ECNE610ManagerialEconomics

APRIL 2014

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Chapter-7

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57The Theory and

Estimation of Cost

Lesson Objectivesdefine 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.

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Definition and use of cost in economic analysis:

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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.

Definition and use of cost in economic analysis:

Implicit costs Refer to the opportunity costs of using its

self-owned, self-employed resources. Implicit costs are the money payments that self-employed resources could have earn in their best alternative use.

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EconomicProfit (Actual profit)

TotalRevenue

Economic Cost

ECONOMIC PROFITSTotal 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

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EconomicProfit

Implicit costs

ExplicitCosts

Accountingcosts (explicit

costs only)

AccountingProfit

Ec

on

om

ic (

op

po

rtu

nit

y) C

os

ts

TOTAL

REVENUE

Profits to anEconomist

Profits to anAccountant

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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 $100,000explicit costs:

Assistant's salary 21,000Material and equipment 20,000Shop rent 5,000

Equals accounting profit $54,000

implicit costs:Adnan's forgone salary 24,000Forgone interest on savings 1,000Entrepreneurial 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.

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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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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

Relationship between production and cost

Marginal Cost = MC

Total Fixed Costs = TFCTotal Variable Costs = TVC

Average Variable Costs = AVC

Total Costs = TC

Average Total Costs = ATC

Average Fixed Costs = AFC

SHORT-RUN PRODUCTION COSTS

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Costs of production usually divided into two sections such as fixed costsfixed costs and variable costsvariable 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.

Total, fixed, and variable costs

Chapter Seven15

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

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.

Average Fixed Costs =Total 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.

Average Variable Costs = Total Variable Costs

Quantity

Short-run cost function

Total Cost = Total Fixed + Variable Costs

Average Total Cost =Total Costs

Quantity

Marginal Cost: the rate of change in total variable cost.

Marginal Cost =Change in Total Costs

Change in Quantity

So Average Cost (AC) = AFC + AVC = TC/Q

TC/Q

Quantity

Co

sts

(do

llar

s)TC

TotalCost

Fixed CostTVC

Variable Cost

TFC

Combining TVCWith TFC to get

Total Cost

SHORT-RUN COSTS GRAPHICALLY

The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand

Copyright©2004 South-Western

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Graphical example of the cost variables

The average total-costaverage 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 scaleefficient scale of the firm.

Explaining Cost Curves and Their Shapes

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

Relationship between Marginal Cost and Average Total Cost

Chapter Seven23

Chapter Seven24

Chapter Seven25

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

Chapter Seven26

Economies 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 u-shaped.

Chapter Seven27

Reasons for economies of scale

specialization of labor and capitalprices of inputs may fall with volume

discounts in firm’s purchasinguse 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

Chapter Seven28

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

Chapter Seven29

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.

Chapter Seven30

Supply chain managementSupply 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.

Chapter Seven31

Supply chain managementWays 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

Chapter Seven32

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

Do you have any question? Do you have any question?

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