 To determine the pricing of the firm’s

products.
 To determine the other components of
the marketing mix.
 To determine the optimal output of the
firm in the short run and the relevant
input mix.
 To determine the optimal scale of the
operation of the firm in the long run.
 To determine whether to accept or
refuse an order from a customer at a
particular price.
 To determine the impact of potential
mergers.
Scenario- A distinction between a cost
function’s time period and a cost
function’s mathematical form.

Types of cost scenario:

The short run
The long run
The learning curve
 Two alternative methods of
estimation

Engineering Analysis
Survivor method
Engineering analysis
Concerned with estimating physical
relationships between inputs and
outputs in order to estimate a
production function.
Can be used to obtain the cost
function of the firm.
Three main shortcomings of engineering
analysis

Some production processs are highly

complex.
No consideration given to indirect cost.
No consideration of optimization of
the input output relationships.
Survivor method

Originally developed by Stigler.

Only applies to long run cost
estimation.
Simply involves categorizing the firms
in the industry according to size, and
recording the growth or decline of the
different size categories.
 Three main shortcomings of
Survivor method

It does not estimate cost or unit costs at

any level of output.
It assumes that the industry is highly
competitive.
It ignores changing technology and its
impact on optimal scale.
Statistical Analysis
 Often used to estimate cost
function.
 7 steps of statistical cost estimation

Statement of Hypothesis
Model Specification
Data Collection
Estimation of Parameters
Selecting the best model
Testing a Hypothesis
Forecasting
Short run cost
At least one factor is fixed.
Changes in cost are caused mainly
by changes in the level of the variable
factor input.
 Problems in short run cost
estimation

Dynamic Environment
If time series analysis is used it must
be recognized that the cost function is
really a dynamic relationship that is
changing over time
 Use of Accounting data
Researchers are inevitably constrained to
using data collected and recorder by the firm’s
accountants.
The application of these principles to cost estimation
involves:
 Adjustment for changes in price
Price of labor, materials and other inputs
must be adjusted so that current prices are
used.
 Measurement of Depreciation
Accountants often measure depreciation
on essentially arbitrary basis from economists
viepoint
Multiproduct firms
Two possible approaches:
 Combination of product into a single
output variable.
 Estimating separate cost functions for
different products.
Timing of Cost
Spillover effects- There is a danger of
recording cost in the wrong time period.