The Theory and Estimation of Cost

Farrukh Wazir Khan

 Chapter 7

The Theory and

Estimation of Cost
• Definition of Cost
• The Short Run Relationship Between Production and Cost
– The Short Run Cost Function
• The Long Run Relationship Between Production and Cost
– The Long Run Cost Function
• The Learning Curve

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 Chapter 7

Definition of Cost
• A cost is relevant if it is affected by a management decision.
– Historical cost is incurred at the time of procurement
– Replacement cost is necessary to replace inventory
• Are historical costs relevant?

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 Chapter 7

Definition of Cost
• There are two types of cost associated with economic analysis
– Opportunity cost is the value that is forgone in choosing one
activity over the next best alternative
– Out-of-pocket cost is actual transfer of value that occur
• Which cost is relevant?

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 Chapter 7

Definition of Cost
• There are two types of cost associated with time
– Incremental cost varies with the range of options
available in the decision making process.
– Sunk cost does not vary with decision options.
• Is sunk cost relevant?

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 Chapter 7

SR Relationship Between
Production and Cost
• A firm’s cost structure is related to its production process.
– Costs are determined by the production technology and
input prices.
• Assuming that the firm is a “price taker” in the input
market.

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 Table 7.1 : Relationship between Production and Cost

Example 1 -
Total
Input TVC
SR Relationship Between (L) Q (TP) MP (wL)
Production and Cost 0 0 0
1 1,000 1,000 500
2 3,000 2,000 1,000
• Total variable cost (TVC) is 3 6,000 3,000 1,500
associated with the variable input 4 8,000 2,000 2,000
– Assume w=$500 per unit (price-taker) 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

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 SR Relationship Between
Production and Cost

• Total cost (TC) is the cost associated with all of the

inputs. It is the sum of TVC and TFC.

• Marginal Costs
• Average Costs

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 SR Relationship Between
Production and Cost
• 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

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 Table 7.1 : Relationship between Production and Cost

Example 1.2 -
Total
Input TVC
SR Relationship (L) Q MP (wL) MC
Between 0 0 0
Production and Cost 1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
• Observe : 3 6,000 3,000 1,500 0.17
– When MP is increasing, MC 4 8,000 2,000 2,000 0.25
is decreasing or increasing? 5 9,000 1,000 2,500 ?
0.50
6 9,500 500 3,000 1.00
– When MP is decreasing, MC
7 9,850 350 3,500 1.43
is decreasing or increasing?
8 10,000 150 4,000 3.33
9 9,850 -150 4,500

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 Fig 7.1 : SR Relationship Between Production and Cost

SR Relationship Between Production and Cost

• TP and TVC are mirror images of each other

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 SR Relationship Between
Production and Cost

• 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?

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 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)

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 Table 7.2 : The Short Run Cost Function
Example 2 - ATC = AFC + AVC

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 The Short Run Cost Function
• Production cost graph or map is

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 The Short Run Cost Function
• Important Map Observations
– AFC declines steadily over the range of production. Why?

– In general, ATC is u-shaped. Why?

– MC intersects the minimum point (q*) on ATC. Why?

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 The Short Run Cost Function
• Important Map Observations
– What is the economic significance of q*?

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 The Cost Curves
Shifts in the Cost curves:

􀂗 The location of the firms short run cost curves will change only
when things other than the output level changes especially
- the state of technology and
- the price of variable inputs.

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 Example : Input Price Effect

Example 3 -
The Short Run Cost Function
• A change in input prices
will shift the cost curves.
– If fixed input costs are
reduced then ATC will
shift downward.
AVC and MC will remain
unaffected.

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 Example : Input Price Effect:

The Short Run Cost Function

• A change in input prices

will shift the cost curves.
– If variable input costs
are reduced then MC,
AVC, and AC will all s
hift downward.

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 The Long-Run Cost Function
• LRAC is made up for SRACs
– SRAC curves represent
various plant sizes
– Once a plant size is
chosen, per-unit
production costs are
found by moving
along that particular
SRAC curve

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 The Long-Run Cost Function
• The LRAC is the lower envelope of all of the SRAC
curves.
– Minimum efficient scale is the lowest output level
for which LRAC is minimized

Is LRAC a function of market size?

What are implications?
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 The Long-Run Cost Function

• Reasons for Economies of Scale…

 Increasing returns to scale
 Specialization in the use of labor and capital
• Economies in maintaining inventory
• Discounts from bulk purchases
• Lower cost of raising capital funds
• Spreading promotional and R&D costs
 Management efficiencies

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 The Long-Run Cost Function

• Reasons for Diseconomies of Scale…

 Decreasing returns to scale
 Input market imperfections
 Management coordination and control
problems

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 The Learning Curve
• Measures the percentage decrease
in additional labor cost each time
output doubles.
– An “80 percent” learning curve
implies that the labor costs
associated with the incremental
output will decrease to 80% of
their previous level.

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 The Learning Curve
• A downward slope in the learning curve indicates the
presence of the learning curve effect
– Why? Workers improve their productivity with
practice
• The learning curve effect shifts the SRAC downward

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 Appendix 7A

Appendix - Production Cost : Calculus

􀂗 The general form of the short run production cost function is: TC = F (Q)
􀂗 There are three specific forms of this function are used in economic
analysis: the cubic, the quadratic, and the linear.

􀂗 Cubic function: TC = 100 +60Q – 3Q2 + 0.1Q3

􀂗 Quadratic relationship: TC = 100 +60Q + 3Q2
􀂗 Linear relationship: TC = 100 +60Q

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 Appendix 7A
Example 4 - Production Cost : Calculus

This is a short run cost function with a TFC = $100, when Q = 0

Calculate - TVC, AFC, AVC, ATC and MC

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Reference:

Managerial Economics: Economic Tools for Today’s Decision Makers

By Paul G. Keat, Philip K. Y. Young, Stephen E. Erfle

Chapter 7

Farrukh Wazir Khan