Opportunity Costs & Economies of Scale PDF

Opportunity Costs & Economies of Scale Economic Theory 12  Opportunity Costs: The loss of potential gain from other alternatives when one alternative is chosen. *...

Opportunity Costs & Economies of Scale Economic Theory 12  Opportunity Costs: The loss of potential gain from other alternatives when one alternative is chosen. * Remember way back when I mentioned trade-offs?* Examples: - A student spends three hours and $20 at the movies the night before an exam. The opportunity cost is time spent studying and that money to spend on something else. - A farmer chooses to plant wheat; the opportunity cost is planting a di erent crop, or an alternate use of the resources (land and farm equipment). - A commuter takes the train to work instead of driving. It takes 70 minutes on the train, while driving takes 40 minutes. The opportunity cost is an hour spent elsewhere each day. ff  We might not consider lost studying time or $7 spent on a smoothie costly decisions, but what about bigger choices—like the decision to stretch and buy a more expensive home versus a starter home, or to spend $1,500 more on an upgraded trim package for your next car? Opportunity costs are neglected even more when making higher priced purchases. The excitement of consuming today is valued significantly more than the thought of consuming in the future. From a business standpoint: Companies need to make these tough decisions everyday to either protect, or off-set their opportunity costs. - It’s human nature: We grow impatient, tugged by the immediacy of a promised bene t versus a payo that’s possibly years down the road. fi ff  Calculating Opportunity Costs: We can express opportunity cost in terms of a return (or profit) on investment by using the following mathematical formula: Opportunity Cost = RMPIC − RICP RMPIC = Return on most profitable investment choice. RICP = Return on investment chosen to pursue. Let’s try this out (example): Assume a company that is faced with the following two mutually exclusive options: Option A: Invest excess capital in the stock market. Option B: Invest excess capital back into the business for new equipment to increase production. Consider a company that is faced with the following two mutually exclusive options: Option A: Invest excess capital in the stock market Option B: Invest excess capital back into the business for new equipment to increase production  What is the RMPIC? = 10% What is the RICP? = 8% Assume the expected return on investment (ROI) in the stock market is 10% over the next year. While the company estimates that the equipment update would generate an 8% return over the same time period. So… using the formula RMPIC - RICP = Opportunity cost? The opportunity cost of choosing the equipment over the stock market is 2% (10% - 8%). In other words, by investing in the business, the company would forgo the opportunity to earn a higher return—at least for that first year. Assume the expected return on investment (ROI) in the stock market is 10% over the next year, while the company estimates that the equipment update would generate an 8% return over the same time period. The opportunity cost of choosing the equipment over the stock market is 2% (10% - 8%). In other words, by investing in the business, the company would forgo the opportunity to earn a higher return—at least for that rst year. fi  If the business purchases a new machine, it will be able to increase its production. Knowing that the machine setup and employee training will be intensive, and the new machine will not be up to maximum efficiency for the first couple of years, the company estimates that it would net an additional $500 in profit in the first year, then $2,000 in year two, and $5,000 in all future years. By these calculations, choosing the securities makes sense in the first and second years. However, by the third year, an analysis of the opportunity cost indicates that the new machine is the better option ($500 + $2,000 + $5,000 - $2,000 - $2,200 - $2,420) = $880. (Machine choice return years) (Stock market return years) First year Second year All future profit profit years Alternatively, if the business purchases a new machine, it will be able to increase its production. Knowing that the machine setup and employee training will be intensive, and the new machine will not be up to maximum e ciency for the rst couple of years, the company estimates that it would net an additional $500 in pro t in the rst year, then $2,000 in year two, and $5,000 in all future years. * Do we see how investing the opportunity cost in machinery was a better decision over investing the companies capital into the stock market? ffi fi fi fi  Effects of Economies of Scale on Production Costs 1. It reduces the per-unit fixed cost. As a result of increased production, the fixed cost gets spread over more output than before. 2. It reduces per-unit variable costs. This occurs as the expanded scale of production increases the efficiency of the production process.  Economies of Scale: Is an increase in the magnitude of goods produced where the average cost of production decreases. In other words, the price to make an additional unit of product comes down as the company grows.  (Long-run average costs) (Cost) (Market Quarter) The graph above plots the long-run average costs faced by a rm against its level of output. When the rm expands its output from Q1 to Q2, its average cost falls from C1 to C2. Thus, the rm can be said to experience economies of scale up to output level Q2. In economics, a key result that emerges from the analysis of the production process is that a pro t-maximizing rm always produces that level of output which results in the lowest average cost per unit of output. fi fi fi fi fi Examples: Stores such as Costco and Walmart are examples of economies of scale. They utilize this principle by buying huge quantities of goods in order to receive low bulk prices, and they pass on the savings to their customers. Internal economies of scale: Are the cost savings that a particular company enjoys as it grows and expands its operations. These savings arise from factors that are unique to the company and its operations. External economies of scale: Are the cost savings that an entire industry or region enjoys as a result of its collective size and growth. These savings arise from factors that are external to any one particular company.  Cost advantages of large-scale production: When you get big enough, and start to form conglomerates, this is what large-scale production looks like.