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ECO 5011; MANAGERIAL ECONOMICSTERM PAPER AND GROUPS ASSIGNMENTS QUESTIONS

NBI) In all questions you need to make use of both theory and practice. Give clear

references/sources for theory(ies) and all data that you may be presenting. II) Your work should be about 20 pages for term paper and 10 pages for group

assignments, typed in A4 paper, Times New Roman Scripts, 1.5 line spacingIII) Submission is deadline is: IV) Both hard and soft copies have to be submitted. Submit softcopy via

[email protected] . Hard copy can be submitted at school dean’s office at MU Dar Business School

TERM PAPER QUESTION (30%) – to be attempted individually

With a point of departure from the managerial economics theory(ies) of your choice, describe how managerial economics is applicable in your work place or in any other work place of your choice.

GROUPS ASSINMENTS QUESTIONS (10%) – Each group to attempt one question assigned to it.

Group 1 Identify an organization of your choice and describe the economic decision making process with a focus on economic aspects that are taken into account in making a decision of your choice. Group 2Choose a firm/organization of your interest show its consumers and their behaviour

Groups 3Choose a firm/organization of your interest and show how it estimates the demand for goods and services it produces

Groups 4Choose any firm and discuss the quantity and quality (where possible) of the factors of production that it uses in its production process. Groups 5Choose a firm/organization of your interest and show its cost drivers quantitatively

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