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Cost Function

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functions. The types are: 1. Linear Cost Function 2.

Quadratic Cost Function 3. Cubic Cost Function.

Type # 1. Linear Cost Function:

A linear cost function may be expressed as follows:

TC = k + (Q)

where TC is total cost, k is total fixed cost and which is a constant and

(Q) is variable cost which is a function of output.

TC = Y = a + bQ.

from the basis of following (implicit) assumptions:

(i) When output is zero, total cost is equal to total fixed cost.

Moreover, the shorter the short run, the more certain is the manager

that fixed costs are sunk (historical) costs by definition. If total fixed

cost remains constant at all levels of output up to capacity, any

increase in total cost is traceable to change in total variable cost.

range of output, a doubling of inputs would lead to an exactly doubling

of output. In other words, there would be constant returns to the

variable factor.

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The linear cost function in Fig. 15.2 reflects the short run cost

condition of the firm. In the short run, capacity (or plant size) is fixed.

So the firm can vary its level of rate of output up to capacity (i.e., with

the existing plant).

(iii) Average (total) cost declines with an expansion of output.

AC = Y/Q

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MC Y/Q = b

MC = d (TC)/ dQ

equation. Such a constant MC curve appears as horizontal line parallel

to the output axis as in Fig. 15.3.

The shorter the short run the greater the likelihood that statistical cost

functions will have a bias towards linearity. This bias may, as Coyne

argues, may be justifiable and, in fact, reasonably valid if it

occurs over the relevant range of a firms TPP curve.

Extrapolation of linear cost functions requiring output

beyond the relevant range in either direction and used for

predictive purposes will generate misleading and

statistically insignificant results.

If we apply the linear cost function in the cricket bat example we

observe that the cost curve assumes the existence of a linear

production function. If a linear cost function is found to exist, output

of cricket bat would expand indefinitely and there would be a one-to-

one correspondence (relationship) between total output and total cost.

observed. Such a function would exist for the cricket bat factory only if

the relevant range of output under consideration was very small.

If there is diminishing return to the variable factor the cost function

becomes quadratic. There is a point beyond which TPP is not

proportionate. Therefore, the marginal physical product of the vari-

able factor will diminish.

And if TPP actually falls MPP will be negative. In other words, there is

a point beyond which additional increases in output cannot be made.

So costs rise beyond this point, but output cannot. Such cost function

is illustrated in Fig. 15.4.

We have noted that if the cost function is linear, the equation used in

preparing the total cost curve in Fig. 15.2 is sufficient. But the

quadratic cost function has one bend one bend less than the highest

exponent of Q.

being produced. However, as Q increases, fixed cost remains

unchanged. Therefore, increases in total costs are traceable to changes

in variable cost.

quadratic cost functions is the area of diminishing returns to the

variable factors). If the cost function is linear, variable cost increases

at a constant rate.

regardless of the current level of operating capacity at which the firm

is producing. Rather, the truth is that as output reaches the physical

capacity limitations of existing plant and equipment in the short run,

variable costs rise because of the operation of the Law of Diminishing

Returns (or variable proportions).

Most economists agree that linear cost functions are valid over the

relevant range of output for the firm. Over this range of output, no

statistically significant improvement on the linear hypothesis is

achieved by the inclusion of second or higher degree terms in output;

moreover, supplementary tests, such as the examination of

incremental cost ratios, , usually confirm the linear hypothesis.

In traditional economics, we must make use of the cubic cost function

as illustrated in Fig. 15.5. Such a cost function is not of much empirical

use. It does not provide statistically significant improvements over the

linear or quadratic cost function. Moreover, it is very difficult to

calculate, interpret and apply, to test statistical hypothesis regarding

cost behaviour in manufacturing concerns.

assumptions:

1. When Q = 0, total cost is equal to total fixed cost.

(as in the previous two cases).

return to the variable factor; thereafter a point is reached (the

inflection point) at which there is constant return to the variable

factor; finally, there is diminishing return to the variable factor. In

short, the cubic cost curve has two bends, one bend less than the

highest exponent of Q.

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