Week 4A - COMM/FRE 295 September 26, 2010 Cost; Short &...

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COMM/FRE 295 September 26, 2010 Cost; Short & Long Run
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Topics Examined • Types of cost (economic vs accounting; opportunity, sunk, fixed, etc.) • Costs in the short run – Link between short run production function and short run cost – Marginal cost, average cost, etc • Cost in the long run • Long run average cost and economies of scale • Cost minimizing input mix in the long run • Economies of scope & the learning curve
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Opportunity Cost and Calculation of Profit • Opportunity cost is cost associated with not using resource in best alternative • Opportunity cost must be added to other costs when calculating economic profit – If you quit your $60,000/year job and start a small business, use $60,000 as a cost of your labour/management when calculating profits – If you own a building and start a small business, you should add the foregone rent to your other business costs
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Rental Rates • For durable capital such as a truck, a building or land, use the rental value rather than the asset’s sales value to calculate the annual opportunity cost • If there is no rental value, use depreciation plus cost of capital • e.g., If truck costs $25,000 and will be worth $20,000 after one year due to depreciation, then opportunity cost is $5,000 plus foregone interest on $25,000 investment
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Zero Economic Profits • Opportunity cost data is often not available. Financial statements are based on the accounting definition of cost • Effective managers always think in terms of opportunity cost! • Zero accounting profits is a problem for the business, but zero economic profits is fine • Why? All resources (including management & owned capital) have been costed at their best alternative use (i.e., you could not do better by shifting resources elsewhere)
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Sunk Costs Sunk costs are expenditures that can’t be recovered (e.g. education) • Shouldn’t be used for calculating economic profits – A machine costs $20,000 to purchase; (i) it can be rented out for $1000/month, or (ii) the machine has no value to anyone but you. – In (i), opportunity cost is $1000/month, so this cost should be used for calculating profits. In (ii), the cost of the machine is fully sunk so no cost should be used for calculating profit • Never use original $20,000 for calculating profits
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Variable versus Fixed Costs Variable costs change with output (e.g., materials, packaging, some labour) Fixed costs do not change with output (e.g., management salaries, insurance, rent, etc.)
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This note was uploaded on 01/03/2011 for the course COMM 290 taught by Professor Brian during the Winter '09 term at The University of British Columbia.

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Week 4A - COMM/FRE 295 September 26, 2010 Cost; Short &...

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