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The Theory of Cost

The Theory of Cost. Focus on relevant costs in decision making Short-run issues: Recognize possibility of diminishing returns and its impact on marginal costs as output increases

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The Theory of Cost

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  1. The Theory of Cost • Focus on relevant costs in decision making • Short-run issues: Recognize possibility of diminishing returns and its impact on marginal costs as output increases • Long-run issues: Identify economies of scale, economies of scope and their impact on unit production costs as scale increases • Understand that increasing scale does not always decrease costs

  2. The Importance of Cost • One of two major factors in profit maximizing decision • What is the other? • Increase sales by $1, what’s the impact on profit? • Decrease cost by $1, what’s the impact on profit?

  3. Nature of Costs • Historical v. replacement • Opportunity v. out-of-pocket • Sunk v. incremental • Explicit v. implicit • Short-run v. long-run • Fixed v. variable • Economic v. accounting

  4. Relevant Costs • Depreciation: Accounting concept often has little relationship with the actual loss of value. • Inventory: Accounting concept based on acquisition cost. • Unutilized facilities: Empty space may appear to have no cost. • Profitability measures: Accounting v. economic

  5. Graphing Costs • TC, TFC, TVC • ATC, AFC, AVC • MC • See Figure 9.3, p. 330

  6. Relationship between Production and Cost • Production is a key determinant of cost • AVC = TVC/Q = wL/Q = w(L/Q) = w(1/APL) • MC = dTVC/dQ = d(wL)/dQ = w(dL/dQ) + L(dw/dQ) = w(1/MPL)

  7. Long-Run Cost Curves • The long run is the planning horizon • We manage the future • All inputs are variable in LR • LAC often referred to as the envelope curve • Refer to Figure 9.4, p. 332

  8. Economies of Scale • Output is growing proportionately faster than input use • LAC is downward sloping • Reasons for economies of scale

  9. Diseconomies of Scale • Output is growing proportionately slower than input use • LAC is upward sloping • Reasons for diseconomies of scale

  10. Learning Curves • Depicts the declining AC over time due to experience in production • Algebraically: C = aQb; where b is negative and represents the rate that input costs decline over time • log C = log a + b log Q

  11. Cost-Volume-Profit Analysis • Break-even analysis • Assuming constant prices and constant AVC • Operating leverage • importance of FC in the firm’s operations • examines change in operating profit due to a change in sales volume • important concept--DOL or sales elasticity of operating profit

  12. Typical Cost Functions • TC = a + bQ - cQ2 + dQ3 • TFC = a • TVC = bQ - cQ2 + dQ3 • ATC = a/Q + b - cQ + dQ2 • AFC = a/Q • AVC = b - cQ + dQ2 • MC = b - 2cQ + 3dQ2

  13. Alternative Cost Functions • Straight-line cost functions • TC = a + bQ • AC = a/Q + b; AVC = MC = b • Increasing at an increasing rate • TC = a + bQ + cQ2 • AC = a/Q + b + cQ; AVC = b + cQ; MC = b + 2cQ • Graphical presentation

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