THE COST FUNCTION: AN INTRODUCTION

How do companies determine the price that they charge to sell certain goods?
Although it might seem random, companies frequently use a cost function to
determine how many units of an item they should produce and what price they should
sell it for. The cost function is just a mathematical formula that gives the total cost to
produce a certain number of units. Let's take a more in depth look at the cost function
and see how it works.
What Is the Cost Function?
The cost function, usually denoted C(x) where x represents a positive number
and is generally an integer, represents the total cost of producing x units of an item. In
other words, if you want to know the cost of producing 50 units of an item, you would
plug in 50 for every x in the cost function, and then, using order of operations, simplify
the expression to a number, or dollar, figure.
Additional Uses of the Cost Functions
Besides the total cost, you can use the cost function to find the average
cost and marginal cost of production. To find the average cost, you will simply divide
the total cost by the total number of units produced. The marginal, or additional, cost
represents the cost of producing one additional unit of the good. In other words, if you
produce 100 battery chargers, the marginal cost will tell you how much extra it costs to
produce that 100th charger. To find the marginal cost, you will find the total cost for the
unit and subtract from it the total cost for producing one fewer unit.
Now let's see how you would actually use the cost function.
Example Problems
1. The cost function to produce x tires is given as C(x)=.012x + 5,000.
First, let's find the cost to produce 1500 tires. To find this, you can simply plug in 1500
for x and then evaluate the cost function:
C(1500) = .012*1,500 + 5,000 = $5,180
Thus, it costs $5,180 to produce 1,500 tires.

Next, let's find the average cost of producing those 1500 tires. To find this, simply
divide the total cost, $5,180, by the number of tires, 1500. You should get approximately
$3.45. Note that although it costs on average $3.45 to produce each tire, the individual
cost of producing each tire, or the marginal cost, is not $3.45. Let's see why.
To find the marginal cost of producing the 1500th tire, we can take the total cost
of producing 1500 tires and subtract from that the total cost of producing 1499 tires. We
already found C(1500) = $5,180. If you plug in 1499 for x, you should get $5,017.99.
Subtracting these two values gives $.01 or 1 cent. Thus, the marginal cost of producing
the 1500th tire is approximately one cent.
2. The cost function for a property management company is given as C(x) = 50x +
100,000/x + 20,000 where xrepresents the number of properties being managed.
First, let's find the cost of managing 500 properties. Just substitute 500 in for x into the
formula to find the answer:
C(500) = (50*500) + (100,000/500) + 20,000 = 25,000 + 200 + 20,000 = $45,200
Next, let's find the point where the total cost is minimized. Hopefully, you remember that
the minimum, or maximum, of any function can be found by taking its derivative and
setting that equal to zero to find the critical points. Then, you'll examine the critical
points to see if each is a minimum or a maximum or neither.
To find C'(x), you will have to use the power rule, and it may be helpful to
rewrite C(x) as C(x) = 50x + 100,000x^-1 + 20,000. For C'(x) you should get:
The ability to use calculus to find minima and maxima is very useful in many areas of
study. Economics is no exception. If we can maximize our profit and minimize our costs,
our business goals can approach the optimum. Below is a chart of economic terms and
formulas that will allow us to solve some economics problems and make use of our
derivative skills:
Total Cost

C(x)

Marginal Cost

C'(x)

Average Cost
Price Function

p(x)

Revenue

R(x) = x p(x)

Function
Marginal
Revenue

R'(x)

Profit Function

P(x) = R(x) - C(x)

Marginal Profit

P'(x) = R'(x)
- C'(x)

We see that whenever we find Marginal Cost or Marginal Revenue, or Marginal Profit,
we are finding the instantaneous rate of change or derivatrive. As we often want to
minimize average cost in business, it becomes important to business problem solving to
recognize that:

Example Problem:

Given the cost function:

(a) Find the average cost and marginal cost functions.
(b) Use graphs of the functions in part (a) to estimate
the production level that minimizes the average cost.
(c) Use calculus to find the minimum average cost.
(d) Find the minimum value of the marginal cost.

Given Problem, #8,

Lesson 4.7

To find average cost,

we know that we need
to use the formula: .

To find the marginal

cost, we use the
formula: C'(x)

We now move on to part (b)

We plot the graph of
the average cost (red),
and the graph of the
marginal cost (green).
By observation, it
appears that the value
of x (number of items
produced) where the
two graphs intersect is
about x = 140.

We now work on part (c)

> solve(0=.0008*x^3-.09*x^2-339,x);
-11.52974818 - 54.70830486 I, -11.52974818 +
54.70830486 I, 135.5594964

Because of our
principle that: "If the
average cost is a
minimum, then
marginal cost =
average cost," we set
the average cost
formula equal to the
marginal cost formula
and attempt to solve.
Here we need a
computer algebra
system to find the
solution to this cubic
equation. We see there
are two imaginary
solutions and one real
solution. The answer is
approximately,
This agrees
with our visual estimate
above.

Cost Function
A cost function specifies the cost C as a function of the number of items x.
Thus, C(x) is the cost of x items, and has the form
Cost = Variable cost + Fixed cost

where the variable cost is a function of x and the fixed cost is a constant. A cost function
of the form
C(x) = mx + b
is called a linear cost function; the variable cost is mx and the fixed cost is b. The
slope m, the marginal cost, measures the incremental cost per item.
Example
The daily cost to your company to print x paperback sci-fi novels is
C(x) = 3.50x + 1200 dollars.
Note that C is measured in dollars, and x is measured in books (paperback sci-fi novels,
to be precise).
The marginal cost is m = 3.5, and the fixed cost is b = 1200.
C(0) = 3.50(0) + 1200 = 1200
Cost for 100 books is:
C(100) = 3.50(100) + 1200 = 1550

For 101 books:

C(101) = 3.50(101) + 1200 = 1553.5
This is the marginal cost, m = 3.5.
In general increasing x by 1 book increases the cost by m = 3.5.
(Recall the interpretation of m.)
The daily cost to print each additional book is $ 3.5
The variable cost is $=3.5x
REVENUE FUNCTION
The revenue resulting from one or more business transactions is the total
payment received, sometimes called the gross proceeds. If R(x) is the revenue
from selling x items at a price of m each, then R is the linear
functionR(x) = mx and the selling price m can also be called the marginal

revenue.
Example
Suppose that your publishing company sells sci-fi paperbacks to a large retailer
for $6.50 per book. Then
R(x) = 6.50x dollars.
The marginal revenue is m = $6.50 per book.
PROFIT FUNCTION
The profit is the net proceeds, or what remains of the revenue when costs are
subtracted. If the profit depends linearly on the number of items, the slope m is called
the marginal profit. Profit, revenue, and cost are related by the following formula.
Profit

=
P=

Revenue Cost
RC

If the profit is negative, say $500, we refer to a loss (of $500 in this case). To break
even means to make neither a profit nor a loss. Thus, break even occurs when P = 0, or
R=C

Break Even

The breakeven point is the number of items x at which break even occurs.
Example
Going back to the sci-fi novels, we already have the cost and revenue functions:
C(x) = 3.50x + 1200 dollars.
R(x) = 6.50x dollars.

Daily cost to make x books

Revenue from the sale of x books

The Profit Function is P(x) =

P(x)

=
R(x) C(x)
=
6.50x (3.50x + 1200)
=
6.50x 3.50x 1200
=
3x 1200
Break-even occurs when the profit is zero, so set P(x) = 0, and solve for x.
3x 1200
=
0

3x =
x=

1200
400

The marginal profit is the coefficient of x in the profit function.: $3.00/item.

Thus, you should sell 400 books per day to break even, and more than that to make a
profit of $3.00 per additional book. ($3.00 is the marginal profit.)

Sometimes if it more convenient to express models in equation form:

Function and Equation Form of Mathematical Models
As an example, take a look at the above cost and revenue functions again:
C(x) = 3.50x + 1200
R(x) = 6.50x

Cost function
Revenue function

Instead of using function notation, we could express the cost and revenue functions
using equation notation:
C = 3.50x + 1200
Cost equation
R = 6.50x

Revenue equation

Here, the independent variable is x, and the dependent variables are C and R. Function
notation and equation form, using the same letter for the function name and the
dependent variable, are often used interchangeably, so we can say, for example, that
the cost equation above specifies C as a function of x.

Business Applications
In the final section of this chapter lets take a look at some applications of derivatives in
the business world. For the most part these are really applications that weve already
looked at, but they are now going to be approached with an eye towards the business
world.
Lets start things out with a couple of optimization problems. Weve already looked at
more than a few of these in previous sections so there really isnt anything all that new
here except for the fact that they are coming out of the business world.
Example 1 An apartment complex has 250 apartments to rent. If they
rent x apartments then their monthly profit, in dollars, is given by,

How many apartments should they rent in order to maximize their profit?
Solution
All that were really being asked to do here is to maximize the profit subject to the
constraint that x must be in the range
.

First, well need the derivative and the critical point(s) that fall in the
range
.

Since the profit function is continuous and we have an interval with finite bounds we
can find the maximum value by simply plugging in the only critical point that we have
(which nicely enough in the range of acceptable answers) and the end points of the
range.

So, it looks like they will generate the most profit if they only rent out 200 of the
apartments instead of all 250 of them.
Note that with these problems you shouldnt just assume that renting all the apartments
will generate the most profit. Do not forget that there are all sorts of maintenance costs
and that the more tenants renting apartments the more the maintenance costs will be.
With this analysis we can see that, for this complex at least, something probably needs
to be done to get the maximum profit more towards full capacity. This kind of analysis
can help them determine just what they need to do to move towards that goal whether it
be raising rent or finding a way to reduce maintenance costs.
Note as well that because most apartment complexes have at least a few units empty
after a tenant moves out and the like that its possible that they would actually like the
maximum profit to fall slightly under full capacity to take this into account. Again,
another reason to not just assume that maximum profit will always be at the upper limit
of the range.
Lets take a quick look at another problem along these lines.
Example 2 A production facility is capable of producing 60,000 widgets in a day and
the total daily cost of producing x widgets in a day is given by,

How many widgets per day should they produce in order to minimize production

costs?
Solution
Here we need to minimize the cost subject to the constraint that x must be in the
range
. Note that in this case the cost
function is not continuous at the left endpoint and so we wont be able to just plug
critical points and endpoints into the cost function to find the minimum value.
Lets get the first couple of derivatives of the cost function.

The critical points of the cost function are,

Now, clearly the negative value doesnt make any sense in this setting and so we
have a single critical point in the range of possible solutions : 50,000.
Now, as long as
the second derivative is positive and so, in the range
of possible solutions the function is always concave up and so producing 50,000
widgets will yield the absolute minimum production cost.
Now, we shouldnt walk out of the previous two examples with the idea that the only
applications to business are just applications weve already looked at but with a
business twist to them.

There are some very real applications to calculus that are in the business world and at
some level that is the point of this section. Note that to really learn these applications
and all of their intricacies youll need to take a business course or two or three. In this
section were just going to scratch the surface and get a feel for some of the actual
applications of calculus from the business world and some of the main buzz words in
the applications.
Lets start off by looking at the following example.
Example 3 The production costs per week for producing x widgets is given by,

Answer each of the following questions.

(a) What is the cost to produce the 301st widget?
(b) What is the rate of change of the cost at

Solution
(a) We cant just compute
as that is the cost of producing 301
widgets while we are looking for the actual cost of producing the 301 st widget. In other
words, what were looking for here is,

So, the cost of producing the 301st widget is $295.91.

(b) In this part all we need to do is get the derivative and then compute
.

Okay, so just what did we learn in this example? The cost to produce an additional item
is called the marginal cost and as weve seen in the above example the marginal cost
is approximated by the rate of change of the cost function,

. So, we

define the marginal cost function to be the derivative of the cost function or,
. Lets work a quick example of this.
Example 4 The production costs per day for some widget is given by,

What is the marginal cost when

and
?

Solution
So, we need the derivative and then well need to compute some values of the
derivative.

So, in order to produce the 201st widget it will cost approximately $10. To produce the
301st widget will cost around $38. Finally, to product the 401st widget it will cost
approximately $78.
Note that it is important to note that
producing the
imply!

is the approximate cost of

item and NOT the nth item as it may seem to

Lets now turn our attention to the average cost function. If

function for some item then the average cost function is,

Here is the sketch of the average cost function from Example 4 above.

is the cost

We can see from this that the average cost function has an absolute minimum. We can
also see that this absolute minimum will occur at a critical point with
since it clearly will have a horizontal tangent there.
Now, we could get the average cost function, differentiate that and then find the critical
point. However, this average cost function is fairly typical for average cost functions so
lets instead differentiate the general formula above using the quotient rule and see what
we have.

Now, as we noted above the absolute minimum will occur when

and this will in turn occur when,

So, we can see that it looks like for a typical average cost function we will get the
minimum average cost when the marginal cost is equal to the average cost.
We should note however that not all average cost functions will look like this and so you
shouldnt assume that this will always be the case.
Lets now move onto the revenue and profit functions. First, lets suppose that the price
that some item can be sold at if there is a demand for x units is given by
. This function is typically called either the demand function or the price function.
The revenue function is then how much money is made by selling x items and is,

The profit function is then,

Be careful to not confuse the demand function,

profit function,

- upper case P. Bad notation maybe, but there it is.

Finally, the marginal revenue function is

function is
one more unit is sold.

- lower case p, and the

and the marginal profit

and these represent the revenue and profit respectively if

Lets take a quick look at an example of using these.

Example 5 The weekly cost to produce x widgets is given by

and the demand function for the widgets is given by,

Determine the marginal cost, marginal revenue and marginal profit when 2500

widgets are sold and when 7500 widgets are sold. Assume that the company sells
exactly what they produce.
Solution
Okay, the first thing we need to do is get all the various functions that well need.
Here are the revenue and profit functions.

Now, all the marginal functions are,

The marginal functions when 2500 widgets are sold are,

The marginal functions when 7500 are sold are,

So, upon producing and selling the 2501 st widget it will cost the company
approximately $25 to produce the widget and they will see an added $175 in revenue
and $150 in profit.
On the other hand when they produce and sell the 7501 st widget it will cost an
additional $325 and they will receive an extra $125 in revenue, but lose $200 in profit.
Well close this section out with a brief discussion on maximizing the profit. If we
assume that the maximum profit will occur at a critical point such that
we can then say the following,

We then will know that this will be a maximum we also were to know that the profit was
always concave down or,

So, if we know that

then we will

maximize the profit if

equals the marginal revenue.

or if the marginal cost