Economic Efficiency & Cost

1. Economic Efficiency & Cost MBA NCCU Managerial Economics Jack Wu

2. 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

3. 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.

4. 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.

5. Econ Efficiency: Conditions • for all users, same marginal benefit • for all suppliers, same marginal cost • marginal benefit = marginal cost

6. 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

7. 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.

8. Invisible Hand • Outcome of price competition in market • Marginal benefit = price • Marginal cost = price • Single price in market

9. 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.

10. Price Ceiling Upper limit that sellers can charge and buyers can pay • rent control • regulated price for electricity

11. RENT CONTROL: EQUILIBRIUM 1100 supply b Price ($ per month) 1000 equilibrium 900 excess demand demand 0 290 300 310 Quantity (Thousand units a month)

12. RENT CONTROL: SURPLUSES buyer surplus gain = cfeg buyer surplus loss = dgb seller surplus loss = cfeg + geb a d 1100 h supply b Price ($ per month) 1000 c g 900 f e demand 0 290 300 310 Quantity (Thousand units a month)

13. 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

14. Price Floor Lower limit that sellers can charge and buyers can pay • minimum wage • agricultural price supports

15. MINIMUM WAGE: EQUILIBRIUM a excess supply supply Wage ($ per hour) 4.20 b 4.00 equilibrium c demand 0 8 10 11 Quantity (Billion worker-hours a week)

16. MINIMUM WAGE: SURPLUSES seller surplus gain = fdge seller surplus loss = ghb buyer surplus loss = fdge + egb a supply f e Wage ($ per hour) 4.20 b 4.00 d g h c demand 0 8 10 11 Quantity (Billion worker-hours a week)

17. 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

18. 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

19. TAX: EQUILIBRIUM $10 804 e supply Price ($ per ticket) 800 b 794 h demand 0 900 920 Quantity (Thousand tickets a year)

20. TAX: SURPLUSES buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg a $10 804 f e supply Price ($ per ticket) 800 d g b 794 j h demand i c 0 900 920 Quantity (Thousand tickets a year)

21. 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

22. Costs

23. Introduction • Cost and economies of scale • Cost and economies of scope • Relevant / Opportunity costs • Irrelevant Costs/ Sunk costs

24. 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

25. Expense Statement

26. Fixed and Variable Costs

27. Economies of scale • Economies of scale (increasing returns to scale): average cost decreases with scale of production

28. Scale Economies: Sources • large fixed costs • research, development, and design • information technology • falling average variable costs • distribution of gas and water • container ships

29. Diseconomies of scale • Definition: Diseconomies of scale (decreasing returns to scale) – average cost increases with scale of production

30. Economies of scale: Strategic implications • Either produce on large scale or outsource • Seller side – monopoly/oligopoly • Buyer side – monopsony/oligopsony

31. 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

32. Expenses for two products

33. 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

34. 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

35. Opportunity Cost • definition -- net revenue from best alternative course of action • two approaches • show alternatives • report opportunity costs

36. 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.

37. INCOME STATEMENT SHOWING ALTERNATIVES Income statement reporting opportunity costs

38. 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.

39. 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.

40. 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?

41. INCOME STATEMENT SHOWING ALTERNATIVES Income statement omitting sunk costs