Chapter 7

The Theory and

Estimation of Cost

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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 long-

run 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
per-unit 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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