ECONOMIC EFFICIENCY & COSTIMBA NCCU
Managerial Economics
Jack Wu
ECONOMIC EFFICIENCY
CASE: AIRPORTS IN NEW YORK AREA, 2008
Newark , Continental Airlines (72% of takeoff and landing slots), 35.4 million passengers
Kennedy , Delta Airline (31% of takeoff and landing slots), 47.8 million passengers
LaGuardia, US Airways (32% of takeoff and landing slots), 23.1 million passengers
OUTCOMES OF LANDING FEE POLICY The Port Authority charges airlines landing fees based
on aircraft weight. The fees are on average of $6 per passenger and do not vary with the time of day.
During peak hours, the demand for takeoffs and landings at Newark exceeds capacity.
FAA presented a 10-year plan limiting scheduled takeoffs and landings to 81 per hour and establishing an auction for landing and takeoff slots.
However, the Port Authority, major airlines resisted the FAA plan.
FAA abandoned the plan and sought other ways to relieve congestion at Newark.
APPLICATION OF MANAGERIAL ECONOMICS
Takeoff and landing slots at an airport with limited runway capacity are a scarce resource.
However, if the slots are allocated by administrative rule, the allocation of resources might not be economically efficient.
ECON EFFICIENCY: CONDITIONS
for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost
ECONOMIC EFFICIENCY V.S. TECHNICAL EFFICIENCY
Contrast economic efficiency vis-à-vis technical efficiency
Technical efficiency producing at lowest possible cost doesn’t consider how much benefit the item
provides
ADAM SMITH’S INVISIBLE HAND: PRICE
Competitive market achieves three sufficient condition for economic efficiency:
buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient
i) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.
INVISIBLE HANDOutcome of price
competition in market Marginal benefit =
price Marginal cost = price Single price in market
EXAMPLE OF INVISIBLE HAND Major policy issue: how to allocate licenses for
3G wireless telecommunications; “beauty contest” -- France auction – Germany, UK, US
pioneer: in early 1990s, US Federal Communications Commission showed that spectrum licenses were worth billions;
created pressure on other governments to allocate by auction and not favoritism.
Auction ensures that item goes to user with highest marginal benefit.
UCLA ANDERSON SCHOOL, 1989
Half an invisible hand is worse than none priced photocopying paper free bond paper
PRICE CEILING
Upper limit that sellers can charge and buyers can pay rent control regulated price for electricity
0
1100
290 300 310
supply
demand
b
equilibriumexcess demand
Quantity (Thousand units a month)
Pri
ce (
$ p
er
month
)
RENT CONTROL: EQUILIBRIUM
1000 900
0
1100
290 300 310
supply
demand
b
Quantity (Thousand units a month)
Pri
ce (
$ p
er
month
)
RENT CONTROL: SURPLUSES
1000 900
d
g
e
buyer surplus gain = cfeg buyer surplus loss = dgbseller surplus loss = cfeg + geb
c
f
RENT CONTROL: LOSSES
deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur
price elasticities of demand and supply _demand more inelastic --> larger loss _ supply more elastic --> larger loss
PRICE FLOOR
Lower limit that sellers can charge and buyers can pay minimum wage agricultural price supports
0
4.20
8 10 11
supply
demand
a
b
c
equilibrium
excess supply
Quantity (Billion worker-hours a week)
Wage (
$ p
er
hour)
MINIMUM WAGE: EQUILIBRIUM
4.00
0
4.20
8 10 11
supply
demand
a
b
c
Quantity (Billion worker-hours a week)
Wage (
$ p
er
hour)
MINIMUM WAGE: SURPLUSES
4.00
f
d
e
g
seller surplus gain = fdgeseller surplus loss = ghb buyer surplus loss = fdge + egb
h
MINIMUM WAGE: LOSSES
deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur
price elasticities of demand and supply _supply more inelastic --> larger loss _demand more elastic --> larger loss
TAX: COMMODITY TAX
“the only two sure things in life are death and taxes” buyer’s price - tax = seller’s price payment vis-à-vis incidence
US: airlines pay tax Asia: passengers pay
0
800
900
e
Quantity (Thousand tickets a year)
Pri
ce (
$ p
er
tick
et)
supply
demand
$10
TAX: EQUILIBRIUM
b
h
804
794
920
0
800
900
e
Quantity (Thousand tickets a year)
Pri
ce (
$ p
er
tick
et)
supply
demand
$10
TAX: SURPLUSES
b
h
804
794
920
f
d
j
buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg
g
INCIDENCE
incidence and deadweight loss depend on price elasticities of demand and supply
ideal tax (no deadweight loss): inelastic demand/supply
who pays the tax not relevant
COSTS
INTRODUCTION
Cost and economies of scale Cost and economies of scope Relevant / Opportunity costs Irrelevant Costs/ Sunk costs
ECONOMIES 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
EXPENSE STATEMENT
DailyProduction(thousands) Labor
PrintingPress
Inkand
PaperElectricpower Total
0 $5000 $1000 $0 $200 $620010 $5000 $1500 $1200 $300 $800020 $5000 $2000 $2400 $400 $980030 $5000 $2500 $3600 $500 $1160040 $5000 $3000 $4800 $600 $1340050 $5000 $3500 $6000 $700 $1520060 $5000 $4000 $7200 $800 $1700070 $5000 $4500 $8400 $900 $1880080 $5000 $5000 $9600 $1000 $2060090 $5000 $5500 $10800 $1100 $22400
FIXED AND VARIABLE COSTS
DailyProduction(thousands)
FixedCost
VariableCost
TotalCost
MarginalCost
AverageFixedCost
AverageVariable
CostAverage
Cost0 $6200 $0 $620010 $6200 $1800 $8000 $0.18 $0.62 $0.18 $0.8020 $6200 $3600 $9800 $0.18 $0.31 $0.18 $0.4930 $6200 $5400 $11600 $0.18 $0.21 $0.18 $0.3940 $6200 $7200 $13400 $0.18 $0.16 $0.18 $0.3450 $6200 $9000 $15200 $0.18 $0.12 $0.18 $0.3060 $6200 $10800 $17000 $0.18 $0.10 $0.18 $0.2870 $6200 $12600 $18800 $0.18 $0.09 $0.18 $0.2780 $6200 $14400 $20600 $0.18 $0.08 $0.18 $0.2690 $6200 $16200 $22400 $0.18 $0.07 $0.18 $0.25
ECONOMIES OF SCALE
Economies of scale (increasing returns to scale): average cost decreases with scale of production
SCALE ECONOMIES: SOURCES
large fixed costs research, development, and design information technology
falling average variable costs distribution of gas and water container ships
DISECONOMIES OF SCALE
Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production
ECONOMIES OF SCALE: STRATEGIC IMPLICATIONS
Either produce on large scale or outsource Seller side – monopoly/oligopoly Buyer side – monopsony/oligopsony
ECONOMIES 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
Organization Output Labor Printing Ink etc. TotalPress Cost
Separate production Daily Globe 50,000 $5,000 $3,500 $6,700 $15,200 Afternoon Globe 50,000 $5,000 $3,500 $6,700 $15,200 Two papers $30,400Combined production Two papers 100,000$10,000 $3,500 $13,400 $26,900
EXPENSES FOR TWO PRODUCTS
ECONOMIES OF SCOPE
source -- joint cost: cost of inputs that do not change with scope of production
examples:� cable television + telephone banking + insurance manufacturing: refrigerator + air-conditioner
strategic implication -- produce/deliver multiple products
RELEVANCE
consider only relevant costs and ignore all other costs which costs are relevant depends on course of
action relevant costs may be hidden irrelevant costs may be shown in accounts
OPPORTUNITY COST
definition -- net revenue from best alternative course of action
two approaches� show alternatives� report opportunity costs
EXAMPLE Williams bought a warehouse and paid
$300,000 for it. She used her own money $200,000 and made a bank loan of $100,000.
A developer were willing to buy warehouse for 2 million.
If Williams sells warehouse, she could invest proceeds in government bonds and get a secure income $160,000 (2 million*8%).
She could work elsewhere for salary $400,000.
Continue Warehouse Operations
Shutdown
Revenue $700,000 $560,000 Expenses $220,000 $0
Profit $480,000 $560,000
Revenue $700,000
Cost $780,000
Profit ($80,000)
Income statement reporting opportunity costs
INCOME STATEMENT SHOWING ALTERNATIVES
SUNK COST
definition -- cost that has been committed and cannot be avoided
alternative courses of action� prior commitments� planning horizon
Fewer commitments fewer sunk costs;
longer planning horizon fewer sunk costs.
EXAMPLE Jupiter Athletic is about to launch a line of
new athletic shoes. Some month ago, management prepared an ad campaign with total budget of $310,000.
They forecast the ad would generate sales of 20,000 units. Each sale’s unit contribution margin (price- average variable cost) is $20. The total contribution margin is $20*20000=$400,000. Their expected profit generated from ad is $400,000-310,000=$90,000.
EXAMPLE: CONTINUED
Recently, a major competitor launch a new shoe. Jupiter estimates sales fall to 15,000 units. The contribution margin becomes $20*15,000=$300,000.
Should Jupiter cancel the launch?
Continue Product Launch
Cancel Launch
Contribution margin $300,000 $0 Graphic arts
consultant fee $50,000 $50,000
Road Runner charge $60,000 $30,000 Daily Globe charge $200,000 $20,000
Profit ($10,000) ($100,000)
Contribution margin $300,000 Graphic arts cost $0
Road Runner charge $30,000 Daily Globe charge $180,000
Profit $90,000
Income statement omitting sunk costs
INCOME STATEMENT SHOWING ALTERNATIVES
DISCUSSION QUESTION
Suppose that MM system operates two call centers: A and B. Table reports the total costs at the two centers for various rates of customer service. To serve a total of 5000 calls per day in the cheapest way, how many calls should the company serve from A center and how many from B center? Explain why.
DISCUSSION QUESTIONService Rate(calls/day) Total costs from A center Total costs from B center
1000 $5000 $8000
2000 $11000 $16000
3000 $18000 $24000
4000 $26000 $32000
5000 $35000 $40000