Chapter 7

The Theory and Estimation of Cost

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2

Chapter Seven

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

Chapter Seven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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

Chapter Seven

The law of diminishing returns (Chapter 6) implies that MC will eventually increase
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7

Chapter Seven

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)

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

10

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

11

Short-run cost function

Graphical example of the cost variables

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

12

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
Chapter Seven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

14

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

15

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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16

Chapter Seven

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

17

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18

Chapter Seven

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19

Chapter Seven

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

20

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21

Chapter Seven

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 shortrun 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
Chapter Seven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

23

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24

Chapter Seven

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

25

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 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26

Chapter Seven

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

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

27

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

Chapter Seven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 28

Global application

Example: manufacturing chemicals in China labor content relatively low high use of equipment and raw materials noncost reasons for outsourcing

Chapter Seven

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

29