Chapter 7

The Theory and

Estimation of Cost

Copyright 2011 Pearson Education,

Chapter Seven 1
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 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
Copyright 2011 Pearson Education,
Chapter Seven 2
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 Learning objectives

define the cost function

distinguish between economic cost

and accounting cost

explain how the concept of relevant

cost is used

Copyright 2011 Pearson Education,

Chapter Seven 3
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 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
Copyright 2011 Pearson Education,
Chapter Seven 4
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 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
Copyright 2011 Pearson Education,
Chapter Seven 5
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 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
Copyright 2011 Pearson Education,
Chapter Seven 6
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 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

Copyright 2011 Pearson Education,

Chapter Seven 7
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 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
TVC W
MC
Q MP
The law of diminishing returns (Chapter 6)
implies that MC will eventually increase
Copyright 2011 Pearson Education,
Chapter Seven 8
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 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

Copyright 2011 Pearson Education,

Chapter Seven 9
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 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
Copyright 2011 Pearson Education,
Chapter Seven 10
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 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)

Copyright 2011 Pearson Education,

Chapter Seven 11
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 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 firms inputs,
TC = TFC + TVC

Copyright 2011 Pearson Education,

Chapter Seven 12
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 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
Copyright 2011 Pearson Education,
Chapter Seven 13
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 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 firms inputs
AC = AFC + AVC = TC/Q
Marginal cost (MC) is the change in a
firms total cost (or total variable cost)
resulting from a unit change in output
MC = TC/Q = TVC/Q
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Chapter Seven 14
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 Short-run cost function
Graphical example of the cost
variables

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Chapter Seven 15
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 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
Copyright 2011 Pearson Education,
Chapter Seven 16
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 Short-run cost function
A reduction in the firms fixed cost
would cause the average cost line to
shift downward

A reduction in the firms variable

cost would cause all three cost lines
(AC, AVC, MC) to shift

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Chapter Seven 17
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 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

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Chapter Seven 18
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 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

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Chapter Seven 19
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 Long-run cost function
In the long run, all inputs to a firms
production function may be changed

because there are no fixed inputs,

there are no fixed costs
the firms 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
Copyright 2011 Pearson Education,
Chapter Seven 20
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 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
Copyright 2011 Pearson Education,
Chapter Seven 21
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 Long-run cost function
Economies of scale: situation where a
firms long-run average cost (LRAC)
declines as output increases

Diseconomies of scale: situation

where a firms LRAC increases as output
increases

In general, the LRAC curve is u-shaped.

Copyright 2011 Pearson Education,
Chapter Seven 22
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 Long-run cost function
Reasons for long-run economies

specialization of labor and capital

prices of inputs may fall with volume
discounts in firms 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
Copyright 2011 Pearson Education,
Chapter Seven 23
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 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
Copyright 2011 Pearson Education,
Chapter Seven 24
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 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

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 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

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Chapter Seven 26
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 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
Copyright 2011 Pearson Education,
Chapter Seven 27
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 Economies of scope
Economies of scope: reduction of a
firms unit cost by producing two or
more goods or services jointly rather
than separately

Closely related to economies of scale

Copyright 2011 Pearson Education,

Chapter Seven 28
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 Supply chain management
Supply chain management (SCM): efforts
by a firm to improve efficiencies through
each link of a firms 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
Copyright 2011 Pearson Education,
Chapter Seven 29
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 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
Copyright 2011 Pearson Education,
Chapter Seven 30
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 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
Copyright 2011 Pearson Education,
Chapter Seven 31
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 Global application
Example: manufacturing chemicals in
China

labor content relatively low

high use of equipment and raw
materials
noncost reasons for outsourcing

Copyright 2011 Pearson Education,

Chapter Seven 32
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