Mba1014 production and costs 110513

Go Global !
Managerial Economics :
Production & Costs
By
Stephen Ong
Visiting Fellow, Birmingham City University
Visiting Professor, College of
Management, Shenzhen University
May 2013

Agenda
1. Production
2. Cost of production
3. The Long Run

Learning Objectives
To discuss the production function and its
various forms
To provide examples of types of inputs into a
production function for a manufacturing or
service company
To understand the law of diminishing returns
To discuss the cost function and distinguish
between economic cost and accounting cost
To explain how the concept of relevant cost is
used
To understand total, variable, average and
fixed cost
To distinguish between short-run and long-
run cost
To provide reasons for the existence of
economies of scale

Overview
The production function
Short-run analysis of average
and marginal product
Long-run production function
Importance of production
function in managerial
decision making

Production Function
A production
function describes
the relationship
between a flow of
inputs and the
resulting flow of
outputs in a
production process
during a given
period of time.
Q = f(L, K, M, …)
where
Q = quantity of output
L = quantity of labour
input
K = quantity of capital
input
M = quantity of
materials input

Production function
 Production function: defines the
relationship between inputs and the
maximum amount that can be produced
within a given period of time with a given
level of technology
Q=f(X1, X2, ..., Xk)
Q = level of output
X1, X2, ..., Xk = inputs used in
production

Production function
Key assumptions
given ‘state of the art’
production technology
whatever input or input
combinations are included in a
particular function, the output
resulting from their utilization is
at the maximum level

Production function
For simplicity we will often
consider a production function of
two inputs:
Q=f(X, Y)
Q = output
X = labour
Y = capital

Production function
 Short-run production function shows
the maximum quantity of output that
can be produced by a set of inputs,
assuming the amount of at least one
of the inputs used remains
unchanged
 Long-run production function shows
the maximum quantity of output that
can be produced by a set of inputs,
assuming the firm is free to vary
the amount of all the inputs being
used

Short-run analysis of Total,
Average, and Marginal product
 Alternative terms in reference to inputs
‘inputs’
‘factors’
‘factors of production’
‘resources’
 Alternative terms in reference to outputs
‘output’
‘quantity’ (Q)
‘total product’ (TP)
‘product’

Fixed and Variable Inputs
A fixed input
is an input
whose
quantity a
manager
cannot change
during a given
period of time.
A variable
input is an
input whose
quantity a
manager can
change during
a given period
of time.

Short-Run vs. Long-Run
The short-run is a period
of time during which at
least one input is fixed,
while the long-run is a
period of time during
which all inputs are
variable.

Total Product
The total
quantity of
output produced
with given
quantities of
fixed and
variable inputs.
TP or Q = f(L, K ),
where
TP or Q = total product
or total quantity
produced
input (variable)
(fixed)

Average Product
The amount
of output per
unit of
variable
input.
APL = TP÷L or Q÷L,
where
APL = average
product of labour

Marginal Product
The additional
output
produced with
an additional
unit of variable
input.
MPL = ΔTP÷ΔL
or ΔQ÷ΔL
where
MPL = marginal
product of labour

Average and Marginal
Product Curves

Marginal product (MP) = change in
output (Total Product) resulting from
a unit change in a variable input
Average product (AP) = Total Product
per unit of input used
X
Q
MPX
X
Q
APX

if MP > AP then
AP is rising
if MP < AP then
AP is falling
MP=AP when AP
is maximized

Law of diminishing returns:
as additional units of a variable input
are combined with a fixed input, after
some point the additional output (i.e.,
marginal product) starts to diminish
nothing says when diminishing
returns will start to take effect
all inputs added to the
production process have the
same productivity

Law of Diminishing Marginal
Returns
The phenomenon illustrated by
that region of the marginal
product curve where the curve
is positive, but decreasing, so
that total product is increasing
at a decreasing rate.

Do increases in health care expenditures
reflect increases in output or do they
reflect inefficiencies in the production
process? The United States is relatively
wealthy, and it is natural for consumer
preferences to shift toward more health
care as incomes grow. However, it may
be that the production of health care in
the United States is inefficient.
A PRODUCTION FUNCTION FOR HEALTH CARE
A PRODUCTION FUNCTION
FOR HEALTH CARE
Additional expenditures on health
care (inputs) increase life expectancy
(output) along the production
frontier. Points A, B, and C represent
points at which inputs are efficiently
utilized, although there are
diminishing returns when moving
from B to C. Point D is a point of input
inefficiency.

MALTHUS AND THE FOOD CRISIS
TABLE 2
INDEX OF WORLD
FOOD PRODUCTION
PER CAPITA
YEAR INDEX
1948-
52
100
1961 115
1965 119
1970 124
1975 125
1980 127
1985 134
1990 135
1995 135
2000 144
2005 151
2009 155
The law of diminishing marginal
returns was central to the thinking of
political economist Thomas Malthus
(1766–1834). Malthus predicted that
as both the marginal and average
productivity of labor fell and there
were more mouths to feed, mass
hunger and starvation would result.
Malthus was wrong (although he was
right about the diminishing marginal
returns to labour).
Over the past century,technological
improvements have dramatically
altered food production in most
countries (including developing
countries, such as India). As a result,
the average product of labour and total
food output have increased.
Hunger remains a severe problem in
some areas, in part because of the low
productivity of labour there.

Cereal yields have increased. The average world
price of food increased temporarily in the early
1970s but has declined since.
MALTHUS AND THE FOOD CRISIS
CEREAL YIELDS AND THE WORLD PRICE OF FOOD

The Three Stages of Production in
the short run:
Stage I: from zero units of the
variable input to where AP is
maximized (where MP=AP)
Stage II: from the maximum AP
to where MP=0
Stage III: from where MP=0 on

In the short run, rational firms should be
operating only in Stage II
 Q: Why not Stage III?  firm uses more
variable inputs to produce less output
 Q: Why not Stage I?  underutilizing
fixed capacity, so can increase output per
unit by increasing the amount of the variable
input

What level of input usage within Stage
II is best for the firm?
 answer depends upon:
• how many units of output the firm can
• sell the price of the product
• the monetary costs of employing the
variable input

 Total revenue product (TRP) = market
value of the firm’s output, computed
by multiplying the total product by
the market price
TRP = Q x P

Marginal revenue product (MRP) =
change in the firm’s TRP resulting from a
unit change in the number of inputs used
MRP = MP x P =
X
TRP

 Total labour cost (TLC) = total cost of using
the variable input labour, computed by
multiplying the wage rate by the number of
variable inputs employed
TLC = w x X
 Marginal labour cost (MLC) = change in total
labour cost resulting from a unit change in
the number of variable inputs used
MLC = w

Summary of relationship between
demand for output and demand for a
single input:
A profit-maximizing firm operating in
perfectly competitive output and input
markets will be using the optimal amount of
an input at the point at which the monetary
value of the input’s marginal product is
equal to the additional cost of using that
input
 MRP = MLC

Multiple variable inputs
Consider the relationship between
the ratio of the marginal product of
one input and its cost to the ratio of
the marginal product of the other
input(s) and their cost
k
k
w
MP
w
MP
w
MP
2
2
1
1

Will the standard of living in the United States, Europe, and
Japan continue to improve, or will these economies barely keep
future generations from being worse off than they are today?
Because the real incomes of consumers in these countries
increase only as fast as productivity does, the answer depends
on the labour productivity of workers.
LABOUR PRODUCTIVITY AND THE STANDARD OF LIVING
TABLE 3
LABOUR PRODUCTIVITY IN DEVELOPED
COUNTRIES
UNITED
STATES JAPAN FRANCE GERMANY
UNITED
KINGDOM
GDP PER HOUR WORKED (IN 2009 US
DOLLARS)
$56.90 $38.20 $54.70 $53.10 $45.80
Years Annual Rate of Growth of Labor Productivity (%)
1960-1973 2.29 7.86 4.70 3.98 2.84
1974-1982 0.22 2.29 1.73 2.28 1.53
1983-1991 1.54 2.64 1.50 2.07 1.57
1992-2000 1.94 1.08 1.40 1.64 2.22
2001-2009 1.90 1.50 0.90 0.80 1.30

Long-run production function
 In the long run, a firm has enough time to
change the amount of all its inputs
 The long run production process is
described by the concept of returns to scale
Returns to scale = the resulting
increase in total output as all
inputs increase

If all inputs into the production process
are doubled, three things can happen:
output can more than double
 ‘increasing returns to scale’ (IRTS)
output can exactly double
 ‘constant returns to scale’ (CRTS)
output can less than double
 ‘decreasing returns to scale’ (DRTS)

One way to measure returns to scale
is to use a coefficient of output
elasticity:
if EQ > 1 then IRTS
if EQ = 1 then CRTS
if EQ < 1 then DRTS
inputsallinchangePercentage
QinchangePercentage
QE

Returns to scale can also be
described using the following
equation
hQ = f(kX, kY)
if h > k then IRTS
if h = k then CRTS
if h < k then DRTS

Graphically, the returns to scale
concept can be illustrated using
the following graphs
Q
X,Y
IRTS
Q
X,Y
CRTS
Q
X,Y
DRTS

Food grown on large farms in the United
States is usually produced with a
capital-intensive technology.
However, food can also be produced
using very little capital (a hoe) and a lot
of labour (several people with the
patience and stamina to work the soil).
Most farms in the United States and
Canada, where labor is relatively
expensive, operate in the range of
production in which the MRTS is
relatively high (with a high capital-to-
labour ratio), whereas farms in
developing countries, in which labour is
cheap, operate with a lower MRTS (and
a lower capital-to-labour ratio).
A PRODUCTION FUNCTION FOR WHEAT

A PRODUCTION FUNCTION FOR WHEAT
ISOQUANT DESCRIBING THE
PRODUCTION OF WHEAT
A wheat output of 13,800
bushels per year can be
produced with different
combinations of labour and
capital.
The more capital-intensive
production process is shown
as point A,
the more labour- intensive
process as point B.
The marginal rate of technical
substitution between A and B
is 10/260 = 0.04.

Estimation of production
functions
 Examples of production functions
 short run: one fixed factor, one variable factor
Q = f(L)K
 cubic: increasing marginal returns followed by
decreasing marginal returns
Q = a + bL + cL2 – dL3
 quadratic: diminishing marginal returns but no
Stage I
Q = a + bL - cL2

Estimation of production
functions
Examples of production functions
power function: exponential for one input
Q = aLb
if b > 1, MP increasing
if b = 1, MP constant
if b < 1, MP decreasing
Advantage: can be transformed into a linear
(regression) equation when expressed in log
terms

Estimation of production functions
 Examples of production functions
Cobb-Douglas function:
exponential for two inputs
Q = aLbKc
if b + c > 1, IRTS
if b + c = 1, CRTS
if b + c < 1, DRTS

Statistical estimation of production
functions
inputs should be measured as ‘flow’
rather than ‘stock’ variables, which is
not always possible
usually, the most important input is
labour
most difficult input variable is capital
must choose between time series and
cross-sectional analysis

Aggregate production functions: whole
industries or an economy
 gathering data for aggregate
functions can be difficult:
 for an economy … GDP could be
used
 for an industry … data from
Census of Manufactures or
production index from Federal
Reserve Board
 for labour … data from Bureau
of Labour Statistics

Importance of production
functions in managerial
decision making
Capacity planning: planning the amount
of fixed inputs that will be used along
with the variable inputs
Good capacity planning requires:
accurate forecasts of demand
effective communication between the
production and marketing functions

decision making
Example: cell phones
 Asian consumers want new phone
every 6 months
 demand for 3G products
 Nokia, Samsung, SonyEricsson
must be speedy and flexible

decision making
Example: Zara
 Spanish fashion retailer
 factories located close to stores
 quick response time of 2-4 weeks

decision making
Application: call centers
 service activity
 production function is
Q = f(X,Y)
where Q = number of calls
X = variable inputs
Y = fixed input

functions in managerial decision
making
Application: China’s
workers
 Is China
running out of
workers?
 Effect of
industrial boom
 eg bicycle
factory in
Guangdong
Province

Overview
Definition and use of cost
Relating production and cost
Short run and long run cost
Economies of scope and scale
Supply chain management
Ways companies have cut
costs to remain competitive

Cost Function
A mathematical or
graphic expression that
shows the relationship
between the cost of
production and the level
of output, all other
factors held constant.

Opportunity Cost
The economic measure of
cost that reflects the use of
resources in one
activity, such as a production
process by one firm, in terms
of the opportunities forgone
in undertaking the next best
alternative activity.

Explicit and Implicit Costs
A cost is explicit if
it is reflected in a
payment to another
individual, such as
a wage paid to a
worker, that is
recorded in a firm’s
book keeping or
accounting system.
A cost that
represents the
value of using a
resource that is not
explicitly paid out
and is often difficult
to measure because
it is typically not
recorded in a firm’s
accounting system.

Profit
The difference
between the total
revenue a firm receives
from the sale of its
output and the total
cost of producing that
output.

Accounting vs.
Economic Profit
 Accounting profit is
the difference
between total
revenue and total
cost where cost
includes only the
explicit costs of
production.
 Economic profit is
the difference
between total
revenue and total
cost where cost
includes both the
explicit and any
implicit costs of
production.

Short Run Cost Function
A cost function for a
short-run production
process in which there is
at least one fixed input of
production.

Fixed vs. Variable Costs
Fixed cost is the
total cost of using
the fixed
input, which
remains constant
regardless of the
amount of output
produced.
Variable cost
is the total
cost of using
the variable
input, which
increases as
more output is
produced.

Short Run Costs
COST FUNCTION DEFINITION
Total fixed cost TFC = (PK) x (K)
Total variable cost TVC = (PL) x (L)
Total cost TC = TFC + TVC
Average fixed cost AFC = TFC ÷ Q
Average variable
cost
AVC = TVC ÷ Q
Average total cost ATC = TC ÷ Q = AFC +
AVC
Marginal cost MC = ΔTC ÷ ΔQ = ΔTVC
÷ ΔQ

Average and Marginal Cost
Curves

Relationship Between Short
Run Production and Cost
AC
MC
Q1 Q2

Importance of cost
in managerial decisions
Ways to contain or cut costs popular
during the past decade -
most common: reduce number of
people on the payroll
outsourcing components of the
business
merge, consolidate, then reduce
headcount

Definition and use of
cost in economic analysis
 Relevant cost: a cost that is affected by a
management decision
 Historical cost: cost incurred at the time of
procurement
 Opportunity cost: amount or subjective value
that is forgone in choosing one activity over
the next best alternative
 Incremental cost: varies with the range of
options available in the decision
 Sunk cost: does not vary in accordance with
decision alternatives

Relationship between
production and cost
Cost function is simply the
production function expressed
in monetary rather than
physical units
We assume the firm is a ‘price
taker’ in the input market

production and cost
 Total variable cost (TVC) = the cost
associated with the variable input,
found by multiplying the number of
units by the unit price
 Marginal cost (MC) = the rate of
change in total variable cost
The law of diminishing returns implies that MC
will eventually increase
MP
W
Q
TVC
MC

production and cost
Plotting TP and
TVC illustrates
that they are
mirror images of
each other
When TP
increases at an
increasing rate,
TVC increases at
a decreasing rate

Short-run cost function
For simplicity use the following
assumptions:
 the firm employs two inputs, labour and capital
 the firm operates in a short-run production period
where labour is variable, capital is fixed
 the firm produces a single product
 the firm employs a fixed level of technology
 the firm operates at every level of output in the
most efficient way
 the firm operates in perfectly competitive input
markets and must pay for its inputs at a given
market rate (it is a ‘price taker’)
 the short-run production function is affected by the
law of diminishing returns

Standard variables in the short-
run cost function:
Quantity (Q) is the amount of output
that a firm can produce in the short
run
Total fixed cost (TFC) is the total cost
of using the fixed input, capital (K)

Standard variables in the short-run
cost function:
Total variable cost (TVC) is the
total cost of using the variable
input, labour (L)
Total cost (TC) is the total cost of
using all the firm’s inputs,
TC = TFC + TVC

cost function:
Average fixed cost (AFC) is the
average per-unit cost of using the
fixed input K
AFC = TFC/Q
Average variable cost (AVC) is the
average per-unit cost of using the
variable input L
AVC = TVC/Q

cost function:
Average total cost (AC) is the average
per-unit cost of all the firm’s inputs
AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a
firm’s total cost (or total variable
cost) resulting from a unit change in
output
MC = DTC/DQ = DTVC/DQ

Graphical example of the cost variables

Important observations
AFC declines steadily
when MC = AVC, AVC is at a
minimum
when MC < AVC, AVC is falling
when MC > AVC, AVC is rising
The same three rules apply for
average cost (AC) as for AVC

A reduction in the firm’s fixed cost
would cause the average cost line to
shift downward
A reduction in the firm’s variable cost
would cause all three cost lines (AC,
AVC, MC) to shift

Alternative specifications of the
Total Cost function (relating
total cost and output)
cubic relationship
as output increases, total
cost first increases at a
decreasing rate, then
increases at an increasing
rate

Alternative specifications of the
Total Cost function (relating total
cost and output)
quadratic relationship
as output increases, total cost
increases at an increasing rate
linear relationship
as output increases, total cost
increases at a constant rate

Innovations have reduced costs and greatly increased carpet
production. Innovation along with competition have worked
together to reduce real carpet prices.
Carpet production is capital intensive. Over time, the major
carpet manufacturers have increased the scale of their
operations by putting larger and more efficient tufting machines
into larger plants. At the same time, the use of labour in these
plants has also increased significantly. The result?
Proportional increases in inputs have resulted in a more than
proportional increase in output for these larger plants.
RETURNS TO SCALE IN THE CARPET INDUSTRY
TABLE 5 THE U.S. CARPET INDUSTRY
CARPET SALES, 2005 (MILLIONS OF DOLLARS PER YEAR)
1. Shaw 4346
2. Mohawk 3779
3. Beaulieu 1115
4. Interface 421
5. Royalty 298

It is important to understand the characteristics of production costs
and to be able to identify which costs are fixed, which are variable,
and which are sunk.
Good examples include the personal computer industry (where most
costs are variable), the computer software industry (where most costs
are sunk), and the pizzeria business (where most costs are fixed).
Because computers are very similar, competition is intense, and
profitability depends on the ability to keep costs down. Most
important are the cost of components and labour.
A software firm will spend a large amount of money to develop a new
application. The company can recoup its investment by selling as
many copies of the program as possible.
For the pizzeria, sunk costs are fairly low because equipment can be
resold if the pizzeria goes out of business. Variable costs are low—
mainly the ingredients for pizza and perhaps wages for a workers to
produce and deliver pizzas.
SUNK, FIXED, AND VARIABL E COSTS:
COMPUTERS, SOFTWARE, AND PIZZAS

The production of aluminum begins with the mining of bauxite. The process used to
separate the oxygen atoms from aluminum oxide molecules, called smelting, is the
most costly step in producing aluminum. The expenditure on a smelting
plant, although substantial, is a sunk cost and can be ignored. Fixed costs are
relatively small and can also be ignored.
THE SHORT-RUN COST OF ALUMINUM SMELTING
TABLE 7 PRODUCTION COSTS FOR ALUMINUM SMELTING
($/TON) (BASED ON AN OUTPUT OF 600
TONS/DAY)
PER-TON COSTS THAT ARE
CONSTANT FOR ALL OUTPUT LEVELS
OUTPUT 600
TONS/DAY
OUTPUT 600
TONS/DAY
Electricity $316 $316
Alumina 369 369
Other raw materials 125 125
Plant power and fuel 10 10
Subtotal $820 $820
PER-TON COSTS THAT INCREASE WHEN
OUTPUT EXCEENDS 600 TONS/DAY
Labor $150 $225
Maintenance 120 180
Freight 50 75
Subtotal $320 $480
Total per-ton production costs $1140 $1300

Long Run Production Function
A production
function showing
the relationship
between a flow of
inputs and the
resulting flow of
output, where all
inputs are
variable.
Q = f(L, K)
where
Q = quantity of output
input (variable)
input (variable)

Input Substitution
A manager’s choice of inputs
will be influenced by:
The technology of the
production process
The prices of the inputs of
production
The set of incentives facing the
given producer

Technology of the Production
Process
Capital-intensive
method of
production is a
process that uses
large amounts of
capital equipment
relative to the
other inputs to
produce the firm’s
output.
Labour-intensive
method of
production is a
process that uses
large amounts of
labour relative to
the other inputs
to produce the
firm’s output.

The Incentives Facing a Given
Producer
The Role of
Competitive
Environments
Labour Issues
Nonprofit
Organizations
Political and
Legislative
Influences

Long Run Average Cost
Function
This is defined as the
minimum average or unit
cost of producing any level of
output when all inputs are
variable.

Long-run cost function
 In the long run, all inputs to a firm’s
production function may be changed
 because there are no fixed inputs, there
are no fixed costs
 the firm’s long run marginal cost
pertains to returns to scale
 at first increasing returns to scale, then
as firms mature they achieve constant
returns, then ultimately decreasing returns
to scale

Long Run Average Cost
Curve
Q
$
SRAC1
SRAC2
SRAC3
SRAC4
LRAC

In long run, the firm can
choose any level of
capacity
Once it commits to a
level of capacity, at least
one of the inputs must
be fixed. This then
becomes a short-run
problem
The LRAC curve is an
envelope of SRAC
curves, and outlines the
lowest per-unit costs the
firm will incur over a
range of output

When a firm experiences
increasing returns to scale:
a proportional increase in all inputs
increases output by a greater
proportion
as output increases by some
percentage, total cost of production
increases by some lesser percentage

Economies of scale: situation
where a firm’s long-run average
cost (LRAC) declines as output
increases
Diseconomies of scale: situation
where a firm’s LRAC increases as
output increases
In general, the LRAC curve is u-
shaped.

Economies and Diseconomies of
Scale
Economies of
scale exist when the
firm can achieve
lower unit costs of
production by
adopting a larger
scale of production,
represented by the
downward sloping
portion of along-run
average cost curve.
Diseconomies of
scale exist when the
firm incurs higher
unit costs of
production by
adopting a larger
scale of production,
represented by the
upward sloping
portion of a long-run
average cost curve.

Economies and Diseconomies of
Scale - Graphical
SATC1
SATC2
SATC3
LRAC
$
QQ1
Economies of scale
Declining LRAC
Diseconomies of scale
Increasing LRAC

Reasons for long-run economies
specialization of labour and capital
prices of inputs may fall with
volume discounts in firm’s
purchasing
use of capital equipment with better
price-performance ratios
larger firms may be able to raise
funds in capital markets at a lower
cost
larger firms may be able to spread
out promotional costs

Factors Creating Economies of Scale
Specialization and division of labour
Technological factors
The use of automation devices
Quantity discounts
The spreading of advertising costs
Financial factors

Reasons for diseconomies of scale
scale of production becomes so large
that it affects the total market demand
for inputs, so input prices rise
transportation costs tend to rise as
production grows, due to handling
expenses, insurance, security, and
inventory costs

Factors Creating Diseconomies
of Scale
The inefficiencies of managing
large-scale operations.
The increased transportation
costs that result from
concentrating production in a
small number of very large
plants.

Learning By Doing
The drop in unit costs as
total cumulative production
increases because workers
become more efficient as
they repeat their assigned
tasks.

Learning curve
Learning curve: line showing
the relationship between labour
cost and additional units of
output
• downward slope indicates
additional cost per unit declines
as the level of output increases
because workers improve with
practice

Learning curve
 Learning curve:
• measured in terms of percentage decrease in
additional labour cost as output doubles
Yx = Kxn
Yx = units of factor or cost to
produce the xth unit
K = factor units or cost to produce
the Kth (usually first) unit
x = product unit (the xth unit)
n = log S/log 2
S = slope parameter

Minimum Efficient Scale
That scale of
operation at which
the long-run
average cost curve
stops declining or
at which
economies of
scale are
exhausted.
$
Q
LRAC
MES

Methods for Determining MES
Surveys of expert opinion
(engineering estimates)
Statistical cost estimation
The survivor approach

Surveying Expert Opinion
Surveying expert opinion is a time-
consuming process that relies on
the judgments of those individuals
closely connected with different
industries.
Reporting biases may obviously
occur with this approach.

Statistical Estimation
Researchers attempt to estimate the
relationship between unit costs and
output levels of firms of varying sizes
while holding constant all other
factors influencing cost in addition to
size.
This is usually done with multiple
regression analysis.

Survivor Approach
The size distribution of firms is
examined to determine the scale of
operation at which most firms in the
industry are concentrated.
The underlying assumption is that
this scale of operation is most
efficient and has the lowest costs
because this is where most firms
have survived.

Economies of scope
Economies of scope: reduction
of a firm’s unit cost by
producing two or more goods or
services jointly rather than
separately
Closely related to economies of
scale

Supply chain management
 Supply chain management (SCM): efforts by
a firm to improve efficiencies through each
link of a firm’s supply chain from supplier to
customer
• transaction costs are incurred by using
resources outside the firm
• coordination costs arise because of
uncertainty and complexity of tasks
• information costs arise to properly
coordinate activities between the firm and
its suppliers

Supply chain management
Ways to develop better supplier
relationships
strategic alliance: firm and outside
supplier join together in some sharing
of resources
competitive tension: firm uses two or
more suppliers, thereby helping the
firm keep its purchase prices under
control

Ways companies cut
costs to remain competitive
 the strategic use of cost
 reduction in cost of materials
 using information technology to reduce costs
 reduction of process costs
 relocation to lower-wage countries or
regions
 mergers, consolidation, and subsequent
downsizing
 layoffs and plant closings

Global application
Example: manufacturing
chemicals in China
 labour content relatively low
 high use of equipment and
raw materials
 non cost reasons for
outsourcing

Conclusion
“The British supermarkets are leading
a race to the bottom. Jobs are being
lost and producers are having to pay
less attention to social and
environmental agreements…”
Alistair Smith, Banana Link

Casestudy : FORD and the World
Automobile Industry (2009)
1. Read and prepare the
Casestudy on FORD
for discussion and
presentation next
week.
2. Identify and evaluate
the challenges facing
FORD’s global
business by
conducting External
Environment analysis
(PESTEL);and
Industry (5+1 Forces)
analysis.

Core Reading
• Keat, Paul G. and Young, Philip KY (2009)
Managerial Economics, 6th edition, Pearson
• Samuelson, William F. and Marks, Stephen
G.(2010) Managerial Economics, 6th edition, John
Wiley
• Pindyck, Robert S. and Rubinfeld, Daniel L.(2013)
Microeconomics, 8th edition, Pearson
• Samuelson, P.A. and Nordhaus, W. D.
(2010)“Economics” Irwin/McGraw-Hill, 19th
Edition
• Porter, Michael E. (2004)“Competitive Strategy –
Techniques for Analyzing Industries and Competitors”
Free Press

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