10 • Economics Primer: Basic Principles
more profitable to keep its price high (letting Pepsi steal some of its market) than to respond with a price cut of its own.2 Finally, whether Pepsi’s higher sales revenue translates into higher profit depends on the economic relationship between the additional sales revenue that Pepsi’s price cut generated and the additional cost of producing more Pepsi-Cola. That profits rose rapidly after the price reduction suggests that the additional sales revenue far exceeded the additional costs of production.
This chapter lays out basic microeconomic tools for business strategy. Most of the elements that contributed to Pepsi’s successful price-cutting strategy in the 1930s will be on display here. An understanding of the language and concepts in this chapter will, we believe, “level the playing field,” so that students with little or no background in microeconomics can navigate most of this book just as well as students with extensive economics training. The chapter has five main parts: (1) costs; (2) demand, prices, and revenues; (3) the theory of price and output determination by a profit-maximizing firm; (4) the theory of perfectly competitive markets; and (5) game theory.3
COSTS
A firm’s profit equals its revenues minus its costs. We begin our economics primer by focusing on the cost side of this equation. We discuss four specific concepts in this section: cost functions; long-run versus short-run costs; sunk costs; and economic versus accounting costs.
Cost Functions
Total Cost Functions
Managers are most familiar with costs when they are presented as in Tables P.1 and P.2, which show, respectively, an income statement and a statement of costs of goods manufactured for a hypothetical producer during the year 2008.4 The information in these tables is essentially retrospective. It tells managers what happened during the past year. But what if management is interested in determining whether a price
TABLE P.1
Income Statement: 2008
(1) |
Sales Revenue |
|
$35,600 |
(2) |
Cost of Goods Sold |
|
|
|
Cost of Goods Manufactured |
$13,740 |
|
|
Add: Finished Goods Inventory 12/31/07 |
$ |
3,300 |
|
Less: Finished Goods Inventory 12/31/08 |
$ |
2,950 |
|
|
|
$14,090 |
(3) |
Gross Profit: (1) minus (2) |
|
$21,510 |
(4) |
Selling and General Administrative Expenses |
|
$8,540 |
(5) |
Income from Operations: (3) minus (4) |
|
$12,970 |
Interest Expenses |
|
$1,210 |
|
Net Income Before Taxes |
|
$11,760 |
|
Income Taxes |
|
$4,100 |
|
Net Income |
|
$7,660 |
|
|
|
|
|
All amounts in thousands.
Costs • 11
TABLE P.2
Statement of Cost of Goods Manufactured: 2008
Materials: |
|
|
Materials Purchases |
$8,700 |
|
Add: Materials Inventory 12/31/07 |
$1,400 |
|
Less: Materials Inventory 12/31/08 |
$1,200 |
|
(1) Cost of Materials |
$8,900 |
|
(2) Direct Labor |
$2,300 |
|
Manufacturing Overhead |
|
|
Indirect Labor |
$700 |
|
Heat, Light, and Power |
$400 |
|
Repairs and Maintenance |
$200 |
|
Depreciation |
$1,100 |
|
Insurance |
$50 |
|
Property Taxes |
$80 |
|
Miscellaneous Factory Expenses |
$140 |
|
(3) Total Manufacturing Overhead |
$2,670 |
|
Total Cost of Manufacturing: (1) 1 (2) 1 (3) |
$13,870 |
|
Add: Work-in-Process Inventory 12/31/07 |
$2,100 |
|
Less: Work-in-Process Inventory 12/31/08 |
$2,230 |
|
Cost of Goods Manufactured |
|
$13,740 |
|
|
|
All amounts in thousands.
reduction will increase profits, as with Pepsi? The price drop will probably stimulate additional sales, so a firm needs to know how its total costs would change if it increased production above the previous year’s level.
This is what a total cost function tells us. It represents the relationship between a firm’s total costs, denoted by TC, and the total amount of output it produces in a given time period, denoted by Q. Figure P.1 shows a graph of a total cost function. For each level of output the firm might produce, the graph associates a unique level of total
FIGURE P.1
Total Cost Function
The total cost function TC(Q) shows the total costs that the firm would incur for a level of output Q. The total cost function is an efficiency relationship in that it shows the lowest possible total cost the firm would incur to produce a level of output, given the firm’s technological capabilities and the prices of factors of production, such as labor and capital.
TC(Q)
Total cost
Q Output
12 • Economics Primer: Basic Principles
cost. Why is the association between output and total cost unique? A firm may currently be producing 100 units of output per year at a total cost of $5,000,000, but if it were to streamline its operations, it might be able to lower costs, so that those 100 units could be produced for only $4,500,000. We resolve this ambiguity by defining the total cost function as an efficiency relationship. It represents the relationship between total cost and output, assuming that the firm produces in the most efficient manner possible given its current technological capabilities. Of course, firms do not always produce as efficiently as they theoretically could. The substantial literature on total quality management and reengineering attests to the attention managers give to improving efficiency. This is why we stress that the total cost function reflects the current capabilities of the firm. If the firm is producing as efficiently as it knows how, then the total cost function must slope upward: the only way to achieve more output is to use more factors of production (labor, machinery, materials), which will raise total costs.5
Fixed and Variable Costs
The information contained in the accounting statements in Tables P.1 and P.2 allows us to identify the total cost for one particular level of annual output. To map out the total cost function more completely, we must distinguish between fixed costs and variable costs. Variable costs, such as direct labor and commissions to salespeople, increase as output increases. Fixed costs, such as general and administrative expenses and property taxes, remain constant as output increases.
Three important points should be stressed when discussing fixed and variable costs. First, the line dividing fixed and variable costs is often fuzzy. Some costs, such as maintenance or advertising and promotional expenses, may have both fixed and variable components. Other costs may be semifixed: fixed over certain ranges of output but variable over other ranges.6 For example, a beer distributor may be able to deliver up to 5,000 barrels of beer a week using a single truck. But when it must deliver between 5,000 and 10,000 barrels, it needs two trucks, between 10,000 and 15,000, three trucks, and so forth. The cost of trucks is fixed within the intervals (0, 5,000), (5,000, 10,000), (10,000, 15,000), and so forth, but is variable between these intervals.
Second, when we say that a cost is fixed, we mean that it is invariant to the firm’s output. It does not mean that it cannot be affected by other dimensions of the firm’s operations or decisions the firm might make. For example, for an electric utility, the cost of stringing wires to hook up houses to the local grid depends primarily on the number of subscribers to the system, and not on the total amount of kilowatt-hours of electricity the utility generates. Other fixed costs, such as the money spent on marketing promotions or advertising campaigns, arise from management decisions and can be eliminated should management so desire.7
Third, whether costs are fixed or variable depends on the time period in which decisions regarding output are contemplated. Consider, for example, an airline that is contemplating a one-week-long fare cut. Its workers have already been hired, its schedule has been set, and its fleet has been purchased. Within a one-week period, none of these decisions can be reversed. For this particular decision, then, the airline should regard a significant fraction of its costs as fixed. By contrast, if the airline contemplates committing to a year-long reduction in fares, with the expectation that ticket sales will increase accordingly, schedules can be altered, planes
Costs • 13
can be leased or purchased, and workers can be hired. In this case, the airline should regard most of its expenses as variable. Whether the firm has the freedom to alter its physical capital or other elements of its operations has important implications for its cost structure and the nature of its decision making. This issue will be covered in more detail below when we analyze the distinction between long-run and short-run costs.
Average and Marginal Cost Functions
Associated with the total cost function are two other cost functions: the average cost function, AC(Q), and the marginal cost function, MC(Q). The average cost function describes how the firm’s average or per-unit-of-output costs vary with the amount of output it produces. It is given by the formula
AC(Q) 5
TC(Q)
Q
If total costs were directly proportional to output—for example, if they were given by a formula, such as TC(Q) 5 5Q or TC(Q) 5 37,000Q, or more generally, by TC(Q) 5 cQ, where c is a constant—then average cost would be a constant. This is because
cQ AC(Q) 5 Q 5 c
Often, however, average cost will vary with output. As Figure P.2 shows, average cost may rise, fall, or remain constant as output goes up. When average cost decreases as output increases, there are economies of scale. When average cost increases as output increases, there are diseconomies of scale. When average cost remains unchanged with respect to output, we have constant returns to scale. A production process may exhibit economies of scale over one range of output and diseconomies of scale over another.
FIGURE P.2
Average Cost Function
AC(Q)
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Average cost |
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The average cost function AC(Q) shows the firm’s |
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average, or per-unit, cost for any level of output Q. |
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Average costs are not necessarily the same at each |
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Q Output |
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level of output. |
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14 • Economics Primer: Basic Principles
FIGURE P.3
Economies of Scale and Minimum Efficient Scale
This average cost function exhibits economies of scale at output levels up to Q9. It exhibits constant returns to scale between Q9 and Q0. It exhibits diseconomies of scale at output levels above Q0. The smallest output level at which economies of scale are exhausted is Q9. It is thus known as the minimum efficient scale.
Average cost
AC(Q)
Q′ Q′′
Q Output
Figure P.3 shows an average cost function that exhibits economies of scale, diseconomies of scale, and constant returns to scale. Output level Q9 is the smallest level of output at which economies of scale are exhausted and is thus known as the minimum efficient scale. The concepts of economies of scale and minimum efficient scale are extremely important for understanding the size and scope of firms and the structure of industries. We devote all of Chapter 2 to analyzing economies of scale.
Marginal cost refers to the rate of change of total cost with respect to output. Marginal cost may be thought of as the incremental cost of producing exactly one more unit of output. When output is initially Q and changes by DQ units and one knows the total cost at each output level, marginal cost may be calculated as follows:
MC(Q) 5
TC(Q 1 DQ) 2 TC(Q)
DQ
For example, suppose when Q 5 100 units, TC 5 $400,000, and when Q 5 150 units, TC 5 $500,000. Then DQ 5 50, and MC 5 ($500,000 2 $400,000)/50 5 $2,000. Thus, total cost increases at a rate of $2,000 per unit of output when output increases over the range 100 to 150 units.
Marginal cost often depends on the total volume of output. Figure P.4 shows the marginal cost function associated with a particular total cost function. At low levels of output, such as Q9, increasing output by one unit does not change total cost much, as reflected by the low marginal cost. At higher levels of output, such as Q9, a one-unit increase in output has a greater impact on total cost, and the corresponding marginal cost is higher.
Businesses frequently treat average cost and marginal cost as if they were identical, and use average cost when making decisions that should be based on marginal cost. But average cost is generally different from marginal cost. The exception is when total costs vary in direct proportion to output, TC(Q) 5 cQ. In that case,
MC(Q) 5 |
c(Q 1 DQ) 2 cQ |
|
|
5 c |
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||
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DQ |
|
Costs • 15
FIGURE P.4
Relationship between Total Cost and Marginal Cost
Total cost
TC(Q′′ + 1)
TC(Q′′ )
TC(Q′ + 1)
TC(Q′ )
TC(Q)
Marginal cost
Q′ Q′ + 1 Q′′ Q′′ + 1
MC(Q)
MC(Q′′)
MC(Q′ )
Q′ |
Q′′ |
|
Q Output |
The marginal cost function MC(Q) on the right graph is based on the total cost function TC(Q) shown in the left graph. At output level Q9, a one-unit increase in output changes costs by TC (Q9 1 1) 2 TC(Q9), which equals the marginal cost at Q9, MC(Q9). Since this change is not large, the marginal cost is small (i.e., the height of the marginal cost curve from the horizontal axis is small). At output level Q0, a one-unit increase in output changes costs by TC(Q0 1 1) 2 TC (Q0), which equals the marginal cost at Q0. This change is larger than the one-unit change from Q9, so MC(Q0) . MC(Q9). Because the total cost function becomes steeper as Q gets larger, the marginal cost curve must increase in output.
which, of course, is also average cost. This result reflects a more general relationship between marginal and average cost (illustrated in Figure P.5):
•When average cost is a decreasing function of output, marginal cost is less than average cost.
•When average cost neither increases nor decreases in output—because it is either constant (independent of output) or at a minimum point—marginal cost is equal to average cost.
FIGURE P.5
Relationship between Marginal Cost and Average Cost
When average cost is decreasing (e.g., at output Q9), AC . MC (i.e., the average cost curve lies above the marginal cost curve). When average cost is increasing (e.g., at output Q0), AC , MC (i.e., the average cost curve lies below the marginal cost curve). When average cost is at a minimum, AC 5 MC, so the two curves must intersect.
Average cost, marginal cost
AC decreases |
MC(Q) |
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AC increases |
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MC < AC |
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MC > AC |
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AC(Q) |
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AC at |
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minimum |
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MC = AC |
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Q′ |
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Q″ |
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Q Output |
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