Lecture 7 and 8.pptv;lsmv;ms;mvavlml;vvm

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1. Chapter 7
The Theory and
Estimation of Cost
1

2. 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
2

3. Learning objectives
define the cost function
distinguish between economic cost and
accounting cost
explain how the concept of relevant cost is
used
3

4. 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
4

5. 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
5

6. 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
6

7. 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
7

8. Relationship between production and cost
MP
W
Q
TVC
MC 



8
•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
The law of diminishing returns (Chapter 6)
implies that MC will eventually increase

9. 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
9

10. 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
10

11. 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)
11

12. 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 firm’s
inputs,
TC = TFC + TVC
12

13. 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
13

14. 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 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 = TC/Q = TVC/Q
14

15. Short-run cost function
•Graphical example of the cost variables
15

16. 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
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17. Short-run cost function
•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
17

18. 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
18

19. 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
19

20. 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
 at first increasing returns to scale, then as
firms mature they achieve constant returns,
then ultimately decreasing returns to scale
20

21. 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
21

22. Long-run cost function
•Economies of scale: situation where a firm’s
long-run average cost (LRAC) declines as
output increases
•Diseconomies of scale: situation where a
firm’s LRAC increases as output increases
•In general, the LRAC curve is u-shaped.
22

23. Long-run cost function
•Reasons for long-run economies
–specialization of labor and capital
–prices of inputs may fall with volume discounts in
firm’s 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
23

24. 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
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25. 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
25

26. 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
26

27. Learning curve
•Learning curve:
•measured in terms of percentage decrease in
additional labor cost as output doubles
Y
x = Kx
n
Y
x = 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
27

28. Economies of scope
•Economies of scope: reduction of a firm’s
unit cost by producing two or more goods
or services jointly rather than separately
Closely related to economies of scale
28

29. Supply chain management
•Supply chain management (SCM): efforts by a firm
to improve efficiencies through each link of a firm’s
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
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30. 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
30

31. 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
31

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