Managerial Economics 8th Edition

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CHAPTER SIX

COST ANALYSIS

OBJECTIVES

1. To explain relevant costs and related concepts. In particular, to contrast

opportunity cost and fixed costs and to contrast accounting profits and
economic profits. (Relevant Costs)

2. To explain the relationship between production and cost. To apply the

concepts of the short run and long run to cost. (The Cost of Production)

3. To explore economies of scale and scope. (Returns to Scale and Scope)

4. To apply optimization concepts to cost minimization and optimal decision

making. (Cost Analysis and Optimal Decisions)

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TEACHING SUGGESTIONS

I. Introduction and Motivation

The same motivation that applies to production applies to cost. However, cost
is in some sense a broader concept than production in that 1) it summarizes
the underlying production process and 2) it includes factors not taken into
account by production analysis, that is, opportunity costs.

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II. Teaching the "Nuts and Bolts"

Opportunity Cost, etc. We begin by emphasizing the difference between

accounting concepts and decision making concepts. One way to highlight the
differences in class is to put the following on the board and to let the students
fill in the yes's and no’s and to give reasons.

Type of Cost Relevant to Relevant to

Accountant? Decision Maker?
Fixed Cost Yes No
Sunk Cost Yes No
Variable Cost Yes Yes
Opportunity Cost No Yes

From a discussion of opportunity cost one can go into the idea of economic
profit. From our experience, we find it useful to continually reiterate the idea
of economic profit as we do problems and examples. This is to prepare
students for the idea of long-run equilibrium later in the course.

Cost and production. Here we like to discuss the shapes of the cost curves
and how they depend on underlying assumptions about production. Again,
we are careful to distinguish short-run and long-run ideas.

Returns to Scale and Scope. Students are very interested in these concepts.
The instructor might also choose to introduce the notion of the lee learning
curve (not covered in the chapter) and take care to distinguish the learning
curve from increasing returns to scale.

Optimization. Again, following the philosophy of the book, we present

optimization yet again, this time in the context of cost. In this concluding
section we introduce the shut-down rule. We also consider multiple products
and transfer pricing.

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ADDITIONAL MATERIALS

I. Short Readings

E. Chhabra, “ Select Homecare Weighs new Wage and Labor Regulations,”

The New York Times, June 19, 2014, p. B4.

J. Trop, “ Steel Industry feeling Stress as Automakers Turn to Aluminum,”

The New York Times, February 24, 2014, p. B1.

N. Hodge, “Big Law Mergers Fuel Skepticism,” The Wall Street Journal,
November 11, 2013, p. B1.

C. J. Hughes, “Manhattan’s Vanishing Gas Stations,” The New York Times,

August 23, 2013, p. B9.

C. Rogers, “Open All Night: America’s Car Factories,” The Wall Street
Journal, August 17, 2013, p, B1.

M. L. Wald, “US moves to Abandon Costly Reactor Fuel Plant,” The New
York Times, June 26, 2013, p. A15.

S. McCartney, “How Airlines Spend your Airfare,” The Wall Street Journal,
June 7, 2012, p. D1.

N. Hodge, “Pentagon Loses War to Zap Airborne Laser from Budget,” The
Wall Street Journal, February 11, 2011, pp. A1, A10.

W. S. Cohen, “Obama and the Politics of Outsourcing,” The Wall Street

Journal, October 12, 2010, pp. A1, A10.

“E-commerce Favors Large Companies,” The Economist, July 3, 2010, p. 74.

J. Whalen, “Glaxo Tries Biotech Model to Spur Drug Innovations,” The Wall
Street Journal, July 1, 2010, pp. A1, A14.

L. A. E. Schuker and E. Smith, “Hollywood Eyes Shortcut to TV,” The Wall

Street Journal, May 22, 2010, pp. A1, A4.

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R. Smith, “What Utilities have Learned from Smart-Meter Tests,” The Wall
Street Journal, February 22, 2010, p. R6.

E. Smith and L. A. E. Schuker, “Unlocking DVD Release Dates,” The Wall

Street Journal, February 12, 2010, p. B4.

R. G. Mathews, “Fixed Costs Chafe at Steel Mills,” The Wall Street Journal,
June 10, 2009, p. B2.

J. Surowiecki, “The Free-Trade Paradox,” The New Yorker, May 26, 2008, p.
30.

Evan Perez, “How Delta’s Cash Cushion Pushed it onto a Wrong Course,”
The Wall Street Journal, October 29, 2004, p. A1.

“Wal-Mart: How Big can it Grow?” The Economist, April 17, 2004, pp. 67-
69.

II. Longer Readings

R. Mosheim and C. Lovell, “Scale Economies and Inefficiency of US Dairy

Farms,” American Journal of Agricultural Economics 91(3), August 2009,
777–794.

P. J. Ferraro and L. O. Taylor, “Do Economists Recognize an Opportunity Cost

When They See One?” Contributions to Economic Analysis and Policy, Vol. 4,
2005.

R. S. Kaplan and D. P. Norton, "Using the Balanced Scorecard as a Strategic

Management System," Harvard Business Review, Jan.-February. 1996, pp.
75-85. (Reprint # 96107).

R. Cooper and R.S. Kaplan, "Measure Costs Right: Make the Right
Decisions," Harvard Business Review, Sept.-Oct. 1988, pp. 96-103.

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III. Cases

Fineprint Company (A), (B) and (C), (UVA-C-2193, 2194, and 2195), Darden
Business School, University of Virginia, 2004.

Blackheath Manufacturing Company, (UVA-C-2197), Darden Business

School, University of Virginia, 2004.

Blackheath Manufacturing Company Revisited, (UVA-C-2198), Darden

Business School, University of Virginia, 2004.

Gibberson’s Glass Studio, (UVA-C-2205), Darden Business School,

University of Virginia, 2004.

Wendy’s Chili: A Costing Conundrum (UVA-C-2206hgbkm), Darden

Business School, University of Virginia, 2004.

Align Technology, Inc.: Matching Manufacturing Capacity to Sales Demand

(9-603-058), Harvard Business School, 2002.

Monster.com: Success Beyond the Bubble (9-802-024), Harvard Business

School, 2002.

Chemical Bank: Implementing the Balanced Scorecard, (9-195-210),

Harvard Business School, 1999. Teaching Note (5-198-090).

The Growth of Intel and the Learning Curve, (OIT27), Stanford Business
School, 1999. (Available from Harvard Business School Publishing.)

Choice International, 1995 (9-795-165), Harvard Business School, 1996.

Teaching Note (5-796-073)

Sony Corp.: The Walkman Line (9-195-076), Harvard Business School, 1997.
Teaching Note (5-195-077).

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IV. Quips and Quotes

In the long run, we are all dead. (John Maynard Keynes)

The easiest way to make money is to stop losing it.

If you start to take Vienna, take Vienna. (Napoleon Bonaparte)

(Was Napoleon aware of the sunk-cost fallacy?)

On opportunity costs:

There's not much to be said for old age except that it’s better than the
alternative. (J.K. Galbraith)

On the whole, I'd rather be in Philadelphia. (on W. C. Field's gravestone)

Most people my age are dead. (Casey Stengel)

If it wasn't for golf, I'd probably be a caddy today. (Professional golfer George
Archer)

Cost means sacrifice, and cannot, without risk of hopelessly confusing ideas,
be identified with anything that is not sacrifice. (J. E. Cairnes)

Costs merely register competing attractions. (Frank H. Knight)

Cost [is] of two kinds, either (1) the endurance of pain, discomfort, or
something else undesirable, or (2) the sacrifice of something desirable, either
as an end or a means. (Henry Sidgwick)

V. Mini-Case, Economies of Scale in Public Schools

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 Economies of Scale
in Public Schools

Over the last 20 years, there have been growing concerns about the
quality and cost of public education. Parents, teachers, school
administrators, and general taxpayers have an interest in maintaining
quality schools while holding down costs. One crucial question is the
extent to which economies of scale exist in public schools. Can schools
with greater enrollments provide quality instruction at a lower cost per
pupil?
Empirical studies of per-pupil costs across schools indicate the answer
is yes. In a study of Maryland public elementary and middle-level
schools, John Riew compared costs (in 1979) across a sample of
schools of different sizes, using multiple regression analysis to measure
the degree of scale economies.1 The basic regression equations were
designed to measure the relationship between a school’s average
operating costs per pupil (the dependent variable) and its enrollment
(the main independent variable). The regression also included
independent variables measuring teacher training, teacher experience,
professional support staff, and teachers’ aides to account for the
separate effect of “school quality” indices on cost. Finally, the
regressions included the school’s utilization rate (the ratio of actual
enrollment to the school’s capacity). If, as expected, short-run average
costs decline, increasing a school’s utilization rate should mean a
reduction in its average cost per pupil.
The regression results confirm that economies of scale are present in
both types of schools. For elementary schools, average cost per pupil
declines significantly over the range from 200 to 400 students before
leveling off as enrollments approach 500 students. For a typical school,
an increase in enrollment from 200 to 300 students, with all

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other variables held constant, affords a savings of $115 in average
operating expenditures per pupil. In addition, if this increase also
represents a rise in utilization (say, from 50 to 75 percent given a school
capacity of 400 students), then there is an additional average cost
reduction of $97. Thus, the combined average cost savings for this
enrollment increase come to $212 per student.
For middle schools, economies of scale occur at higher enrollments,
in a range between 500 and 900 students, and are exhausted as
enrollments approach 1,000 students. An increase in enrollment from
600 to 800 students reduces the average cost per student by $142. The
accompanying increase in utilization (say, from 60 to 80 percent given
a school capacity of 1,000 students) produces an additional savings of
$55. Thus, the combined average cost savings come to $197 per
student.
The average cost savings are comparable with elementary and middle
schools but occur at different enrollment levels and stem from a
different mix of scale economies and utilization. For elementary
schools, increasing utilization is the key to average cost savings. In this
respect, massive enrollment declines during the 1970s and early 1980s
contributed to cost escalation, whereas enrollment increases in the last
decade should contribute to cost declines. For middle schools, scale
economies are the most important factor. The efficient operation of
these schools with their more varied programs, specialized teaching,
and administrative functions requires a larger population of students.

1
See J. Riew, “Scale Economies, Capacity Utilization, and School Costs: A Comparative
Analysis of Secondary and Elementary Schools,” Journal of Education Finance (Spring
1986): 433-446.

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 Answers to Back-of-the-Chapter Problems

1. The fact that the product development was lengthier and more expensive
than initially anticipated is no reason to charge a higher price. These
development costs have been sunk and are irrelevant for the pricing
decision. Price should be based on the product’s relevant costs (the
marginal cost of producing the item) in conjunction with product demand
(as summarized by the product’s price elasticity).

2. This statement confuses average quantities and marginal quantities.

Though average total cost is always greater than average variable cost,
marginal cost certainly can exceed average cost. For instance, when
short-run production is pushed past the point of diminishing returns,
marginal costs tend to turn steeply upward and exceed average cost.

3. a. The profit associated with an electronic control device (ECD) is:

E = 1,500 - [500 + (2)(300)] = $400. If the firm sells the two microchips
separately (instead of putting them into an ECD), its total profit is M =
(550 - 300)(2) = $500. Thus, the firm should devote all of its capacity to
the production of microchips for direct sale. Producing ECDs is not
profitable.

b. If there is unused microchip capacity, the firm earns $400 in additional

profit for each ECD sold. Producing ECDs now becomes profitable.

c. If $200 (of the $500 average cost) is fixed, each ECD’s contribution
becomes E = 1,500 - [300 + (2)(300)] = $600. The firm should produce
ECDs in the short run; this is more profitable than selling chips directly.

4. a. In the short run, the merged banks hope for sizeable cost savings by
eliminating redundant operations, for instance, closing branch banks. In

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 the longer term, the banks, by combining the provision of several related
services, hope to benefit from economies of scope on both the supply side
and the demand side. On the supply side, similar services may take
advantage of the same inputs. For example, it may be easier to train a
financial services officer to do a number of related transactions than to
train separate officers for each type of transaction. The information to
process one type of transaction, such as a customer's credit history, may
also be relevant for other transactions. On the demand side, one-stop
shopping allows consumers to conserve on transaction costs. Rather than
going to several different firms for each type of transaction, the customer
can do everything in one stop.

b. It is possible for national banks to operate more efficiently than regional

banks or state banks, but this depends on both production and transaction
costs. Since banking is an information intensive industry, banks may be
able to take advantage of economies of scope and scale in information
collection and transmission. For example, national banks could provide
a customer with access to his or her personal accounts nationwide and
could use the same information for a variety of related transactions. On
the other hand, the mortgage market depends on local information about
the real estate market. National banks may not possess any informational
advantages in these markets. In addition, national banks may have higher
administrative costs associated with monitoring a large organization.
Determining whether national banks have cost advantages requires a
careful study of costs.

c. Some of the mergers are based on economies of scope, particularly where

the institutions have different but related products, such as banking and
insurance. Other mergers are based on geographical expansion. Given
that different products may be offered in different regions, these
expansions could be said to represent economies of scope and economies
of scale. Simple economies of scale may be driving some of the mergers.

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5. a. Setting MR = MC implies 10,000 - 400Q = $4,000. Thus, Q* = 15 games.

b. The contribution is: R - VC = ($150,000 - 45,000) - ($4,000)(15) =

$45,000. The opportunity cost of the entrepreneur’s labor is $20,000,
and the required annual return on the $100,000 investment is 20 percent
or $20,000. Thus, her economic profit is $45,000 - 20,000 - 20,000 =
$5,000.

6. a. The running shoe producer's demand is P = 48 - Q/200. and its costs are
C = 60,000 + .0025Q2. We confirm the table entries simply by
computing prices, revenues, and costs for appropriate levels of output
Q.

b. The firm maximizes profit by setting MR = MC. Therefore, MR = 48 -

Q/100 and MC = .005Q. Setting MR = MC implies: Q* = 3,200. In
turn, P* = $32.

7. a. To maximize profit set MR = MC. Therefore, 10 -.5w = 5, or w = 10

weeks. Profit from the film is: [(10)(10) - .25(10)2] – (5)(10) = 75 – 50
= $25 thousand.

b. The “total” marginal cost (including the opportunity cost of lost profit)
of showing the hit an extra week is: 5 + 1.5 = $6.5 thousand. Setting
MR = MC = 6.5 implies: w = 7 weeks.

c. On the cost side, there are economies of scale and scope. (With shared
fixed costs, 10 screens under one roof are much cheaper than
10 separate theaters.) Demand economies due to increased variety
probably also exist. Filmgoers will visit your screens knowing that
there’s likely to be a movie to their liking.

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 d. Obviously, DVD rentals and sales compete with (and potentially
cannibalize) theater revenues. The delay makes sense as long as the
extra theater profits from extending the run exceed the video profits
given up.

8. a. Setting MR = MC implies 96 - .8Q = 16 + .2Q, or Q* = 80. In turn, P

= $64, and π = 5,120 - 2,080 = $3,040.

b. She is correct that Qmin = 40 units. At this output, AC = 960/40 = 24 and

this exactly matches MC = 16 + (.2)(40) = 24. Her second claim
is incorrect. Optimal output is Q* = 80 where MR = MC.

c. Yes, it is cheaper to produce 80 units in two plants (each producing at

Qmin = 40). Total cost is (AC)(Q) = ($24)(80) = $1,920. This is cheaper
than the single-plant cost ($2,080) of part (a).

9. a. We are given that MC = $20,000, and from the price equation, we derive
MR = 30,000 - .2Q. Setting MR = MC implies Q = 50,000, confirming
that GM’s current output level is profit maximizing.

b. Fixed costs should not be mixed with variable costs in determining

output and price decisions. Removing the allocated fixed cost means
taking out 160,000,000/40,000 = $4,000 per unit. Thus, the true
marginal cost per unit is $22,000 - $4,000 = $18,000. Note that the actual
MC in the West. Coast factory is lower than the MC in the Michigan
plants. Thus, GM should expand its West Coast output (to 60,000 units
to be exact).

10. a. Given that C = 175,000 + 300Q + .1Q 2, Firm K’s marginal cost, is:
dC/dQ = 300 + .2Q. Setting MR = MC implies: 800 - .3Q = 300 + .2Q.
Therefore, Q* = 1,000 and P* = $650. The profit associated with coats

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 is:  = R – C = 650,000 – 575,000 = $75,000. Firm K’s total profit is:
75,000 + 50,000 = $125,000.

b. If Firm K continues to produce 1,000 regular coats (as in part a) it will

be able to fulfill only 100 coats of the 200 corporate coats ordered,
implying an opportunity cost of $200 per coat (in foregone profit). Thus,
the full MC of producing the last regular coat is 200 + [300 + .2Q].
Setting MR = MC implies Q* = 600. Thus, if the firm had sufficient
corporate coat orders, it would be willing to cut output from 1,000 to
600 coats. But, with only 200 corporate coats orders (and surplus
capacity for producing 100 coats) regular coats need only be cut from
1,000 to 900.
Rather than cut winter production of regular coats, the firm should
consider whether it is more profitable to make additional coats during
the summer (when there is plenty of unused capacity) and store them in
inventory to sell in the winter. This will free up winter capacity and will
be optimal if inventory costs are sufficiently low.

c. When demand falls permanently to P = 600 - .2Q, the firm’s new optimal
output and price (after setting MR = MC) are Q* = 500 and P* = 500.
Firm K’s profit from coats drops to:  = R – C = 250,000 – 350,000 = -
$100,000. Total profit is -$50,000. During the winter (while the firm is
committed to the factory lease), the firm should adopt this price and
production plan in order to minimize its loss. When its lease expires in
June, the firm should shut down.

11. a. We have: MCE = 1,000 + 10Q and MC = 3000 + 10Q. Setting MR = MC

implies: 10,000 - 60Q = 3,000 + 10Q. Thus, Q = 100 cycles and P =
$7,000.

b. Purchasing engines implies a marginal cost of 2,000 + 1,400 = $3,400

(compared to the $4,000 MC in part a). Again setting MR = MC implies:
Q = 110 and P = $6,700. However, the firm should continue to produce
some engines itself (up to the point where MCE = 1,400). Setting 1,000

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 + 10QE = 1,400 implies QE= 40 engines. The firm should produce 40
engines and buy the remaining 110 – 40 = 70 engines.

*12. a. MPL = 120,000 watches/60,000 labor hours = 2 watches per hour. The
marginal labor cost is: ($8/hour)/(2 watches/hour) = $4/watch. Total
MC is: $6 + $4 = $10/watch. To maximize profit, the firm sets MR =
MC. Therefore, 28 - Q/10,000 = 10, or Q = 180,000 watches. However,
the firm’s limited capacity makes this output impossible. The best the
firm can do is to produce up to its capacity, Q* = 120,000 watches. To
sell this quantity, the firm sets P* = 28 - 120,000/20,000 = $22. The
firm's contribution is: (22-10)(120,000) = $1,440,000.

b. Marginal labor cost on the night shift is $12/2 = $6. The relevant MC if
the night shift is used is: MC = $6 + $6 = $12. Setting MR = 12, one
finds Q* = 160,000 watches and P* = $20. Contribution is:
R - VC = $3,200,000 - [1,200,000 + 480,000] = $1,520,000.

c. Demand drops permanently to P = 20 - Q/20,000. A good bet is that the

firm will now use only the day shift, implying MR = MC = 10. It follows
that 20 - Q/10,000 = 10 or Q* = 100,000 watches. In turn, P* = 20 -
100,000/20,000 = $15. Contribution is now $500,000. In the short run
(when its $600,000 in costs are fixed), the firm minimizes its losses by
producing 100,000 units. If these losses continue, the firm should shut
down in the long run, i.e., when its lease is up.

Discussion Question
Most information goods are characterized by high fixed costs and low
or negligible marginal costs. In this case, the firm’s average total cost
will decline as output increases. Thus, minimum efficient scale will be
very high compared with total demand, implying a small number of
firm’s will split the market (each operating at a large, efficient scale).
Home grocery delivery (though it involves the internet for securing
customers and defining the transactions) has a significant marginal cost

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component (physical delivery of the goods from warehouse to home).
The demise of Internet grocery services seems to be due to the fact that
most households would rather “do it themselves” the traditional way,
than pay the higher cost of third-party delivery. (For the same reason,
Amazon.com has enjoyed little success in expanding its business to
bulky items such as large electronics because of higher storage and
delivery costs.)
Conversely, the lower transaction cost of e-commerce allows small
sellers to cheaply transact with potential buyers (and allows buyers to
find small sellers). A small seller of rare books or a provider of custom-
made hiking boots can thrive by gleaning customers over the Internet.
In each instance, the good or service is differentiated and does not
exhibit obvious economies of scale, allowing small sellers to compete
evenhandedly with large firms. See Chapter 10 for a full discussion.
Network externalities operate on the demand side to explain why
bigger can be better. They simply reinforce the economic and strategy
implications of (supply-side) economies of scale and scope. Network
externalities imply a market dominated by a small number of large firms.
The presence of network externalities provides a strong incentive for
firms to attract customers – via advertising, joint partnerships, and (most
important) price cuts.

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 Spreadsheet Problems
S1. a. and b. Varying labor usage in the spreadsheet from 1 thousand hours to
9 thousand hours traces out a U-shaped AC curve. In turn, SAC achieves
a minimum of $4.00 at L* = 4.0. To confirm this, use the spreadsheet
solver to minimize cell I10 (AC) by changing cell C5.

c. At L = 9 and K = 9, the resulting output is Q = 108. What input mix

should the firm use to produce this output at minimum cost in the long
run? Using the spreadsheet solver, minimize cell I9 (cost) by changing
cells C5 and F5 subject to output in cell I3 being greater or equal to 108.
The result is L* = 6.0 and K* = 13.5.

d. Doubling the inputs of part c (setting L* = 12 and K* = 27) generates

twice the output (Q = 216). Thus, production exhibits constant returns
to scale.

e. The firm’s inverse demand curve is: P = 9 – Q/72. In the short run with
K = 9, we invoke the optimizer to maximize total profit in cell I12 by
changing labor usage in cell C5. Thus, L* = 9, K = 9, and * = 342. In
the long run, the objective is to maximize total profit in cell I12 by
changing cells C5 and F5. The result is K* = 22.5, L* = 10, Q = 180,
and * = 450. Increasing the scale of operations (from K = 9 to K =
22.5) is the key to the significant increase in profit.

S2. a. Using the spreadsheet optimizer, we determine the multinational firm’s

optimal plan: Maximize total profit in cell E20 by changing outputs and
sales in cells C10, D10, C8 and D8, subject to cell F9 being greater or
equal to zero. The solution is: QH = 150, QF = 70, DH = 90, DF = 130,
and  = $19,000. At this solution, we see that MRH = MRF = MCH =
MCF = 120.

b. If the firm must charge a uniform worldwide price, we reoptimize the

spreadsheet after adding the constraint that the price difference in cell

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 C12 must be equal to zero. The new solution is: QH = 150, QF = 70, DH
= 106.67, DF = 113.33, P = 193.33, and  = $18,583.

Appendix Problems

Transfer Pricing:

1. a. The transfer price should reflect the marginal cost associated with the
input (the chip). Obviously, the chip is not free to the company (its
marginal cost is positive). If a zero price is set, copiers will seem to be
less costly (and more profitable) than they actually are.

b. A markup policy maximizes the chip division's internal profit but at the
expense of the company's total profit. Facing a transfer price that is too
high, the copier division will perceive its product as less profitable than
it actually is and will produce too few copiers.

2. a. Facing PT = $600, the copier division's profit is:

πA = RA - CA - 600Q = (4,000Q - 3Q2) - [360,000 + 1,000Q] - 600Q.
Thus MπA = 2,400 - 6Q, or Q* = 400 copiers (the same answer as in the
text.)

b. With the proper transfer price set, the copier division should simply
maximize its profit; in doing so, it produces a level of output that is
optimal for the company as a whole.

3. The chip division produces a quantity such that MCM = PM = $300.

Therefore, 200 + QM = 300, or QM = 100. Facing a $300 chip price, the
copier division maximizes its profit by setting MR = MCA + 300. The
result is Q* = 450 and P* = $2,650. It buys 100 chips internally and the
remaining 350 externally.

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