Chapter 7

Report
Chapter 7
The Theory and
Estimation of Cost
Chapter Seven
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
1
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
Chapter Seven
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Publishing as Prentice Hall.
2
Learning objectives
define the cost function
distinguish between economic cost and
accounting cost
explain how the concept of relevant cost is
used
Chapter Seven
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
3
Learning objectives
understand total, variable, average and
fixed cost
distinguish between short-run and longrun cost
provide reasons for the existence of
economies of scale
Chapter Seven
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4
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
Chapter Seven
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5
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

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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
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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
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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
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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
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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)
Chapter Seven
Copyright 2009 Pearson Education, Inc.
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11
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
Chapter Seven
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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
Chapter Seven
Copyright 2009 Pearson Education, Inc.
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13
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
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Short-run cost function

Graphical example of the cost variables
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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
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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
Chapter Seven
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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
Chapter Seven
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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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19
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
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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
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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.
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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 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

Chapter Seven
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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
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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 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
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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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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
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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
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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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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

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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

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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

Chapter Seven
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