T7:

Cost Theory and

Estimation

by
Assoc. Prof. Sami Fethi
 CH 7: Cost
Theory
The Nature of Costs

 Explicit Costs
 Accounting Costs
 Economic Costs
 ImplicitCosts
 Alternative or Opportunity Costs

 Relevant Costs
 Incremental Costs
 Sunk Costs are Irrelevant

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
The Nature of Costs

• Costs are incurred as a result of

production.
• Economists define cost in terms of
opportunities that are sacrificed when a
choice is made. Therefore, economic costs
are simply benefits lost .
• Accountants define cost in terms of
resources consumed. Accounting costs
reflect changes in stocks (reductions in
good things, increases in bad things) over
a fixed period of time.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Explicit Costs

 Explicit costs are actual expenditures of

the firm to hire, rent, or purchase the
inputs it requires in production. These
includes the wages to hire labor, the rental
price of capital, equipment, and buildings,
and the purchase price of raw materials
and semi finished products.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Implicit Costs

 Implicit costs refers to the value of the

inputs that are owned and used by the firm
in its own production activity. These includes
the highest salary that the entrepreneur
could earn in his or her best alternative
employment and the highest return that the
firm could receive from investing its capital in
the most rewarding alternative use or renting
its land and buildings to the highest bidder.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Economic Costs

 Economic cost refers the sum of explicit and

implicit costs. These costs must be
distinguished from accounting costs, which
refer only to the firm’s actual expenditures,
or explicit cost, incurred for purchased or
hired inputs.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Alternative or Opportunity Costs

 The cost to the firm of using a purchased or

owned input is equal to what the input could
earn in its best alternative use.
• The firm must include the alternative or
opportunity costs because the firm cannot
retain a hired input if it pays a lower price for
the input than another firm.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Relevant and Irrelevant Costs

 Relevant Costs: The costs that should be

considered in making a managerial decision;
economic or opportunity costs.
Incremental costs: the total increase in
costs for implementing a particular
managerial decision.
• Irrelevant or Sunk Costs: The cost that are
not affected by a particular managerial
decision.
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Short-Run Cost Functions

 In short-run period, some of the firm’s

inputs are fixed and some are variable, and
this leads to fixed and variable costs.
 Total costs is the cost of all the productive
resources used by the firm. It can be
divided into two separate costs in the short
run.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Total fixed and variable costs

 Total Fixed Costs: The total obligations of

the firm per time period for all the fixed
inputs the firm uses.
 Total Variable Costs: The total obligations
of the firm per time period for all the
variable inputs the firm uses.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Short-Run Cost Functions

Total Cost = TC = f(Q)

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

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Average Costs

 Average total cost (also called average cost)

equals total cost per unit of output produced

ATC = TC/Q
 Average fixed cost equals fixed cost divided
by quantity produced
AFC = FC/Q
 Average variable cost equals variable cost
divided by quantity produced
AVC = VC/Q
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Average Costs and Marginal Cost

 Average total cost is also the sum of average fixed

cost and average variable cost.
ATC = AFC + AVC

 Marginal (incremental) cost is the increase in total

cost resulting from a one-unit increase in output.
Marginal decisions are very important in
determining profit levels.
MC = ΔTC/ΔQ

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Average Costs and Marginal Cost

•The marginal cost curve, average variable

cost curve and average total cost curves are
generally U-shaped.
•The U-shape in the short run is attributed to
increasing and diminishing returns from a
fixed-size plant, because the size of the plant
is not variable in the short run.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Average Costs and Marginal Cost

•The marginal cost and average cost curves are

related
When MC exceeds AC, average cost must
be rising
When MC is less than AC, average cost
must be falling
•This relationship explains why marginal cost
curves always intersect average cost curves
at the minimum of the average cost curve.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Graphical Presentation Theory

$ MC will intersect the AVC at the

minimum of the AVC [always].
MC
ATC
AVC
ATC* R MC will intersect the ATC
at the minimum of the ATC.
AVC* TC = ATC* x Q** J The vertical distance between
TVC = AVC* x Q* ATC and AVC at any output is
the AFC. At Q** AFC is RJ.

Q* Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Relationship Between Marginal and Average Costs

If MC > ATC, then ATC is rising

If MC = ATC, then ATC is at its minimum
If MC < ATC, then ATC is falling

If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum
If MC < AVC, then AVC is falling

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

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

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Short-Run Cost Functions-Example

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
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
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Graphical Presentation Theory

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Average Cost Curves-GraphicalTheory
meaning

• The average fixed cost curve slopes

down continuously.
• The average total cost curve is the
vertical summation of the average fixed
cost curve and the average variable
cost curve
The ATC curve is always higher than
AFC and AVC curves
• While output gets big and AFC decline
to zero, the AVC curve approaches the
ATC curve.
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Wage Rate

Average Variable Cost

AVC = TVC/Q = w/APL

Marginal Cost
TC/Q = TVC/Q = w/MPL

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Long-Run Cost Curves

•The long run is the period of time during which:

Technology is constant
All inputs and costs are variable
The firm faces no fixed inputs or costs
The long run period is a series of short run
periods. [For each short run period there is a
set of TP, AP, MP, MC, AFC, AVC, ATC, TC,
TVC & TFC for each possible scale of plant].

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Long-Run Cost Curves

Long-Run Total Cost = The minimum total

costs of producing various levels of output
when the firm can build any desired scale
of plant: LTC = f(Q)
Long-Run Average Cost = The minimum
per-unit cost of producing any level of
output when the firm can build any desire
scale of plant: LAC = LTC/Q
Long-Run Marginal Cost = The change in
long-run total costs per unit change in
output: LMC = LTC/Q
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

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

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Derivation of Long-Run Cost Curves Theory

From point A on
the expansion path
in the first panel
with w=$ 10 and
r=$ 10, the firm
uses 4 units of
labor 4L and 4
units of capital 4k
and the minimum
totalcost producing
1Q is $80. This is
shown as point A’
and A’’ on the long-
run total cost curve
in the middle panel
and bottom panel.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
Relationship Between Long-Run and Short-Run CH 7: Cost
Theory
Average Cost Curves The top panel of the
figure is based on the
assumption that the
firm can build only
four scales of plant
SAC1 etc.., while the
bottom panel is based
on the assumption
that the firm can build
many more or an
infinite number of
scales of plant. At A’’
min av cost of
producing o/p is $80.
At B* the firm can
produce 1.5Q at an av
cost of $70 by using
either SAC1 or SAC2
and so on..

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Possible Shapes of the LAC Curve Theory

The left panel shows a U-shaped LAC curve which

indicates first decreasing and then increasing returns
to scale. The middle panel shows a nearly L-shaped
LAC curve which shows that economies of scale
quickly give way to constant returns to scale or
gently rising LAC. The right panel shows an LAC
curve that declines continuously, as in the case of
natural monopolies. 28
© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Learning Curves Theory

The learning curve shows the decline in the

average input cost of production with rising
cumulative total outputs over time. The learning
curve also shows that the average cost is about $
250 for producing the 100th unit at point F etc..
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Learning Curves Theory

Average Cost of Unit Q = C = aQb

Estimation Form: log C = log a + b Log Q
The Learning curve can be express algebraically as follows:
(C is cost of the Qth unit of output)

ln C = ln a + b ln Q
Linearized version, can be easily estimated and interpreted.

ln C = 3 – 0.3 ln Q
If Q increases by 1%, then unit (average) costs decrease by 0.3%.

Useful to make predictions for the future: how much does the
average cost for the 100th unit as well as 200th:

lnC =3 – 0.3ln100 = 2.4 ==> C = antilog of (2.4) =$251.19

lnC =3 – 0.3ln200 =2.31==>C =antilog of (2.31) =$204.03
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Cost-Volume-Profit Analysis

Cost-volume-profit or breakeven analysis examines

the relationship among the TR, TC, and total profits
of the firm at various levels of o/p. This technique is
often used by business executives to determine the
sales volume required for the firm to break even
and the total profits and losses at other sales levels.
The analysis uses a cost-volume-profit chart in
which the TR and TC curves are represented by
straight lines and the break-even o/p (Q B) is
determined at their intersection.
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Cost-Volume-Profit Analysis
The slope of the total
revenue TR curve
refers to the product
price of $10 per unit.
The vertical intercept
of the total cost of
(TC) curve refers
TFC of $200, and the
slope of the TC
curve to the AVC of
$5. The break-even
with TR=TC $400 at
the output (Q) of $40
units per time period
at the point B.

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Cost-Volume-Profit Analysis

Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

Breakeven Volume TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC/(P - AVC)

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Break-even o/p

QBE = TFC/(P - AVC)

P = 40
TFC = 200
AVC = 5
QBE = 40

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Theory

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
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Theory

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory
Operating Leverage and the other concepts

Operating leverage: The ratio of the firm’s total

fixed costs to its total variable costs.
Contribution margin per unit: The excess of the
selling price of the product over the average
variable costs of the firm (i.e. P-AVC) that can be
applied to cover the fixed costs of the firm and to
provide profits.
Degree of operating leverage (DOL): The
percentage change in the firm’s profits divided by
the percentage change in output or sales; the
sales elasticity of profits.
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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

Operating Leverage

Operating Leverage = TFC/TVC

Degree of Operating Leverage = DOL

% Q( P  AVC )
DOL  
%Q Q( P  AVC )  TFC

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 CH 7: Cost
Theory

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.
 CH 7: Cost
Theory

The End

Thanks

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© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.