Chapter 8

The Theory and Estimation of Cost

Managerial Economics: Economic Tools for Todays Decision Makers, 4/e By Paul Keat and Philip Young

Before We StartGroup Presentation

So popular? b 1-b or c Q = aL K
b+c > 1 IRTS b+c = 1 CRTS b+c < 1 DRTS Short Run Analysis: MPK = c Q/K & MPL = b Q/L b & c are elasticities of K & L factors LogQ=loga+blogL+clogK + dlogT where T technology
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Theory and Estimation of Cost

Definition of Cost The Short Run Relationship Between Production and Cost
The Short Run Cost Function

The Long Run Relationship Between Production and Cost

The Long Run Cost Function

The Learning Curve

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Definition of Cost A cost is relevant if it is affected by a management decision.

Historical cost is incurred at the time of procurement Replacement cost is necessary to replace inventory

Are historical costs relevant?

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Definition of Cost There are two types of cost associated with economic analysis
Opportunity cost is the value that is forgone in choosing one activity over the next best alternative Out-of-pocket cost is actual transfer of value that occur

Which cost is relevant?

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Definition of Cost There are two types of cost associated with time
Incremental cost varies with the range of options available in the decision making process. Sunk cost does not vary with decision options.

Is sunk cost relevant?

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

SR Relationship Between Production and Cost A firms cost structure is related to its production process.
Costs are determined by the production technology and input prices.
Assuming that the firm is a price taker in the input market.

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SR Relationship Between Production and Cost Total variable cost (TVC) is associated with the variable input
Assume w=$500 per unit (pricetaker)
Total Input (L) 0 1 2 3 4 5 6 7 8 9 Q (TP) 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850 MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

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SR Relationship Between Production and Cost TP and TVC are mirror images of each other

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Kings Dominion Example

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SR Relationship Between Production and Cost Total cost (TC) is the cost associated with all of the inputs. It is the sum of TVC and TFC.
TC=TFC+TVC
Marginal Costs Average Costs
Tool Set for Production Cost Analysis

vs.
Production Process Analysis

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SR Relationship Between Production and Cost Marginal cost (MC) is the change in total cost associated a change in output.
TC MC Q

TC (TFC TVC ) TFC TVC TVC MC 0 Q Q Q Q Q

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SR Relationship Between Production and Cost

Add marginal cost to the table
Total Input (L) 0 1 2 3 4 5 6 7 8 9 Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850 MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150 TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

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SR Relationship Between Production and Cost

Observe that:
When MP is increasing, MC is decreasing. When MP is decreasing, MC is increasing.
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Total Input (L) 0 1 2 3 4 5 6 7 8 9

Q 0 1,000 3,000 6,000 8,000 9,000 9,500 9,850 10,000 9,850

MP 1,000 2,000 3,000 2,000 1,000 500 350 150 -150

TVC (wL) 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

MC 0.50 0.25 0.17 0.25 0.50 1.00 1.43 3.33

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SR Relationship Between Production and Cost The relationship between MP and MC is

TVC w L L 1 w MC w w Q Q Q MP MP

Law of diminishing returns implies that MC will eventually increase! Why?

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function Average total cost (ATC) is the average per-unit cost of using all of the firms inputs (TC/Q)
Average variable cost (AVC) is the average per-unit cost of using the firms variable inputs (TVC/Q) Average fixed cost (AFC) is the average per-unit cost of using the firms fixed inputs (TFC/Q)
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function

Add ATC = AFC + AVC to the table

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The Short Run Cost Function

ATC = AFC + AVC

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The Short Run Cost Function Production cost graph or map is

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The Short Run Cost Function

Important Map Observations
AFC declines steadily over the range of production. Why?
In general, ATC is u-shaped. Why?

MC intersects the minimum point (q*) on ATC. Why?

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function

Important Map Observations
What is the economic significance of q*?

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The Short Run Cost Function Average total cost (ATC) is the average per-unit cost of using all of the firms inputs (TC/Q) At Q* - ATC is minimized or inputs are used most efficiently given the production function
Going at 55 MPH
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function

A change in input prices will shift the cost curves.

If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected. Computer Chip
Case
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Short Run Cost Function

A change in input prices will shift the cost curves.

If variable input costs are reduced then MC, AVC, and AC will all shift downward.
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Airline Industry Managerial Case 4/e Economics,

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The Short Run Cost Function

Yahoo Group Discussion

What is different about dot.com businesses?

Irrational Exuberance
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The LR Relationship Between Production and Cost In the long run, all inputs are variable.
What makes up LRAC?

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The Long-Run Cost Function LRAC is made up for SRACs

SRAC curves represent various plant sizes Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Long-Run Cost Function The LRAC is the lower envelope of all of the SRAC curves.
Minimum efficient scale is the lowest output level for which LRAC is minimized

Is LRAC a function of market size? What are implications?

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

The Long-Run Cost Function

Reasons for Economies of Scale
Increasing returns to scale Specialization in the use of labor and capital
Economies in maintaining inventory Discounts from bulk purchases Lower cost of raising capital funds Spreading promotional and R&D costs

Management efficiencies

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The Long-Run Cost Function Reasons for Diseconomies of Scale

Decreasing returns to scale Input market imperfections Management coordination and control problems

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The Learning Curve

Measures the percentage decrease in additional labor cost each time output doubles.
An 80 percent learning curve implies that the labor costs associated with the incremental output will decrease to 80% of their previous level.
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The Learning Curve A downward slope in the learning curve indicates the presence of the learning curve effect
Why? Workers improve their productivity with practice

The learning curve effect shifts the SRAC downward

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Production Cost Homework Page 378

Problem 10

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