Economic Analysis for Business Decisions Production and Cost II

Overview: Production and Cost II • Opportunity Costs in Practice – Example: Valuing a 1998 Boeing 737-700 • Economies of Scale and Scope • Learning Effects 1 The 1998 Boeing 737-700 Check the Airliner Price Guide 2 Cost Saving From a 1998 737-700 • The User Cost of Capital UCCt = rVt + (Vt - Vt+1 ) = r ($27.4 m) + ($27.4m - $25.8m) = 9.2% ($27.4 m) + ($27.4m - $25.8m) = $ 4.11 m • Equivalently, in terms of percent depreciation, UCCt = (r + %dep’n)Vt % dep’n = (Vt - Vt+1 )/Vt = (27.4 - 25.8)/27.4 = 5.8% 3 Calculating Delta’s cost of capital, r Four steps: 1. Determine Debt/Equity Structure Total Market value of Debt D: $4.7 Bn (from Moody’s or Annual Report) Market Capitalization E: $6.21 Bn (from Yahoo Finance – spring 2001) 2. Calculate Cost of Equity with CAPM r e = r f + β equity Risk Risk rel. free rate to market 5.16% + 1 . 14 (r m − rf ) (1*) Market risk premium (6% ) = 12 . 0 % Calculating Delta’s cost of capital (cont.) 3. Calculate Cost of Debt Weighted average of cost of each maturity of debt used by Delta (from Moody’s): rd = 9%. Corporate tax rate τ = 39.6%. 4. Weighted Average Cost of Capital ⎛ E ⎞ ⎛ D ⎞ WACC= re ⎜ ⎟ (1−τ ) ⎟ + rd ⎜ ⎝ E + D⎠ ⎝ E + D⎠ (2*) ⎛ 6.21 ⎞ ⎛ 4. 7 ⎞ 12.0%⎜ ⎟ + 9%⎜ ⎟(1− 39.6% ) = 9.2% ⎝ 4.7 + 6.21 ⎠ ⎝ 4.7 + 6.21 ⎠ (*) If relevant, equations (1) and (2) will be provided to you on the exam. 4 Economies of Scale and Scope • Cost savings associated with ‘size’ of business • Economies of Scale – Unit cost savings at higher scales of production – (AC falls with higher Q) • Economies of Scope – Costs savings from producing multiple products – ‘Joint production economies’ 5 Economies of Scale, AC and MC • Economies of Scale – AC decreases with Q, so MC < AC so MC = AC so MC > AC • Constant Costs – AC constant with Q, – “Scalable Business” • Diseconomies of Scale – AC increases with Q, Example: Software or CD’s 70 60 50 40 30 20 10 0 0 5 10 15 20 25 Output 6 Example: Producing Near Full Capacity 70 60 50 40 30 20 10 0 0 5 10 15 20 25 Output Full Range: U-Shaped Average Cost 15 13 Range of Economies of Scale 11 9 7 5 Range of Diseconomies of Scale Point of Constant Costs 3 1 0 1 2 3 4 5 6 7 8 9 10 -1 Output 7 A Terminology Pothole • “Returns to Scale” refers to physical properties of production – Double inputs yields more than double output – “Increasing returns to scale” • With constant input prices, same concepts as scale economies – Increasing returns = economies of scale, etc. • Other differences are not important for us Economies of Scope • Cost savings associated with the simultaneous production of several products – Unit costs are lower than if products are produced separately • Sources? • Examples 8 Learning Effects • Costs savings that arise from repetition, practice or experience of ongoing production. • Sources? • Examples 9 Estimation of Learning Curves • How is the effect of learning on costs quantified? – With cost data, estimate learning curves – (use consultants if necessary) • Why quantify the effect of learning on costs? – Only way to know precise benefit of today’s production on tomorrow’s costs Empirical Learning Curves Typically Log-Log Specification Ln(AC per Lot) = α + β Ln(Cumulative Lot Number) Why? Typical Data Pattern L n (A C p e r L o t) A C per Lot 150 100 50 0 0 10 20 30 Lot Number (or Cumulative Production) 40 4.8 4.6 4.4 4.2 4 3.8 0 1 2 3 4 Ln(Lot Number (or Cum. Prod.)) 10 Learning Curve ‘Strategy’ • Overproduce Now for Lower Costs in Future • Needs to be undertaken with care – In the 1980’s, some people thought overproduction of this kind always made sense 11 Learning Curve ‘Strategy’: Assumptions • Demand: – Will be sufficient to absorb higher output • Learning: – – – – Learning will occur, or can be managed No “Technological risk” Competitors cannot “free ride” on your learning No forgetting Take Away Points • User cost of capital is an important component of economic costs. It consists of economic depreciation and the opportunity cost of capital. • Scale and learning effects are important sources of competitive advantage and entry barriers. • Scale effects refer to movements along the AC curve, learning effects are shifts of the AC curve 12