BEC 30325: MANAGERIAL ECONOMICS

Session 07

Cost Theory and

Estimation

Dr. Sumudu Perera

 Session Outline
• The Nature of Costs 2
• Explicit Costs
• Implicit Costs
• Short-Run Cost Functions
• Long-Run Cost Curves

Dr.Sumudu Perera 10/27/16

 The Nature of Costs

• Explicit Costs
• Accounting Costs
• Economic Costs
• Implicit Costs
• Alternative or Opportunity Costs
• Relevant Costs
• Incremental Costs
• Sunk Costs are Irrelevant

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 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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 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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 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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 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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 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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 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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 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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 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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 Short-Run Cost Functions

Total Cost = TC = f(Q)

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

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 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
13 AVC = VC/Q
 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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 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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 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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 Graphical Presentation

$ 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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 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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 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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 Short-Run Cost Functions-Example

Q TFC TVC TC AFC AVC ATC MC

0 60 0
1 60 20
2 60 30
3 60 45
4 60 80
5 60 135
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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 Graphical Presentation

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 Average Cost Curves-Graphical 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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 Wage Rate

Average Variable Cost

AVC = TVC/Q = w/APL

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

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 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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 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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 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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 Derivation of Long-Run Cost Curves

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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Relationship Between Long-Run and Short-Run
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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 Possible Shapes of the LAC Curve

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
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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.