# PowerPoint Slides © Michael R. Ward, UTA 2014. Cost Curves Econ 5313 Want to compare MR to MC. So far, we assumed that MC was constant. This is OK for

Jan 11, 2016

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#### decreasing returns

Problem 1.1

PowerPoint Slides Michael R. Ward, UTA 2014Cost Curves

Econ 5313

Want to compare MR to MC.So far, we assumed that MC was constant.This is OK for small decisions.Small enough that MC is not altered muchSmall enough that estimates of any change are not worth performing.But may not be appropriate for larger decisions. Possibilities include:Scale economiesScope economiesLearning-by-doing2Production Experiment

Econ 5313

Need series of volunteers (one at a time). We are going to see how many widgets can be made with 1 worker, 2 workers, etc. Widget production entails folding a piece of paper twice and stapling the folds together.Q=f(K,L) where Q is the widget, K is capital (stapler) and L is labor (student volunteers).Widgets are fragile and break if the fall to the ground.Neatness does not count.Our goal is to fill values in this table.3Production Experiment

Econ 5313

Our goal is to fill values in this tableKLQ1001112131415164Production Experiment

Econ 5313

Our real goal is to learn about returns to scale. First we want to fill in some additional columns.How do we define Average Product of Labor(APL)?APL = Q/LHow do we define Marginal Product of Labor (MPL)?MPL = DQ/DLKLQAPMP1001112131415165Production Experiment

Econ 5313

The tabular data can be graphed and usually looks like this.

What do we call it when MP is rising?Increasing Returns to Scale (IRS)What do we call it when MP is falling?Decreasing Returns to Scale (DRS)6Production Experiment

Econ 5313

What caused the increasing returns to scale in our experiment?Division of Labor (also called Specialization)What caused the decreasing returns to scale in our experiment?Congestion: Only one stapler to be shared by allCoordination: Had to agree on roles for all participants and had to hand off work incomplete product to next team memberJust about all production processes share these properties.Division of Labor in Smiths Pin FactoryCongestion from fixity of various inputsCoordination from communication with ever more participants7Implications

Econ 5313

Often, this is where a manager add the most firm valueHow do you eke out ever more gains from increased division of labor without invoking the curse of congestion and coordination?This is THE feature behind the industrial revolutionEx Fords assembly line but also Fords extensive vertical integrationPrecursor of the MBA was the efficiency expertA dominant feature of the information revolution is communicationReducing the coordination problem implies greater specialization.Also, participants in production need not be in one firm but can be along the supply chain8Implications

Econ 5313

What does a hump shaped marginal product curve imply for the shape of the marginal cost curve?Suppose a unit of K cost \$10 and a unit of L cost \$10Fill in this table from the experiment:

AC = TC/QMC = DTC/DQKLQAPMPTCACMC1112131415169Implications

Econ 5313

A hump shaped marginal product curve implies a U shaped the marginal cost curve.10Implications

Econ 5313

In the real world, MC are from increments from more than one inputMeasuring marginal productivity a little trickierBut general principle still usually generates U shaped MC curveCosts minimization is at bottom of the U

Econ 5313

Akio Morita and the Sony transistor radio way back at the founding of the companyHe was offered the opportunity to sell 100,000 units but turned it downBecause of capacity issues, he estimated his unit costs at, \$20 for 5K, \$15 for 10K, and \$40 for 100KExpansion is not always desirable

12Scale Economies

Econ 5313

For some production processes, MC always below ACNo U shape, increasing returns to scale everywhereThis is particularly true for information goodsEx Computer software, music, movies, video games, smart phone apps, online auctions, social networksNow, costs minimization can lead to ever bigger firmsRole in dotcom bubble of 1999-2000?Example: Webvan going to offer online grocery shoppingUse web interface for ordering like AmazonPurchased small pickup trucks specially designed to be refrigerated for deliveriesOnly makes sense for huge volumeCompany failure meant \$1 billion loss on trucks alone13Scope Economies

Econ 5313

Suppose we redid our production experiment with two different widget designs. You make equal numbers of two designs in one processYou make one in one process and the other in a different processWhich organizational form leads to the least costly production?If 1, then economies of scopeIf 2, then diseconomies of scopeC(Q1, Q2) versus C(Q1) + C(Q2)14Scope Economies

Econ 5313

Where do economies of scope come from?Usually, economies of scale in some componentEx: Auto assembly Why do they make trucks, sedans, minivans, sports cars etc.?Typically buy components but make engines (why?)Hard to contract over due to holdup problemsBut design and tooling represents a huge FCMake just one version of a 4 cylinder (or V6, or V8) and put it into as many models as possible15Breakfast Sausage Producer

Econ 5313

Regional - Used 18 trucks in distribution to 21 southern and Midwestern statesBut demand is seasonal peaks in winterTrucks were idle in summer not exploiting scale economiesPossible Solutions:Outsource distribution supplier can smooth capacity utilization over other products from other customers, but vulnerable to holdupVertically integrate parent uses trucks for other products during summer, but blunts incentives16Pet Food Producer

Econ 5313

A pet food company has 2,500 products (SKUs) with 200 different formulas They receive a lot of pressure from large customers like Wal-Mart to reduce prices To respond to Wal-Mart, the company shrinks it product offerings70 SKUs w/13 formulas This led to a 25% savings for the company because of reduced production costsHow?17Pet Food Producer

Econ 5313

Production with each new formula requires that the production line shut down for setupLine workers idle during this timeThe production line exhibits scale economies

18Learning-By-Doing

Econ 5313

Learning curves or Learning-By-Doing (LBD) slightly different from scale economiesScale economies from producing 20 units versus 10 units in a period of timeLearning-By-Doing from producing 10 units in a period of time after producing 10 units in the previous periodNot necessarily due to division of laborDue to tweaking the process based on what you discovered the first time19Microchip Makers

Econ 5313

Microchip makers stamp out increasingly complicated chips onto silicon wafersTest each chip to check for defectsAlso test to correct design or production defectsFirst batch has whopping 90% defect rateFix most glaring mistakesNext batch has 80% defect rateJust doubled the yield per unit of effort!Fix a few more mistakesContinued tweaking typically ultimately yields 15% defect rate at end of product lifecycleOne reason why prices of consumer electronics falls

20Airplane Manufacturer

Econ 5313

Every time an airplane manufacturer doubles production, marginal costs decrease by 20%Number produced in time period may not changeQMCTCAC1\$100.00 \$100.00 \$100.00 2\$80.00 \$180.00 \$90.00 3\$70.21 \$250.21 \$83.40 4\$64.00 \$314.21 \$78.55 5\$59.56 \$373.77 \$74.75 6\$56.17 \$429.94 \$71.66 7\$53.45 \$483.39 \$69.06 8\$51.20 \$534.59 \$66.82 9\$49.29 \$583.89 \$64.88 10\$47.65 \$631.54 \$63.15 21Airplane Manufacturer

Econ 5313

Same information graphically22Airplane Manufacturer

Econ 5313

Am Air is considering a large airframe purchase from a Boeing. Because of this order, Boeings unit costs will be lower in the future. Boeing will be able to charge lower prices to future customers, airlines in competition with Am Air. Am Air could be providing a competitive advantage to its competitors! What are possible contracting solutions? Am Air gets kickbacks on future orders (probably violates antitrust laws)Am Air gets a percent of increase in Boeings stock market value when the deal is announced or buy calls (probably violates security laws)Exclusive contract for airframe and favorable prices

23Anticipating Learning-by-Doing

Econ 5313

Every time you double production, your costs decrease by 50%. The first unit costs you \$64 to produce On a project for 4 units, what is your break-even price?

24Anticipating Learning-by-Doing

Econ 5313

On a project for 4 units, what is your break-even price? You can win another project for 2 more units. What is your break-even price for those units?QMCTCAC1\$64 \$64 \$64 2\$32 \$96 \$48 3\$21 \$117 \$39 4\$16 \$133 \$33 5\$13 \$146 \$29 6\$11 \$157 \$26 25

From the BlogChapter 7Nissan-Renault AllianceThoreau was a polluterJoe Fresh at JCPAirline OperationsAuto AllianceRental Car FormatsLearning-by-doing is Embodied in the Manager

Econ 531326

Main PointsIncreasing Returns Usually from division of laborDiminishing Returns Usually from congestion and coordination problemsEfficient firms balance the twoSolving some congestion issues allows for more specializationScale economies means that costs fall as you produce moreScope economies means that the costs of producing one good are lower because you produce another goodOften from scale economies in a common componentLearning-by-Doing means that current production will lower future costsAnticipate this when planning over the product lifecycle

Econ 531327

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