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Production Costs Prices and Markets Session 4 Prof. Amine Ouazad
Production Costs
Prices and Markets
Session 4
Prof. Amine Ouazad
– Timeline for Prices and Markets – 1 & 2 Supply, Demand and Markets
Single Firm’s Decision
3 Consumer Choice and Demand
4 Production and Costs
5 Pricing with Market Power
6 How Pricing Depends on the Demand Curve
7&8 Explicit & Implicit Price Discrimination
Interacting Firms: Perfect Competition
9 Competitive Supply and Market Price
10 Short-Run Costs and Prices
11 Applications of Perfect Competition
Interacting Firms: Imperfect Competition
12 Static Games and Nash Equilibrium
13 Strategic Commitment
14 Imperfect Competition
14 Explicit and Implicit Collusion
We are here!
Optimal pricing starts in the next session
We’re introducing basic tools
(demand, costs, pricing)
useful for all subsequent
sessions
Coverage for Quiz #1
Measuring Costs: Sunk costs?? • You have hired a consultant whose fees are $10,000:
• He suggests supply chain reorganization strategy
• For additional cost of $15,000 this will save you $18,000 in inventory costs
• Should you follow his suggestion?
• Sunk Costs: Costs that are immutable and hence the same for all alternatives.
• Sunk Cost Fallacy: People tend to take into account costs that their decisions cannot possibly impact on.
• Heuristic: Ignore sunk costs
(a) Simplifies decision making.
(b) Avoids mistake of including these costs for some options but not for others.
Opportunity Costs
Opportunity Cost: The opportunity cost of the resources in the project is the return on its next best alternative use. Heuristic Treat this opportunity cost as an explicit cost of the project. Correct cost-benefit analysis: “Do the project if revenue exceeds cost”; Correct marginal benefit-marginal cost analysis Economic profit takes into account the opportunity cost of capital & other assets ≠ Accounting Profit uses other rules, such as historical prices
Kaiser Aluminium in 2001: § Had a long-term contract through which it could buy electricity (from BPA) at $23 per megawatt hour. § Market price of electricity skyrocketed (as high as $1,000 per MWh) in late 2000 § Aluminum prices had collapsed in the meantime but still profitable at $23 § What should/did Kaiser do?
Try at Home: Identify Costs
A young chef opened her own restaurant. To do so, (a) she quit her job, which was paying $42,000 per year; (b) she cashed in a $30,000 certificate of deposit that was yielding 5%; (c) she took over a building she owned, previously rented for $15,000/year; (d) she decorated the restaurant with a forged Picasso that she once bought by mistake and is still paying $4,000 a year for. In the first year, she sold $180,000 worth of food and incurred expenses of $72,000 for food, $60,000 for extra help, and $ 6,000 for utilities. She anticipates future sales and costs to be the same (assume zero inflation).
Q. Was this restaurant a good idea (monetarily)?
This Session: Production and Costs
1. Ignore sunk costs, use & include opportunity costs
2. Fixed Costs
3. Marginal Costs
4. Cost Curve Economies of Scale and Mergers
Next Session Pricing with Market Power
Total Cost, Fixed and Variable Costs Cost curve c(Q) = minimum cost of producing Q units of the good. Cost is split into fixed and variable costs, c(Q)= FC + v(Q).
• Fixed costs FC are paid for serving the first customer, regardless of production Q. Also known as: entry cost, first-copy cost, setup costs
• These costs could be eliminated by never starting up. • Variable costs v(Q) depend on production Q.
• Long-run: when all variable inputs can be adjusted. • Short-run: when some inputs are fixed.
Time horizon: Short and Long run Long run time horizon is industry-specific!
Aircraft leasing agreements allow fast adjustments of the number of airplanes.
Building a new nuclear reactor takes at least a few years (>4 years for the Taishan nuclear reactor).
Fixed Costs? – Research and Development
“The R&D costs of 68 randomly selected new drugs
were obtained from a survey of pharmaceutical firms.”
Cost in US$ includes:
1. Out-of-pocket cost. 2. Cost of abandoned projects. 3. Opportunity cost of capital.
The financial cost of tying up investment capital in multiyear drug development projects, earning no return until and unless a project succeeds.
Total cost estimated at $800M !
What an
economist adds
Mergers and savings: and
How big are the savings??
AT&T Wireless and Cingular estimate them to be, for 2007, $1B in operating costs (7% of total) and $1.4B in capital expenditure (CAPEX) (15% of total).
One analyst’s report put the present value of the cost savings at $21B.
• Q1: What are the cost savings in this case, in Europe, in Singapore?
• Q2: Why did Britain’s Vodafone lose in its bid to acquire AT&T Wireless?
Cingular acquired AT&T Wireless in 2004. The companies say the deal lets them cut costs, improve spotty network coverage, and expand in rural areas and speed up availability of high-speed data services that make laptops as portable as cellphones. AT&T Wireless CEO John Zeglis hinted at a tough time for rivals. “Hey Verizon,” he joked. “Can you hear us now?” [USA Today, 28 Feb 2004, 1A.]
Mergers and Fixed Cost Savings Case Study – AT&T and Cingular
• Where are the biggest cost savings?
(a) In the mid-west
(b) In the north-east
In Penn Station, NYC
“It’s so slow, it feels like I’m on
a dial-up modem.”
an iPhone user in the NYTimes,
Sep 2009
Mergers and Savings - AT&T & Cingular Some Takeaway Points
1. Sunk costs cannot be recovered through a merger Installation costs of antennas cannot be recovered.
2. Fixed costs can be saved through a merger Customer services, Site Sharing, Spectrum Sharing, Network Sharing.
3. Fixed costs are large in the mobile phone industry Serving the first customer requires a large network of antennas with substantial maintenance.
4. Vodafone would not have had substantial savings of fixed costs with AT&T. Vodafone’s bid reflects its valuation of AT&T + the cost savings.
5. Fixed cost savings are higher in less dense areas.
Fixed or variable costs?
A student’s question
You listed examples or key elements of long-run fixed costs. I didn’t find the costs which I see as key in the banking sector, in which I had previous experience: maintenance of IT systems and maintenance of buildings. Apart from salary costs, these elements constitute the majority of retail banks’ expenses and in the short term are not influenced by the number of customers. Do you perceive these costs as long-term fixed costs?
• Short Run Fixed Costs SRFC.
• Long Run Fixed Costs LRFC.
• In most of the course, FC = LRFC, specified otherwise.
This Session: Production and Costs
1. Ignore sunk costs, use & include opportunity costs
2. Fixed Costs Mergers and Savings
3. Marginal Costs
4. Cost Curve Economies of Scale and Mergers
Next Session Pricing with Market Power
Tullow finds oil, Financial Times, Sept 9, 2011
Discovery of a new 700m barrel oil field. `Rob Mundy, oil and gas analyst at Liberum Capital, said the outcome “does seem to be as good as it looks”. The discovery had served to “open up an entire new fairway and a number of basins containing significant new prospects”.’
• What sunk costs should be ignored?
• What fixed costs should be included?
• What are the oil field’s likely marginal cost(s)? The industry’s marginal cost?
Marginal Cost Cost of producing the last unit of the good, serving the last customer.
This Session: Production and Costs
1. Ignore sunk costs, use & include opportunity costs
2. Fixed Costs Mergers and Savings
3. Marginal Costs
4. The Cost Curve
Next Session Pricing with Market Power
Cost curves: Marginal and Average Cost
Total cost Average/Unit Cost Profit Marginal Cost Average Variable Costs Average Fixed Costs
QQcQac )()( =
smooth )()(
discrete )1()()(
dQQdcQmc
QcQcQmc
=
−−=
Example: c (Q) = 100 + 3Q + Q2
( )( ) vc Qavc QQ
=
( ) fcafc QQ
=
( ) ( )c Q fc vc Q= +
Cost Curves: An Enduring Idea
• The cost curve is one of McKinsey’s “Enduring Ideas”. • “Competitive Cost Analysis”:
Staff Paper, 1980, Carter Bales, P. C. Chatterjee, Donald Gogel, and Anupam Puri.
• “The industry cost curve as a strategic tool”: Staff Paper, 1981, Don C. Watters.
Sessions covering cost curves Firm cost curve (Now), Industry cost curve (Session 9). ➥ Impact of demand shocks on price changes (Sessions 9 and 10). ➥ Profitability of capacity investments (Session 11).
General Case
0
5
10
15
20
25
30
35
40
0 1 2 3 4 5 6 7 8 9 10 11 Output (1000s)
Total Cost c(Q)
$ (1000s)
Variable Cost vc(Q)
Fixed Cost
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7 8 9 10 11
Output (1000s)
$ (1000s)
Average Fixed Costafc(Q)
Analysis of cost curves: Average FC
Average fixed cost:
Fixed cost divided by the number of units
produced
All the Cost Curves
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7 8 9 10 11 Output (1000s)
$ (1000s)
Average Variable Cost
avc(Q)
Marginal Cost mc(Q)
Average Cost ac(Q)
0
1
2
3
4
5
6
7
0 1 2 3 4 5 6 7 8 9 10 11
Output (1000s)
$ (1000s)
Average Variable Cost
avc(Q)
Marginal Costmc(Q)
Average Costac(Q)
VC (2)
ac (2)
All the Cost Curves
c (2)
c (Q) = area of rectangle between (0, 0) and point on AC curve vc (Q) = area under MC curve up to Q
Economies of Scale: A Long Run Concept
We say a firm has… If average cost is …
Economies of scale No economies of scale Diseconomies of Scale
Decreasing Constant Increasing
Q
AC Minimum Efficient Scale of Output Firms with scale other than MES
have a cost disadvantage.
In the early days of professionalized corporate
management, leaders discovered that minimum efficient scale was a key
determinant of competitive success. - McKinsey MES
Sources of Economies of Scale
Returns to Specialization automobile assembly line, coding, consulting Indivisible Inputs Fedex planes,
build a power plant as you produce more Setup Costs software; R&D for drugs Distribution Network Costs cable, water, fixed phone lines
Economies of Scale → A motive for Mergers; A legal rationale for Natural Monopolies.
Specific Cost Curves
• Constant Marginal Cost • Increasing Marginal Cost c (Q) = 100 + 3Q + Q2 Example: c (Q) = 50 + 0.3Q
Cost
Quantity
Cost
Quantity
ac(q) ac(q)
mc(q)
mc(q)
Case #2: Large fixed cost Increasing marginal cost
Case #1: Large Fixed cost Flat marginal cost
“For digital goods, the marginal cost of distribution and
manufacture is effectively near zero.” Google Chairman
Eric Schmidt
This Session: Production and Costs
1. Ignore sunk costs, use & include opportunity costs
2. Fixed Costs Mergers and Savings
3. Marginal Costs
4. Cost Curve Economies of Scale and Mergers
Next Session Pricing with Market Power
Wrap up – Take Away Points from the Cost Session
1. Sunk costs: Ignore them. 2. Opportunity costs: use them. 3. Costs are either fixed, or variable. 4. Profit depends on the Price and the Average Cost 5. Fixed Costs are sources of Economies of Scale 6. Techniques for later use:
a) Marginal cost and average cost b) Leading examples of cost curves (see Course Guide §4.8) c) U-shaped average cost – most interesting, has economies of scale &
increasing marginal cost.
Recommended exercises: • 4.3 to 4.8
Pricing: Can We Do Better Than This?
Q: Why is Microsoft charging $299 for Windows 7 Professional? A: Because it has no competitors, it charges whatever it wants
Q: What price should the Eurotunnel charge? A: “We will price to match our competitors (ferries)”
– Eurotunnel Prospectus
– Timeline for Prices and Markets – 1 & 2 Supply, Demand and Markets
Single Firm’s Decision
3 Consumer Choice and Demand
4 Production and Costs
5 Pricing with Market Power
6 How Pricing Depends on the Demand Curve
7&8 Explicit & Implicit Price Discrimination
Interacting Firms: Perfect Competition
9 Competitive Supply and Market Price
10 Short-Run Costs and Prices
11 Applications of Perfect Competition
Interacting Firms: Imperfect Competition
12 Static Games and Nash Equilibrium
13 Imperfect Competition
14 Explicit and Implicit Collusion
15 Strategic Commitment
Tools Next time: Pricing
Coverage for Quiz #1
