The Theory of Cost Focus on relevant costs in decision making Short-run issues: Recognize possibility of diminishing returns and its impact on marginal costs as output increases Long-run issues: Identify economies of scale, economies of scope and their impact on unit production costs as scale increases Understand that increasing scale does not always decrease costs

The Importance of Cost One of two major factors in profit maximizing decision What is the other? Increase sales by $1, what’s the impact on profit? Decrease cost by $1, what’s the impact on profit?

Nature of Costs Historical v. replacement Opportunity v. out-of-pocket Sunk v. incremental Explicit v. implicit Short-run v. long-run Fixed v. variable Economic v. accounting

Relevant Costs Depreciation: Accounting concept often has little relationship with the actual loss of value. Inventory: Accounting concept based on acquisition cost. Unutilized facilities: Empty space may appear to have no cost. Profitability measures: Accounting v. economic

Graphing Costs TC, TFC, TVC ATC, AFC, AVC MC See Figure 9.3, p. 330

Relationship between Production and Cost Production is a key determinant of cost AVC = TVC/Q = wL/Q = w(L/Q) = w(1/AP L ) MC = dTVC/dQ = d(wL)/dQ = w(dL/dQ) + L(dw/dQ) = w(1/MP L )

Long-Run Cost Curves The long run is the planning horizon We manage the future All inputs are variable in LR LAC often referred to as the envelope curve Refer to Figure 9.4, p. 332

Economies of Scale Output is growing proportionately faster than input use LAC is downward sloping Reasons for economies of scale

Diseconomies of Scale Output is growing proportionately slower than input use LAC is upward sloping Reasons for diseconomies of scale

Learning Curves Depicts the declining AC over time due to experience in production Algebraically: C = aQ b ; where b is negative and represents the rate that input costs decline over time log C = log a + b log Q

Cost-Volume-Profit Analysis Break-even analysis –Assuming constant prices and constant AVC Operating leverage –importance of FC in the firm’s operations –examines change in operating profit due to a change in sales volume –important concept--DOL or sales elasticity of operating profit

Typical Cost Functions TC = a + bQ - cQ 2 + dQ 3 TFC = a TVC = bQ - cQ 2 + dQ 3 ATC = a/Q + b - cQ + dQ 2 AFC = a/Q AVC = b - cQ + dQ 2 MC = b - 2cQ + 3dQ 2

Alternative Cost Functions Straight-line cost functions –TC = a + bQ –AC = a/Q + b; AVC = MC = b Increasing at an increasing rate –TC = a + bQ + cQ 2 –AC = a/Q + b + cQ; AVC = b + cQ; MC = b + 2cQ Graphical presentation