Chapter 6 Cost analysis and
Measurement
KEY CONCEPTS •
•
•
•
•
•
•
•
•
•
•
•
•
historical cost
current cost
replacement cost
opportunity cost
explicit cost
implicit cost
incremental cost
profit contribution
sunk cost
cost function
short-run cost functions
long-run cost functions
planning curves
•
•
•
•
•
•
•
•
•
•
•
operating curves fixed cost
variable cost
short-run cost curve
long-run cost curve
economies of scale
cost elasticity
capacity
minimum efficient scale
multiplant economies of scale
multiplant diseconomies of scale
learning curve
OVERVIEW
•
•
•
•
•
•
•
•
•
•
•
What Makes Cost Analysis Difficult
Opportunity Cost
Incremental and Sunk Costs in Decision
Analysis
Short-run and Long-run Costs
Short-run Cost Curves
Long-run Cost Curves
Minimum Efficient Scale
Firm Size and Plant Size
Learning Curves
Economies of Scope
Cost-volume-profit Analysis
一. Nature of costs
• 1.Accounting cost and Economic cost
2. Historical costs Versus Current
Costs
Historical cost: the actual cash
outlay
Current cost: the present cost of
previously acquired items
3.Replacement Cost
– Cost of replacing productive capacity
using current technology.
• 4.Opportunity Cost
– foregone value.
– second-best use.
• 5.Explicit and Implicit Costs
– Explicit costs= cash expenses
– Implicit costs= noncash expenses
• 6.Incremental Cost and marginal cost
– Incremental cost: the change in cost tied
to a managerial decision.
– Incremental cost can involve multiple units
of output.
Marginal cost: a single unit of output.
• 7.Sunk Cost
– Irreversible expenses incurred
previously.
– **Sunk costs are irrelevant to present
decisions.
Definition of the Operating Period
– At least one input is fixed in the S.R.
– All inputs are variable in the L.R.
• Fixed and Variable Costs
二.Short-run Costs
1.Categories:
Total Cost = Fixed Cost + Variable
Cost
– ATC = AFC + AVC
– MC = ∂TC/∂Q
2. Cost curves
**Short-run Cost Relations
– Short-run cost curves show
minimum cost in a given production
environment.
True or false:
1. An implicit cost usually involves the use
of resources owned by the owner of
the firm.
2. Costs are money payments for the use
of resources.
3. Variable costs depend on how much
output is produced.
4. Short run is a period of time that is
less than 1 year.
??List the inputs that generate explicit
costs and implicit costs
• A self-employed automobile mechanic
uses his own tools, rents a building,
buys replacement parts, and hires a
teenager as a helper.
• ??opportunity cost
• A piece of land is used to raise wheat .
If the farmer could make $2000 by
growing corn on this land, $1800 by
growing peanuts, $1700 by growing
soybeans, and $1500 by raising cattle,
what is the opportunity cost of the
wheat.
Which of the following are short-run and
which are long-run adjustments?
(a) Wendy’s builds a new restaurant;
(b) Acme Steel Corporation hires 200
more production workers;
(c) A farmer increases the amount of
fertilizer used on his corn crop;
(d) An Alcoa plant adds a third shift of
workers.
•
The MES (minimum efficient scale) is the
smallest level of output needed to attain all
economies of scale and minimum long-run
ATC.
•
If long-run ATC drops quickly to its
minimum cost which then extends over a long
range of output, the industry will likely be
composed of both large and small firms. If
long-run ATC descends slowly to its minimum
cost over a long range of output, the
industry will likely be composed of a few
large firms. If long-run ATC drops quickly
to its minimum point and then rises abruptly,
the industry will likely be composed of many
small firms.
三.Long-run Cost Curves
•
•
•
•
1.Types of LR costs
2.LRAC and SRAC( envelope of SACs)
3.law
4. economy of scale/diseconomies of
scale
• 5. minimum efficient scale
• ６.shift of long run cost curve:
learning curve
• 7. break even analysis
LRAC and SRAC
Suppose a firm has only three possible plantsize options represented by the ATC
curves.
??What plant size to choose in producing
50, 130,160, and 250 units?
Draw the firm’s long-run average-cost
curve on the diagram and define this
curve.
Long-run Average Costs
To understand LRAC
• LRAC: shows the lowest average total
cost at which any output level can be
produced after the firm has had time
to make all appropriate adjustments
in its plant size.
??Why U-shaped LRAC
Law--AC
• Economies of scale: the reduction in
LRAC as the scale of the firm’s
output is increased.
• Diseconomies of scale:
Returns to scale and economies of
scale
C
LAC
O
q1
q2
Q
Elasticity and LRAC
1.Output Elasticity
εQ = ∂Q/Q ÷ ∂Xi/Xi
If
• εQ > 1 →increasing returns.
• εQ = 1 →constant returns.
• εQ < 1 →decreasing returns.
2.Cost elasticity:
εC = ∂C/C ÷ ∂Q/Q.
• εC < 1 :falling AC, increasing returns.
• εC = 1 : constant AC, constant returns.
• εC > 1 rising AC, decreasing returns.
5.Minimum Efficient Scale
Definition of MES: output level at the
minimum point on the LRAC curve.
Competitive Implications of MES:
long run average cost
C
C
C
LAC
LAC
LAC
O
Q
(a)
O
Q
(b)
O
Q
(c)
6.Learning Curves
• Definition : average cost reduction
over time due to production
experience.
**Learning → shift of LRAC curve
**Learning curve advantages≠ economies of
scale effects
Learning Curve Examplep159
AC2004=$100
AC2005=$90
Learning rate=(1- AC2/AC1) *100%
• Strategic Implications of the
Learning Curve Concept
– When learning results in 20% to 30%
cost savings, it becomes a key part of
competitive strategy.
7.Cost-volume-profit Analysis
• (1)．Break even quantity
•
QBE=TFC/ (P-AVC)
•
Example
(2)．Degree of Operating
Leverage
– DOL is the elasticity of profit with
respect to output.
**DOL/profit elasticity= %△profit/%△Q
DOL=Q(P-AVC)/[Q(P-AVC)-TFC]
**DOL=(P-AVC)/P-AC
五.Production costs in the long run
1.Types of costs:
TC; ATC; MC (ATC and MC: U shape)
2. Economies of scale and diseconomies of scale
①Economies of scale: when increasing the scale of
production lead to a lower cost per unit of output.
Q up----LAC down
• Reasons: labor and managerial specialization\
ability to purchase and use more efficient capital
goods\ other factors such as advertising or other
start up costs\ economy of bulk buying.
②Diseconomies of scale: where costs per
unit of output increase as the scale of
production increases. Q up---LAC down.
• Reasons: the growing complexities of
managing a larger organization\ distant
management, worker alienation and problems
with communication and coordination..
③ Constant return to scale:
Q↑or↓→unchanged ATC
3. The relationship between LAC and SAC
SR: fixed inputs
LR: variable inputs= a firm could choose the
size of its factory and once a factory is
chosen, the firm must deal with the shortrun costs associated with that plant size.
LATC is called the envelope curve of SATCs.
4.Minimum efficient scale and industry
structure
Minimum efficient scale: MEC
the smallest level of output at which a firm
can minimize its average costs in the long
run..
If the MES is a large percentage of the
market, and if the firms are to be large
enough to gain the full economies of scale,
there will not be room for many firms.
If the MES exceeds 50%, there is only room
for one firm large to gain full economies
of scale. In this case, the industry is said
to be a natural monopoly.
Transportation Costs and
MES
– Terminal, line-haul and inventory costs
can be important.
– High transport costs reduce MES
impact.
Firm Size and Plant
Size
• Multi-plant Economies and
Diseconomies of Scale
– Multi-plant economies are cost
advantages from operating several
plants.
– Multi-plant diseconomies are cost
disadvantages from operating several
plants.
Economics of Multi-plant
Operation: an Example
• Plant Size and Flexibility
Economies of Scope
• Economies of Scope Concept
– Scope economies are cost advantages
that stem from producing multiple
outputs.
– Big scope economies explain the
popularity of multi-product firms.
– Without scope economies, firms
specialize.
• Exploiting Scope Economies
– Scope economics often shape