Cost Concepts and Pricing Behavior

1. Sunk Costs

Costs that do not vary according to different decisions

• Eg. A student buys a book for $50 and can sell it for $20. Sunk costs amount for $30
• Eg. Market research, R&D (frequent in IT sector)

Managerial decision-making:

1. Ignore sunk costs and consider only avoidable costs to be very careful before committing to costs that will become sunk, since such commitments cannot be reversed
2. Exploit investments in sunk costs as a way to strategically influence the behavior of competitors

- Major entry barrier because they increase the cost of exit

Relationship between fixed and sunk costs: - sunk costs are the amount of fixed costs that cannot be recouped

2. Incremental Costs

Change in costs between undertaking a course of action and not undertaking it

• A special case of opportunity cost in which the next best alternative is defined as doing nothing
• Undertaking a marketing campaign, building a new facility, etc.

+ Relevant cost for decision making along with the opportunity and replacement costs

3. Long-Run Average Costs (LAC)

- In the L-R: all inputs and all costs are variable

- In the S-R different average cost curves are associated with different plant sizes, while in the L-R manager is free to choose the optimal plant size for producing the desired level of output

Managerial task:

• Determine the most efficient operation scale (large scale-mass marketing, low prices, small scale-niche marketing, high prices)
• Adjust the levels of all inputs + long-run average curve is U shaped

4. Decreasing Returns to Scale (Increasing Costs)

Arise due to management problems

• It becomes difficult to manage the firm effectively and coordinate various operations and divisions
• Number of meetings, paperwork, phone bills increase more than proportionately to the increase in the scale of operation

In practice: Decreasing returns prevail at much larger levels of output/increasing returns prevail at small levels of output

5. What is Important for Setting Prices- Pricing Behavior

- To get the price of a product managers use Lerner index and Markup factor

- Price equals MC multiplied by markup factor

Lerner index - Measures the difference between price and marginal cost as a fraction of the price of the product

                                   L=P-MC/P

• Firm sets its price equal to MC à Lerner index is zero, price equals the cost of production, high competition products
• Price higher than MC à Lerner index >0, Exclusive products

6. Shape of the LAC (Long-Run Average Cost Curve)    à  U shaped

- Initially an expansion of output allows the firm to produce at lower long-run average cost  àEconomies of scale

- Further increases in output lead to an increase in average costs à Diseconomies of scale

 - Sometimes technology allows production of different levels of output at the same minimum average costà  Constant returns to scale

7. Learning Curve

AC usually decline due to firms gaining experience in the production

Shows the decline in the average input costs with rising cumulative total outputs over time

Reasons for learning curve effects:

• Labor efficiency, Shared experience effects (Standardization, specialization), Better use of equipment (Changes in the resource mix, input mix)
• Pricing policy - Eg. Texas Instruments adopted an aggressive price strategy based on the learning curve. Believing that the learning curve in chip production was very steep, it kept unit prices very low in order to increase its cumulative total output very rapidly and thereby benefit from learning by doing.