SM5301

BUSINESS ECONOMICS
 Chapter 7:
Cost theory and
Estimation
The Nature of Costs
• Explicit Cost - Accounting Costs
• Economic Costs - Implicit Costs (Opportunity
Costs)
• Relevant Costs
• Historical cost is incurred at the time of procurement
• Replacement cost is necessary to replace inventory
• Are historical costs relevant?
• Incremental cost
• Sunk cost
• Is sunk cost relevant?
Short-Run Cost Functions
Total cost (TC) is the cost associated with all
of the inputs. It is the sum of TVC and TFC.
TC=TFC+TVC
Total Cost = TC = f(Q)
Total Fixed Cost = TFC
Total Variable Cost = TVC
 Total
• Total variable cost (TVC) Input TVC
is associated with the (L) Q (TP) MP (wL)
variable input 0 0 0
• Assume w=$500 per unit 1 1,000 1,000 500
2 3,000 2,000 1,000
3 6,000 3,000 1,500
4 8,000 2,000 2,000
5 9,000 1,000 2,500
6 9,500 500 3,000
7 9,850 350 3,500
8 10,000 150 4,000
9 9,850 -150 4,500
• Marginal cost (MC) is the change in total cost
associated a change in output.

TC
MC 
Q

TC (TFC  TVC) TFC TVC TVC

MC      0
Q Q Q Q Q
• Add marginal Total
Input TVC
cost to the
(L) Q MP (wL) MC
table 0 0 0
1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
 Total
• Observe that: Input TVC
• When MP is (L) Q MP (wL) MC
increasing, 0 0 0
MC is 1 1,000 1,000 500 0.50
decreasing. 2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
• When MP is
4 8,000 2,000 2,000 0.25
decreasing, 5 9,000 1,000 2,500 0.50
MC is 6 9,500 500 3,000 1.00
increasing. 7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
• The relationship between MP and MC is

TVC w  L L 1 w
MC    w  w 
Q Q Q MP MP

Law of diminishing returns implies that

MC will eventually increase! Why?
The Short Run Cost Function
• Average total cost (ATC) is the average per-unit cost
of using all of the firm’s inputs (TC/Q)
• Average variable cost (AVC) is the average per-unit cost
of using the firm’s variable inputs (TVC/Q)
• Average fixed cost (AFC) is the average per-unit cost of
using the firm’s fixed inputs (TFC/Q)
The Short Run Cost Function
• Add ATC = AFC + AVC to the table
The Short Run Cost Function
• ATC = AFC + AVC
Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q
Breakeven quantity
Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

Breakeven quantity TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC/(P - AVC)

Operating Leverage

Operating Leverage = TFC/TVC

Operating leverage refers to the ratio of firm’s total fixed costs
to total variable costs. The higher the ratio, the more leveraged
the firm is said to be.

Degree of Operating Leverage = DOL The responsiveness or

sensitivity of firm’s total profits to a change in its output or sales is
measured by DOL.

% Q( P  AVC )
DOL  
%Q Q( P  AVC )  TFC