Cost function
- 1. ` Cost Analysis and Estimation
- 2. What Makes Cost Analysis Difficult? Link Between Accounting and Economic Valuations Accounting and economic costs often differ. Historical Versus Current Costs Historical cost is the actual cash outlay. Current cost is the present cost of previously acquired items. Replacement Cost Cost of replacing productive capacity using current technology.
- 3. Opportunity Cost Opportunity Cost Concept Opportunity cost is foregone value. Reflects second-best use. Explicit and Implicit Costs Explicit costs are cash expenses. Implicit costs are noncash expenses.
- 4. Incremental and Sunk Costs in Decision Analysis Incremental Cost Incremental cost is the change in cost tied to a managerial decision. Incremental cost can involve multiple units of output. Marginal cost involves a single unit of output. Sunk Cost Irreversible expenses incurred previously. Sunk costs are irrelevant to present decisions.
- 5. Short-run and Long-run Costs How Is the Operating Period Defined? At least one input is fixed in the short run. All inputs are variable in the long run. Fixed and Variable Costs Fixed cost is a short-run concept. All costs are variable in the long run.
- 6. Short-run Cost Curves Short-run Cost Categories Total Cost = Fixed Cost + Variable Cost For averages, ATC = AFC + AVC Marginal Cost, MC = ∂TC/∂Q Short-run Cost Relations Short-run cost curves show minimum cost in a given production environment.
- 7. Short Run Cost Graphs AFC Q Q 1. 2. AVC 3. Q AFC AVC ATC MC MC intersects lowest point of AVC and lowest point of ATC. When MC < AVC, AVC declines When MC > AVC, AVC rises
- 8. Relationships Among Cost & Production Functions AP & AVC are inversely related. (ex: one input) AVC = WL /Q = W/ (Q/L) = W/ AP L As AP L rises, AVC falls MP and MC are inversely related MC = dTC/dQ = W dL/dQ = W / (dQ/dL) = W / MP L As MP L declines, MC rises prod. functions cost functions MP L L MC AP AVC Q Q cost
- 13. Long-run Cost Curves Economies of Scale Long-run cost curves show minimum cost in an ideal environment.
- 14. Long Run Cost Functions All inputs are variable (can adjust) in the long run. LAC is long run average cost ENVELOPE of SAC curves LMC is flatter than SMC curves. The optimal plant size for a given output Q 2 is plant size 2. (A SR concept.) However, the optimal plant size occurs at Q 3 , which is the lowest cost point overall. (A LR concept.) Q LAC LMC SAC 2 SMC 2 Q 2 Q 3
- 15. Long Run Cost Function (LAC) Envelope of SAC curves
- 16. Cost Elasticity and Economies of Scale Cost elasticity is ε C = ∂C/C ÷ ∂Q/Q. ε C < 1 means falling AC, increasing returns. ε C = 1 means constant AC constant returns. ε C > 1 means rising AC, decreasing returns.
- 18. Economists think that the LAC is U-shaped Downward section due to: Product-level economies which include specialization and learning curve effects. Plant-level economies , such as economies in overhead, required reserves, investment, or interactions among products (economies of scope). Firm-level economies which are economies in distribution and transportation of a geographically dispersed firm, or economies in marketing, sales promotion, or R&D of multi-product firms.
- 19. Flat section of the LAC Displays constant returns to scale The minimum efficient scale (MES) is the smallest scale at which minimum per unit costs are attained. Upward rising section of LAC is due to: Diseconomies of scale. These include transportation costs, imperfections in the labor market, and problems of coordination and control by management. The maximum efficient scale (Max ES) is the largest scale before which unit costs begin to rise. Modern business management offers techniques to avoid diseconomies of scale through profit centers, transfer pricing, and tying incentives to performance. CRS region MES Max ES DRS LAC
- 20. 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 competitive strategy for new products.
- 21. Cost-volume-profit Analysis Cost-volume-profit Charts Cost-volume-profit analysis shows effects of varying scale. Breakeven analysis shows zero profit points of cost coverage.