1. The Theory and Estimation of Cost
Chapter 7
The Theory and Estimation of Cost
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

2. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

3. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Learning objectives
define the cost function
distinguish between economic cost and accounting cost
explain how the concept of relevant cost is used
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

4. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

5. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

6. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

7. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

8. 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
The law of diminishing returns (Chapter 6) implies that MC will eventually increase
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

9. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

10. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

11. 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)
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

12. 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 firm’s inputs,
TC = TFC + TVC
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

13. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

14. 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 firm’s inputs AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a firm’s total cost (or total variable cost) resulting from a unit change in output MC = DTC/DQ = DTVC/DQ
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

15. Short-run cost function
Graphical example of the cost variables
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

16. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

17. Short-run cost function
A reduction in the firm’s fixed cost would cause the average cost line to shift downward
A reduction in the firm’s variable cost would cause all three cost lines (AC, AVC, MC) to shift
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

18. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

19. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

20. Long-run cost function
In the long run, all inputs to a firm’s production function may be changed
 because there are no fixed inputs, there are no fixed costs
 the firm’s 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

21. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

22. Long-run cost function
Economies of scale: situation where a firm’s long-run average cost (LRAC) declines as output increases
Diseconomies of scale: situation where a firm’s LRAC increases as output increases
In general, the LRAC curve is u-shaped.
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

23. Long-run cost function
Reasons for long-run economies
specialization of labor and capital
prices of inputs may fall with volume discounts in firm’s 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

24. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

25. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

26. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

27. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

28. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Economies of scope
Economies of scope: reduction of a firm’s unit cost by producing two or more goods or services jointly rather than separately
Closely related to economies of scale
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

29. Supply chain management
Supply chain management (SCM): efforts by a firm to improve efficiencies through each link of a firm’s 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

30. 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
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

31. 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
Chapter Seven
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32. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Global application
Example: manufacturing chemicals in China
labor content relatively low
high use of equipment and raw materials
noncost reasons for outsourcing
Chapter Seven
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.