Economics For Managers: Cost Functions

Economics for Managers
Cost Functions
Learning Objective: Session 8
 At the end of this session, you should be

able to:
– Identify the output level at which the average total
cost is minimized both for the short run and the
long run
Now, suppose …
 Reacting to demand-supply dynamics you

decide to up output to 300. Or later to 400.
And then to 500
 For each output level you can arrive at a new
minimum cost combination of Inputs 1 and 2.
(Assume that input prices remain the same;
though you don’t have to!)
From Quantities to Costs
 We can estimate the minimum cost combinations of inputs 1

and 2 for any targeted production
– Hypothetical Example 100: (10,5), 200: (15,7.5), 300: (18,9)
 Given the input prices for the inputs we can then estimate the
costs for these combinations of inputs 1 and 2 for different
levels of output.
– Hypothetical Example 100: (10x5,5x10), 200:
(15x5,7.5x10), 300: (18x5,9x10)
And plotting the costs for
various levels of output, gives
us what?
Long Run Cost Function
Long Run Cost Function
 We plotted a simple LR Cost Curve

 How would it look, for example, for industries
that have increasing returns to scale (like our
Telecom example)
Think! Try!
Like this?
initial economies
of scale followed
by diseconomies
of scale due to
limiting factors
Note the language ….
 We talked about ‘returns to scale’ in the

context of production functions and quantities
and now we are talking about ‘economies..
and diseconomies of scale’ because we have
brought in monetary units and costs
Economies and Diseconomies of
Scale
 For eg:TC=100,000Q-1000Q2+10Q3
is an eg of LTC because when output is zero,

TC is zero; TC is a f(Q).
The second power of Q represents economies
of scale
 The third power of Q represents
diseconomies of scale
But ….
 assumes that the manager has the flexibility

to choose exactly the optimum input
combination for every targeted level of
output. In other words, we are assuming that
all input factors are controllable/ variable
 However, many a time we are concerned
about firms taking decisions in the short run
 Therefore…..
Short Run Decisions
 In the short run, one or more of the inputs

maybe fixed (in quantity terms)
 Therefore, we talk of short run cost functions
Short Run Cost Fn
 How will it look? What will it reflect? Consider

our two-input example where one of the
inputs (say input 1) is fixed (say at 15 units)
[remember the cost of input 1 was Rs.5/unit]
Again, think! Try!

Short Run Cost Fn and Fixed
Costs
 How will it look? What will it reflect? Consider

our two-input example where one of the
inputs (say input 1) is fixed (say at 15 units)
 Since input 1 is fixed in quantity, the cost
corresponding to it also fixed
 In our example = 15x5 =75. This is what
businesses refer to as the fixed cost
Total Costs
 But the total costs for the firm is the sum of

the costs of both inputs 1 and 2. Costs of
input 1 are what constitutes the fixed costs
 What about the costs of input 2?
 The quantities of input 2 will increase with
output and therefore are referred to as
variable costs
Total Costs (Short Run) Curve
 Want to attempt to plot the curve of total costs?
First what?
Total Costs
Which element
will you plot first?
Output
What next?
Total Costs
75 Fixed Costs
Output
Unit Cost of Input 2 =

B Rs.10. And, as we saw in
yesterday’s example if the
marginal product of input
A 2 exhibits increasing
returns followed by
Total Costs
decreasing returns …
What do curves A and B
represent?
75 Fixed Costs
Output
Total Costs
Variable Costs
Total Costs
75 Fixed Costs
Output
Short run cost function
 See example in Table 7.1 of P&R

Unit Economics Analytics
 In the graph we have fixed costs, total

variable costs, total costs and output
 We will now convert these to average cost
functions to get a better idea of unit
economics
Look at the excel sheet
of family of cost fns
The family of cost functions
 TC= 200+5Q-.04Q2 + .001Q3

It is a short run cost function.
So,
 Average Fixed Cost
 Average Variable Cost
 Average Total Cost and as always ………
 ??????
The family of cost functions
 Average Fixed Cost (AFC)

 Average Variable Cost (AVC)
 Average Total Cost (ATC) and as always
 Marginal cost (MC)
 AFC, AVC and ATC are easy to understand; it is
just per unit output versions of FC, TVC, and TC
 But what is MC?
Marginal Cost
 MC tells us how much it will cost to expand

output by one unit. Mathematically, MC is
therefore the first derivative of TC
 Or MC = dTC/dQ
 So given a TC function, we can get the MC
function
Think!
 For Microsoft, what would be the marginal

costs for producing one more copy of MS-
Office?
Near zero…
 Producing first copy is always expensive but

producing subsequent copies is very cheap!
MC is near zero!
Example of a Short Run Decision
 We will first look at an example of analyzing

output decisions given a capacity decision
that is already taken
Example: Output Decision
 TC=200+5Q-.04Q2+0.001Q3
 Assume a pencil manufacturing unit for which this is
the Short Run Cost Function for the range 10 million
to 80 million pieces. Costs are in millions of rupees
and Q is also in millions. Assume it is currently
producing 40 million units
 Why this form? Because as output increases,
depending on the nature of the production function
(the technology), costs may not behave linearly. And
therefore, we take higher orders of Q.
 What is the Fixed Cost?
 TC=200+5Q-.04Q2+0.001Q3
 Fixed Costs = 200
 Find out total cost, and average total cost, average
fixed cost and average variable cost
 TC=200+5Q-.04Q2+0.001Q3
 Find out total cost, and average total cost and
average variable cost
 Plot ATC, AFC and AVC against output
 TC=200+5Q-.04Q2+0.001Q3
 You have plotted ATC, AFC and AVC
 What other (important) cost function is left?
 TC=200+5Q-.04Q2+0.001Q3
 So, AC=TC/Q=200/Q+5-0.04Q+0.001Q2
 And MC=dTC/dQ=??
 TC=200+5Q-.04Q2+0.001Q3
 So, AC=TC/Q=200/Q+5-0.04Q+0.001Q2
 And MC=dTC/dQ=5-0.08Q+0.003Q2
Plot the MC curve along with

ATC, AFC and AVC
REFER TO THE EXCEL SHEET
AND PLOTS.
What do you notice? Remember
last session when we worked with
average and marginal outputs?
 TC=200+5Q-.04Q2+0.001Q3
 So, AC=TC/Q=200/Q+5-0.04Q+0.001Q2
 And MC=dTC/dQ=5-0.08Q+0.003Q2
 If your objective is to minimize the average

total cost, what level of output would you
choose?
 TC=200+5Q-.04Q2+0.001Q3
 So, ATC=TC/Q=200/Q+5-0.04Q+0.001Q2
 And MC=dTC/dQ=5-0.08Q+0.003Q2
 If your objective is to minimize the average total

cost, what level of output would you choose?
 An output level of 54: at this level note (again!)
MC = ATC
ANALYTICS:
Importance of functions!
Digital firms
 Do these findings hold true for digital firms as

well?
 What will the MC curve look like? Are the
MCs U-shaped?
Short Run and Long Run Cost
Functions
 TC=200+5Q-.04Q2+0.001Q3
 This was an example of a short run cost
function. How would a long run cost function
be different?
Long run cost functions
 Long run cost functions are similar but there

will be no fixed factor input, and therefore no
fixed costs. If there is a fixed factor, it is
interpreted as technology.
Capacity Decision
 In the earlier example we looked at an output

decision given a capacity
 Now we look at the capacity decision itself:
the long run decision
Example of a Long Run Cost
Function
 TC=100,000Q-1000Q2+10Q3
 The second power of Q represents
economies of scale
 The third power of Q represents
diseconomies of scale
 A firm is planning to enter with a capacity of
25 million pencils.
 TC = ??
Example of a Long Run Cost
Function
 TC=100,000Q-1000Q2+10Q3
 A firm is planning to enter with a capacity of
25 million pencils.
 TC = Rs.20,31,250
 Now? Should he go ahead with this
decision?
Capacity Decision
 Assuming objective is to minimize ATC

 AC @ 25 = (20,31,250)/25 = Rs.81250 per
million
 TC=100,000Q-1000Q2+10Q3
 So, what is the capacity that minimizes ATC?
And what is the minimum ATC?
Capacity Decision
 TC=100,000Q-1000Q2+10Q3
 ATC= 100000-1000Q+10Q2
ANALYTICS:
 dATC/dQ=-1000+20Q=0 Importance of
functions &
 20Q=1000 calculus!
 Q=50 mill
 At 50 mill , ATC=75,000 which is the
minimum ATC

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Economics for Managers

 At the end of this session, you should be

 Reacting to demand-supply dynamics you

 We can estimate the minimum cost combinations of inputs 1

 We plotted a simple LR Cost Curve

 We talked about ‘returns to scale’ in the

is an eg of LTC because when output is zero,

 assumes that the manager has the flexibility

 In the short run, one or more of the inputs

 How will it look? What will it reflect? Consider

Again, think! Try!

 How will it look? What will it reflect? Consider

 But the total costs for the firm is the sum of

Unit Cost of Input 2 =

 See example in Table 7.1 of P&R

 In the graph we have fixed costs, total

The family of cost functions

 TC= 200+5Q-.04Q2 + .001Q3

 Average Fixed Cost (AFC)

 MC tells us how much it will cost to expand

 For Microsoft, what would be the marginal

 Producing first copy is always expensive but

 We will first look at an example of analyzing

Plot the MC curve along with

 If your objective is to minimize the average

 If your objective is to minimize the average total

 Do these findings hold true for digital firms as

 Long run cost functions are similar but there

 In the earlier example we looked at an output

 Assuming objective is to minimize ATC

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