ME8

•Cost Theory and estimation

•Types of costs
•Costs in the short-run
•Costs in the long-run
•Learning curves – empirical cost functions
•Break-even analysis
The Nature of Costs
• Explicit Costs: Actual Expenditures of the firms, such as on rent,
purchase of inputs
• Used for accounting purposes and are called Accounting costs
• Used in financial reporting
• Implicit Costs: value of inputs owned by the firm, but does not incur
actual expenditure such as building owned, salary of entrepreneur
• Alternative or Opportunity Costs
• Economic Costs includes the implicit costs and are used in managerial
decision making
• Ex: Raw material purchased for Rs 100, but now valued at Rs 60
• Accountant would report cost at Rs 100
• Economist at Rs 60, that is at its current or replacement value
• Failure may lead to wrong decision making
• Profit at Rs 60 and may be loss at Rs 100: Rs 60 is the relevant cost
because that is the value if sold; Rs 40 is the sunk cost
• Depreciation of machine of Rs 1000 at 10% in straight line
method gives zero value , but market value continues to be
Rs 120 then economic cost is Rs 120 and to be used for
managerial decision
• Marginal costs are change in cost if output changes by one
unit
• Incremental Costs are change in total costs from
implementing a particular decision such as introduction of
new product line, new advertising campaign
• Sunk Costs are those that are not affected by the decision
and are Irrelevant
Short-Run Cost Functions

Cost function shows minimum cost of producing various levels of

output using optimum or least cost input combinations
All inputs are valued at OC
Total Cost = TC = f(Q) comprises of
Total Fixed Cost = TFC such as costs on rental, machines,
interest payments on borrowed capital
Total Variable Cost = TVC such as those on raw materials,
fuels
TC = TFC + TVC
 Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
• From the table it is seen that first marginal cost is falling and then rising:
diminishing returns initially not operating
• TVC rises at decreasing rate(firm uses little of variable units in relation to fixed
units: law of diminishing returns not operating)
• Then law of diminishing returns sets in and TVC rises at increasing rate
• Since TC= TFC + TVC, the TC curve would have same shape as the TVC but
would lie above by the TFC at each level of output
• AVC, ATC, MC curves first fall and then rise
• AFC declines continuously
• AVC is slope of line from origin to TVC
• MC is slope of TC or TVC
• MC decreases and then increases; reaches its minimum before AVC and
intercepts from below
• AVC will have U shape
• ATC will be U shape with its minimum to right of minimum AVC( because
decreasing AFC more than increasing AVC)
 Average Variable Cost : U-shape
AVC = TVC/Q =wL/Q =w/APL
Since APL first rises, reaches a maximum, and then
falls, AVC first falls, reaches minimum and then rises,
thus giving U-shape
ATC will also be U-shaped
ATC continues to fall after the AVC begins to rise so
long as decline in AFC exceeds the rise in AVC
 U- shaped Marginal Cost can be explained similarly
TC/Q = TVC/Q = (wL)/Q= w(L)/Q =w/MP
Since the marginal product of labor first rises ,
reaches maximum, and then falls, the MC first falls,
reaches a minimum and then rises
Rising portion of marginal product reflects the
operation of law of diminishing returns
 Long-Run Cost Functions

All inputs variable

Long run depends on the industry
LTC derived from firm’s expansion path showing minimum long run costs of
producing various levels of output Long-Run Total Cost = LTC = f(Q)
For 1Q, cost is Rs 80, for 2Q the cost is Rs 100, and so on
As in case of short run, LTC first falls because of increasing returns to scale,
and then rises because decreasing returns to scale sets in
Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q and intersects LAC from
below
Slope of tangent to LTC gives LMC , and slope of line from origin to LTC gives
LAC
• U shape of SAC curve is based on law of diminishing returns
• U shape of LAC curve depends on increasing, constant, and decreasing returns
to scale
• LAC shows lowest cost of producing output when firm can build most
appropriate plant to produce each level of output
• If there are only four scales of plant, then there will be kink in the LAC
• 1 unit operate through first plant, but if 2 units to be produced then have another plant
whose cost of production will be less than that by the first plant
• More flexibility in long run to choose appropriate plant
• If 3 units then can operate with second plant if cost of producing is same as that by a
larger plant
• But as scale increases, say 4 units choose a larger plant whose cost of production is lower
• If firm can build many more scales of plant, the kinks will smoothen out
• In the limit the LAC is the tangent or “envelope” to the SAC curves and shows
the minimum average cost of producing various levels of output
• Only at one point can the firm utilize the optimum scale of plant at its lowest
point- to the left on declining portion and to the right on rising portion
• Long run is referred as planning horizon because firm build plant that minimizes
cost, and once built operates in the short run
© Oxford University Press, 2016. All rights reserved.
 Economies of scale
• LAC curve U- shaped on assumption that economies of scale at low
levels of output and diseconomies at high levels of output
• Economies of scale where outputs grow proportionately faster than
inputs- Increasing returns to scale reflected in declining LAC curve
• Assumption that input prices remain constant
• Decreasing returns to scale in rising portion
• Increasing returns because of technological and financial reasons
• Technological: division of labor, specialization, physical properties
such as doubling diameter of pipeline does not double cost
• Financial : because of bulk purchases may receive discounts, bank
loans at lower interest rates
• Decreasing returns: as scale of operation increases becomes more
difficult to manage, coordinate various operations, etc.
• In real world , increasing returns at small levels of output and
decreasing returns at larger levels of output
• At lowest point the increasing and decreasing returns balance each
other
• In real world LAC nearly flat bottom and to be L-shaped rather than U-
shaped
• Economies of scale gets exhausted and constant or near constant
returns prevail
• LAC declines continuously in case of natural monopolies such as
electricity and public transportation- govt allows single firm in such
cases
• Economies of Scope different from economies of scale: when two or
more products produced together than each alone, such as airlines
operating passenger and cargo services, or second product use by-
product of another, which is otherwise firm had to dispose at cost
 Empirical Estimation

Functional Form for Short-Run Cost Functions

Theoretical Form Linear Approximation

TVC  aQ  bQ 2  cQ 3 TVC  a  bQ

TVC a
AVC   a  bQ  cQ 2
AVC   b
Q Q

MC  a  2bQ  3cQ 2 MC  b
• Learning Curves
• As firms gain experience average cost declines, because
workers become more efficient
• Learning by doing
• Well documented in manufacturing and services sectors:
airplanes, shipbuilding
• Texas Instruments adopted this in chip production through
aggressive pricing: kept unit prices low to benefit from learning
by doing
• Low employee turnover, training are some of the deciding
factors
• Can be expressed algebraically as :C = aQb
• Estimation Form: log C = log a + b Log Q
• Use Regression analysis with historical data on cost and output
 Average Cost of Unit Q = C = aQb
Estimation Form: log C = log a + b Log Q
Cost-Volume-Profit Analysis

Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)
Breakeven Volume TR = TC

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

QBE = TFC/(P - AVC)

P = 10
TFC = 200
AVC = 5
QBE = 40
• Profit Maximisation: TR- TC
• Using Calculus, wrt output, will give the output
where profit would be maximum.
• MR= MC
• Break Even Point
• (P - AVC) is called the contribution margin per unit
• So where would be the shut-down point
• P above AVC means that after covering the VC,
there is still something left to cover the FC; which in
any case has already been incurred.
• Shut down point where P=AVC, because below this
point even the variable cost is not getting covered
 1. You are thinking of opening a hardware store. It would cost Rs
500,000 per year to rent the location and buy stock. In
addition you would have to quit Rs 50,000 per year job as an
accountant.
• Define opportunity cost
• What is your opportunity cost of running a hardware store
for a year? If you thought you could sell Rs 510,000 worth
of merchandise in a year, should you open the store?
Explain
2. You are thinking of setting up a lemonade stand. The stand
itself costs Rs 200. The ingredients for each cup of lemonade
cost Rs 0. 50.
a) What is your fixed cost of doing business? What is
your variable cost per cup?
b) Construct a table showing total cost, average total
cost, marginal cost for output levels varying from 0 to 10 gallons. (
There are 16 cups in a gallon)
3. A publishing house has estimated its total output( book),
and total cost. Assuming the firm’s total cost function as

TC = 120 + 50 Q – 10 Q2 + Q3
a) Find out the equations for TVC, AVC, and MC functions
b) The level of output at which AVC and MC are minimum.
Prove that AVC and MC curves are U-shaped
c) Find the AVC and MC for the level of output at which
AVC curve is minimum
• Suppose total revenue and cost functions are as given
below
• TR = 50,000 Q – 5Q2
• TC = 5000 + 10Q + 4Q2
•  Determine the output that will maximise the revenue
• If the agents’ commission is 10%, what will be the agents’
earning
• Determine the output that will maximize the profit, and the
agents’ commission thereon.