ECON254

Lecture 3
Cost concepts for decision making
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OUTLINE
The purpose of this lecture is to:
•explain the difference between alternative types of
cost
•explain why different types of cost are relevant to
different types of decision
•explain the use of incremental analysis in decision
making
•to explore the ways in which costs can be reduced in
the long run and the strategic implications of different
sources of cost advantage
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COSTS FORMULAS
OUTLINE/ RECAP
 Total costs:
 Total Fixed Cost (TFC) = all costs fixed in short-run
 Total Variable Cost (TVC) = all costs variable in the short-run
 TVC and the law of diminishing returns
 Total Cost (TC) = TFC + TVC

 Average (or ‘per unit’) costs:

 Average Fixed Cost (AFC) = TFC/Q
 Average Variable cost (AVC) = TVC/Q
Marginal Cost!
 Average (Total) Cost (AC) = TC/Q MC is the increase in
(AC) = AFC + AVC TC as a result of a 1
unit increase in Q.
Therefore MC is the
 Marginal Cost (MC) = ΔTC/ΔQ rate of change (or
‘slope’) of the TC curve
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AN EXAMPLE OF THE
COSTS OF PRODUCTION
Total Total Average
Output per Total fixed variable Average variable Average Marginal
day costs costs Total costs fixed costs costs Cost Total costs Cost
Q (TFC) (TVC) (TC) (AFC) (AVC) (AC)   (TC)  (MC)
0 10.00 0.00 10.00 - - - 10.00
5.00
1 10.00 5.00 15.00 10.00 5.00 15.00 15.00
3.00
2 10.00 8.00 18.00 5.00 4.00 9.00 18.00
2.00
3 10.00 10.00 20.00 3.33 3.33 6.67 20.00
1.00
4 10.00 11.00 21.00 2.50 2.75 5.25 21.00
2.00
5 10.00 13.00 23.00 2.00 2.60 4.60 23.00
3.00
6 10.00 16.00 26.00 1.67 2.67 4.33 26.00
4.00
7 10.00 20.00 30.00 1.43 2.86 4.29 30.00
5.00
8 10.00 25.00 35.00 1.25 3.13 4.38 35.00 6.00
9 10.00 31.00 41.00 1.11 3.44 4.56 41.00 7.00
10 10.00 38.00 48.00 1.00 3.80 4.80 48.00 8.00
11 10.00 46.00 56.00 0.91 4.18 5.09 56.00
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4 MINUTE QUIZ!
Complete the following table to test your understanding of the key cost and profit concepts:

Quantity Total Total Total Average Average Average Marginal Average Total Profit
fixed variable cost fixed variable total cost Revenue Revenue
cost cost cost cost cost (Price)

1 100 20 120 100 20 120 20 100 100 -20

2 100 35 135 50   17.5 67.5 15 60 120 -15

3 100 40 140  33.33 13.3333 46.6667 5 50 150 10

4 100 50 150 25 12.5 37.5  10 30 120 -30

5 100 65 165 20 13  33 15 20 100 -65

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AN EXAMPLE OF THE ‘Totals’ don’t
COSTS OF PRODUCTION communicate
much to us!

TC

TVC

TFC
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AN EXAMPLE OF THE
COSTS OF PRODUCTION ‘Averages’ &
‘marginals’
communicate
the current
position of the
firm well!

MC

AC
AVC

AFC
 THE RELATIONSHIP 8
BETWEEN AVERAGE &
MARGINAL COSTS

MC Diminishing
AC marginal returns:
Costs (£)

When more of a variable

Diminishing marginal
returns set in here
factor (e.g. labour) is
added to a fixed factor
(e.g. a kitchen), then
initially output rises
quickly, but as we keep
adding more and more
MC always (workers) leads to
intersects the AC smaller and smaller (i.e.
curve through it’s diminishing) additions to
lowest point
output.

Output (Q)
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IMPORTANCE OF
AVERAGE COSTS
Average cost concepts are useful for two decisions:
1)What price to charge.
2)Deciding whether or not to continue to produce.

Example:
Both of the firms in the following scenarios are currently making a
loss – should either continue to produce?
•Firm A: fixed cost £100, variable cost £100, revenue £90.
•Firm B: fixed cost £100, variable cost £100, revenue £110.

Short-run shut down Price : When Price = AVC

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REVENUE & PROFIT
OUTLINE / RECAP
Defining total, average and marginal revenue:

Given a simplifying assumption – all produced is sold:

• Total Revenue: TR = P × Q
Marginal Revenue!
• Average Revenue: AR = TR / Q MR is the increase in
TR as a result of a 1
• Marginal Revenue: MR = TR / Q
unit increase in Q
sold.
Therefore MR is the
rate of change (or
Profit:
‘slope’) of the TR
curve
• Profit: π = TR - TC
• Average (or per unit) profit: π/Q = AR - AC
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PROFIT MAXIMISING
The marginal cost conditions are important for
determining the profit maximizing output of a firm:

£ MC

AC • Here we have
overlaid revenue
P=AR & cost curves
PROFIT • Profit maximised
at output where:
AC MC = MR

AR

MR
O Qm Q
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QUESTIONS?
Either:

Or:

Question / Discussion Board

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‘ECONOMIC’ COSTS AND
PROFIT
The accounting process deals only with explicit costs.

Economics is concerned with full costs - opportunity costs.

Therefore it also considers implicit costs.

The firm pays out to:

•Labour costs (Workers) – Wages
•Land – Rent
•(Raw materials – an explicit cost)
•Capital – interest
•Entrepreneurship – ‘normal’ Profit (explains zero supernormal
profit in competitive markets)
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INCREMENTAL
COSTS & REVENUES
Incremental Costs are costs incurred due to a decision.
In any managerial decision:
•only take into account costs and revenues that are actually affected
by the decision
•take into account all the costs and revenues affected by the
decision
 If Incremental Revenues > Incremental Costs: then proceed

Sunk Costs are non-recoverable costs, they are therefore NOT

relevent to the decision
DEFINITION: sunk costs are costs incurred in the past which cannot
be recovered e.g. by selling the asset.
TYPES OF 15
INCREMENTAL
COSTS
There are 3 main categories of relevant incremental costs:

1) Present Period Explicit Costs

2) Opportunity Costs

3) Future Costs
TYPES OF 16
INCREMENTAL
REVENUES
There are 2 main categories of incremental revenues:

1) Direct Returns

2) Costs avoided
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SHORT-RUN VERSUS
LONG-RUN COSTS
The defining difference between short-run and long run
is that:
•In the short-run at least one factor is fixed
• Hence the of existence diminishing marginal returns
•In the long run all factors can be varied.
• This means the scale of the operations can be altered.
• Each possible scale of operations will have its own
associated short-run average cost curve (SRAC).
• Output scale based on demand forecasts
 DERIVING LONG-RUN 18

AVERAGE COST CURVES:

FACTORIES OF FIXED SIZE

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3 LRAC

1 factory 5 factories
Costs

2 factories 4 factories
3 factories

O
Output
 LONG-RUN AVERAGE 19
COST CURVES
MINIMUM
All areas above the LRAC
are attainable levels of cost

LRAC
Costs

Minimum Point

All areas below the LRAC are

unattainable levels of cost LRAC envelopes
the SR cost curves

O
Output
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TYPICAL LONG-RUN
AVERAGE COST CURVE

Economies Constant Diseconomies LRAC

Costs

of scale costs of scale

Increasing Decreasing
returns to returns to
scale up scale from
to here here

O Output
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RETURNS TO SCALE
There are different possible returns to increasing scale
of production:
Increasing returns to scale
 if increasing your inputs gives a more than proportionate
increase in output
 Probably benefiting from economics of scale/scope
Constant returns to scale
 if increasing your inputs gives you a proportionate increase
in output
Decreasing returns to scale
 if increasing your inputs gives a less than proportionate
increase in output
 Probably suffering from diseconomies of scale/scope
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• Specialisation /
division of labour
• Multi-stage
production
• Greater efficiency
from large machines
• Indivisibilities
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ECONOMIES OF
SCOPE
• Formally – Economies of scope when the costs of joint
production are less than the costs of separate production.
• Generally – Economies of scope when increasing the range of
products produced by a firm, it also reduces the cost of
producing each one.
There are three key sources of economies of scope:
1) Common inputs;
2) Inputs which can be leveraged at low cost from one application
to another;
3) By-products.
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ECONOMIES OF
SCOPE
Economies of scope can have profound strategic
implications:
1.Can overcome benefits of incumbent firms, thus
reducing barriers to entry;
2.Can erect a barrier to entry requiring a full product
range to enter the market.
3.Show imperative for firms to find additional revenue
streams which they can exploit.
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4 MINUTE QUIZ
Identify (make a list of) sources of economies of scale
and scope evidenced in this feature of Amazon.com:
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FACTORS CAUSING
COSTS TO FALL
There are a range of dynamic sources of cost advantage which
firms need to exploit.
1. External economies from geographical concentration of specialist
suppliers.
2. Firms can reduce costs by process innovations.
• Discovering new sources of supply
• Discovering new ways of working (e.g. standardisation, specialisation)
• Improved organizational design / Resource Management.
• Entrepreneurs play an important role

3. Choice of location.
• Availability, suitability and cost of factors of production.
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FACTORS CAUSING
COSTS TO FALL
4. Experience curve effect (lowers costs)
•Workers more practiced (lowers labour cost)
•Managers are better able to organise production via:
• Standardisation,
• Specialisation,
• Optimising resource mix,
• Networking for resources
• or even Product redesign.
• Even by observing firms in apparently unrelated fields.
•Important strategic implications - maintaining a dominant position.
Although not infinite, subject to a ‘sudden stop’!
•However, on the flip side - too much emphasis risk losing flexibility
and innovation.
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EXAMPLES
Research by Boston Consulting Group in 1960s showed costs typically
reduced by 20-30% (real terms) each time experience doubled.

To produce 100 goods, MC labour = £100,000

200 goods, MC labour = £80,000 (80% of £100,000)
400 goods, MC labour = £64,000 (80% of £80,000)
80% Learning Curve Effect

Research by NASA (1978) finds ‘improvement curves’:

• Complex machine tools for new models 75-85%
• Repetitive electrical operations 75-85%
• Shipbuilding 80-85%
• Aerospace 85%
• Purchased Parts 85-88%
• Repetitive welding operations 90%
• Repetitive electronics manufacturing 90-95%
• Repetitive machining or punch-press operations 90-95%
• Raw materials 93-96%
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PRODUCTIVITY
Controlling costs includes ensuring an optimum level of
productivity.
The production function focuses on the ability to supply.
Where Inputs: Raw materials; Capital (K) and Labour (L)
•Simplest case: Q = f(K,L)

In the short-run, capital may be fixed so: Q = f(K*,L)

The managers only short-run decision is how much labour to hire.
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EXAMPLE
Observe changes in output as increase units of labour

Fixed Variable Marginal Average

Input Input Change in Product of Product of
(Capital) (Labour) Labour Output Labour Labour
K* L ∆L Q MPL=∆Q/∆L APL=Q/L
2 0 - 0 - -
• Total Product = Q
2 1 1 76 76 76
shows total amount
2 2 1 248 172 124
production
2 3 1 492 244 164 • Marginal Product
2 4 1 784 292 196 shows the increase
2 5 1 1100 316 220 in product from
(2)
2 6 1 1416 316 236 each worker.
2 7 1 1708 292 244 • Average Product
(3) 2 8 1 1952 244 244 shows the average
2 9 1 2124 172 236 contribution per
(1) 2 10 1 2200 76 220 worker to output
2 11 1 2156 -44 196
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EXAMPLE
(1)

TPL

(2)

(3)

APL

MPL
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OPTIMAL AMOUNT OF
A VARIABLE FACTOR
The optimal amount of any variable factor to employ is where the
marginal cost just equals the marginal benefit.
i.e. in the case of labour this is where:
The marginal cost of labour
MCL = VMPL (MCL) EQUALS the value of the
Where: marginal product of labour
(VMPL):
VMPL = P*MPL
MCL = w

What if the wage rate (w) was $400 in our example?

The market price of output is a given P* = $3
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EXAMPLE
Variable Marginal Value Marginal Unit cost of
Input Price of Product of Product of labour
(Labour) output Output Labour Labour (wages)

L P Q MPL=∆Q/∆L VMPL=P*MPL w
0 3 0 - - 400
1 3 76 76 228 400
2 3 248 172 516 400
3 3 492 244 732 400
4 3 784 292 876 400
Here the value
5 3 1100 316 948 400
of labour output
6 3 1416 316 948 400 is greater than
7 3 1708 292 876 400 cost
8 3 1952 244 732 400
9 3 2124 172 516 400
10 3 2200 76 228 400
Here it is less
11 3 2156 -44 -132 400

This corresponds with our theory, the market value of labour is the value
marginal productivity, i.e. we expect the wage rate w = VMPL
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LONG RUN
In the long-run, Capital can be increased.
Manager uses short-run calculations of marginal productivity to
decide future investment in capital (K).
If operating in decreasing returns to labour, may suggest more
capital for next period.

Example
Point 2 - peak MPL (with K*=2) was between 5&6 units of labour.
At 9 workers employed (slide 33), operating in decreasing returns
to labour portion of marginal productivity curve.
Depending on cost of capital, suggests in next period employ
another unit of capital.
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QUESTIONS?
Either:

Or:

Question / Discussion Board

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SUMMARY
• First we recapped formulas for common costs, i.e. TC, AC, MC and
explain the difference between alternative types of cost (i.e. fixed and
variable) including average of these, including looking at these
graphically.
• We also considered costs and revenues combined to determine profits.
• We then explained why different types of cost are relevant to different
types of decision, including the use of incremental analysis in decision
making.
• We also explored the ways in which costs can be reduced in the long run
and the strategic implications of different sources of cost advantage.
• Sources of cost advantage included economies of scale and scope and
other factors causing costs to fall.
• We finally considered productivity and the optimal amount of a variable
factor.
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READING
Core Text:
•Sloman, Garrat, Guest & Jones (2016) Chapters 9-10
Other Texts:
•Begg & Ward (2016) Chapter 3
•Earl & Wakeley (2004) Chapters 6
•Jones (2004) Chapter 7 (p1331-141) & 8
•McAleese (2004) Chapter 5