Managerial Economics—FINALS.pdf

# Cost and production concepts Cost and production concepts form the bedrock of understanding how businesses operate and make decisions to maximize profitability and efficiency. ## 1. Cost and production concepts ### 1.1 Key definitions and concepts * **Average cost**: Reflects the cost on a per unit basis [1](#page=1). * **Marginal cost**: The cost of producing an additional unit of a good or service [2](#page=2). * **Marginal Physical Product (MPP)**: Also known as marginal product, it is the change in output as a result of one additional unit of input being added to production [2](#page=2). * **Marginal Revenue Product (MRP)**: The marginal revenue (market value) created by using one additional unit of a resource [1](#page=1). * **Profit maximization**: Optimal output levels are achieved when marginal revenue equals marginal cost ($MR = MC$) [1](#page=1). ### 1.2 Returns to scale Returns to scale describe how output changes in response to a proportional change in all inputs [2](#page=2). * **Increasing return to scale**: Occurs when inputs (labor and capital) increase by 100%, and the increase in output is greater than 100% [2](#page=2). * **Constant Return to Scale**: Occurs when inputs (labor and capital) increase by 100%, and output also increases by 100% [1](#page=1). * **Decreasing Return to Scale**: Occurs when inputs (labor and capital) increase by 100%, and the increase in output is less than 100% [1](#page=1). ### 1.3 Economies and diseconomies of scale * **Economies of Scale**: Cost benefits gained by companies when production becomes more efficient, leading to an increase in production while lowering costs. Economies of scale exist if the result (related to efficiency gains) is less than one [1](#page=1). * **Diseconomies of Scales**: Firms will see their average costs increase if they further increase their scale [1](#page=1). ### 1.4 Related concepts * **Minimum Efficient Scale**: The balance point at which a company can produce goods at a competitive price, used to determine the ideal output quantity at the lowest average cost per unit [2](#page=2). * **Doubling Rate**: The reduction in average cost that occurs each time cumulative production doubles [1](#page=1). * **Economies of Scope**: Producing two or more products simultaneously results at a lower cost than producing them individually. Economies of scope exist if the result is greater than 0 [1](#page=1) [2](#page=2). * **Joint Products**: Two or more products generated within a single production process, such as gasoline, diesel, kerosene, lubricant, tar, paraffin, and asphalt obtained from crude oil [2](#page=2). * **Derived demand**: The demand for a certain good or service resulting from a demand for related, necessary goods or services [1](#page=1). * **Core Competencies**: The combination of skills, resources, and processes that give an organization a competitive advantage [1](#page=1). * **Economic Rent**: The difference between the amount a provider can charge for a limited input and the minimum amount they would accept [1](#page=1). ### 1.5 Production planning approaches * **Cost Approach to Production Planning**: Starts with the goods and services a firm intends to provide, then decides on the production configuration that will achieve the intended output at the lowest cost [1](#page=1). * **Resource Approach to Production Planning**: Starts when a firm determines where it excels in certain operational components, then decides what kinds of goods or services would best exploit these capabilities [2](#page=2). ### 1.6 Learning and productivity * **Learning Curve**: A fundamental concept demonstrating that as individuals or organizations gain more experience in performing a task, their efficiency increases, leading to lower costs and faster production times [2](#page=2). * **Learning By Doing**: Improvement in overall productivity from increased management knowledge on how to employ productive resources better. Examples include learning to use equipment better, project-based learning, research projects, debates, field trips, and computer programming [2](#page=2). * **Productivity**: A means of tracking improvements and comparing operations to those of other firms [2](#page=2). ### 1.7 Production decision horizons * **Short-run production decision**: Characterized by fixed capacity [2](#page=2). * **Long run production decision**: Businesses have sufficient time to expand, contract, or modify facilities. Capacity is a key distinguishing characteristic of long-run decisions, alongside the nature of costs [2](#page=2). > **Tip:** Understanding the distinction between short-run and long-run production decisions is crucial. In the short run, at least one input is fixed, limiting flexibility. In the long run, all inputs are variable, allowing for greater strategic adjustments. --- # Economics of organization and business expansion This section explores how businesses organize their operations and strategically expand through various integration methods, focusing on the underlying economic principles that guide these decisions. ### 2.1 Value chains and organizational structure The network of operations involved in creating a product can be visualized as a sequence of stages, known as a **value chain**. Understanding this chain is crucial for identifying opportunities for business expansion and organizational efficiency [3](#page=3). ### 2.2 Business expansion strategies: Integration Businesses can expand their operations through different forms of integration, each targeting specific parts of the value chain or diversifying into new areas. #### 2.2.1 Horizontal integration **Horizontal integration** involves expanding into new activities within the same stage of a value chain or a similar one. The primary drivers for this strategy are achieving **cost efficiencies** and increasing **market power** [3](#page=3). #### 2.2.2 Vertical integration **Vertical integration** occurs when a business expands into activities within the same value chain but at a different stage. This can manifest in two ways [3](#page=3): * **Upstream integration**: Expanding into an earlier stage of the value chain [3](#page=3). * **Downstream integration**: Expanding into a later stage of the value chain [3](#page=3). When two stages of a value chain are performed by different divisions within the same company instead of separate entities, it can lead to **double marginalization**, which reduces haggling over prices and sales conditions. A **best price policy** can be sought by downstream firms to ensure they receive the lowest possible price from upstream firms [3](#page=3). A challenge that can arise in vertical arrangements is **adverse selection**, where one party possesses private information advantageous to themselves, potentially creating a less favorable arrangement for the other party [3](#page=3). #### 2.2.3 Conglomerate mergers and diversification A **conglomerate merger** involves expanding into a new activity that is part of a completely different value chain. A **conglomerate** is a business enterprise that participates in multiple, distinct value chains. A key attraction of conglomerates is **diversification**, which allows them to weather difficult economic times in one industry by having a presence in other markets [3](#page=3) [4](#page=4). ### 2.3 Economic theories of organization and expansion #### 2.3.1 Transaction cost economics **Transaction cost economics** is a theory that explains when a firm should expand, contract, or even divest business units. It centers on **transaction costs**, which are the costs involved in making an exchange, whether internal or external [4](#page=4). The **Coase Hypothesis** posits that firms should expand as long as their internal transaction costs are lower than the external transaction costs for the same type of exchange [4](#page=4). > **Tip:** Understanding transaction costs helps businesses decide whether to produce a good or service in-house or to outsource it. #### 2.3.2 Internal organizational structures and challenges Businesses often organize their internal divisions to manage different aspects of their operations: * **Cost Center**: A division focused on meeting output goals at the minimum possible cost to contribute to the overall profitability of the corporation [4](#page=4). * **Profit Center**: A division treated as an independent business with its own revenues and costs, aiming to maximize the difference between them [4](#page=4). **Transfer price** is the measurement of value for exchange items, serving as revenue for the selling division and cost for the acquiring division. Transfer pricing typically comprises two components: **outlay cost** and **opportunity cost** [4](#page=4). > **Example:** If Division A sells a component to Division B within the same company, the transfer price is the amount Division B pays to Division A for that component. #### 2.3.3 Labor economics and organizational incentives * **Efficiency Wage**: A wage paid to an employee that is slightly above their marginal revenue product to incentivize productivity and job retention [4](#page=4). * **Classical Approach to Setting Wages**: This approach suggests that an employee's wage should not exceed the marginal revenue product corresponding to their effort [4](#page=4). A significant challenge in organizational management is the **principal-agent problem**, which arises when an employer cannot fully monitor an employee's actions, leading to insufficient information about whether the employee is acting in the employer's best interest [4](#page=4). **Information overload**, where critical information fails to reach the right person at the right time, can also hinder effective decision-making within organizations [4](#page=4). --- # Market structures and competitive strategies This topic examines different market models, such as perfect competition and monopolistic competition, and the strategies firms employ to compete, including cost leadership and product differentiation. ### 3.1 Market structures Market structures describe the characteristics of a market that influence the behavior and outcomes of firms operating within it [5](#page=5) [6](#page=6). #### 3.1.1 Perfect competition Perfect competition is considered the gold standard of a market. It is characterized by several key features [5](#page=5): * **Price Taker:** Individual firms or companies must accept the prevailing prices in the market and lack the market share to influence it [5](#page=5). * **Homogeneous Goods:** Every seller offers the same good, and buyers are indifferent to which seller they purchase from if prices are the same [5](#page=5). * **Perfect Information:** Producers understand the capabilities of other producers and have immediate access to resources. Both buyers and sellers are aware of all prices charged by other sellers [5](#page=5). The dynamics of perfect competition involve: * **Supply Curves:** These determine the total quantity sellers would provide at any given price. Market supply curves are generally upward sloping, reflecting firms' willingness to increase production with improved profitability and the potential for some firms to re-enter the market when prices improve sufficiently [5](#page=5). * **Market Equilibrium:** This is the quantity and price at which buyers and sellers agree; it is the intersection point of the market demand and market supply curves [5](#page=5). * **Invisible Hand:** This is the price adjustment process that moves a market towards equilibrium when the market price is above or below the equilibrium price. Adam Smith described this as a force [5](#page=5) [6](#page=6). * **Comparative Statics:** This involves examining the impact of a change on the equilibrium point [6](#page=6). Within a perfectly competitive market, economic surplus is divided between consumers and producers: * **Consumer Surplus (or Buyer Surplus):** This is the difference between what a customer would have paid for a unit and the lower equilibrium price they actually paid. It occurs when the price consumers pay is less than their willingness to pay [6](#page=6). * **Producer Surplus:** This is the difference between the price producers sell their goods for and the minimum price they would have been willing to sell them [6](#page=6). * **Deadweight Loss:** This refers to surplus that is no longer captured by either consumers or producers [6](#page=6). #### 3.1.2 Other market models * **Monopolistic Competition:** This model is similar to perfect competition but allows for slight variations in goods from seller to seller. It occurs when many companies offer products that are similar but not identical [6](#page=6). * **Contestable Market Model:** This is an idealized market similar to perfect competition but with a modest number of sellers, each holding a significant portion of overall sales [6](#page=6). ### 3.2 Competitive strategies Firms employ various strategies to compete effectively in markets, especially those with high levels of competition [6](#page=6). * **Cost Leadership Strategy:** This involves an aggressive program by a firm to keep its costs below those of other sellers in a highly competitive market. The fundamental advice is to maintain lower costs compared to competitors [6](#page=6). * **Product Differentiation Strategy:** This strategy focuses on making a firm's products distinguishable from those of its competitors. It is an aggressive approach to set products apart in a highly competitive market [6](#page=6). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Average cost | The cost of production measured on a per-unit basis. | | Constant Return to Scale | A condition where a 100% increase in inputs (like labor and capital) results in a 100% increase in output. | | Marginal Revenue equals Marginal Cost (MR = MC) | The principle that profit maximization for a firm occurs at the output level where the additional revenue from selling one more unit equals the additional cost of producing that unit. | | Core Competencies | The unique combination of skills, resources, and processes that provide an organization with a competitive advantage in the market. | | Cost Approach to Production Planning | A production planning method that begins with the firm's intended goods and services and then determines the most cost-effective production configuration to achieve the desired output. | | Decreasing Return to Scale | A situation where a 100% increase in inputs (labor and capital) leads to an output increase of less than 100%. | | Derived Demand | The demand for a good or service that arises from the demand for another, related, or necessary good or service. | | Diseconomies of Scales | A phenomenon where a firm's average costs increase as it further expands its scale of operations. | | Doubling Rate | The decrease in average cost that occurs each time cumulative production doubles, reflecting efficiency gains. | | Economic Rent | The difference between the price a provider can charge for a scarce input and the minimum price they would be willing to accept for it. | | Economies of Scale | Cost benefits realized by companies as production becomes more efficient, typically seen when increasing production leads to lower costs per unit. | | Economies of Scope | A situation where producing two or more products simultaneously results in a lower total cost compared to producing them individually. | | Marginal Revenue Product (MRP) | The additional market value generated by employing one more unit of a resource in production. | | Increasing Return to Scale | A condition where a 100% increase in inputs (labor and capital) results in an output increase greater than 100%. | | Joint Products | Two or more products that are generated within a single production process, such as gasoline, diesel, and kerosene from crude oil. | | Learning By Doing | Improvement in overall productivity that arises from increased experience and knowledge of management in employing productive resources more effectively. | | Marginal Product | The change in total output resulting from the addition of one more unit of input. | | Learning Curve | An economic concept showing that as individuals or organizations gain experience with a task, their efficiency increases, leading to lower costs and faster production. | | Long run production decision | A production decision where businesses have sufficient flexibility to expand, contract, or modify their facilities. | | Minimum Efficient Scale | The balance point at which a company can produce goods at a competitive price, representing the ideal output quantity at the lowest average cost per unit. | | Productivity | A measure of overall efficiency that tracks improvements and allows for comparison of operations with other firms. | | Return to Scale | The rate at which output changes in response to a proportional change in all inputs. | | Resource Approach to Production Planning | A production planning method where a firm identifies its core operational strengths and then determines what goods or services would best leverage these capabilities. | | Marginal Cost | The cost incurred from producing one additional unit of a good or service. | | Short run production decision | A production decision where businesses face limitations due to existing facilities, skill sets, and technology. | | Value Chain | The network of operations involved in the creation of a product, often represented as a sequence of stages. | | Horizontal Integration | A form of business expansion where the new activity is in the same or a similar stage of a value chain as the existing business. | | Vertical Integration | A classification of business expansion where the new activity is in the same value chain but at a different stage, either earlier or later. | | Conglomerate Merger | A business expansion where the new activity is part of a significantly different value chain from the existing business. | | Market Power | The ability of a firm to influence the market price of a good or service. | | Upstream Integration | A type of vertical integration where a business expands into an earlier stage of its value chain. | | Downstream Integration | A type of vertical integration where a business expands into a later stage of its value chain. | | Double Marginalization | A situation where two stages of a value chain are performed by different divisions of the same company, leading to potentially less favorable pricing than if performed by separate entities. | | Adverse Selection | A situation where one party in a transaction has private information that can be used to gain an advantage, potentially to the detriment of the party lacking that information. | | Conglomerate | A business enterprise that participates in multiple, distinct value chains. | | Diversification | The strategy of having a presence in various markets to provide stability during difficult economic times in a particular industry. | | Information overload | The failure of critical information to reach the appropriate individuals at the appropriate time. | | Transaction Cost Economics | A theory that explains when a firm should expand, contract, or divest business units based on the costs associated with making exchanges. | | Transaction Cost | The costs incurred in making an exchange, which can be either internal (within the firm) or external (with other firms). | | Coase Hypothesis | The principle suggesting that firms should continue to expand as long as internal transaction costs are lower than external transaction costs for similar exchanges. | | Cost Center | A division within a corporation whose primary goal is to meet its output targets at the minimum possible cost, contributing to overall profitability. | | Profit Center | A division treated as a separate business with its own revenues and costs, aiming to maximize the difference between its revenues and costs. | | Transfer Price | The value assigned to an exchanged item that serves as revenue for the selling division and a cost for the acquiring division. | | Outlay Cost | The direct cost incurred in producing or acquiring a good or service, which is one of the two components of transfer pricing. | | Efficiency Wage | An incentive payment offered to an employee, set slightly above their marginal revenue product, to encourage productivity and job retention. | | Classical Approach to Setting Wages | The principle that an employee's wage should not exceed the marginal revenue product associated with their effort. | | Principal-Agent Problem | A situation where an employer cannot fully monitor an employee's actions, leading to insufficient information about whether the employee is acting in the employer's best interest. | | Informativeness Principle | A suggestion to include performance measures reflecting individual employee effort in employee contracts. | | Signalling | Observable actions taken by a potential employee that help distinguish them as a high-quality worker. | | Tournament Theory | The idea that paying a CEO exceptionally high compensation, beyond their direct contributions, incentivizes other executives to exert greater effort for the chance of similar future rewards. | | Market | The collective activity of buyers and sellers for a specific product or service. | | Perfect Competition Model | An idealized market structure considered the benchmark for efficiency and competition. | | Price Taker | An individual or company that must accept the prevailing market price, lacking the market share to influence it. | | Homogeneous | A characteristic where sellers offer identical goods, and buyers are indifferent between sellers if prices are the same. | | Perfect Information | A market condition where producers are aware of each other's capabilities, have access to the same resources, and both buyers and sellers know all current prices. | | Supply Curves | Graphs that depict the total quantity of a good or service that sellers are willing to provide at various prices. | | Market Supply Curves | Curves that illustrate the relationship between the total quantity supplied and the market price, typically upward sloping due to firms' willingness to increase production with profitability. | | The Market Equilibrium | The point where the quantity demanded by buyers equals the quantity supplied by sellers, determined by the intersection of market demand and supply curves. | | Invisible Hand | A metaphor coined by Adam Smith describing the self-regulating process that moves a market towards equilibrium, driven by the self-interest of individuals. | | Comparative Statics | The examination of how changes in economic variables affect the equilibrium point of a market. | | Consumer Surplus or Buyer Surplus | The difference between the maximum price a consumer is willing to pay for a unit of a good and the lower equilibrium price they actually pay. | | Producer Surplus | The difference between the price at which a producer sells a good and the minimum price they would have been willing to sell it for. | | Deadweight Loss | A loss of economic efficiency that occurs when the equilibrium for a good or service is not achieved, resulting in a surplus that benefits neither consumers nor producers. | | Monopolistic Competition | A market model similar to perfect competition but where the goods sold have slight variations from seller to seller, leading to differentiated products. | | Contestable Market Model | An idealized market that resembles perfect competition but has a moderate number of sellers, each holding a significant share of total sales. | | Cost Leadership Strategy | A strategy employed in highly competitive markets where a firm aggressively focuses on keeping its costs lower than those of its competitors. | | Product Differentiation Strategy | A strategy used in competitive markets where a firm aggressively works to make its products distinct and distinguishable from those of other firms. |