Theory of Cost

Cost In Economic Analysis

• By definition, a cost is considered to be relevant if
it is affected by a management decision. Any cost
not affected by a decision is considered irrelevant.
• Both economists and managerial or cost
accountants (as opposed to financial accountants)
use the concept of relevant cost when analyzing
business problems and recommending solutions.
• some important ways to distinguish between relevant and irrelevant
cost.
opportunity Cost Versus out-of-pocket Cost

• Opportunity cost, is the amount or subjective

value that is forgone in choosing one activity
over the next best alternative.
• Out of Pocket cost the is monetary payment.
– On occasion, economists refer to opportunity cost
as implicit cost, and refer to out-of-pocket cost as
explicit cost.
 Historical VS replacement Cost
• Suppose a manufacturer of a video game system has an inventory of
$750,000 worth of 16-bit chips left over from a discontinued system.
Strong protectionist measures by Congress have created a shortage
of these chips, driving their market value up to $1,000,000.
• Meanwhile, the firm decides to reenter the video game market.
(This time, it will manufacture the product in Thailand and will begin
production with the
leftover inventory of chips.) How much will it cost the firm to use
this inventory? Although the historical cost is $750,000, the
replacement value is $1,000,000.
• The relevant cost is replacement cost.
 Economic vs Accounting cost
• Economic cost. All cost incurred to attract
resources into a company’s employ. Such cost
includes explicit cost usually recognized on
accounting records and opportunity cost.
 Fixed versus Variable
• Fixed Cost(FC); Costs that do not change with changes in
output; include the costs of fixed inputs used in production
e.g.
• Sunk Cost ; Sunk costs are thus the amount of these fixed
costs that cannot be recouped.
• variable costs(VC); Costs that change with changes in
output; include the costs of inputs that vary with output
e.g.
• Total cost(TC); Sum of fixed and variable costs
TC = FC + VC
 Short Run vs Long run Cost
• Since the short run is the period of time in
which at least one factor of production remain
constant/fixed; so in short run there is fixes
cost.
– STC = FC + VC
• In the long run all factors become variables so
there is no fixed cost in the long run.
– LTC = TVC
Graphs of TC, VC, FC
 Some other variant of cost
• Average fixed cost (AFC) is defined as fixed costs
(FC) divided by the number of units of output:
AFC = FC/Q.
• Average variable cost (AVC) is defined as
variable cost (VC) divided by the number of
units of output: AVC = VC(Q)/Q
• Average total cost (ATC) is defined as total cost
(TC) divided by the number of units of output:
ATC = C(Q)/ Q
Calculation of Average cost
 Marginal Cost (MC)
• The most important cost concept is marginal
(or incremental) cost. Conceptually,
marginal cost (MC) is the cost of producing an
additional unit of output, that is, the change
in cost attributable to the last unit of output:
MC = ΔC/ ΔQ
Computation of Marginal Cost
 Relations among Costs
• C(Q) = VC(Q) + FC
If we divide both sides of this equation by total
output (Q), we get
C(Q)/Q = VC(Q)/Q + FC/Q
But C(Q)/Q = ATC, VC(Q)/Q = AVC, and FC/Q = AFC.
• Thus, ATC = AVC + AFC
The difference between average total costs and
average variable costs is ATC - AVC = AFC.
Graphical relationship of various cost
components
 The Relation between Short-Run Production and Total Variable Cost

Graph
Total s
Input(L) Output(Q) TVC(L*500) MC Points
(1) (2) (3) (4) (5)
0 $0

1 1,000 500 $0.50 A(A´)

2 3,000 1,000 0.25 B(B´)

3 6,000 1,500 0.16 C(C´)

4 8,000 2,000 0.25 D(D´)

5 9,000 2,500 0.5 E(E´)

6 9,500 3,000 1 F(F´)

7 9,850 3,500 1.42 G(G´)

8 10,000 4,000 3.33 H(H´)

 Cost and Output Relationship
The relationship between diminishing returns and increasing marginal cost can
also be illustrated algebraically. First, assume the variable input is labor (L),
and its unit cost is some given wage rate (W ).
Now let us start by defining marginal cost as:
MC =∆TVC/ ∆Q (7.1)
• Because TVC =L x W, we can say that ∆ TVC = ∆ L * W (7.2)
• Substituting Equation (7.2) into Equation (7.1) gives us MC = (∆L * W)/ ∆Q =
∆L /∆Q * W (7.3)
• Recalling the definition of MP, we know that MPL = ∆Q>∆L. Incorporating
this observation into Equation (7.3) gives us MC =1 /MPL* W = W/MPL (7.4)
• Clearly, Equation (7.4) tells us that, assuming a constant wage rate, MC will
decrease when MP increases and will increase when MP decreases (i.e.,
when the law of diminishing returns takes effect).
 Cost and Output Relationship
A. Productivity and cost are inversely related.
B. In general, marginal pulls average up or down
depending on if it is above or below average.
alternative specifications of the Total Cost
function
 long-run Cost
• n the long run, all costs are variable because the
manager is free to adjust the levels of all inputs.
 Economies of scale
• The economies of scale (or increasing returns to scale [IRTS]). If a firm’s long-run
average cost declines as output increases, the firm is said to be experiencing
economies of scale.
• If long-run average cost increases as output increases, economists consider this
to be a sign of diseconomies of scale (or decreasing returns to scale [DRTS]).
• There is no special term to describe the situation in which a firm’s long-run
average cost remains constant as output increases or decreases. We say that
such a firm experiences efficient scale (or constant returns to scale [CRTS]) over
a range of outputs.
• The smallest output where minimum LRAC is achieved is called minimum
efficient scale. This is often shortened to MES or MinES to distinguish it from the
largest output level for which minimum LRAC is achieved, called maximum
efficient scale (MaxES)
Plausible Reasons of Economies of Scale
long-run average Cost
 Economies of scope
• Economies of scope; This term can be defined as
the reduction of a firm’s unit cost by producing two
or more goods or services jointly rather than
separately.
Or Economies of scope exist when the total cost of
producing Q1 and Q2 together is less than the
total cost of producing Q1 and Q2 separately, that
is, when
C(Q1, 0) + C(0, Q2) > C(Q1, Q2)
 Cost complementarities
• Cost complementarities exist in a
multiproduct cost function when the marginal
cost of producing one output is reduced when
the output of another product is increased.
 Functional Relationship
• The concepts of economies of scope and cost complementarity
can also be examined within the context of an algebraic
functional form for a multiproduct cost function.
• For example, suppose the multiproduct cost function is quadratic:
C(Q1, Q2) = f + aQ1Q2 + (Q1)2 + (Q2)2

• For this cost function,

MC1 = aQ2 + 2Q1
Notice that when a < 0, an increase in Q2 reduces the marginal
cost of producing product 1.
• Thus, if a < 0, this cost function exhibits cost complementarity. If
a > 0, there are no cost complementarities.
 Formula: Quadratic Multiproduct Cost
Function
• The multiproduct cost function
C(Q1, Q2) = f + aQ1Q2 + (Q1)2 + (Q2)2
has corresponding marginal cost functions,
MC1(Q1, Q2) = aQ2 + 2Q1 and MC2(Q1, Q2) = aQ1 + 2Q2

• To examine whether economies of scope exist for a quadratic

multiproduct cost function, recall that there are economies of scope if
C(Q1, 0) + C(0, Q2) > C(Q1, Q2)
or, rearranging, C(Q1, 0) + C(0, Q2) - C(Q1, Q2) > 0
This condition may be rewritten as
f + (Q1)2 + f + (Q2)2 - [f + aQ1Q2 + (Q1)2 + (Q2)2] > 0
which may be simplified to f - aQ1Q2 > 0
Thus, economies of scope are realized in producing output levels Q1 and
Q2 if f > aQ1Q2
Summary of the Properties of the Quadratic
Multiproduct Cost Function
• The multiproduct cost function
• C(Q1, Q2) = f + aQ1Q2 + (Q1)2 + (Q2)2
1. Exhibits cost complementarity whenever
a<0.
2. Exhibits economies of scope whenever
– f-aQ1Q2 > 0.
 Numerical Illustration
• Suppose the cost function of firm A, which produces two goods,
is given by
C = 100 - .5Q1Q2 + (Q1)2 + (Q2)2
The firm wishes to produce 5 units of good 1 and 4 units of
good 2.
1. Do cost complementarities exist? Do economies of scope
exist?
• Firm A is considering selling the subsidiary that produces good
2 to firm B, in which case
it will produce only good 1. What will happen to firm A’s costs if
it continues to produce 5 units of good 1?
 Numerical Illustration
• For this cost function, a = -1/2 < 0, so indeed there are cost complementarities. To
check for economies of scope, we must determine whether f - aQ1Q2 > 0.
• This is clearly true since a < 0 in this problem. Thus, economies of scope exist in
producing 5 units of good 1 and 4 units of good 2.
• To determine what will happen to firm A’s costs if it sells the subsidiary that
produces good 2 to firm B, we must calculate costs under the alternative
scenarios. By selling the subsidiary, firm A will reduce its production of good 2
from 4 to 0 units; since there are cost complementarities, this will increase the
marginal cost of producing good1.
• Notice that the total costs to firm A of producing the 5 units of good 1 fall from
C(5, 4) = 100 - 10 + 25 + 16 = 131
to
C(5, 0) = 100 + 25 = 125
But the costs to firm B of producing 4 units of good 2 will be
C(0, 4) = 100 + 16 = 116
Firm A’s costs will fall by only $6 when it stops producing good 2, and the costs to
firm B of producing 4 units of good 2 will be $116. The combined costs to the two
firms of producing the output originally produced by a single firm will be $110 more
than the cost of producing by a single firm.
Numerical Illustration
 Fill this Table

A firm’s fixed costs for 0 units of output and its average total cost of
producing different output levels are summarized in the following table.
Complete the table to find the fixed cost, variable cost, total cost, average
fixed cost, average variable cost, and marginal cost at all relevant levels of
output.
 solution

Q FC VC TC AFC AVC ATC MC

0 15000 0 15000
100 15000 15000 30000 150 150 300 150
200 15000 25000 40000 75 125 200 100
300 15000 37500 52500 50 125 175 125
400 15000 75000 90000 37.5 187.5 225 375
500 15000 147500 162500 30 295 325 725
600 15000 225000 240000 25 375 400 775