Economic Analysis for Managers (ECO 501)Fall:2012 Semester

Khurrum S. Mughal

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Cost Theory & Analysis◦ Economic Concept of Cost◦ Short-Run Cost Function◦ Profit Contribution Analysis◦ Breakeven Analysis◦ Operating Leverage

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Theme of the Lecture

Opportunity costs are the value of the other products that the resources used in production could have produced at their next best alternative

Explicit costs include the ordinary items that an accountant would include as the firms expenses

Implicit costs include opportunity costs of resources owned and used by the firm’s owner

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Economic Concept of Cost

Normal Profit and Costs◦ Economic Profit is revenue less economic costs,

where the economic costs also include the normal returns to management or capital of the owner.

Cost of Long-Lived Assets◦ The economic costs of such assets would be the

change in market value from the beginning to the end of the period

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Economic Concept of Cost

Marginal Costs are the change in total cost due to one unit change in output

Incremental Costs is the additional cost of implementing a managerial decision

Sunk Costs are expenditures that have been made in the past or that are to be made in the future due to some contractual obligation

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Economic Concept of Cost

Cost Theory & Analysis◦ Economic Concept of Cost◦ Short-Run Cost Function◦ Profit Contribution Analysis◦ Breakeven Analysis◦ Operating Leverage

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Theme of the Lecture

A period of time so short that the firm cannot alter the quantity of some of its inputs

Typically plant and equipment are fixed inputs in the short run

Fixed inputs determine the scale of the firm’s operation

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Short-Run

Total Cost = TC = f(Q)Total Fixed Cost = TFC

Total Variable Cost = TVCTC = TFC + TVC

Short-Run Cost Functions

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Q TFC TVC TC0 60 0 601 60 20 802 60 30 903 60 45 1054 60 80 1405 60 135 195

Short-Run Cost Functions

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TFC

Short-Run Cost Functions

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Average Total Cost = ATC = TC/QAverage Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC = TVC/Q

ATC = AFC + AVCMarginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions

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Q TFC TVC TC AFC AVC ATC MC

0 60 0 60 - - - -1 60 20 80 ? ? ? ?2 60 30 90 ? ? ? ?3 60 45 105 ? ? ? ?4 60 80 140 ? ? ? ?5 60 135 195 ? ? ? ?

Short-Run Cost Functions

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Q TFC TVC TC AFC AVC ATC MC

0 60 0 60 - - - -1 60 20 80 60 20 80 202 60 30 90 30 15 45 103 60 45 105 20 15 35 154 60 80 140 15 20 35 355 60 135 195 12 27 39 55

Short-Run Cost Functions

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Short-Run Cost Functions

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Total Cost Function TC = 1000 + 10Q – 0.9Q2 + 0.04Q3

Rate of output resulting in minimum average variable cost?

Minimum Average Variable Cost

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Cost Theory & Analysis◦ Economic Concept of Cost◦ Short-Run Cost Function◦ Profit Contribution Analysis◦ Breakeven Analysis◦ Operating Leverage

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Theme of the Lecture

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Profit Contribution is the difference between price and average variable cost (P – AVC)

You can find out the output rate necessary to cover all fixed costs and earn required profit (πR)

FC = $10,000, P = $30, AVC = $28, πR = $20,00018

Profit Contribution Analysis

Cost Theory & Analysis◦ Economic Concept of Cost◦ Short-Run Cost Function◦ Profit Contribution Analysis◦ Breakeven Analysis◦ Operating Leverage

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Theme of the Lecture

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A special case where you find the breakeven point by placing πR= 0

FC = $10,000, P = $30, AVC = $28

TC = 10,000 + 28Q TR = 30Q

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Breakeven Analysis

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Linear Breakeven Analysis

Reve

nue,

Co

st

Rate of Output, Q

Linear Breakeven Analysis

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Cost Theory & Analysis◦ Economic Concept of Cost◦ Short-Run Cost Function◦ Profit Contribution Analysis◦ Breakeven Analysis◦ Operating Leverage

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Theme of the Lecture

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If fixed costs are relatively large than variable costs the firm is said to be highly leveraged

It experiences more variation in profit for a percentage change in output.

Can be analyzed using profit elasticity Eπ

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Operating Leverage