The theory and estimation of
costs
Chapter 7
Importance of cost in managerial
decisions
• Cost has become very important in recent years
as increasing competitive pressures, changing
technology and customer demand have made it
harder for firms to achieve high profit margins.
These have let firms to outsourcing and
relocation of manufacturing facilities to lower
wage countries. For ex. Nike.
• Firms in order to cut costs and remain
competitive, entered mergers, consolidations.
For ex. BP and Mobil
Cost concepts
• Relevant costs
– Any cost is considered relevant if it is affected by a management
decision
• A) Historical vs replacement cost
– According to the principle of relevant cost, the firm should use
replacement cost.
• B) opportunity cost vs out-of-pocket cost
• Opportunity cost is one of the most important and useful
concept in economical analysis. It is often referred as
indirect cost or implicit cost. While referring to out-ofpocket cost as direct cost.
• C) sunk vs incremental cost
• Such cost is the cost that does not vary with decision
alternatives. Incremental cost is the cost that varies with
the range of options available in a decision.
Relationship between production
and costs
• This is expressed for a SR case when one
input is used at a given wage rate. (see
table)
• Input L Q TVC(LW) MC
Short run cost function
• Lets specify the model with the use of L
and K.
• L is variable input and K is fixed input.
• Firm operates in perfectly competitive
labor market. Thus wage is given.
• Before specifying the cost function, lets
look at the following table:
• Insert table and figures here
Alternative cost functions
•
•
•
•
•
•
A) cubic: TC=a +bQ-cQ2+dQ3
Insert figures here
B) quadratic: TC=a +bQ+cQ2
Insert figures here
C) Linear: TC=a +bQ
Insert figures here
Long run cost function and
economies of scale
• In the long run all inputs are variable.
• As output increases, total cost increases, but not
at a constant rate.
• Long run cost function shows the same behavior
of production function. First increasing return to
scale then decreasing return to scale.
• In a long run, average cost curve is illustrated as
below:
• Insert figure here
Factors affecting economies of
scale and diseconomies of scale
For economies of scale
• Specialization in use of labor and capital
• Indivisible nature of capital equipment
• Productive capacity of capital rising faster
purchase price
• Economies in maintaining inventory of past
• Discounts from bulk purchases
• Lower cost of raising capital funds
• Management efficiencies
Reasons for diseconomies of scale
• Disproportionate rise in transportation
costs
• Input market imperfections (wage driven
up)
• Management coordination and control
problem
• Disproportionate rise in staff and indirect
labor