The Theory of Cost

1
The Theory of Cost

• Focus on relevant costs in decision making
• Short-run issues Recognize possibility of
  diminishing returns and its impact on marginal
  costs as output increases
• Long-run issues Identify economies of scale,
  economies of scope and their impact on unit
  production costs as scale increases
• Understand that increasing scale does not always
  decrease costs

2
The Importance of Cost

• One of two major factors in profit maximizing
  decision
• What is the other?
• Increase sales by 1, whats the impact on
  profit?
• Decrease cost by 1, whats the impact on profit?

3
Nature of Costs

• Historical v. replacement
• Opportunity v. out-of-pocket
• Sunk v. incremental
• Explicit v. implicit
• Short-run v. long-run
• Fixed v. variable
• Economic v. accounting

4
Relevant Costs

• Depreciation Accounting concept often has little
  relationship with the actual loss of value.
• Inventory Accounting concept based on
  acquisition cost.
• Unutilized facilities Empty space may appear to
  have no cost.
• Profitability measures Accounting v. economic

5
Graphing Costs

• TC, TFC, TVC
• ATC, AFC, AVC
• MC
• See Figure 9.3, p. 330

6
Relationship between Production and Cost

• Production is a key determinant of cost
• AVC TVC/Q wL/Q w(L/Q) w(1/APL)
• MC dTVC/dQ d(wL)/dQ w(dL/dQ) L(dw/dQ)
  w(1/MPL)

7
Long-Run Cost Curves

• The long run is the planning horizon
• We manage the future
• All inputs are variable in LR
• LAC often referred to as the envelope curve
• Refer to Figure 9.4, p. 332

8
Economies of Scale

• Output is growing proportionately faster than
  input use
• LAC is downward sloping
• Reasons for economies of scale

9
Diseconomies of Scale

• Output is growing proportionately slower than
  input use
• LAC is upward sloping
• Reasons for diseconomies of scale

10
Learning Curves

• Depicts the declining AC over time due to
  experience in production
• Algebraically C aQb where b is negative and
  represents the rate that input costs decline over
  time
• log C log a b log Q

11
Cost-Volume-Profit Analysis

• Break-even analysis
• Assuming constant prices and constant AVC
• Operating leverage
• importance of FC in the firms operations
• examines change in operating profit due to a
  change in sales volume
• important concept--DOL or sales elasticity of
  operating profit

12
Typical Cost Functions

• TC a bQ - cQ2 dQ3
• TFC a
• TVC bQ - cQ2 dQ3
• ATC a/Q b - cQ dQ2
• AFC a/Q
• AVC b - cQ dQ2
• MC b - 2cQ 3dQ2

13
Alternative Cost Functions

• Straight-line cost functions
• TC a bQ
• AC a/Q b AVC MC b
• Increasing at an increasing rate
• TC a bQ cQ2
• AC a/Q b cQ AVC b cQ MC b
  2cQ
• Graphical presentation