CostsCostsCostsCosts

OutlineOutline

Economies of scale Economies of scope p Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

2(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scaleEconomies of scale

Fixed cost: cost of inputs that do not change with production rate

Variable cost: cost of inputs that change with the production rate

Fixed/variable costs concepts apply in Short run Long run

3(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scale:Expense statement

Daily Labor Printing Ink Electric TotalProdn

(‘000s)Press and

PaperPower

0 $5000 $1000 $0 $200 $6200

10 $5000 $1500 $1200 $300 $800010 $5000 $1500 $1200 $300 $8000

20 $5000 $2000 $2400 $400 $9800

30 $5000 $2500 $3600 $500 $11600

40 $5000 $3000 $4800 $600 $13400

50 $5000 $3500 $6000 $700 $15200

60 $5000 $4000 $7200 $800 $17000

70 $5000 $4500 $8400 $900 $18800

80 $5000 $5000 $9600 $1000 $20600

90 $5000 $5500 $10800 $1100 $22400

Economies of scale:Fixed/variable costs

Daily Fixed Variable Total Marginal Avg Avg AvgProdn

(‘000s)Cost Cost Cost Cost Fixed

CostVariable

CostCost

0 $6200 $0 $6200

$ $ $ $ $ $ $10 $6200 $1800 $8000 $0.18 $0.62 $0.18 $0.80

20 $6200 $3600 $9800 $0.18 $0.31 $0.18 $0.49

30 $6200 $5400 $11600 $0.18 $0.21 $0.18 $0.39

40 $6200 $7200 $13400 $0.18 $0.16 $0.18 $0.34

50 $6200 $9000 $15200 $0.18 $0.12 $0.18 $0.30

60 $6200 $10800 $17000 $0.18 $0.10 $0.18 $0.28$ $ $ $ $ $ $

70 $6200 $12600 $18800 $0.18 $0.09 $0.18 $0.27

80 $6200 $14400 $20600 $0.18 $0.08 $0.18 $0.26

90 $6200 $16200 $22400 $0 18 $0 07 $0 18 $0 2590 $6200 $16200 $22400 $0.18 $0.07 $0.18 $0.25

Economies of scaleEconomies of scale

E i f l (i i Economies of scale (increasing returns to scale): average cost decreases with scale of production

Economies of scale: SourcesEconomies of scale: Sources

f d Large fixed costsDesign Research and development Information technology

Falling average variable costs Distribution of gas and water Container ships, tankers

7(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scale: TankersEconomies of scale: Tankers

Diseconomies of scaleDiseconomies of scale

Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

9(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scale: Strategic implications

Either produce on large scale or outsource Seller side – monopoly/oligopolyp y g p y Buyer side – monopsony/oligopsony

10(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scale:Google vis-à-vis library

Which link(s) in service chain are scaleable? Compilation of informationp Providing service: servers and network Responding to enquiries

11(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

Economies of scale Economies of scopep Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

12(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scopeEconomies of scope

Economies of scope: total cost of production is lower with joint than with separate production

Diseconomies of scope: total cost of production is higher with joint than with separate production

13(c) 1999-2007, I.P.L. Png & D.E. Lehman

Economies of scopeEconomies of scope

Source: Joint cost – cost of inputs that do not change with scope of production

Strategic implication: Produce/deliver multiple products product mix brand extensions

14(c) 1999-2007, I.P.L. Png & D.E. Lehman

Horizontal boundaries

Economies of scale Economies of scale Should bank merge with

competitor? Should trucking company

acquire smaller rivals? Economies of scopep

Should airline run catering service?

Should bank sell insurance? Should bank sell insurance? Should university open a

medical school?

OutlineOutline

Economies of scale Economies of scope p Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

16(c) 1999-2007, I.P.L. Png & D.E. Lehman

Experience curveExperience curve

Incremental cost falls with cumulativeproduction run over time Unit cost falls with cumulative production runDistinguish from economies of scale within

one production period

17(c) 1999-2007, I.P.L. Png & D.E. Lehman

Experience curveExperience curve

Experience curveExperience curve

Conditions Relatively large human resources input per unit of

productionp Relatively small production runs

Industries/processes (learning percentage)( ) Aerospace (85%)

Shipbuilding (80-85%) Complex machine tools for new models (75-85%) Complex machine tools for new models (75 85%) Repetitive electronics manufacturing (90-95%) Repetitive machining or punch-press operations (90-

95%)

19(c) 1999-2007, I.P.L. Png & D.E. Lehman

95%)

Experience curve:Strategic implication

Must accurately predict cumulative production Then set price accordinglyp g y

Challenge – quantity demanded depends on competition and price.

Example: Airbus A350 vs Boeing 787.

20(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

Economies of scale Economies of scope p Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

21(c) 1999-2007, I.P.L. Png & D.E. Lehman

Opportunity cost: RelevanceOpportunity cost: Relevance

Consider only relevant costs and ignore all other costswhich costs are relevant depends on course of

action

Relevant costs may be hidden Irrelevant costs may be shown in accounts

22(c) 1999-2007, I.P.L. Png & D.E. Lehman

Opportunity costOpportunity cost

Definition – net revenue from best alternative course of action

Two approaches show alternatives report opportunity costs

23(c) 1999-2007, I.P.L. Png & D.E. Lehman

Opportunity cost:Economic Value Added

All forms of financing an investment are costly must pay interest on debtmust provide return on equity

EVA = revenue – all costs (including cost of equity capital)

24(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

Economies of scale Economies of scope p Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

25(c) 1999-2007, I.P.L. Png & D.E. Lehman

Transfer pricingTransfer pricing

Generally, for internal economic efficiency, set transfer price = marginal cost

Special cases Perfectly competitive market: transfer price =

market price Production subject to full capacity: transfer

i hi h t i l b fit f i t lprice = highest marginal benefit from internal useCompare marginal benefit across internal users

26(c) 1999-2007, I.P.L. Png & D.E. Lehman

Compare marginal benefit across internal users

OutlineOutline

Economies of scale Economies of scope p Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

27(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sunk cost

Definition: Cost that has been committed and cannot be avoided.

Alternative courses of action depend on prior commitments planning horizon

28(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sunk costs:Strategic implications

Lock-in Contracts Technology

MS OfficeMobile phone service

Customer investments

29(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sunk vis-à-vis fixed costsSunk vis-à-vis fixed costs

Sunk vis-à-vis fixed costsSunk vis-à-vis fixed costs

Not all fixed costs are sunk: Every scheduled flight must have one pilot and y g p

co-pilot – fixed costs But not sunk – can lay off the pilots depending

l b t ton labor contract.

31(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sunk vis-à-vis fixed costsSunk vis-à-vis fixed costs

Not all sunk costs are fixed: Cost of public service employees is sunk, once p p y

they secure tenure. However, government could have hired only temporary workers (then no sunk costs)(then, no sunk costs).

32(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

Economies of scale Economies of scope p Experience curve Opportunity cost Opportunity cost Transfer pricing Sunk cost Sunk cost

33(c) 1999-2007, I.P.L. Png & D.E. Lehman

MonopolyMonopolyMonopolyMonopoly

Eli Lilly: ProzacEli Lilly: ProzacEli Lilly: ProzacEli Lilly: Prozac

US Court of Appeals limited patent to August 2001Lilly market value dropped $36 bill.Barr market value rose $1.1 bill.

How should Lilly adjustpricingadvertising

35(c) 1999-2007, I.P.L. Png & D.E. Lehman

Moore’s LawMoore s Law

Moore: Number of transistors on integrated circuit doubles every 18 months

Does cost of computing halve every 18 months?

36(c) 1999-2007, I.P.L. Png & D.E. Lehman

Market powerSeller sideSeller side

Pure competition – least freedom in pricing Monopolistic competition

Medical clinic Medical clinic Small-scale systems integration

Oligopolyg p y Hospital ERP systems, anti-virus software, microcomputer

operating systemoperating system Monopoly – single supplier of good or a service

with no close substitute: most freedom in pricing

37(c) 1999-2007, I.P.L. Png & D.E. Lehman

Market powerBuyer sideBuyer side

Monopsony – single buyer

l f b Oligopsony – few buyers

38(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutlineOutlineOutline

sources of market power operating scalep g limiting competition buyer market power buyer market power

39(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sources of Market PowerSources of Market Power

unique resources human natural

intellectual property patentp copyright

40(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sources of Market PowerSources of Market Power

economies of scale / scope

product differentiation

government regulationg g

41(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

sources of market power operating scalep g limiting competition buyer market power buyer market power

42(c) 1999-2007, I.P.L. Png & D.E. Lehman

Operating Scale:Marginal Revenue and PriceMarginal Revenue and Price

250

infra-marginal units

130

150

demand (marginal benefit)

units

50

70marginal revenue

-50

0.4 0.8 1.2 1.4 1.6 2

Quantity (Million units a year)

43(c) 1999-2007, I.P.L. Png & D.E. Lehman

Quantity (Million units a year)

Operating Scale:Revenue, Cost, and ProfitRevenue, Cost, and Profit

Price ($)

Sales

Total Revenue

($)

Marginal Revenue

($)

Total Cost ($)

Marginal Cost ($)

Profit ($)

200 0.0 0 50 -50200 0.0 0 50 50190 0.2 38 190 52 10 -40 180 0.4 72 170 56 20 16 170 0.6 102 150 62 30 40 160 0 8 128 130 70 40 58160 0.8 128 130 70 40 58150 1.0 150 110 80 50 70 140 1.2 168 90 92 60 76 130 1.4 182 70 106 70 76 120 1.6 192 50 122 80 70110 1.8 198 30 140 90 58 100 2.0 200 10 160 100 40 90 2.2 198 -10 182 110 16

44(c) 1999-2007, I.P.L. Png & D.E. Lehman

Operating Scale: Profit MaximumProfit Maximum

To maximize profit operate at scale where To maximize profit, operate at scale where marginal revenue = marginal cost

Justification: Justification:If marginal revenue > marginal cost, sell more and increase profit.more and increase profit.If marginal revenue < marginal cost, sell less and increase profit.

45(c) 1999-2007, I.P.L. Png & D.E. Lehman

p

Operating Scale:P fi M iP fi M iProfit MaximumProfit Maximum

46(c) 1999-2007, I.P.L. Png & D.E. Lehman

Operating Scale:Profit MaximumProfit Maximum

contribution margin = total revenue less i blvariable cost

profit-maximizing scale: selling additional unit does not change the contribution margin

47(c) 1999-2007, I.P.L. Png & D.E. Lehman

Glaxo: LifeLife--andand--Death MonopolyDeath Monopoly

“Once its products were approved, a big drug firm such as Glaxo could sell them at almost whatever price it wanted” (Economist, Jan. 28 1995)28, 1995)

True or false?True or false?

48(c) 1999-2007, I.P.L. Png & D.E. Lehman

Operating Scale: DemandDemand

set price, or sales

49(c) 1999-2007, I.P.L. Png & D.E. Lehman

Operating Scale:Demand ChangeDemand Change

Find new scale where marginal revenue = marginal costg g

should change price should change price new scale and price depend on both new

demand and costsdemand and costs

50(c) 1999-2007, I.P.L. Png & D.E. Lehman

Prozac: Prozac: Demand ReductionDemand Reduction

200

250

nit)

150

200

marginal costce (

$ pe

r un

50

100

marginal cost

original demand

Pric

0

50

0.4 0.8 1.2 1.6 2

new demand

new marginal

51(c) 1999-2007, I.P.L. Png & D.E. Lehman

revenueQuantity (Million units a year)

Operating Scale:Cost ChangeCost Change

Find new scale where marginal revenue = marginal costg g

change in MC --> should change price (but change in MC > should change price (but less than change in MC)

change in fixed cost --> should not change change in fixed cost > should not change price or scale

52(c) 1999-2007, I.P.L. Png & D.E. Lehman

Operating Scale:Reduction in Marginal CostReduction in Marginal Cost

53(c) 1999-2007, I.P.L. Png & D.E. Lehman

Moore’s Law and cost of computingMoore s Law and cost of computing

Technological advances

increase in fixed cost reduction in marginal cost ($ per unit of

computing power)

54(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

sources of market power operating scalep g limiting competition buyer market power buyer market power

55(c) 1999-2007, I.P.L. Png & D.E. Lehman

Limiting Competition:CartelCartel

effectiveness depends on

number of sellers in the market industry capacity vs market demand dust y capac ty s a et de a d extent of sunk costs extent of entry and exit barriers y nature (homogeneity) of product

56(c) 1999-2007, I.P.L. Png & D.E. Lehman

Limiting Competition:Vitamins, Inc., 1990Vitamins, Inc., 1990--9999

world’s top three manufacturers -- Roche (40%) BASF (20%) Rhone-Poulenc (15%)(40%), BASF (20%), Rhone-Poulenc (15%)

allocated market shares allocated market shares fixed prices

i d bid rigged bids

57(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

sources of market power operating scalep g limiting competition buyer market power buyer market power

58(c) 1999-2007, I.P.L. Png & D.E. Lehman

Buyer market powerBuyer market power

buyer with market powerrestricts purchases d ito depress price

trades off marginal expenditure marginal benefit

59(c) 1999-2007, I.P.L. Png & D.E. Lehman

Buyer market power:Operating ScaleOperating Scale

60(c) 1999-2007, I.P.L. Png & D.E. Lehman

SummarySummary

Sources of market power Responding to changes in demand and costsp g g Limiting competition Buyer market power Buyer market power

61(c) 1999-2007, I.P.L. Png & D.E. Lehman