Chapter 7: The Theory of Estimation of Cost

The Importance of Cost in Managerial Decisions

• Ways to contain or cut costs over the past decade:
1. Most Common: reduce number of people on the payroll
2. Outsourcing components of the business
3. Merge, consolidate, then reduce headcount

The De nition & Use of Cost in Economic Analysis

• Relevant Cost: a cost that is a ected by a management decision
• Ex. VC & MC

• 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
• Ex. ΔTVC or MC

• Sunk Cost: a cost incurred in the past that is not a ected by a current decision; if a resource
has no opportunity cost (i.e., it has no market value in an alternative use), it is considered to
be sunk.

The Relationship Between Production & Cost

• Cost function is the production function expressed in monetary rather than physical units
• Using marginal cost & marginal product, we can show the relationship between production
and cost
• Total Variable Cost (TVC): the cost associated with the variable input, determined 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 implies that MC will

eventually increase

• Plotting TP & 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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 The Short-Run Cost Function
• For simplicity the following assumptions are made:
• The rm employs two inputs, labor & capital
• The rm operates in a short-run production period where labor is variable, capital is xed
• The rm uses the inputs to produce a single product
• The rm operates with a xed level of technology
• The rm operates at every level of output in the most e cient way
• The rm operates in perfectly competitive input markets & must pay for its inputs at a given
market rate; it is a “price taker” in the input markets
• The short-run production function is a ected by the law of diminishing returns

• Standard variables in the short-run cost function:

• Total Fixed Cost (TFC): the total cost of using the xed input, capital (K)
• Total Variable Cost (TVC): the total cost of using the variable input, labor (L)
• Total Cost (TC): the total cost of using all the rm’s inputs, L & K
• TC = TFC + TVC

• The important relationships among the various measures of cost can be summarized as
follows:
• TC = TFC + TVC
• AC = AFC + AVC (or = TC/Q)
• MC = ΔTC/ΔQ (or = Δ TVC/ΔQ)
• AFC = TFC/Q
• AVC = TVC/Q

• Graphical example of the cost variables

• Important Observations:
• AFC declines steadily over the range of production
• 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
• A reduction in the rm’s xed cost would cause the average cost line to shift downward,
but will not a ect the marginal cost
• A reduction in the rm’s variable cost would cause all three cost lines (AC, AVC, MC) to shift

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 • Indicate the effect that each of the following conditions will have
on a firm’s average variable cost curve and its average cost curve.
a. The movement of a brokerage firm’s administrative offices from
New York City to New Jersey, where the average rental cost is
lower
b. The use of two shifts instead of three shifts in a manufacturing
facility
c. An agreement reached with the labor union in which wage
increases are tied to productivity increases
d. The elimination of sugar quotas (as it pertains to those firms that
use a lot of sugar, such as bakeries and soft drink bottlers)
e. Imposition of stricter environmental protection laws

Question:

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 Alternative Speci cations of the Total Cost Function
1. Most Commonly: speci ed as a cubic relationship between total cost & output
• As output increases, total cost rst increases at a decreasing rate, then increases at an
increasing rate

2. Quadratic Relationship: as output increases, total cost increases at an increasing rate

3. Linear Relationship: as output increases, total cost increases at a constant rate

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 The Long-Run Cost Function
• The Relationship Between Long-Run Production & Long-Run Cost
• In the long run, all inputs to a rm’s production function may be changed
• Because there are no xed inputs, there are no xed costs
• In general, the LRAC curve is u-shaped
• If a rm’s long-run average cost declines as output increases, the rm is said to be
experiencing economies of scale
• If long-run average cost increases as output increases, economists consider this to be a
sign of diseconomies of scale
• The smallest output where minimum LRAC is achieved is called minimum e cient scale

Reasons for Long-Run Economies of Scale

• Specialization in the use of labor & capital
• Prices of inputs may fall as the rm realizes volume discounts in its purchasing
• Use of capital equipment with better price-performance ratios
• Larger rms may be able to raise funds in capital markets at a lower cost than smaller rms
• Larger rms may be able to spread out promotional costs

Reasons for Diseconomies of Scale

1. Scale of Production becomes so large that it a ects the total market demand for inputs, so
input prices rise
2. Transportation costs tend to rise as production grows
• Handling expenses, insurance, security, & inventory costs a ect transportation costs

• In long run, the rm can choose any level of capacity

• Once it commits to a level of capacity, at least one of the inputs must be xed; this then
becomes a short-run problem
• The LRAC curve is an envelope of SRAC curves, & outlines the lowest per-unit costs the rm
will incur over a range of output

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 A Mathematical Example

In the short run, the total cost function can be

represented by a cubic, quadratic, or linear cost
function as follows:
TC = a + bQ − cQ 2 + dQ 3 (Cubic)
TC = a + bQ − cQ 2 (Q uadratic)
TC = a + bQ( Linear )
where a is the total fixed cost.
In the long run, all costs are variable. Therefore, the
total fixed cost a drops in the equations above.

Find Where Diminishing Returns Start

Suppose you are given the following cubic total cost

function.
TC = 60Q − 3Q 2 + 0.1Q 3 .
Diminishing returns starts when MC is minimum. To
find the level output at which this occurs, first find MC by
taking the derivative of TC wrt Q. Then, take the
derivative of MC wrt Q, set it equal to zero and solve for
Q.
MC = d (TC ) / dQ = 60 − 6Q + 0.3Q 2
d ( MC ) / dQ = −6 + 0.6Q = 0
Solving for Q yields Q = 10. Therefore, diminishing
returns takes effect when Q = 10.

Find the Point of Minimum Cost E ciency

The point of minimum cost efficiency occurs at the level

of output where AC is at its minimum. To find this, you
must first find AC by dividing TC by Q. Then take the
derivative of AC wrt Q, set it equal to zero, and solve for
Q. (Alternatively, you can set AC equal to MC and solve
for Q).
AC = TC / Q = 60 − 3Q + 0.1Q 2
d ( AC ) / dQ = −3 + 0.2Q
Q = 15
Therefore, the point of minimum cost efficiency occurs
when Q = 15.
Economies of scale takes place when Q < 15 and
diseconomies of scale takes place when Q > 15. Page 6 of 9


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 Pricing & Output Decisions Under Perfect Competition

A firm in a perfectly competitive market takes

the price (P) determined by market supply and
demand as given and sets it equal to its marginal
cost (MC) to determine its profit maximizing
quantity (Q).
Suppose that market demand and supply are
given by the following equations.
Q D = 160 − 2 P
Q S = 60 + 3P

The firm has the following cost function.

TC = 1000 + 10Q + 0.02Q 2
What is the profit maximizing Q for the firm?
At that level of Q is the firm making a profit or
loss? How much?
First, determine the market price by setting
QD = Qs .
160 − 2 P = 60 + 3P
100 = 5P
P = 20

The firm takes this price as given and sets it

equal to its MC to determine Q.
MC = d (TC ) / dQ = 10 + 0.04Q
Setting P=MC yields
10 + 0.04Q = 20
0.04Q = 10
Q = 250
When Q=250, TR=PQ=20x250=5000.
When Q=250,
TC=1000+10x250+0.04x250x250=4750.
Profit=TR-TC=250.

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 Pricing & Output Decisions Under Monopolistic Competition

Under monopolistic competition, the firm

determines the profit maximizing Q by setting
MR=MC. Suppose the demand equation and the cost
function are given by the following equations.
Q = 200 − 0.5 P
TC = 50 + 16Q − 2Q 2 + 0.2Q 3
What is the profit maximizing Q for the firm? At
that level of Q is the firm making a profit or loss?
How much?
First, to find TR, express the demand equation above
as the inverse demand equation as follows.
0.5 P = 200 − Q
P = 400 − 2Q
Then, TR can be expressed as
TR = P × Q = (400 − 2Q)(Q) = 400 Q− 2 Q 2

Then, MR can be expressed as

MR = d (TR ) / dQ = 400 − 4Q
The profit maximizing Q is determined when
MR=MC. This yields
400 − 4Q = 16 − 4Q + 0.6Q 2
0.6Q 2 = 384
Q = 25.3
Substituting Q=25.3 into the inverse demand
equation, we find
P = 400 − 2Q = 349.4
Substituting Q=25.3 into the cost function we find
TC and multiplying 25.3 by 349.4 we find TR.
TC=2413, TR=8840, and profit=6427

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 Example: Suppose a manufacturer of a video game system has an inventory of $750,000
worth of 16-bit chips left over from a discontinued system.

• Suppose the market value of chips becomes $1,000,000

1. What is the historical cost?

• The historical cost refers to the original purchase or production cost of the inventory,
which in this case is $750,000. This is the amount the rm originally spent to acquire
the 16-bit chips, and it does not change with changes in market conditions or usage
decisions.

2. If the rm decides to reenter the video game market using the 16-bit chips, what
is the relevant cost? The opportunity cost?
• The relevant cost is the cost that will a ect the rm's decision to reenter the market.
Since the rm already owns the chips, the relevant cost is their current market value,
which is $1,000,000. This re ects what the rm could potentially sell the chips for in
the market.

• The opportunity cost is the value of the next best alternative that the rm foregoes by
using the chips. If the rm reenters the video game market and uses the chips, it
forgoes the opportunity to sell them at their current market value of $1,000,000. Thus,
the opportunity cost of using the chips is $1,000,000, since that is what the rm
sacri ces by not selling the chips.

3. Suppose the value of the inventory falls to $550,000 due to the introduction of a
32-bit video game system. In this case, what is the relevant opportunity cost;
what is the sunk cost ?
• Sunk cost is the original cost that has already been incurred and cannot be recovered.
In this case, the sunk cost is the $750,000 the rm initially spent to acquire the 16-bit
chips. Regardless of the current market value, this amount has already been spent
and is irrelevant to future decision-making.

4. If the 16-bit chip becomes completely obsolete due to the introduction of a 64-bit
game system, what are the relevant costs?
• If the 16-bit chips become completely obsolete, their market value would likely be
zero. In this case:
• The opportunity cost would be $0, because there would be no alternative use or
value for the chips if they are obsolete.
• The sunk cost would still be the $750,000 the rm originally spent on the chips. This
amount remains irrelevant to future decisions because it cannot be recovered.

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