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