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3 Main Types of Cost Functions

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The following points highlight the three main types of cost


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.

It may alternatively be expressed as:


TC = Y = a + bQ.

It is depicted in Fig. 15.2. The cost function here is derived


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.

To be more specific, if factor prices remain constant over the relevant


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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(ii) We assume away the operation of the Law of Diminishing Returns.


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.

Average cost may be expressed as:


AC = Y/Q

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where Y is total cost and Q is output.

Marginal cost may be expressed as:


MC Y/Q = b

If-the cost function is continuous, marginal cost may be expressed as

MC = d (TC)/ dQ

In both the situations, MC = b and MC is constant and is a linear cost


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.

In other words, diminishing returns to the variable factor would not be


observed. Such a function would exist for the cricket bat factory only if
the relevant range of output under consideration was very small.

Type # 2. Quadratic Cost Function:


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.

Total cost is equal to fixed cost when Q 0, i.e., when no output is


being produced. However, as Q increases, fixed cost remains
unchanged. Therefore, increases in total costs are traceable to changes
in variable cost.

It is to be highlighted that the major difference between the linear and


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.

It is quite reasonable to assume that linear cost functions exist


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.

Type # 3. Cubic Cost Function:


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.

The cubic cost function is based on three implicit


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

2. Total fixed cost remains constant at levels of output up to capacity


(as in the previous two cases).

3. With an output expansion there is an initial stage of increasing


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.