Chapter 7

The Theory and

Estimation of Cost

Chapter Seven

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Overview
Definition and use of cost
Relating production and cost
Short run and long run cost
Economies of scope and scale
Supply chain management
Ways companies have cut
costs to remain competitive
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Learning objectives
define the cost function
distinguish between economic cost and
accounting cost
explain how the concept of relevant cost is
used

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Learning objectives
understand total, variable, average and
fixed cost
distinguish between short-run and longrun cost
provide reasons for the existence of
economies of scale
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Importance of cost
in managerial decisions

Ways to contain or cut costs popular

during the past decade

most common: reduce number of people

on the payroll

outsourcing components of the business

merge, consolidate, then reduce

headcount

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Definition and use of

cost in economic analysis
Relevant cost: a cost that is affected by a
management decision
Historical cost: cost incurred at the time of
procurement
Opportunity cost: amount or subjective
value that is forgone in choosing one activity
over the next best alternative
Incremental cost: varies with the range of
options available in the decision
Sunk cost: does not vary in accordance with
decision alternatives

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Relationship between
production and cost

Cost function is simply the production

function expressed in monetary rather
than physical units
We assume the firm is a price taker in
the input market

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Relationship between
production and cost

Total variable cost (TVC) = the cost

associated with the variable input, found by
multiplying the number of units by the unit
price

Marginal cost (MC) = the rate of change in

total variable cost
TVC W
MC

Q
MP

The law of diminishing returns (Chapter 6)

implies that MC will eventually increase
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Relationship between
production and cost
Plotting TP and TVC
illustrates that they
are mirror images of
each other
When TP increases at
an increasing rate,
TVC increases at a
decreasing rate

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Short-run cost function

For simplicity use the following assumptions:

the firm employs two inputs, labor and capital
the firm operates in a short-run production
period where labor is variable, capital is fixed
the firm produces a single product
the firm employs a fixed level of technology
the firm operates at every level of output in
the most efficient way
the firm operates in perfectly competitive input
markets and must pay for its inputs at a given
market rate (it is a price taker)
the short-run production function is affected by
the law of diminishing returns

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Short-run cost function

Standard variables in the short-run cost

function:
Quantity (Q) is the amount of output that
a firm can produce in the short run
Total fixed cost (TFC) is the total cost of
using the fixed input, capital (K)

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Short-run cost function

Standard variables in the short-run cost

function:
Total variable cost (TVC) is the total cost
of using the variable input, labor (L)
Total cost (TC) is the total cost of using all
the firms inputs,
TC = TFC + TVC

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Short-run cost function

Standard variables in the short-run cost

function:
Average fixed cost (AFC) is the average
per-unit cost of using the fixed input K
AFC = TFC/Q
Average variable cost (AVC) is the
average per-unit cost of using the
variable input L
AVC = TVC/Q

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Short-run cost function

Standard variables in the short-run cost

function:
Average total cost (AC) is the average
per-unit cost of all the firms inputs
AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a
firms total cost (or total variable cost)
resulting from a unit change in output
MC = TC/Q = TVC/Q

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Short-run cost function

Graphical example of the cost variables

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Short-run cost function

Important observations
AFC declines steadily
when MC = AVC, AVC is at a minimum
when MC < AVC, AVC is falling
when MC > AVC, AVC is rising

The same three rules apply for average

cost (AC) as for AVC
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Short-run cost function

A reduction in the firms fixed cost would

cause the average cost line to shift
downward
A reduction in the firms variable cost
would cause all three cost lines (AC, AVC,
MC) to shift

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Short-run cost function

Alternative specifications of the Total Cost

function (relating total cost and output)

cubic relationship
as output increases, total cost first
increases at a decreasing rate, then
increases at an increasing rate

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Short-run cost function

Alternative specifications of the Total Cost

function (relating total cost and output)

quadratic relationship
as output increases, total cost
increases at an increasing rate

linear relationship
as output increases, total cost
increases at a constant rate

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Long-run cost function

In the long run, all inputs to a firms

production function may be changed
because there are no fixed inputs,
there are no fixed costs
the firms long run marginal cost
pertains to returns to scale
at first increasing returns to scale, then
as firms mature they achieve constant
returns, then ultimately decreasing returns
to scale

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Long-run cost function

When a firm experiences increasing

returns to scale:

a proportional increase in all inputs

increases output by a greater proportion

as output increases by some

percentage, total cost of production
increases by some lesser percentage

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Long-run cost function

Economies of scale: situation where a

firms long-run average cost (LRAC)
declines as output increases

Diseconomies of scale: situation where

a firms LRAC increases as output
increases

In general, the LRAC curve is u-shaped.

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Long-run cost function

Reasons for long-run economies

specialization of labor and capital
prices of inputs may fall with volume
discounts in firms purchasing
use of capital equipment with better
price-performance ratios
larger firms may be able to raise funds
in capital markets at a lower cost
larger firms may be able to spread out
promotional costs

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Long-run cost function

Reasons for diseconomies of scale

scale of production becomes so large that

it affects the total market demand for
inputs, so input prices rise

transportation costs tend to rise as

production grows, due to handling
expenses, insurance, security, and
inventory costs

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Long-run cost function

In long run, the firm can
choose any level of capacity
Once it commits to a level of
capacity, at least one of the
inputs must be fixed. This
then becomes a short-run
problem
The LRAC curve is an
envelope of SRAC curves,
and outlines the lowest perunit costs the firm will incur
over a range of output

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Learning curve

Learning curve: line showing the

relationship between labor cost and
additional units of output

downward slope indicates additional cost

per unit declines as the level of output
increases because workers improve with
practice

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Learning curve

Learning curve:
measured in terms of percentage decrease in
additional labor cost as output doubles
Yx = Kxn
Yx = units of factor or cost to
produce the xth unit
K = factor units or cost to produce
the Kth (usually first) unit
x = product unit (the xth unit)
n = log S/log 2
S = slope parameter

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Economies of scope

Economies of scope: reduction of a

firms unit cost by producing two or more
goods or services jointly rather than
separately
Closely related to economies of scale

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Supply chain management

Supply chain management (SCM):

efforts by a firm to improve efficiencies
through each link of a firms supply chain
from supplier to customer

transaction costs are incurred by using

resources outside the firm
coordination costs arise because of
uncertainty and complexity of tasks
information costs arise to properly
coordinate activities between the firm and
its suppliers

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Supply chain management

Ways to develop better supplier

relationships
strategic alliance: firm and outside
supplier join together in some sharing
of resources
competitive tension: firm uses two or
more suppliers, thereby helping the firm
keep its purchase prices under control

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Ways companies cut

costs to remain competitive
the strategic use of cost
reduction in cost of materials
using information technology to reduce
costs
reduction of process costs
relocation to lower-wage countries or
regions
mergers, consolidation, and subsequent
downsizing
layoffs and plant closings

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Global application

Example: manufacturing chemicals in

China
labor content relatively low
high use of equipment and raw
materials
noncost reasons for outsourcing

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