the theory of cost focus on relevant costs in decision making short-run issues: recognize...
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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
The Importance of Cost
• One of two major factors in profit maximizing decision
• What is the other?
• Increase sales by $1, what’s the impact on profit?
• Decrease cost by $1, what’s the impact on profit?
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
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
Graphing Costs
• TC, TFC, TVC
• ATC, AFC, AVC
• MC
• See Figure 9.3, p. 330
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)
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
Economies of Scale
• Output is growing proportionately faster than input use
• LAC is downward sloping
• Reasons for economies of scale
Diseconomies of Scale
• Output is growing proportionately slower than input use
• LAC is upward sloping
• Reasons for diseconomies of scale
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
Cost-Volume-Profit Analysis
• Break-even analysis– Assuming constant prices and constant AVC
• Operating leverage– importance of FC in the firm’s operations– examines change in operating profit due to a
change in sales volume– important concept--DOL or sales elasticity of
operating profit
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
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
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