Control costs before they control you

JWI 515, Managerial Economics, Week5 Summary, 11/11/12

This was a challenging week with many key economic concepts to think about and grasp. We learned the importance of cost function and the necessity to control costs before they control us. The nature of competitive markets, techniques to map out the market structure and the use of Porter's 5 forces model to arrive at competitive economic strategy were explored.

"control costs before they control you" is a principle that carries profound insight with applications every day in business and in life.

Dr DP

I. Hirschey, Chapter 8: Cost Analysis and Estimation; Week5 Lecture1
**********************************************************************************
Successful managers control costs effectively (Hirschey, 2009)
Control costs or they will control you (Week5, lecture1)

Different types of costs are
*******************************
fixed cost - does not vary with output; buildings, machinery
variable cost - fluctuates with output; utility, wages, rent, office supplies raw materials
historical cost - what was paid in the past
current cost - the current value
replacement cost - cost of duplicating productive capability with existing technology
opportunity cost - foregone value associated with current use of asset rather than going with next best alternative
economic cost = explicit cost + non cash implicit cost
incremental cost - change in cost caused by a managerial decision
marginal cost - change in cost from a one-unit change in output
sunk cost - expense made in the past that cannot be recovered in future

Cost Function
**************
Cost function: Cost-Output relation
Short run cost function: used for day to day operation; determines plant capacity; fixed costs will not change in short run eg buildings, machinery
Long run cost function: used for long range planning; determine minimum cost of output for a given plant size & technology in current operating environment

Economy of Scale & Scope
********************************
Economy of scale - long run average cost (LRAC) declines with firm's size
Minimum efficient scale - ouput level at which LRAC is minimized
Maximum efficient scale - optimum output level with least cost per unit beyond which average cost will rise and diseconomy of scale will set in
Diseconomy of scale - LRAC increases with firm's size
Economy of scope - cost of joint production of outputs is less than cost of producing multiple outputs separately
Breakeven - when Cost equals Revenue


II. Hirschey, Chapter 10: Competitive Markets; week5 lecture2
***********************************************************************
To win in the market place, these key concepts should be noted:

Companies and markets are not static - they change and evolve from one market structure to another
Competitive market concepts help make sound economic decisions.
Map countours of market, understand market structure and maximize profit
Understanding demand, production and costs.

Market - all firms and individuals, current and potential, willing and able to buy or sell a product
*******
Market structure - competititve environment in which exchange of goods or services occur
*******************************************
 # - number and size of buyers, sellers and potential entrants
 cost info - access & availability of product price and cost information; price takers vs price makers
 product differentiation - degree of real/perceived product differentiation; what sets the product apart in quality, advertising, promos, customer service
 scale - production characteristics; minimum efficient scale
 entry - ease of entry into the marketplace; barriers - patents, licenses, economy of scale, lawsuit restrictions, regulations
 other - shipping distance of perishable items

Potential entrant - poses credible threat to price-output decisions of incumbent firms
Product differentiation - real or perceived differences in quality of goods and services;
  caused by physical differences, superior R&D; effective advertising & promotion
Price competition - most vigorous in markets with homogeneous products with few perceived differences

Barrier to entry - industry characteristic that creates advantage for incumbents over new arrivals; legal rights - patents & licenses
Barrier to mobility - creates advantage for large leading firms over smaller nonleading rivals
  eg. economies of scale or scope, large capital or skilled labor requirements, ties of customer loyalty
Barrier to exit - restricts incumbents to redloy assets to another industry

Types of competition
***************************
Perfect competition - large # of buyers and sellers of the same product; each participant is a price taker, too small to influence prices
Monopoly - one firm dominates the entire market
Monopolistic competition - multiple firms with similar products that are not substitutable, price makers offering high prices
Oligopoly - a few firms dominate the market

Marginal analysis
*********************
Total profit maximized when marginal revenue equals marginal cost
Productive efficiency - production of goods in least cost way
Allocative efficiency - appropriate allocation of resources among firms to yield correct mix of goods and services demanded

III. Welch, What’s Right about Wal-Mart
**********************************************
Helps consumers and employees win and grow.
Improves lives for customers by holding down low prices, doing more to households than any social or govt program.
Business model threatens rivals. Purchasing power frightens suppliers - forces them to look inside businesses to lower costs. Huge market share gives it enormous leverage.
Employee wealth sharing, salaries, life insurance, benefits, development through training and opportunity (international growth) & upward mobility.
Ethical, fair, tough.

IV. Week 5 DQ1 - How to mitigate diseconomy of scale
***************************************************************
For large companies to mitigate the effects of increased per unit costs when diseconomies of scale are operative, focus on:
Coordination - ensure business units grow together
Communication - counter effect of lengthening hiearchy
Motivation - pay for performance; give performance incentive to employees
Technical - manage complexity

V. Week 5  DQ 2: How WalMart wins in the Competitive Market place
*********************************************************************************
Wal-Mart is the most profitable discount retailer in one of the most viciously competitive markets imaginable.
Wal-Mart is able to achieve such a high level of success through both upturns and downturns in the economy because of:
Low cost leadership focus, economy of scale, purchase power that dictates price to suppliers, diversification of products and geography