Theory of Cost

Copyright © 2018 Pearson India Education Services Pvt.
Ltd
Chapter 7
The Theory and Estimation

of Cost
Managerial Economics, 7e Authors: Keat, Young, Erfle and Banerjee

Chapter Outline
• Importance of cost in managerial decisions
• Definition and use of costs in economic analysis
• Relationship between production and cost
• Short-run cost function
• Long-run cost function
• Learning curve
• Economies of scope and scale
• Supply chain management
• Ways companies have cut costs to remain competitive
Learning Objectives
• Define the cost function and the difference between the short
and long run
• Distinguish between economic cost and accounting cost
• Explain how the concept of relevant cost is used in economic
analysis
• Define total, variable, average and fixed cost
• Explain the linkage between the production and cost function
• Provide reasons for the existence of economies of scale and
scope
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
– Consolidation of shared services
– Outsourcing components of the business
– Mergers and consolidation (usually with a
reduction in employees)
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
Definition and Use of
Cost in Economic Analysis
• Incremental cost: varies with the range of
options available in the decision The total cost incurred due to an
additional unit of product being
produced.
• Sunk cost: does not vary in accordance with

decision alternatives
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
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 Variable input= No of
units * Unit price
• Marginal cost (MC) = the rate of change in
total variable cost
– The law of diminishing returns implies that MC

will eventually increase
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
Short-run Cost Function
• Short-run cost function 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
• More short run cost function assumptions.
– 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
• 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)
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

firm’s inputs,
TC = TFC + TVC
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
function:
– Average total cost (AC) is the average per-unit

cost of all the firm’s inputs
AC = AFC + AVC = TC/Q
– Marginal cost (MC) is the change in a firm’s total

cost (or total variable cost) resulting from a unit
change in output
MC = DTC/DQ = DTVC/DQ
• Graphical example of the cost variables
• 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
Two critical relationships:
• Productivity and cost are inversely related.

Productivity reduces the cost of the firm in form of lesser labor requirements and lesser
operating time. So, it reduces costs. Higher productivity is associated with lower costs.
• The marginal cost pulls average either up or

down depending on if it is above or below
average.
• A reduction in the firm’s fixed cost would
cause the average cost line to shift downward
• A reduction in the firm’s variable cost would

cause all three cost lines (AC, AVC, MC) to shift
downward.
• 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
• 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
Long-run Cost Function
• In the long run, all inputs to a firm’s
production function may be changed
– Because there are no fixed inputs, there are no

fixed costs
– The firm’s long run marginal cost pertains to
returns to scale
– In general, at first firms achieve increasing returns
to scale, then as they mature they have constant
returns, then they may experience decreasing
returns to scale

Theory of Cost

Uploaded by

Copyright:

Available Formats

Theory of Cost

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Theory of Cost

Uploaded by

Copyright:

Available Formats

Copyright © 2018 Pearson India Education Services Pvt.

The Theory and Estimation

Managerial Economics, 7e Authors: Keat, Young, Erfle and Banerjee

– Most common: reduce number of people on the

• Historical cost: cost incurred at the time of

• Opportunity cost: amount or subjective value

• Sunk cost: does not vary in accordance with

• We assume the firm is a ‘price taker’ in the

– The law of diminishing returns implies that MC

– the firm employs two inputs, labor and capital

– the firm operates at every level of output in the

– Quantity (Q) is the amount of output that a firm

– Total fixed cost (TFC) is the total cost of using the

– Total variable cost (TVC) is the total cost of using

– Total cost (TC) is the total cost of using all the

– Average fixed cost (AFC) is the average per-unit

– Average variable cost (AVC) is the average

– Average total cost (AC) is the average per-unit

– Marginal cost (MC) is the change in a firm’s total

– AFC declines steadily

The same three rules apply for average cost (AC) as

• Productivity and cost are inversely related.

• The marginal cost pulls average either up or

• A reduction in the firm’s variable cost would

– quadratic relationship: as output increases, total

– linear relationship: as output increases, total cost

– Because there are no fixed inputs, there are no

You might also like