Cost Analysis and

Cost Management
Reading
•Required: Jones, T. T. (2004). Business economics and
managerial decision making. John Wiley & Sons (Chap
7,8)
•Recommended: Griffiths, A., & Wall, S. (2005). Economics
for business and management. Pearson Education.
(Chap 3)
1. Supply Function
Law of supply
•As the price of a good rises (falls) and
other things remain constant, the
quantity supplied of the good rises (falls)
Market supply curve
•The supply curve shows the amount of a good that will be
produced at alternative prices
•The supply curve is upward sloping
•Change in amount supplied:
• Changes in the price of a good lead to a change in the quantity
supplied of that good
• Corresponds to a movement along a given supply curve
•Change in supply
• Changes in variables other than the price of good, lead to a
change in supply
• Corresponds to a shift of the entire supply curve
 Supply Curves
• Firm Supply Curve -
Able to the greatest quantity
$/Q Produce of a good supplied at
each price the firm is
profitably able to
supply, ceteris
paribus.
Unable to
Produce

Q/time unit
 Supply
P
Curve
S

P2

P1

Q
Q1 Q2
Supply
Curve
Determinants of Supply
Supply change:
•Input prices
•Tech or Govt Regulations
•Tax/ Subsidy
•Number of firms
•Natural conditions
•Production expectation
Determinants of Supply
•Input prices [-]
•Tech or Govt regulations
•Lower-cost tech [+]
•Govt regulations have an adverse effect on
businesses [-]
•Number of firms [+]
•Production expectation [-]
Determinants of Supply
•Tax
•Excise tax:
• A tax on each unit of output sold
• Shifts the supply curve up by the amount of the tax
•Ad-valorem tax:
• A percentage tax
• Shift the supply curve counterclockwise, the new
curve will shift further away from the original curve as
the price increase
Determinants of Supply
Determinants of Supply
Direct Supply Function
Qsi = f()
Qsi : Quantity supplied of the good
Pi = price of the good
Te = technology
Ip = input prices
A = all other things
•A function that
describes how much of
a good will be produced
at alternative prices of
that good, alternative
input prices, and
alternative values of
that other variables
affecting supply
Change in Supply
versus Change in
Amount Supplied
A Supply Curve
Qsx = 2,000 + 3Px - 4Pr – Pw

where Px is the price of a iPad, Pr

represents the price of a iPod and Pw is the
price of an input used to make televisions
If Pr = 100 and Pw = 2,000
Then we have one point on the supply curve
and the relationship between Qsx and PX
Qsx = 2,000 + 3Px - 4(100) -1(2,000)

Qsx = 3Px – 400 direct supply function

Px = 400/3 + (1/3)Qsx inverse supply function

Equilibrium: No Tendency to Change
P S

•Superimpose demand
and supply
•If No Excess Demand willing

•and No Excess & able

Supply
•No tendency to P
e
change
D

Q
2. Production Economics
Technology of Production
•firm: A unit that produces a good or service for sale.
Some are proprietorships, partnerships, corporations.
•goal is to maximize profit
Profit
•Difference between revenue and cost
•Revenue--receipts of firms from sales
•Cost--more elusive
• ultimately the opportunities forgone
• can be regarded as the sum, taken over all the resources employed, of
the factor prices times factor quantities
What is Production?
•The creation of goods and services from inputs or
resources
• Production of a car, refining a gallon of home
heating oil, education, medical services, etc.
 Production Function
•Maximum output firm can produce for every
specified combination of inputs
•Alternatively, shows the minimum quantity of input
necessary to produce a given level of output
 Production Function
•Technical efficiency is implied when discussing a
production function.
•Not the same as economic efficiency. Economic
efficiency occurs when the firm is producing a given
amount of output at the lowest cost (more on this
concept later…)
•Production functions are determined by the
technology available to most effectively use plant,
equipment, labor, materials, and other resources
•inputs: labor, capital, and resources
 Production Function continued
• Generally Q =f(X1, X2, X3, …, Xn)
• Q = f(K,L)
• short run--period of time in which one or more factors (inputs) of
production cannot be changed; there are fixed inputs (factors of
production)
• Fixed input: level of usage cannot readily be changed; must pay for it
even if firm produces no output
• Q = f(K,L)
• long run--all inputs are variable
• Q = f(K,L)
 A Production Function
Units of Capital (K)

0 1 2 3 4 5 6 7 8 9 10
0 0 0 0 0 0 0 0 0 0 0 0
1 0 25 52 74 90 100 108 114 118 120 121
2 0 55 112 162 198 224 242 252 258 262 264
Units of Labor (L)

3 0 83 170 247 303 342 369 384 394 400 403

4 0 108 220 325 400 453 488 511 527 535 540
5 0 125 258 390 478 543 590 631 653 663 670
6 0 137 286 425 523 598 655 704 732 744 753
7 0 141 304 453 559 643 708 766 800 814 825
8 0 143 314 474 587 679 753 818 857 873 885
9 0 141 318 488 609 708 789 861 905 922 935
10 0 137 314 492 617 722 809 887 935 953 967
 Production Function continued
•Productivity:
•Total product (TP):
•Average product (AP):
APL = Q/L
APK = Q/K
• Marginal product (MP):
MPL = DQ/DL
MPK = DQ/DK
 Production with
One Variable Input
 We will use labor as an example of the input X here.
Therefore L is the input, labor in this notation

average product = output/labor input

marginal product of labor = change in output/change
in labor input
• MPL = DQ/DL (if the input is infinitely divisible, and
therefore a continuous variable, then MP = dQ/dL)

- where L is the quantity of an input of

production, in this case labor
Amount of Labor (L) Amount of Capital Output (Q) Average Product Marginal Product
(K) (AP) (MP)

0 10 0 -- --

1 10 10 10 10

2 10 30 15 20

3 10 60 20 30

4 10 80 20 20

5 10 95 19 15

6 10 108 18 13

7 10 112 16 4

8 10 112 14 0

9 10 108 12 -4

10 10 108 10 -8
law of diminishing returns
• as the use of an input increases (with other inputs fixed), a point will
eventually be reached at which the resulting additions to output
decrease.
• ceteris paribus, as equal increments of one variable resource are
applied to fixed amounts of other resources per unit of time, after a
certain point the resulting increases in total product (output) become
smaller and smaller.
• Total output does not decrease in the region relevant to our
discussion...the size or rate of the increases in total output
diminishes.
Three Stages of Production
• stage one – range over which AP is increasing
• stage two – from where AP reaches its maximum to the
point where MP reaches zero
• stage three – TP is declining, meaning MP is negative
Production with Two Variable Inputs
(the long run because both inputs are variable)

✹Isoquants
Defines the combinations of inputs that yield the same level of
output
✹Marginal Rate of Technical Substitution
The rate at which a producer can substitute between two inputs
and maintain the same level of output
✹MRTS of labor for capital is the amount by which the
input of capital can be reduced when one extra unit of
labor is used, so output remains constant
• MRTS = -change in capital input/change in
labor input
• MRTS = DK/ DL
• can be shown that the MRTS is equal to the
ratio of the marginal products of L and K by
using the formula for MP
• MRTSLK = MPL/MPK
 MPL = DQ/DL

DL = DQ/ MPL

DK = DQ/ MPK

since MRTS = DK/ DL

MRTS = (DQ/ MPK)/( DQ/ MPL)

MRTS = MPL / MPK

 Continuous Functions

MRTS = dK/dL
 Isoquant
Capital

MRTS = -(ΔK/ΔL)

MRTS = -[(KA – KB)/(LA – LB)]

A MRTS = the slope between pt. A and pt. B

KA

KB B

quantity = x
Labor

LA LB
Optimal Combination of Inputs
1. Isocost Line -- all possible combinations of L and K that
can be purchased for a given cost
Or a line that represents the combinations of inputs that will
cost the producer the same amount of money

TC = PL L + PK K
rewrite in the form of a equation for a line y = a + bx

TC - PL L = PK K

TC/PK - (PL/PK) L = K

K = TC/PK – (PL/PK) L
 Cost Minimization
therefore slope of isocost curve is PL/PK

remember slope of isoquant MRTSLforK = MPL/MPK

MRTS = PL/PK

therefore MPL/MPK = PL/PK

MRTS is equal to the ratio of input prices

MPL/PL = MPK/PK
Equal marginal product for all inputs
 Isocost Line Optimal Combination
Capital of Inputs (with a fixed budget)

MRTS = PL/PK

Note: The isoquants do not

cross even though they may
look like they do on this
diagram. Also, as you move
out from the origin, the
isoquants represent larger
quantities of output
Kε

Labor
Lε
Capital Optimal Combination
of Inputs (with a target output level)

MRTS = PL/PK

Kε

Labor
Lε
Returns to Scale
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale
Analytically
•Q = f(K, L)
•If input usage increases by a constant proportion (say, c) and
the proportionate change in output is z:
• f(cK, cL) = zQ
• Notice all inputs are increasing by a factor of c, e.g. we are doubling
both the capital and labor inputs (c = 2 in this case)
More generally, if all inputs increase by a factor of c and output
goes up by a factor of z

• Increasing returns to scale occur if z > c

• Output goes up proportionately more than the increase in input
usage, e.g. z = 3 when c = 2
• Constant returns to scale occur if z = c
• Output goes up the same proportion as the increase in input usage,
e.g. z = 2 when c = 2
• Decreasing returns to scale occur if z < c
• Output goes up proportionately less than the increase in input usage,
e.g. z = 1.5 when c = 2
3. Costs of Production
Cost Function
• Cost Function:
Denote the cost to the firm of producing isoquant Q in the cost-minimizing
combination of production factors
• Types of Cost:
• Short-run Costs:
Fixed costs
Short-run variable costs
• Long-run Costs:
No fixed costs
Long-run variable costs (all costs are variable)
Cost Function
Short Run

Some inputs are variable

Definitions
1. TFC = obligations per unit of time due to fixed resources, e.g.
depreciation of buildings, equipment, property taxes
2. TVC = obligations due to variable resources, rise as output
increases; generally TVC increase at a decreasing rate in the
beginning (variable costs per unit of output are decreasing) but
eventually diminishing marginal returns sets in (TVC increases
at an increasing rate)
3. TC = TFC + TVC
4. AFC
5. AVC is generally U-shaped
6. AC is generally U-shaped
7. MC = addition to TC resulting from addition of
last unit of output

MC = DTC/ DQ
 Marginal Analysis Re-Visited
• Remember: what really is important is what happens at
the margin
• Example: first hour of cycle riding is worth $50, second
hour is worth $35, the third $15, etc.
• Concept of Marginal Benefit
• Remember, the cost of riding is $35 per hour. Assume it
is constant, meaning every hour costs $35.
• Concept of Marginal Cost (usually increases as
output or quantity increases)
MC = DTC/ DQ

= (DTVC + DTFC)/DQ

but DTFC = 0

therefore MC = DTVC/ DQ
One more cost concept: Sunk Costs
• A cost that is irretrievably committed
• These costs cannot be recovered and therefore are not relevant to the
current or future production decisions
• Go back to the motorcycle example. The sunk cost is the portion of the
purchase price (value) of the motorcycle that is immediately lost when one
rides it off the showroom floor. It is not retrievable regardless of what I do
with the motorcycle.
• There are fixed costs associated with keeping the cycle “road-ready” all
year-round:
• Insurance
• Registration and licensing
• Depreciation (this actually is a cost whether or not the cycle is road-
ready all year-around.)
Determinants of SR costs
diminishing returns to labor occur when the marginal product of
labor is decreasing. If labor is only variable factor, what
happens as we increase the firm's output? Increase Q implies
increase labor input and if MPL decreases rapidly, costs more
and more per additional unit of output in terms of the variable
input labor
Assume a fixed wage (w)

• remember MC = DTVC/DQ and DTVC = per unit cost of

labor (w) time amount of extra labor (change L)

MC = DTVC/ DQ = w DL/ DQ
since DTVC = w DL
MPL = DQ/ DL
therefore DL/ DQ = 1/MPL
and MC = w/MPL
Remember AVC = TVC/Q

TVC = wL
Therefore AVC = wL/Q
And APL = Q/L
1/APL = L/Q
Therefore AVC = w/APL
Shape of Cost Curves
TC, Short Run Total Cost Curve
TVC
TC

TVC
TFC

TFC
TFC

Output
$

MC AC

AVC

Q
 Marginal/Average Relationships

MC is below AC implies AC is decreasing

MC is above AC implies AC is increasing

MC = AC when AC is at minimum
Example
•One year contract for cellular phone service at $30 per month
• 300 nationwide anytime minutes
• 1,000 weekend and night minutes
•Cancellation penalty is the balance of the $360 for the year
contract
•Additional minutes
• 40 cents for the first 150 and then at a rate of 30 cents per minute,
whether local or long distance
What are the fixed, variable, and marginal costs of the following
monthly cell phone use?
• You make 200 minutes of “prime-time” calls and 350 minutes of week-end/night calls
• Total Fixed costs: $30
• Total Variable costs: zero
• Average cost: $0.0545 ($30/550 minutes)
• Marginal cost: zero
• You make 400 minutes of “prime-time” calls and 750 minutes of week-end/night calls
• Total Fixed costs: $30
• Total Variable costs: $40 (100 minutes * $0.40)
• Average cost: $0.0608 ($70/1150 minutes)
• Marginal cost: $0.40 per minute
• You make 500 minutes of “prime-time” calls and 450 minutes of week-end/night calls
• Total fixed costs: $30
• Total Variable costs: $75 [(150 minutes * $0.40) + (50 minutes * $0.30)]
• Average cost: $0.1105 ($105/950)
• Marginal cost: $0.30 per minute
Long Run Cost Curves
Remember all inputs are variable
so there are no fixed costs (all costs are variable)
Economies and Diseconomies
of Scale
Strategic advantage:
Definitions
• Economies of Scale – LRAC (long run average cost) falls as
output increases.
• On next slide, from zero output to Q2
• Diseconomies of Scale – LRAC increases as output increases
• On next slide, from Q2 and beyond
• Note: not all inputs have to be changed proportionately so this is not the
same as returns to scale
$

LMC LAC
Economies of scale

Diseconomies of scale

Q2 Q
Reasons for Economies of Scale
• Specialization and division of labor –
productivity gains
• Technological factors
• Threshold for making capital investments
which lead to productivity gains
Reasons for Diseconomies of Scale
• Limitations to efficient and effective
management
• The larger the operation, the more
delegation that occurs
• Direct contact with daily operations is
sacrificed
• Good communication and data sharing
become essential
Shape of LAC depends on Returns to Scale
•Remember from the production section that
returns to scale result from a proportionate
increase in ALL inputs, meaning there are no
fixed inputs and therefore we are discussing
the long run by definition
 Constant Returns
an output increase is accompanied by an equal percentage increase in costs.
Average costs are unchanged as quantity changes

LAC = LMC

Q
•decreasing returns – an increase in output is
accompanied by a greater percentage
increase in costs (than the percentage
increase in output). Average costs increase
as quantity increases. From Q1 and on in
following diagram.
• increasing returns – an increase in output is
accompanied by a smaller percentage
increase in costs (than the percentage change
in output). Average costs decrease as
quantity increases. From origin to Q1 in
following diagram.
 LAC with Increasing and Decreasing Returns
$
SAC5

SAC1 SAC LAC

4
SAC
2
SAC3

Lowest point on AC curve (where

LMC = LAC

Output
Q1