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    This document discusses cost theory and estimation. It defines different types of costs like explicit, implicit, and opportunity costs. It also discusses relevant versus irrelevant costs. It then provides an example calculating explicit costs, implicit costs, business profit, economic profit, and normal return on investment for a business case study. The document also discusses short-run and long-run cost functions and curves, including total cost, average cost, marginal cost, and their theoretical and empirical estimation. It addresses issues with empirical cost data collection and estimation of cost curves.

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    This document discusses cost theory and estimation. It defines different types of costs like explicit, implicit, and opportunity costs. It also discusses relevant versus irrelevant costs. It then provides an example calculating explicit costs, implicit costs, business profit, economic profit, and normal return on investment for a business case study. The document also discusses short-run and long-run cost functions and curves, including total cost, average cost, marginal cost, and their theoretical and empirical estimation. It addresses issues with empirical cost data collection and estimation of cost curves.

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    38 views20 pages

    Chapter 8 Cost 2020

    Uploaded by

    abc
    This document discusses cost theory and estimation. It defines different types of costs like explicit, implicit, and opportunity costs. It also discusses relevant versus irrelevant costs. It then provides an example calculating explicit costs, implicit costs, business profit, economic profit, and normal return on investment for a business case study. The document also discusses short-run and long-run cost functions and curves, including total cost, average cost, marginal cost, and their theoretical and empirical estimation. It addresses issues with empirical cost data collection and estimation of cost curves.

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    Chapter 8

    Cost Theory and


    Estimation
    The Nature of Costs
    • Explicit Costs
    – Accounting Costs
    • Economic Costs
    – Implicit Costs
    – Alternative or Opportunity Costs
    • Relevant Costs – those that will be affected by the
    decision; those that will not be affected are
    irrelevant.
    – Sunk Costs are Irrelevant
    – Incremental Costs are relevant – e.g. make or buy
    decision – compare the savings in cost with increase
    in exp; example - a cattle feed factory to be setup by
    the dairy. V J Sebastian, IMT Ghaziabad, 2019
    The Nature of Costs
    A woman managing a photocopying establishment in the U.S. for $25,000 per
    year decides to open her own duplicating place. Her revenue during the first
    year of operation is $120,000, and her expenses are as follows:
    -----------------------------------------------------------
    Salaries to hired help : $45,000
    Supplies 15,000
    Rent 10,000
    Utilities 1,000
    Interest on bank loan 10,000
    ------------------------------------------------------------
    Total 81,000
    ----------------------------------------------------------------
    Calculate (a) the explicit costs, (b) the implicit costs, (c) business profit, (d)
    economic profit, and (e) normal return on investment in this business.
    a) Explicit costs: $81,000
    b) Implicit cost: $25,000 (i.e., the entrepreneur’s foregone salary).
    c) Business profit ( TR minus explicit costs ) $120,000 - $81,000 = $39,000
    d) Economic profit : 120,000 - (81000+ 25000) = $14,000
    e) The normal return on investment equals the implicit costs of the entrepreneur (i.e.,
    her salary foregone) of $25,000.
    Short-Run Cost Functions

    Total Cost(TC) = f(Q)


    Total Fixed Cost = TFC
    Total Variable Cost = TVC
    TC = TFC + TVC

    V J Sebastian, IMT Ghaziabad, 2019


    Short-Run Cost Functions

    Average Total Cost = ATC = TC/Q


    Average Fixed Cost = AFC = TFC/Q
    Average Variable Cost = AVC = TVC/Q
    ATC = AFC + AVC
    Marginal Cost = TC/Q = TVC/Q
    V J Sebastian, IMT Ghaziabad, 2019
    Short-Run Cost Functions

    Q TFC TVC TC AFC AVC ATC MC


    0 $60 $0 $60 - - - -
    1 60 20 80 $60 $20 $80 $20
    2 60 30 90 30 15 45 10
    3 60 45 105 20 15 35 15
    4 60 80 140 15 20 35 35
    5 60 135 195 12 27 39 55

    V J Sebastian, IMT Ghaziabad, 2019


    Short-Run Cost Functions

    Average Variable Cost


    AVC = TVC/Q = w*L/Q=w/(Q/L)= w/APL
    Marginal Cost
    TC TVC wL w(L) w
         w/MPL
    Q Q Q Q Q / L

    V J Sebastian, IMT Ghaziabad, 2019


    Long-Run Cost Curves

    Long-Run Total Cost = LTC = f(Q)


    Long-Run Average Cost = LAC = LTC/Q
    Long-Run Marginal Cost = LMC = LTC/Q

    Sec G 18-8-2020

    V J Sebastian, IMT Ghaziabad, 2019


    Derivation of Long-Run Cost Curves

    V J Sebastian, IMT Ghaziabad, 2019


    Relationship Between Long-Run and
    Short-Run Average Cost Curves

    V J Sebastian, IMT Ghaziabad, 2019


    Possible Shapes of
    the LAC Curve

    V J Sebastian, IMT Ghaziabad, 2019


    U-Shape of the LAC Curve

    V J Sebastian, IMT Ghaziabad, 2019


    Minimizing Costs Internationally

    • Foreign Sourcing of Inputs


    • New International Economies of
    Scale
    • Immigration of Skilled Labor
    • Brain Drain

    V J Sebastian, IMT Ghaziabad, 2019


    Architecture of Ideal Firm

    • Core Competencies
    • Outsourcing of Non-Core Tasks
    • Learning Organization
    • Efficiency and Flexibility
    • Location Near Markets
    • Agility in Responding to Market Forces

    V J Sebastian, IMT Ghaziabad, 2019


    Empirical Estimation of Cost Functions:
    Data Collection Issues

    • Opportunity Costs Must be Extracted


    from Accounting Cost Data
    • Costs Must be Apportioned Among
    Products
    • Costs Must be Matched to Output Over
    Time
    • Costs Must be Corrected for Inflation
    V J Sebastian, IMT Ghaziabad, 2019
    Empirical Estimation[1]

    Functional Form for Short-Run Cost Functions

    Theoretical Form Linear Approximation

    TVC  aQ  bQ 2  cQ3 TVC  a  bQ

    TVC a
    AVC   a  bQ  cQ 2
    AVC   b
    Q Q

    MC  a  2bQ  3cQ 2
    MC  b

    V J Sebastian, IMT Ghaziabad, 2019


    Empirical Estimation[2]
    Theoretical Form Linear Approximation
    Empirical Estimation
    Long-Run Cost Curves

    • Cross-Sectional Regression Analysis


    • Engineering Method- use info from eng. design
    • Survival Technique- E.g. If small & large firms
    survived for fairly long time, it implies constant returns.

    • We may compare the % share of output from small,


    medium and large firms over the period of study; if they are
    fairly constant it confirms constant returns to scale.
    V J Sebastian, IMT Ghaziabad, 2019
    Empirical Estimation

    Actual LAC versus empirically estimated LAC’

    V J Sebastian, IMT Ghaziabad, 2019

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