COM01P105S23U00

VIDYASAGAR UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION

THEORY OF COST
SLM NO - 23
PAPER CODE: DCOM 105
PAPER NAME: MANAGERIAL ECONOMICS
Structure
Objectives
Relevance of the Unit
23.0 Introduction
23.1 Production Costs in the Short-run
• Types of Cost
• Real cost and Opportunity Cost
• Fixed Cost and Variable Cost
• Semi-variable or Semi-Fixed Cost
• Economic Cost and Accounting Cos
• Sunk Cost and Transaction Cost
23.2 Shape of Cost Curves: Short-run and Long-run
• Shape of Short-run Cost Curve (Average Cost, Average Variable Cost and
Marginal Cost)
• Shape of Marginal Cost Curve – why it is U-Shaped
• Relation between MC and AVC
• Relation between Average Cost Curve and Marginal Cost
• Relation between Short-run and Long-run Average Cost Curve
• Why is a long-run average cost curve U-shaped and flatter than SACS ?
• The law of constant returns to scale
• The law of increasing returns to scale
• The law of diminishing returns to scale
• Long-run marginal cost curve
• Empirical Verification of the U-shaped LAC curve
• Learning Effect
• Estimation of Cost Functions
• Estimation of Typical Short-run Costs
• Estimation of Short-Run Costs at Rockford Enterprises: An Example
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23.3 Derivation of Cost Functions from Production Functions
• Graphical Derivation of Cost curves from Production Function
• Formal Derivation of Cost Curves from a Production Function
• Summary
• Glossary
• Self-assessment Questions
• References
Objectives
1. To define production costs and its different types.
2. To acquaint the readers with behavior of short run and long run cost curves; relationship between
average fixed cost (AFC), average variable cost (AVC) and average cost (AC) curves;
relationship between average cost (AC) and marginal cost (MC) curves; Laws of returns to scale
and their impact on the shape of the long term cost curve, and
3. To give the readers an exposure to the empirical verification of the U-shaped LAC (long run
average cost) curves and to the estimation of cost functions with examples.
Relevance of the Unit

This unit addresses an important area under managerial economics that deals with an in-depth
analysis of different aspects of cost in a business unit. The knowledge that students would gain
from this study material is expected to become highly relevant for fulfilling their academic
interests. The knowledge on theoretical and conceptual aspects of cost has significant practical
implications also.
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23.0 Introduction
Cost exists because resources are scares and productive and have alternative uses. When society
uses a specific combination of resources to produce some product, it forgoes all alternative
opportunities to use those resources for other purposes. The major of the economic cost, or
opportunity cost, of any resource is the value or worth it would have unit’s best alternative use.
There are many other costs such as explicit and implicit costs, economic and accounting costs,
fixed and variable costs, semi-variable costs, sunk cost etc. These the definitions and behaviour
of these costs with reference to levels of production along with their shapes presented in
graphical forms have been discussed in this unit.
23.1 Production Costs in the Short-run

A producer produces a product and sells it in the market to the consumers. This is how the
producer earns revenue from the sale of his/her product. But while a producer / a firm produce
the product, some cost is incurred. Cost of producing the product is called production cost. As
production is defined as the creation of goods and services from inputs or resources such as
labor, machinery and other capital equipment, land, raw material, etc, the costs of these inputs or
resources are called production cost.
Types of Cost
1. Real cost and Opportunity Cost
Real costs are sometimes called imputed costs. These costs are not actually incurred but would
have been incurred if the owned self-factors were not available and used in production.
Example of real cost is the cost of self-employed labor, machinery, land etc. Suppose, a person
uses his own mower to trim his own garden lawn. While he estimates the cost of trimming the
lawn, he does not consider this cost, because he has not paid the cost of using his own mower to
himself. But if he would have to hire this mower from someone else, then the cost of trimming
using a mower should have been included in the calculation of total cost. Because of this reason,
management must not ignore it in making business decisions, though this cost is not recorded in
the accounts book.
Opportunity Cost of goods and services is measured in terms of revenue which could have been
earned by employing those goods and services in some other alternatives uses. It can be defined
as the cost of the best alternative or opportunity foregone.
Let us consider an example of opportunity cost. Suppose a textile mill has a spinning section and
a weaving section. Yarn produced in the spinning section is used in the weaving section. It could
be also sold in the market at the ruling market price. Therefore, the opportunity cost of yarn is
equal to the price that could have been earned by selling the yarn in the market. Suppose the
market price of yarn is Rs. 5 per Kg. then the opportunity cost of yarn is Rs.5 per Kg. only. To
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give another example, suppose you spend as extra hour watching TV you could have used that
extra one hour to do some computer works that would have brought you Rs. 300, or you could
use that extra one hour to prepare a lecture for which you would have been paid Rs. 500, or you
could have used that extra one hour doing some stock market business that would have fetched
you Rs. 400. The opportunity cost of watching TV for one extra our Rs. 500 that you lost by not
preparing your lecture during that time, since that was the best that you could have done
otherwise, or that was the maximum earning you have forgone.
2. Fixed Cost and Variable Cost
Fixed cost are those costs which remain fixed irrespective of the level of output, of
course, up to a certain level of output beyond which the fixed cost will no more remain fixed.
The examples of fixed costs are pay and allowances of officers and staff, depreciation of Plant,
office expenses, rent of buildings, pensions and superannuation charge etc.
Variable costs are those costs which change with the change in the volume of output. The
examples of these costs are payments of wages to the labour employed, prices of raw materials
etc.
1. Semi-variable or Semi-Fixed Cost
These costs are neither perfectly fixed nor perfectly variable. They change in the same
direction with the level of output but not exactly in the same proportion. For example, the cost of
electricity consumption includes a fixed component and a variable component. The variable
component varies disproportionately with the increase in electricity consumption from one slab
to other. Another example is the cost of engaging a salesman. The salesman gets a fixed salary
and a variable commission depending upon his sales performance.
2. Economic Cost and Accounting Cost
Economic Cost: It is the sum total of the costs of both market-supplied resources and owner-
supplied resources. Costs of market supplied resources are the monetary payments to the owner
of these resources from whom producer purchases them. For example, suppose that a firm
produces a personal computer. To manufacture it, the firm requires, say an Intel Pentium Chip
and, therefore, has to pay Rs. 500 for it. This is the cost of the market-supplied resource- the Intel
Pentium Chip. There might be many other inputs in the production of the personal computer
which will be supplied by other. These costs are also known as explicit cost or payments made
out of pocket.
In addition to the out-of-pocket monetary payments, the producer of the Personal Computer may
use some owner-supplied resources ( the resources or inputs that the producer himself
supplies such as his own land-own capital or his own time for managing the firm or such other
inputs for which he does not make any out-of- pocket payments. This cost is known as implicit
cost
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The opportunity cost of using a owner-supplied resources is the least return the owner of a firm
could have received had they taken their own resources to market instead of using it themselves.
Let us illustrate this. Suppose, the owner of a firm uses his own land for doing the business.
Now, the opportunity cost of this resource is what he could have earned or received by leasing it
out to some other firm or an individual. Suppose the amount of money he could have earned by
leasing the land which he himself uses now is Rs. 5000 per annum. Then the opportunity cost of
the owner-supplied land is Rs. 5000 per annum. Similarly, we can calculate the opportunity costs
of other own-supplied resources like own fund, own managerial service etc. now, as the land is
his own, he does not pay anything for it. So, no out-of-pocket monetary or cash payments are
made in these cases. There are, therefore, called implicit cost also. Thus, the economic cost is the
sum total of two types of cost- explicit cost or costs or payments made out of pocket and implicit
or opportunity costs which is equal to the market price of the owner- supplied resources, if they
could be sold in the market.
Accounting Cost: Accounting costs are the costs or expenditures that are made out-of-pocket
which are recorded in the accounting book or statement. In other words, all explicit costs are the
accounting costs. No implicit costs, i.e., the expenditures that are not made out of pocket, are
included in the accounting cost data. They are not considered because of the problem of
calculating these costs.
These two different concepts of costs-economic costs and accounting costs- give rise to two
different concepts of profit which are- economic profit and accounting profit.
Thus,
Total economic cost = Explicit cost+ Implicit cost
= Opportunity cost of using market supplied resources
+ Opportunity cost of using owner-supplied resources.
Accounting costs = Explicit Cost
= Opportunity costs of using market supplied resources.
Economic Profit = Total revenue – Total Economic Cost
= Total revenue- (Explicit costs + Implicit Costs)
Accounting Profit =Total Revenue- Explicit Costs.
3. Sunk Cost and Transaction Costs
Sunk Costs: Sunk costs are those costs that have previously been paid and cannot be recovered.
As an example, suppose that a company’s advertising department has planned to give a 30-
second television ad, which will be aired next quarter broadcast television networks nationwide.
To execute this plan, the company has made Rs. 2 million one-time payment to the Ad
Company. The company has thereby acquired full ownership of the 30-second ad and it can run
the Ad as many times as it can without making any further payments to the advertising firm. This
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payment of Rs. 2 million is a sunk cost because it has already been paid and it cannot be
recovered even if the company decides not to use the Ad after all.
Transaction Cost: these are costs of making a transaction happen, which are additional costs of
doing business over and above the price of the good or service itself. Markets are the
arrangements that reduce the cost of making transaction. Buyers wishing to purchase something
must spend valuable line and resources finding sellers, gathering information about prices and
qualities, and ultimately making the purchase itself. Sellers, on the other hand, wishing to sell
something must spend valuable resources locating buyers (or pay a fee to sales agents to do so),
gathering information about potential buyers (e.g., verifying creditworthiness or legal entitlement
to buy), and finally closing the deal. These costs of making the transaction happen are called
transaction costs. For an easy understanding of this concept let us consider two alternative ways
of selling a used car that you own. One way to find a buyer for your car is to canvass your
neighborhood, knocking on doors until you find a buyer for your car at the price acceptable to
you. This will require a lot of your time and perhaps even involve buying a new pair of shoes.
Alternatively, you could run an advertisement in the local newspaper describing your car and
stating the price you are willing to accept for it. Even though you have to pay a fee for the ad,
you choose this alternative because the transaction costs will be lower by advertising in the
newspaper than by searching door to door.
23.2 Shape of Cost Curves: Short-run and Long-run
Shape of Short-run Cost Curve (Average Cost, Average Variable Cost and Marginal Cost)
Short-run is a period which does not permit the alterations i.e., change in the fixed
equipment and in the size of the organization. Output in the short-run can be adjusted by
changing variable factors such as materials and labor only.
The long-run is a period sufficiently long that all factors including capital can be adjusted.
In the short-run, however, output can be increased by working overtime, hiring more workers,
and operating its plants and machinery more intensively. By ‘operating the plants more
intensively’ we mean that the unused capacity of the firm, if there be any, should be utilized. For
example, if a steel firm is operating at 70per cent of capacity, the unutilized 30 per cent capacity
should be utilized to increase production in the short-run to meet the increased demand for steel.
Shape of the short-run average cost curve depends upon the shape of the average fixed
cost curve and the average variable cost curve since average (total) cost has two components
(average fixed cost and average variable cost ). As the total fixed costs remain fixed irrespective
of the level of output, average fixed cost will gradually fall with the increase in the level of
output. However, the rate of fall in average fixed cost will be slowing down as the level of output
increases. This happens because a given amount of fixed cost is divided by higher and higher
output as the amount of output produced increases. This is illustrated in Figure 23.1 below.
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Table 23.1: Output and Costs
Variable Total Total Total Total Average Average Average Marginal
Input output Fixed Variable Cost Fixed Variable Cost Cost
(Labour (units) (Q) Cost Cost (Rs.) Cost Cost (Total) (Rs.)
Unit) (2) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
(1) (3) (4) (5) (6) (7) (8) (9)
0 0 200 0 200
1 10 200 20 220 20 02 22 2
2 25 200 40 240 8.0 1.6 9.6 2.7
3 45 200 60 260 4.4 1.3 5.7 2.0
4 70 200 80 280 2.8 1.1 3.9 3.2
5 85 200 100 300 2.3 12 3.5 6.7
6 95 200 120 320 2.1 1.3 3.4 12.0
7 100 200 140 340 2.0 1.4 3.4 28.0
8 102 200 160 360 1.96 1.6 3.6 40.
AC,
AVC MC
MC AC
AVC
O output, Q
Figure 23.1
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Total Average
Fixed Fixed
Cost Cost
(F.C.) TFC (A.F.C.)
AFC
O Output O Output
Figure 23.2 Figure 23.3

The shape of the average variable cost curve and, therefore, the shape of the total fixed cost
curve can be derived from the laws of returns to a factor of production. There are three laws of
returns to a factor of production, which taken together are known as the Law of Variable
Proportions. These laws consist of (1) the law of increasing return, (2) the law of constant
return, and (3) the law of decreasing return. If the increasing return to a factor of production
occurs, then the additional production produced by one extra dose of variable input, say labor,
will continue to increase. The total variable cost, here the cost of labor, i.e. wage, will increase at
a constant rate, as more and more of labor is used since wage is assumed to be constant. But the
output will increase at an increasing rate. Therefore, the average variable cost, i.e., the cost of
labor, i.e., labor wage obtained by dividing the total variable cost by output, will be gradually
falling up to that level of output at which the law of diminishing returns will operate. Given that
there is no change in the technology of production, the law of diminishing return will inevitably
occur at a certain level of output. Once the law of diminishing returns starts operating, the output
will increase at a diminishing rate. As a result, average variable cost will gradually increase with
the increase in output since the total variable cast increasing at a constant rate is divided by the
total output that increases at a diminishing rate. This relation between the laws of returns and the
average variable cost is shown in Table 23.1 and Figures 23.2 and 23.3.
Interpretation of Table 23. 1

As the use of labor increases from 0 to 4, total output increases at an increasing rate for
each additional unit of labor, ( see column 2 ), initially by 15 (= 25-10 ), then subsequently by 20
(=45-25 ), and 25 units (=70-45 ). Once the use of labor exceeds 4, the total output increases for
each additional unit of labor, initially by 15 (=85-70), then subsequently by 10 (95-85), 5 (=100-
95) and 2 (102-100). So, increasing returns to the factor, labor, occurs during the use of labor
from 1 to 4, and then decreasing returns occur during the use of labor from 4 to 8 in this
example. Corresponding to these two production phases- the first phase of increasing marginal
returns and the second phase of decreasing returns, average fixed cost declines continuously,
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while average variable cost declines during the first phase and then rises during the second phase
of production.
Figure 23.4: Total product and Marginal product curve Figure 23.5: Relation between AVC and MC
In Figure 4, the law of increasing returns operates up to of labour use and 30 units of output.
This segment of the the TP curve is concave to the labour axis. As a result, the average variable
cost (AVC) falls continuously up to 30 units of output as shown in Figure 5. Once the firm’s
output exceeds 30 units, the output increases at a diminishing rate (see Figure 4).This segment of
the TP curve is concave to the labour axis. The average variable cost (AVC) increases in this
phase of production. Thus, over the entire range of output (O to 50 units) the AVC curve is seen
to have a U-shape. The level of output from where AVC starts increasing i.e., the AVC curve
starts moving, is called optimum level of output as unit cost of production is minimum at this
level of output. Now, we consider the average variable cost curve and the average fixed curve
together. The vertical summation of these two curves gives us the Average (total) Cost Curve
(AC). For example, at X=50 units, the total average cost, CX= average fixed Cost, aX+ average
variable cost, bX. That is, CX=ax + bx. (See Figure 23.5 below). The difference between AVC
and AC is AFC which is gradually falling with the increase in output.
Figure 23.5 shows the relation between AVC and MC. Mathematical derivation of this
relationship is given below.
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Figure 23.6
As output increases and AVC will be gradually decreasing with the increase in output. As AFC
falls very slowly as output increases AVC will be decreasing with the increase in output. We see
from Figure 6 that Ac is also U-shaped. Thus, the laws of variable proportions explain why
average variable cost curve and the average (total) cost curve are U-shaped.
Shape of Marginal Cost Curve – why it is U-Shaped

Shape of marginal cost curve is also determined by the laws of returns. When the law of
increasing returns operates, the marginal product of labour increases and when the law of
diminishing returns operate, the marginal product of labour declines. So long as marginal
product of labour increases (decreases), the marginal cost of production, the
additional variable cost, declines (increases). (Note that the fixed cost does not change. As a
result, it has no affect on marginal cost). This relationship between MC and is derived
below.
…………………(1)
Where
Differentiating TC with respect to output, Q, we obtain
 ……..(2)
 ( Cost of labour units used , Wage)
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 …………..(3)
The result (2) shows that there is an inverse relation between and MC. This is shown in
Figure 5.
Relation between MC and AVC
From (4) above, we see that

i). If AVC falls as output Q increases, if then
.
ii). If AVC increases as Q increases, if , then
iii). If AVC does not change when Q increases, then because . This means
that in this case .
Relation between Average Cost Curve and Marginal Cost

These relationships between MC and AVC shown in Figure 23.5. The marginal cost is
defined as change in the total cost (C) when one additional unit of product is produced.
Mathematically,
where dC is the change in the total cost and dQ is the
change in output produced.
Total cost, C= Average cost (AC) quantity produced, Q
i.e., C= AC Q
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Differentiating C with respect to output, Q. which gives the marginal cost, we obtain
MC
or, AC, MC
or, . AC
(1) Now if AC increases with the increase in output, Q,

i.e., if , then , that is
, since Q is positive.
O Output Q
(2) If AC does not change with the increase in output, Q, Figure 23. 7
Relation between Short-run and Long-run Average Cost Curve

Long-run Cost Curve (LAC)
Why is a long-run average cost curve U-shaped and flatter than SACS ?
The long run is defined as a period of time when all the factors of production are variable. Their
supply is unlimited in the sense that they are available in the proportion the firm wants to use
them for production. Thus, the long run production can be mathematically expressed as
Where Q=output
L= labour
K=capital
Here both the factors of production are variable. Contrast this long run production with the
short run production where is a given amount of capital. As we have seen
above that the behavior of the short run cost curves, namely, total cost curve, average cost curve
and marginal cost curve, is explained by the Laws of Returns to a factor of production, so also
the behaviour of the long- run cost curves can be explained by the Laws of Returns to scale. By
change in scale we mean change in the proportion of the factors of production. For example, it
the firm change L (labour) to and K (capital) to , then there takes place a change in
the scale of production.
Let us here discuss the laws of relations to scale. There are three laws of returns to scale,
namely, (1) the law of constant returns to scale, (2) the law of increasing returns to scale and (3)
the law of diminishing returns to scale.
The law of constant returns to scale: It states that if the firm uses of labour and
of capital, then output will increase in the same proportion. This means that
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if . In other words, it means that if the firm uses an
input combination of times of labour, i.e., , and times of capital, i.e., , (where L and K are
the original input combination) then output will increase t times of the original level of output, ,
i.e., the new level of output will be
The law of increasing returns to scale: This law states that if the firm uses an input bundle of
of labour and of capital, the output will increase more than proportionately.
Mathematically, it can be written as . This mathematical representation of
the increasing returns to scale can be interpreted in the following way: represents the
output produced by using amount of labour and amount of capital. Under the increasing
returns to scale it must be greater than t times the level of output produced by using only L
amount of labour and K amount of capital, i.e., greater than .
The law of diminishing returns to scale.
This law states that if all the inputs are increased in the same proportion, then output will also
increase less than proportionately. Thus, when this law operates the following relation between
inputs and output holds:
.
Now the question is; How will the returns to scale determine the slope of the long-run
average cost curve (LAC)? The question is addressed in the following paragraphs:
1. Constant returns to scale (CRS): In this case, when L and K, the two factors of production, are
changed in the same proportion, output also changes in the same proportion. In other words, if L
and K are changed to and respectively. Output will also change from Q to tQ. Now the
cost of producing Q amount is given by where is the wage rate and is the rate of
interest which is the price of capital. Thus,
Hence,
This result shows that the long-run average cost at Q level of output is same as the long-run
average cost at level of output. This means that in the long-run the average cost of
production remains the same at all levels of output under the constant returns to scale condition.
2. Increasing returns to scale (IRS): IN this case, increases in labour from L to tL and in capital
from K to tK will lead to more than proportionate increase in output, Q. In other words, under
the IRS condition, an increase in output from Q to tQ can be achieved by using of labour and
of capital . That is,
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.
Thus, under the IRS condition the average cost of production in the long-run (LAC) falls as
output increases from .
3. Diminishing Returns to scale: under this condition if labour and capital are increased from L to
tL and from K to tK, then output will increase from Q to . In other words, if the
diminishing returns to scale operate, an increase in output from Q to tQ will require more than
proportionate increase in L and K. Thus,
This means that the long-run average cost will gradually increase with the increase in
output.
The above three conditions taken together will result in an U-shaped (long-run) average cost
curve (see Figure 23.8).
LAC
LAC
O Q (output)
Figure 23.8
Relationship between Short-run Average Cost (SAC) curve and Long-run Average Cost
(LAC) curve:
The long run average cost (LAC) curve is an envelope of the short-run average cost
(SAC) curves. This means that an LAC will contain in it all the short-run average cost (SAC)
curves (see Figure 23.9).
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Figure 23.9
Now we shall answer why the long-run cost (LAC) curve is an envelope of the short-run
cost (SAC) curves. Suppose the firm is producing amount of output. In the short-run the
unit cost of production will be L as the short-run cost curve relevant to the production of
amount of output is . But if it is long-run the unit cost of production will be since in
the long-run the firm can change its scale of operation by building a plant of that size which has
the cost curve . ( is the point of tangency between LAC and ). If the firm produces
for a long time at OM amount of output it can be produced more cheaply with MR unit cost of
production since it is the lowest point of . It is cheaper than what could have been if the
firm used the plant size which has the cost curve . If the firm produces , it can reduce
its average cost of production by changing the scale from that which has the cost curve at
that level of output to that scale which will continue to fall, since each successive short-run cost
curve will have the lowest point on the right and below (14) the lowest point of the preceding
short-run curve. This is the outcome of economics if scale of operation. But once the
diseconomies of scale of operation states to occur, each subsequent SAC curve will shift
upwards to the right. As a result, the long-run cost curve will be having positive slope. Thus, the
lowest point of the LAC which is also the lowest point of the SAC that the corresponding to the
optimum scale of production. However, with the change in the scale of production the unit cost
of production in the long-run has the cost curve , unit cost of production of producing
amount of output will be after the change of scale of operation. Thus, by changing the
scale of operation the firm can reduce the unit cost of production so long as economics of scale
are reaped by the firm. It will go up, even after the change of scale when economics of scale turn
into diseconomies of scale. This happens since the technology of production does not change
with the change in the scale of operation. Thus, given the technology of production, the unit cost
of production will initially fall and then rise with the change in the scale of operation. In each
case, however, the unit cost will be lower than that corresponding to one scale of production. So
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the LAC curve will have U-shape and will contain short-run cost curve each corresponding to
one particular scale of production.
Long-run marginal cost curve
Given the LAC curve, the Long-run marginal Cost (LMC) curve is that curve which will
the LAC curve at the lowest point of the LAC curve from below such that the relation between
the average cost curve and the marginal cost curve is maintained although. The relations are like
this.
1) As AC (SAC or LAC) falls, MC (SMC or LMC) lies below it.
2) As AC (SAC or LAC) rises, MC (SMC or LMC0 lies above it.
3) As AC (SAC or LAC) constant, MC (SMC or LMC) is equal to AC (SAC or LAC).
The Figure is drawn below (Figure 23.10).
LAC, LMC
LMC LAC
O Q, (output)
Figure 23.10
Empirical Verification of the U-shaped LAC curve

The empirical verification of then LAC curve shows that LAC slope downwards with the
increase in the level of output (see Figure below). This L shape of the LAC curve is explained by
the economists in terms of technological change. , , , …………(see Figure
23.11) correspond to changes in the technology of production. As advanced technology of
production is adopted by the firm, the firm moves from to to and so on since
each new technology of production results in the lower unit cost of production.
From Figure 11, we see that if the firm uses one particular technology of production which
corresponds to , the unit cost of production in the long-run will be if the firm produces
amount of output. If it produces amount of output, the unit cost of production will be
, as mean while the technology of production has changed, and this new technology
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of production corresponds to . Similarly, if the firm produces amount of output, the
unit cost of production will be since in the meantime a new technology of production has
been used by the firm. This new technology is represented by .
Continuing in this way we see that unit cost of production continues to fall as the firm
produces more and more output as new technologies of production is adopted by the firm. If we
join the points , we get the LAC curve which slopes downwards although
(Figure 23.11).
LAC
Figure 23.11
Learning Effect
Another factor that contributes to lowering the long-run unit cost of production is the “Learning
effect”. As the workers, managers etc. work for a long period of time, they learn about how to
reduce the unit cost of production. Over time they acquire skill and knowledge and these
qualities of the employees help the firm to reduce the unit cost.
Estimation of Cost Function

As is the case when estimating a production function, specification of an appropriate equation for
a cost function must necessarily precede the estimation of the parameters using regression
analysis. The specification of an empirical cost equation must ensure that the mathematical
properties of the equation reflect the properties of the short-run cost curves like TVC (total
variable cost curve), AVC (average variable cost curve), and SMC (short-run marginal cost
curve) and relation among them, Figure 23.11 illustrates again the typically assumed total
variable cost, average variable cost, and marginal cost curves.
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Estimation of Typical Short-run Costs
Since the shape of any one of the three cost curves determines the shape of the other two,
we begin with the average variable cost curve. Because this curve is U-Shaped, we use the
following quadratic specification:
As explained earlier, input prices are not included as explanatory variables in the cost equation
because the input prices (adjusted for inflation) are assumes to be constant over the relatively
short time span of the time-series data set. In order for the AVC curve to be U-shaped, a must be
positive, b must be negative, and c must be positive; that is,
Given the specification for average variable cost, the specifications for total variable cost
and marginal cost are straightforward. If , it follows that
TVC SMC
AVC
O Quantity (Q) O Quantity (Q)
(a) (b)
Figure 23.11
Note that this equation is a cubic specification of TVC, which conforms to the TVC curve in
Figure 11 (a).
The equation for marginal cost is somewhat more difficult to derive. It can be shown,
however, that the marginal cost equation associated with the above TVC equation is
If, as specified for AVC, a>0, b<0, and c>0, the marginal cost curve will also be U-
shaped.
18
Because all three of the cost curves, TVC, AVC, and SMC, employ the same parameters, it is
necessary to estimate only one of these functions in order to obtain estimates of all three. For
example, estimation of AVC provides estimates of a, b, and c, which can then be used to
generate the marginal and total variable cost functions. The total cost curve is trivial to estimate;
simply add the constant fixed cost to total variable cost.
As for the estimation itself, ordinary least-squares estimation of the total or average
variable cost function is usually sufficient. Once the estimates of a, b, and c, are obtained, it is
necessary to determine whether the parameter estimates are of the hypothesized signs and
statistically significant. The tests for significance are again accomplished using either t-tests or p-
values.
Using the estimates of a total or average variable cost function, we can obtain an estimate
of the output at which average cost is a minimum. Remember that when average variable cost is
at its minimum, average variable cost and marginal cost are equal. Thus we can define the
minimum of average variable cost as the output at which.
Table 23.2
Summary of a Specification Cubic total variable cost function
for Total Variable Cost
Total variable cost
Average variable cost
Marginal cost
AVC reaches minimum point
Restrictions on parameters
AVC
Output
Figure 23.12 A Potential Data Problem
19
Using the specifications of average variable cost and marginal cost presented earlier, we
can write this condition as
or
Solving for Q, the level of output at which average variable cost is minimized is
Table 23.2 summarizes the mathematical properties of a cubic specification for total variable
cost.
Before estimating a short-run function, we want to mention a potential problem that can
arise when the data for average variable cost are clustered around the minimum point of the
average cost curve, as shown in Figure 23.12. If the average variable cost function is estimated
using data pints clustered as shown in the figure, the result is that while is positive and is
negative, a t-test or a p-value would indicate that is not statistically different from 0. This result
does not mean that the average cost curve is not U-shaped. The problem is that because there are
no observations for the larger levels of output, the estimation simply cannot determine whether
or not average cost is rising over that range of output.
Estimation of Short-Run Costs at Rockford Enterprises: An Example

In October 2003, the manager at Rockford Enterprises decided to estimate the total variable,
average variable, and marginal cost functions for the firm. The capital stock at Rockford has
remained unchanged since the third quarter of 2001. The manager collected quarterly
observations on cost and output over this period and the resulting data were as follows:
Quarter Output Average

Variable cost ($)
2001 (III) 300 $39.86
2001 (IV) 100 40.98
2002 (I) 150 29.85
2002 (ii) 250 29.71
2002 (III) 400 49.95
2002(IV) 200 34.87
2003 (I) 350 47.27
2003 (II) 450 61.84
2003 (III) 500 69.53
Average variable cost was measured in nominal (i.e., current) dollars, and the cost data
were subject to the effects of inflation. Over the period for which cost was to be estimated, costs
had increased due to the effects of inflation. The manager’s analyst decided to estimate the
influence of inflation by deflating the nominal costs. Recall that such a deflation involves
20
converting nominal cost into constant dollar cost by dividing the nominal cost by an appropriate
price index. The analyst used the implicit price deflator for GDP published in the Survey of
current Business which can be found at the website for the Bureau of Economic Analysis
(www.bea.doc.gov). The following values for the price deflator were used to deflate the nominal
cost data:
Quarter Implicit Price Deflator

( )
2001 (III) 109.92
2001 (IV) 109.78
2002 (I) 110.14
2002 (ii) 110.48
2002 (III) 110.76
2002(IV) 111.25
2003 (I) 111.90
2003 (II) 112.17
2003 (III) 112.63
To obtain the average variable cost, measured in constant (1996) dollars, for the 300 units
produced in the third quarter of 2001, $39.86 is divided by the implicit price deflator 109.92
(divided by 100), which gives $36.23
Note that it is necessary to divided the implicit price deflator by 100 because the price deflators
in the Survey of Current Business are expressed as percentages. Repeating this computation for
each of the average variable cost figures, the manager obtained the following inflation-adjusted
cost data:
Quarter Output Deflated average

variable cost ($)
2001 (III) 300 $36.26
2001 (IV) 100 37.33
2002 (I) 150 27.10
2002 (ii) 250 26.89
2002 (III) 400 45.10
2002(IV) 200 31.34
2003 (I) 350 42.24
2003 (II) 450 55.13
2003 (III) 500 61.73
Given these inflation-adjusted data, the manager estimated the cost functions. As shown
above, it is sufficient to estimate any one of the three cost curves in order to obtain the other two
21
because each cost equation is a function of the same three parameters: a, b, and c,. the manager
decided to estimate the average variable cost function:
and obtained the following printout form the estimation of this equation:
DEPENDENT VARIABLE: AVC R-SQUARE F-RATIO P-VALUE ON F

OBSERVATIONS: 9 0.9382 45.527 0.0002
VARIABLE PARAMETER STANDARD ERROR T-RATIO P-VALUE

ESTIMATE
INTERCEPT 44.473 6.487 6.856 0.0005

Q -0.143 0.0482 -2.967 0.0254
Q2 0.000362 0.000079 4.582 0.0037
After the estimates were obtained, the manager determined that the estimated coefficients
had the theoretically required signs: . To determine whether these
coefficients are statistically significant, the p-values were examined, and the extract level of
significance for each of the estimated coefficients was acceptably low (all the t-ratios are
significant at better than the 5 percent level of significance).
The estimated average variable cost function for Rockford Enterprises is,
therefore,
(^ denotes estimated value of the variable)
Conforms to the shape of the average variable cost curve in Figure ****. As emphasized
above, the marginal cost and total variable cost equations are easily determined from the
estimated parameters of AVC, and no further regression analysis is necessary. In this case,
and
To illustrate the use of the estimated cost equations, suppose the manager wishes to calculate the
marginal cost, average variable cost, and total variable cost when Rockford is producing 350
units of output. Using the estimated marginal cost equation, the marginal cost associated with
350 units is
Average variable cost for this level of output is
22
and total variable cost for 350 units of output is
The total costs of 350 units of output would, of course, be $13,569 plus fixed cost.
Finally, the output level at which average variable cost is minimized can be computed as
In this example,
At Rockford Enterprises, average variable cost reaches its minimum at an output level of 197
units, when
As you can see from this example, estimation of short-run cost curves is just a straightforward
application of cost theory and regression analysis. Many firms do, in fact, use regression analysis
to estimate their costs of production.
23.3 Derivation of Cost Functions from Production Functions

Costs are derived functions. They are derived from the technological relationships implied by
the production function. We will first show how to derive graphically the cost curves from the
production function. Subsequently we will derive mathematically the total-cost function from a
Cobb-Douglas production function.
A. Graphical Derivation of Cost curves from Production Function
The total cost curve is determined by the locus of points of tangency of successive isocost lines
with higher isoquants.
Assumptions for our example:
a) Given production function (that is, constant technology) with constant returns to scale;
b) Given prices of factors:
W=Rs 20 per man hour
R=Rs 20 per machine hour
23
The following methods of production are part of the available technology of the firm.
They refer to the quantities of L and K required for the production of one ton of output which is
the ‘unit’ level.
The cost of each method for the production of one ‘unit’ of output (given the above factor prices)
is as follows:
(Labor cost to produce one unit of output in tons = 2 man hours of labour X wage of Rs. 20 per
man hour = 2 20 =Rs. 40. Similarly, capital cost per unit of output = 6 machine hour of capital
X rental of Rs. 20 per machine hour = Rs. 120. These are the labour cost and capital cost, given
the method of production . Similarly, the labour cost and capital cost are calculated for other
methods of production .
Clearly the least-cost method of production, given our assumptions, is the second
method . This method will be chosen by the rational entrepreneur for all levels of output
(given the assumption of constant returns to scale). Table 23.4 includes some levels of output
and their respective total cost (for the chosen least-cost method of production, ). The product
expansion path is shown in figure 3.2. It is formed form the points of tangency of the isoquants.
The TC curve may be drawn from the information (on output and costs) provided by the points
of tangency. For example,
At point a,
At point b,
At point d, etc.
24
Table 23.4 Output levels and TC (for activity )
Output X Total cost AC

(in cost) (in rupees) (Rupees per ton)
0 0 150
5 750 150
10 1500 150
15 2250 150
20 3000 150
25 3750 150
30 4500 150
35 5250 150
40 6000 150
45 6750 150
50 7500 150
55 8250 150
60 9000 150
65 9750 150
70 10500 150
K
(Capital)
65
60
55
50 TC = 9,000
45
40 TC = 7,500
35
d 30 TC = 6,000
25
b 20 TC = 4,500
a 15
TC = 3,000
O X=5 X = 10 Labour (L)
Figure 23.13
25
TC
TC
3000 –
2250
1500
750
0 ! ! ! !
5 10 15 20 25 30 35 X (output)
Figure 23.14
Plotting these points on a two-dimensional diagram with TC on the vertical axis and output (X)
on the horizontal axis, we obtain the total-cost curve (Figure 23.14). With our assumption (of
constant returns to scale and of constant factor prices) the AC is constant (Rs. 150) per ‘unit’ of
output, hence the AC will be a straight line, parallel to the horizontal axis (Figure 23.15). It is
important to remember that the cost curves assume that the problem of choice of the optimal
(least-cost) technique has been solved at a previous stage. In other word, the complex problem of
finding the cheapest combination of factor inputs must be solved before the cost curve is defined.
AC
1.50 AC
0 5 10 15 20 25 30 X
Figure 15
B. Formal Derivation of Cost Curves from a Production Function

In applied research one of the most commonly used forms of production function is the Cobb-
Douglas form
26
Given this production function and the cost equation
where
We want to derive the cost function, that is, the total cost as a function of output
We begin by solving the constrained output maximization problem:

Maximize
subject to (cost constraint)
(The bar on top of C has the meaning that the firm has a given amount of money to spend on
both factors of production)
We form the ‘composite’ function
Where Lagrangian multiplier

The first condition for maximization is that the first derivatives of the function with respect to L,
K and be equal to zero:
(3.4)
(3.5)
(3.6)
From equations 3.4 and 3.5 we obtain

and
Dividing these expressions we obtain
Solving for K
Substituting K into the production function we obtain
27
The term in brackets is the constraint term of the function: it includes the three coefficients of the
production function, and the prices of the factors of production, w and r.
Solving the above form of the production function for L, we find
or,
or, (3.8)
Substituting the value of L from expression 3.8 into expression 3.7 for capital we obtain
Thus,
(3.9)
Substituting expression 3.8 and 3.9 into the cost equation we find
28
Rearranging the expression above we obtain
This is the cost function, that is , the cost expressed as a function of

(i) Output, X.
(ii) The production function coefficients, ; (clearly the sum is a measure of
the returns to scale);
(iii) The prices of factors, w, r.
If prices of factors are given (the usual assumption in the theory of the firm), cost depends only
on output X, and we can draw the usual diagrams of cost curves, which express graphically the
cost function
‘ ’ implies that all other determinants of costs, that is, the production technology
and the prices of factors, remain unchanged. If these factors change, the cost curve will shift
upwards or downwards.
29
Summary
This chapter showed how to specify and estimate a popular form of production and cost
functions: the cubic specification. We discussed how to use the results of the estimations to
investigate a variety of production and cost issues that are relevant to managerial decision
making, such as finding the point of diminishing returns and estimating the values of marginal
products and marginal costs.
Estimation of the short-run cubic production function involves estimating the two
parameters A and b. this is accomplished by regressing output on and using the technique
of regression through the origin. Once A and B are estimated to test that A is significantly
negative and B is significantly positive. Once estimates of A and B are obtained for any one of
the three product equations will also have been estimated, since A
and B are the only two parameters in all three equations. The cubic production function exhibits
all the theoretical properties discussed below.
When estimating cost equations, researchers must be careful to adjust for the effects of inflation.
The effects of inflation are removed from the data by “deflating” using price indexes, which can
be obtained from a variety of sources including the Survey of Current Business, published by the
Bureau of Economics. Analysis at the U.S. Department of Commerce, Researchers must also be
careful to use measure the cost of production.
A suitable specification for estimating a set of short-run cost curves (TVC, AVC, and
SMC) is a cubic TVC equations summarized in Table23.2 (reproduced below). If
, the total variable cost curve has the typical S-shape and average
variable cost and marginal cost are U-shaped. Average variable cost reaches its minimum value
at an output level of .
Table 23.3 gives a summary of the short-run cubic production and cost specification.
Table 23.2
Summary of a Specification Cubic total variable cost function
for Total Variable Cost
Total variable cost
Marginal cost
AVC reaches minimum point
30

Table 23.3
Summary of the
Short-Run Cubic Short-run cubic production equations
production and Total product
cost Average product of labour
Specification Marginal product of labour
Diminishing marginal returns Beginning at
Short-run cubic cost equations

Total variable cost
Marginal cost
Average variable cost reaches
minimum at
Glossary
Real costs: Costs those are not actually incurred but would have been incurred if the owned self-
factors were not available and used in production.
Opportunity cost: Cost of the best alternative or opportunity foregone.
Fixed cost: Cost that remains fixed irrespective of the level of output but up to a certain level.
Variable costs: Costs which changes with the change in the volume of output.
Costs: Costs that have previously been paid and cannot be recovered.
Law of Variable Proportions: Three laws of returns to a factor of production taken together
i.e.(1) the law of increasing return, (2) the law of constant return, and (3) the law of decreasing
return.
Self-assessment Questions
Technical problem
1. The following cubic equation is a long-run production function for a firm:
Suppose the firm employs 10units of capital.

a. What are the equations for the total product, average product, and marginal product of labour
curves?
b. At what level of labour usage does the marginal product of labour begin to diminish?
c. Calculate the marginal product and average product of labour when 10 units of labour are being
employed.Now suppose the firm doubles capital usage to 20 units.
31

d. What are the equations for the total product, average product, and marginal product of labour
curves?
e. What happened to the marginal and average product of labour curves when capital usage
increased from 10 to 20 units? Calculate the marginal and average products of labour for 10 units
of labour now that capital usage is 20 units. Compare your answer to part c. Did the increase in
capital usage affect marginal and average product as your expected?
2. A firm estimates its cubic production function of the following form
and obtained the following estimation results:
DEPENDENT VARIABLE: Q R-SQUARE F-RATIO P-VALUE ON F

OBSERVATIONS: 25 0.8457 126.10 0.0001

ESTIMATE
L3 -0.002 0.0005 -4.00 0.0005

L2 0.400 0.080 5.00 0.0001
a. What are the estimated total, average, and marginal product functions?
b. Are the parameters of the correct sign, and are they significant at the 1 percent level?
c. At what level of labour usage is average product at its maximum? Now
recall the following formulas derived I chapter @. , and .
Assume that the wage rate for labour (w) is $200.
d. What is output when average product is at its maximum?
e. At the output level for part d, what are average variable cost and marginal cost?
f. When the rate of labo r usage is 120, what is output? What are AVC and SMC at that output?
g. Conceptually, how could you derive the relevant cost curves from this estimate of the production
functions?
3. Consider estimation of a short-run average variable cost function of the form
Using time-series data, the estimation procedure produces the following computer output:
32

DEPENDENT VARIABLE: AVC R-SQUARE F-RATIO P-VALUE ON F
OBSERVATIONS: 15 0.4135 4.230 0.0407

ESTIMATE
INTERCEPT 30.420202 6.465900 4.70 0.0005

Q -0.079952 0.030780 -2.60 0.0232
Q2 0.000088 0.000032 2.75 0.0176
a. Do the parameter estimates have the correct signs? Are they statistically significant at the 5
percent level of significance?
b. At what level of output do you estimate average variable cost reaches its maximum value?
c. What is the estimated marginal cost curve?
d. What is the estimated marginal cost when output is 700 units?
e. What is the estimated average variable cost curve?
f. What is the estimated average variable cost when output is 700 units?
Applied Problems
(1) You are planning to estimate a short-run production function for your firm, and you have
collected the following data on labour usage and output:
Labour usage Output

3 1
7 2
9 3
11 5
17 8
17 10
20 15
24 18
26 22
28 21
30 23
33

a. Does a cubic equation appear to be a suitable specification, given these data? You may wish to
construct a scatter diagram to help you answer this question.
b. Using a computer and software for regression analysis, estimate your firm’s short-run production
function using the data given here. Do the parameter estimates have the appropriate algebraic
signs? Are they statically significant at the 5 percent level?
c. At what point do you estimate marginal begins to fall?
d. Calculate estimates of total, average, and marginal products when the firm employs 23 workers.
e. When the firm employs 23 workers, is short-run marginal cost (SMC) rising or falling? How can
you tell?
(2) Dimex Fabrication Co., a small manufacturer of sheet-metal body parts for a major U.S.
automaker, estimates its long-run production function to be
Where Q is the number of body parts produced daily, K is the number of sheet-metal presses in
its manufacturing plant, and L is the number of labour-hours per day of sheet-metal workers
employed by Dimex. Dimex is currently operating with eight sheet-metal presses.
a. What is the total product function for Dimex? The average product function? The marginal
product function?
b. Managers at Dimex can expect the marginal product of additional workers to fall beyond what
level of labour employment?
Reference
1. Anindya Sen: Microeconomics: Theory and Application OUP

2. Thomas C R and Maurice S C: Managerial Economics, The McGraw Hill Companies
3. Bernhiem B Douglas and Whinston M D: Microeconomics, The McGraw Hill Companies
4. Koutsoyiannis A: Modern Microeconomics, Mcmillan
34

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VIDYASAGAR UNIVERSITY

DIRECTORATE OF DISTANCE EDUCATION

1. To define production costs and its different types.

Relevance of the Unit

23.1 Production Costs in the Short-run

2 25 200 40 240 8.0 1.6 9.6 2.7

3 45 200 60 260 4.4 1.3 5.7 2.0

4 70 200 80 280 2.8 1.1 3.9 3.2

5 85 200 100 300 2.3 12 3.5 6.7

6 95 200 120 320 2.1 1.3 3.4 12.0

7 100 200 140 340 2.0 1.4 3.4 28.0

8 102 200 160 360 1.96 1.6 3.6 40.

Figure 23.2 Figure 23.3

Interpretation of Table 23. 1

Shape of Marginal Cost Curve – why it is U-Shaped

Differentiating TC with respect to output, Q, we obtain

 ( Cost of labour units used , Wage)

From (4) above, we see that

Relation between Average Cost Curve and Marginal Cost

(1) Now if AC increases with the increase in output, Q,

Relation between Short-run and Long-run Average Cost Curve

The Figure is drawn below (Figure 23.10).

Empirical Verification of the U-shaped LAC curve

Estimation of Cost Function

O Quantity (Q) O Quantity (Q)

Figure 23.12 A Potential Data Problem

Estimation of Short-Run Costs at Rockford Enterprises: An Example

Quarter Output Average

Quarter Implicit Price Deflator

Quarter Output Deflated average

DEPENDENT VARIABLE: AVC R-SQUARE F-RATIO P-VALUE ON F

VARIABLE PARAMETER STANDARD ERROR T-RATIO P-VALUE

INTERCEPT 44.473 6.487 6.856 0.0005

Average variable cost for this level of output is

23.3 Derivation of Cost Functions from Production Functions

Output X Total cost AC

B. Formal Derivation of Cost Curves from a Production Function

We begin by solving the constrained output maximization problem:

Where Lagrangian multiplier

From equations 3.4 and 3.5 we obtain

Dividing these expressions we obtain

Substituting K into the production function we obtain

This is the cost function, that is , the cost expressed as a function of

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Short-run cubic cost equations

1. The following cubic equation is a long-run production function for a firm:

Suppose the firm employs 10units of capital.

Downloaded from Vidyasagar University; Copyright : DDE, Vidyasagar University

and obtained the following estimation results:

DEPENDENT VARIABLE: Q R-SQUARE F-RATIO P-VALUE ON F

VARIABLE PARAMETER STANDARD ERROR T-RATIO P-VALUE

L3 -0.002 0.0005 -4.00 0.0005

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VARIABLE PARAMETER STANDARD ERROR T-RATIO P-VALUE

INTERCEPT 30.420202 6.465900 4.70 0.0005

Labour usage Output

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1. Anindya Sen: Microeconomics: Theory and Application OUP

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Downloaded from Vidyasagar University; Copyright : DDE, Vidyasagar University

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