THEORY OF COST. Cost: The sacrifice incurred whenever an exchange or transformation of resources takes place.
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1 THEORY OF COST Glossary of New Terms Cost: The sacrifice incurred whenever an exchange or transformation of resources takes place. Sunk Cost: A cost incurred regardless of the alternative action chosen in a decision-making problem. Cost Function: A mathematical model, schedule, or graph that shows the cost (such as total, average, or marginal cost) of producing various quantities of output. Opportunity Cost: The value of a resource in its next best alternative use. Opportunity cost represents the return or compensation hat must be foregone as the result of the decision to employ the resource in a given economic activity. Marginal Cost: The incremental increase in total cost that results from a one-unit increase in output. Cost Elasticity: A measure that indicates the percentage change in total costs associated with a 1-percent change in output.
2 MELec9_2:Theory of Cost Page -2- Economies of Scale: Declining long-run average costs as the level of output for the firm (or production plant) is increased. The decline in costs is generally attributed to production or marketing advantages. Diseconomies of Scale: Rising long-run average costs as the level of output is increased. Minimum Efficient Scale: The output level at which longrun average costs are first minimized. Capacity: The output level at which short-run average costs are minimized. Operating Leverage: the use of assets having fixed costs (e.g. depreciation) in an effort to increase expected returns.
3 MELec9_2:Theory of Cost Page -3- Accounting Vs Economic Costs Accountants have been primarily concerned with measuring costs for financial reporting purposes. As a result, they define and measure cost by the historical outlay of funds that takes place in the exchange or transformation of a resource. Economists have been mainly concerned with measuring costs for decision-making purposes. The objective is to determine the present and future costs (or resources) associated with various alternative courses of action. In calculating the cost to the firm of producing a given quantity of output, economists include some additional costs that are typically not reflected in financial reports. Explicit cost are considered by both groups Implicit costs are considered by economists: Opportunity cost of time Opportunity cost of capital Economic Profit = Tot Rev - Exp Cost - Imp Cost
4 MELec9_2:Theory of Cost Page -4- Short-Run Cost Functions In addition to measuring the costs of producing a given quantity of output, economists are also concerned with determining the behavior of costs as output is varied over a range of possible output values. The behavior of costs is expressed in terms of a cost function. Total Cost Function Total Cost = sum of all costs; that is: TC = FC + TVC Note: we use TVC and VC interchangeably 1. For empirical estimation purposes we modify the TC function to exclude FC; or, TC = TVC. 2. The TC (TVC) function is assumed to follow a cubic shape (an empirical assertion). 3. The assumption of a cubic shape requires empiricists to explicitly consider data points (TC,Q combinations) that capture the extreme points (low / high output combinations). 4. Must learn to focus on AC and MC for empirical model-building efforts
5 MELec9_2:Theory of Cost Page -5- Empirical Cost Functions Type Form Problem Linear: TVC = a + bqx Unrealistic 2 Quadratic TVC = a + bqx cqx Extreme points missing 2 3 Cubic: TVC = a + bqx cqx + dqx Multicollinearity Focal Point: Transforming the TVC function to reduce its specification in Q x. Later, we shall focus on using the AC function for most empirical estimation.
6 MELec9_2:Theory of Cost Page -6- Ore Mining Example: Cost Data For 750 hpwr Q L VC FC TC AFC AVC ATC MC ERR a. rent of the ore-mining equipment = $0.20 per horsepower (750 x 0.20 = $150) b. cost of each worker employed is $50 per period. For the Table Above Define: 1. TC = FC + VC 2. AFC = FC Q AVC = VC Q 4. ATC = TC Q or AFC + AVC
7 MELec9_2:Theory of Cost Page MC = TVC Q, note that under a simple linear relationship between TVC and Q, MC is constant: TVC = a + bq, where b = TVC Q = MC 6. Cost Elasticity ε = % TC % Q = TC Q. Q TC where: ε < 1 increasing returns to scale ε = 1 constant ε > 1 decreasing
8 MELec9_2:Theory of Cost Page -8- The cost relationship for the Ore Mining Example:
9 MELec9_2:Theory of Cost Page -9- Max MP Max AP AP MP Cost per Unit MC MIN AVC and the point where AVC = MC ATC AVC MIN MC AFC Cost TC VC FC Quantity Output
10 MELec9_2:Theory of Cost Page -10- The (improbable) Linear Cost Function Revisited 1. TC = FC + VC, and TVC = a + bq 2. AVC = TVC Q, or = a Q + b Note: for a linear cost function, if a = 0 then AVC = b. Otherwise, if a > 0, then AVC declines continuously, but at decreasing rate as output increases. That is, as Q becomes larger, a/q becomes smaller and smaller. TVC TVC = a + bq, where b = Q = MC Cubic TVC Function (with Quadratic MC): Cubic -- Assumes that both marginal cost and average variable cost functions have U-shapes. TC = a + bq - cq 2 + dq 3 a > 0, b < 0, and c > 0
11 MELec9_2:Theory of Cost Page -11- MC = b -2cQ + 3dQ 2 (first partial derivative with respect to Q) By way of example, assume: FC = $100, and TVC = 60Q - 3Q Q 3 then we know, TC = Q - 3Q Q 3 AFC = 100 Q thus, MC is U-shaped AVC = 60-3Q Q 2 ATC = 100 Q Q Q2 NOTE: AVC reaches a min at Q m = - b 2c or AVC = MC MC = d(vc) dq = 60-6Q Q2 Empirical Example: OilGasEX.or6
12 MELec9_2:Theory of Cost Page -12- ANOVA Table Parameter Table
13 MELec9_2:Theory of Cost Page -13- Elasticity Tab (partial)
14 MELec9_2:Theory of Cost Page -14- Regression Constant Variance Test Dependent Variable: Total Cost-Wells Drilled 3,000,000,000 Residual 2,000,000,000 1,000,000, ,000,000, ,000,000 Predicted 1,000,000,000 Normal Probability Plot Dependent Variable: Total Cost-Wells Drilled Sorted Residual 3,000,000,000 2,000,000,000 1,000,000, ,000,000,000-1,000,000,000 0 Expected Residual 1,000,000,000
15 MELec9_2:Theory of Cost Page -15- Long-Run Cost Functions The long-run cost function is obtained directly from the production function by finding the expansion path. Remember, the expansion path for a production process consists of the combinations of inputs X and Y for each level of Q that satisfy the optimality criterion: MP C x x = MP C y y Over the long-run planning horizon, the firm can choose the combination of inputs that minimizes the cost of producing a desired level of output. Using the existing production methods and technology, the firm can choose: the plant size, types and sizes of equipment, labor skills, and raw materials that, when combined, yield the lowest cost of producing the desired amount of output. The long-run average cost function (LAC) consists of the lower boundary (envelope) of all the short-run cost curves.
16 MELec9_2:Theory of Cost Page -16- The relationship between LTC, LMC, and LAC is as follows -- The long-run cost function is obtained directly from the production function by first finding the expansion path for the given production process. The expansion path for a production process consists of the combinations of inputs X and Y for each level of output Q that satisfy the optimality criterion developed earlier. Recall we derived the condition that the MRTS between two inputs must be equal to the ratio of the unit costs of the two inputs for a given input combination to be an optimal solution to either the output-maximization or costminimization problem. MRTS = C x C y
17 MELec9_2:Theory of Cost Page -17- Graphically, the optimal input combination occurred at the point where the production isoquant was tangent to the isocost line. NOTE: LAC = LTC Q LTC and LMC = Q
18 MELec9_2:Theory of Cost Page -18- Economies of Scale Declining long-run average costs over the lower part of the possible outputs are usually attributed to economies of scale. Economies of scale occur over the range of the longrun cost function which corresponds to increasing returns to scale of the production function. Where do economies of scale come from? 1. Plant Economies - specialization in the use of labor and capital - indivisible nature of many types of capital equipment - purchase price of different sizes of equipment 2. Firm Economies - materials procurement / quantity discounts - economies in raising funds (capital procurement) - sales promotion - technological innovation - management Diseconomies of Scale - def: rising long-run average costs - transportation expense - imperfections in the labor market - problems of coordination and control
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