ECNE610
Managerial
Economics
APRIL 2014
Chapter-7
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Dr. Mazharul Islam
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7
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The Theory and
Estimation of
Cost
Dr. Mazharul Islam
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Lesson Objectives
 define
the cost function.
 distinguish between economic cost and
accounting cost.
 explain how the concept of relevant cost is
used.
 understand total, variable, average and fixed
cost.
 distinguish between short-run and long-run
cost.
 provide
reasons for the existence of
economies of scale.
Dr. Mazharul Islam
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Definition and use of cost
in economic analysis:
Economic Costs:
A firm’s economic costs are the opportunity costs
of the resources used, whether those resources
are owned by others or by the firm.
Explicit costs (Accounting Costs)
 Refer to the firm’s actual cash payments for
resources  wages, rent, interest, insurance,
taxes, etc. Such money payments are for the
use of resources owned by others.
Dr. Mazharul Islam
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Definition and use of cost
in economic analysis:
Implicit costs
 Refer to the opportunity costs of using its selfowned, self-employed resources. Implicit
costs are the money payments that selfemployed resources could have earn in their
best alternative use.
Dr. Mazharul Islam
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ECONOMIC PROFITS
Total Revenue: It is the amount received
from the sale of the product; it is equal to
the number of units sold (Q) times the price
received per unit (P).
TR = QxP
Economic
Profit (Actual profit)
Total
Revenue
Economic Cost
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Economic (opportunity) Costs
Profits to an
Economist
Economic
Profit
Implicit
costs
Explicit
Costs
Profits to an
Accountant
T
O
T
A
L
R
E
V
E
N
U
E
Accounting
Profit
Accounting
costs (explicit
costs only)
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A particular example to clarify the
distinction between explicit and implicit
costs.
 Khalid
Al Ghamdi runs a small furniture firm.
He hires one assistant at SAR21,000 per
year, pays annual rent of SAR5000 a year for
his shop, an invested SAR20,000 from his
savings on materials that could have earn
him SAR1000 per year as interest rate. He
has been offered SAR24,000 per year to
work as a manager for competitor. He
estimates his entrepreneurial talents are
worth SAR 3000 per year. Total annual
revenue from furniture sales is SAR 100,000.
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Total revenue
explicit costs:
Assistant's salary
Material and equipment
Shop rent
Equals accounting profit
$100,000
21,000
20,000
5,000
$54,000
implicit costs:
Adnan's forgone salary
24,000
Forgone interest on savings
1,000
Entrepreneurial profit
3,000
Equals economic profit
___________ $26,000


Accounting profit equals total revenue minus explicit costs  used to
determine a firm’s taxable income
However, this ignores the opportunity cost of Ghamdi’s own resources




His forgone salary of $24,000
Annual interest of $1,000 from the savings used to start the business
Entrepreneurial profit $5,000
Economic profit equals total revenue minus all costs, both explicit and implicit

Accounting profit of $54,000 less implicit costs of $28,000  economic profit of
$26,000
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 When
the demand for a firm’s product
changes, the firm’s profitability depends
on how quickly it can adjust the amount
of the various resources that it employed.
Some resources can easily and quickly
adjust such as labor, raw material, fuel
and power but some resources need
much more time to adjust such as
building, machinery and equipment.
Because of this differences in adjustment
time, economists consider everything into
two conceptual periods: the short run and
the long run.
Short
run  at least one resource
(Capital) is fixed.
Long run  all resources are
variable.
Resources can be divided into two
categories
Variable resources can be varied
quickly to change the output rate.
Fixed resources are those resources
which cannot be easily changed.
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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
Dr. Mazharul Islam
SHORT-RUN PRODUCTION COSTS
Total Fixed Costs =
Total Variable Costs =
Total Costs =
Average Fixed Costs =
Average Variable Costs =
Average Total Costs =
Marginal Cost =
TFC
TVC
TC
AFC
AVC
ATC
MC
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Total, fixed, and variable costs
Costs of production usually divided into
two sections such as fixed costs and
variable costs.
Fixed costs are those costs that do not
vary with the quantity of output
produced, e.g. the cost of the factory.
Variable costs are those costs that do
vary with the quantity of output
produced, e.g. the cost of workers.
Dr. Mazharul Islam
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Chapter Seven
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
Short-run cost function
Fixed Costs: Total cost of using the fixed input (K).
Total Fixed Costs = Total costs – Total Variable costs. This costs
also be found by multiplying the number of fixed inputs by the price of
the input.
Total Fixed Costs
Average Fixed Costs =
Quantity
Variable Costs: total cost of using the variable
input, labor (L).
Total Variable Costs = Total costs – Total Fixed costs. This costs
also be found by multiplying the number of variable inputs
by the input price.
Total Variable Costs
Average Variable Costs =
Quantity
Total Cost = Total Fixed + Variable Costs
Average Total Cost =
Total Costs
Quantity
So Average Cost (AC) = AFC + AVC = TC/Q
Marginal Cost:
the rate of change in
total variable cost.
Marginal Cost =
Change in Total Costs
Change in Quantity
= DTC/DQ
Costs (dollars)
SHORT-RUN COSTS GRAPHICALLY
Combining TVC
With TFC to get
Total Cost
Total
Cost
TC
TVC
Fixed Cost
Variable Cost
TFC
Quantity
The Various Measures of Cost: Thirsty Thelma’s
Lemonade Stand
Copyright©2004 South-Western
 Graphical
example of the cost variables
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Explaining Cost Curves and Their Shapes
 The
average total-cost curve is U-shaped.
 At very low levels of output average total
cost is high because fixed cost is spread
over only a few units.
 Average total cost declines as output
increases.
 Average total cost starts rising because
average variable cost rises substantially.
 The bottom of the U-shaped ATC curve
occurs at the quantity that minimizes
average total cost. This quantity is
sometimes called the efficient scale of the
firm.
Relationship between Marginal Cost
and Average Total Cost
 Whenever
marginal cost is less than average
total cost, average total cost is falling.
 Whenever marginal cost is greater than
average total cost, average total cost is
rising.
 Whenever marginal cost is equal to average
total cost, ATC is minimum.
The same three rules apply for average variable
cost (AVC) as for ATC
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
Chapter Seven
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
Chapter Seven
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Chapter Seven
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.
 at first increasing returns to scale, then
as firms mature they achieve constant
returns, then ultimately decreasing returns
to scale
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Economies
Chapter Seven
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 ushaped.
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Chapter Seven
Reasons for economies of scale
 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
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Chapter Seven
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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Chapter Seven
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.
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Chapter Seven
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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Chapter Seven
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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Chapter Seven
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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Do you have any question?
Dr. Mazharul Islam