Empirical Estimation of Cost Functions Medj Final

Hello everyone, good morning.
Today, I will discuss the topic of Empirical Estimation

of Cost Functions.
Empirical Estimation of Cost Functions
 It is essential for many managerial decisions purposes, there are two empirical
estimation of cost functions: short and long run functions
 The short run function helps define short-run marginal costs and thus necessary
for the firm in determining optimal level of output and prices.
 In the long run, the decision that a firm faces involves building the most efficient
size of plant.
That determination will depend on the existence of scale economies and
diseconomies.
The Estimation of Short-run cost Functions: Data and measurement Problem

The most common method of estimation the firm’s short run functions is
 Regression Analysis, whereby total variable cost are regressed against output
and a few other variables, such as input prices and operating conditions, during
the time period when the size of the plant is fixed.
- The firm’s total cost function can then be obtained by simply adding the best
estimate possible of the fixed costs to the total variable costs.
The firms’ average variable and marginal cost functions can be easily
obtained from total variable cost function
- The firm’s cost function are based on the assumption of constant input
prices.
If input prices increase, they will cause an upward lift of the entire cost
function.
Although it may seem easy, there are several data and measurement
difficulties involved in estimating the firm's short-run cost functions.
Empirical Estimation Data Collection Issues

 Opportunity cost must be extracted from accounting cost data.
-Each input that is used in the production process must be valued at its
opportunity cost, which is determined by what it may earn if employed in the best
possible way rather than by the actual expenditure of the input.
- For example, inventories used in current production must be valued at
current market prices rather than at historical cost.
 Cost must be divided among products.

- It should be allocated to various products correctly.
 Cost must be matched to output over time.
 Cost must be corrected for inflation.
- Since input prices typically increase at various rates, it will be necessary to
utilize the price index for each category of inputs to derive the deflated values that
will be used in the regression analysis.
The Functional Form of Short-run Cost Functions

 Economic theory postulates an S-shaped (cubic) TVC curve, with corresponding
U-shaped AVC and MC curves. The general equations for these functions are,
respectively,
 The right
panel of
figure 1
shows a
linear
approximation to the cubic TVC curve, which often gives a good empirical fit of
the data points over the observed range of outputs. The estimated equations of
the linear approximation to the S-shaped or cubic TVC curve and of its
corresponding.
Empirical Estimation Long-run Cost Curves
The empirical estimation of long-run cost curves is even more difficult than the
estimation of short-run cost curves.
The objective of estimating the long-run curves is to determine the best scale of plant
for the firm to build in order to minimize the cost of producing the anticipated level of
output in the long run.
 Cross Sectional Regression Analysis

- present some difficulties, when firms in different geographical regions are
likely to pay different prices for their inputs, and so input prices must be included
together with the levels of output as independent explanatory variables.
- This method are seldom used to estimate long run cost functions because
the period of observation must be sufficiently long for the firm to have change its
scale of plant several times.
- It will become more difficult to reconcile the different accounting and
operational practices of the different firms. For example, some firms pay lower wages
but has many benefits compared to those firms that provide smaller benefits to their
workers. If only wages are included in labor cost, the former firms will mistakenly
seem to have lower labor cost than the latter firms.
- It may also be very difficult to determine if each firm is operating the optimal
scale of plant at the optimal level of output.
 Engineering Technique
- uses knowledge of the physical relationship between inputs and output
expressed by the production function to determine the optimal input combination
needed to produce, various levels of output by multiplying the optimal quantity of
each input by the price of the input, we obtain the long-run cost function of the firm.
- Particularly useful in estimating the cost of new products or improved
products resulting from the application of new technologies, where historical data are
not available.
 Survival Technique
- implicitly assumes a highly competitive form of market structure in which

survival depends only on economic efficiency.
- With large economies of scale over a wide range of outputs, large and more
efficient firms would drive smaller and less efficient firms out of business, thus
leaving only large firms in the industry in the long run.
And that ends my discussion about the Empirical Estimation of Cost Functions.

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Hello everyone, good morning.

Today, I will discuss the topic of Empirical Estimation

Empirical Estimation of Cost Functions

The Estimation of Short-run cost Functions: Data and measurement Problem

Empirical Estimation Data Collection Issues

 Cost must be divided among products.

The Functional Form of Short-run Cost Functions

Empirical Estimation Long-run Cost Curves

 Cross Sectional Regression Analysis

- implicitly assumes a highly competitive form of market structure in which

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