Theory and Estimation of Cost

Chapter 8
The Theory
and
Estimation of
Managerial Economics:
Cost
Economic Tools for Today’s
Decision Makers, 4/e By Paul
Keat and Philip Young
Before We Start…Group Presentation
• So popular?
Q = aLbK1-b or c
• b+c > 1 IRTS
• b+c = 1 CRTS
• b+c < 1 DRTS
• Short Run Analysis: MPK = c Q/K

& MPL = b Q/L
• b & c are elasticities of K & L

factors
• LogQ=loga+blogL+clogK + dlogT
where T  technology
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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
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?

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?
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?
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.

Production and Cost
Total
• Total variable cost Input TVC
(L) Q (TP) MP (wL)
(TVC) is associated
0 0 0
with the variable 1 1,000 1,000 500
input 2 3,000 2,000 1,000
3 6,000 3,000 1,500
• Assume w=$500 4 8,000 2,000 2,000
per unit (price- 5 9,000 1,000 2,500
6 9,500 500 3,000
taker) 7 9,850 350 3,500
8 10,000 150 4,000
9 9,850 -150 4,500
Production and Cost
• TP and TVC are mirror images of
each other
Kings Dominion
Example
Production and Cost
• Total cost (TC) is the cost associated
with all of the inputs. It is the sum of
TVC and TFC.
• TC=TFC+TVC
• Marginal Costs Tool Set for
Production Cost
• Average Costs Analysis
vs.
Production Process Analysis

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

Production and Cost
Total
• Add marginal Input TVC
(L) Q MP (wL) MC
cost to the 0 0 0
table 1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
Production and Cost
Total
• Observe that: Input TVC
(L) Q MP (wL) MC
• When MP is 0 0 0
increasing, 1 1,000 1,000 500 0.50
MC is 2 3,000 2,000 1,000 0.25
decreasing. 3 6,000 3,000 1,500 0.17
• When MP is 4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
decreasing, 6 9,500 500 3,000 1.00
MC is 7 9,850 350 3,500 1.43
increasing. 8 10,000 150 4,000 3.33
9 9,850 -150 4,500
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?

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)
• Add ATC = AFC + AVC to the table

• ATC = AFC + AVC

• Production cost graph or map is

• 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?
• Important Map Observations

• What is the economic significance of q*?

• Average total cost (ATC) is the
average per-unit cost of using all of the
firm’s inputs (TC/Q)
• At Q* - ATC is minimized or inputs
are used most efficiently given the
production function
Going at 55 MPH

• 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. Computer Chip
Case
• A change in input
prices will shift
the cost curves.
• If variable input
costs are reduced
then MC, AVC,
and AC will all
shift downward.
Airline Industry
2003 Prentice Hall Business Publishing Managerial Case
Economics, 4/e Keat/Young
• Yahoo Group
Discussion
• What is different
about dot.com
businesses?
Irrational
Exuberance
The LR Relationship Between
Production and Cost
• In the long run, all inputs are variable.
• What makes up LRAC?

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

• 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?
• 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

• Reasons for Diseconomies of Scale…
 Decreasing returns to scale
 Input market imperfections
 Management coordination and control
problems

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.
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

Production Cost Homework
• Page 378
• Problem 10

Theory and Estimation of Cost

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Theory and Estimation of Cost

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Chapter 8

• Short Run Analysis: MPK = c Q/K

• b & c are elasticities of K & L

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

TC (TFC  TVC ) TFC TVC TVC

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Law of diminishing returns implies that

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

• Important Map Observations

• In general, ATC is u-shaped. Why?

• MC intersects the minimum point (q*) on

• Important Map Observations

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Is LRAC a function of market size?

• Reasons for Economies of Scale…

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

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