ECONOMIC EFFICIENCY & COSTMBA 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

InkandPaper

Electricpower 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

AverageVariableCost

AverageCost

0 $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