Managerial Economics in a Global EconomyChapter 7Cost Theory and Estimation

The Nature of CostsExplicit CostsAccounting CostsEconomic CostsImplicit CostsAlternative or Opportunity CostsRelevant CostsIncremental CostsSunk Costs are Irrelevant

Short-Run Cost FunctionsTotal Cost = TC = f(Q)Total Fixed Cost = TFCTotal Variable Cost = TVCTC = TFC + TVC

Short-Run Cost FunctionsAverage Total Cost = ATC = TC/QAverage Fixed Cost = AFC = TFC/QAverage Variable Cost = AVC = TVC/QATC = AFC + AVCMarginal Cost = TC/Q = TVC/Q

Short-Run Cost FunctionsQTFCTVCTCAFCAVCATCMC0$60$0 $60----16020 80$60$20$80$202603090301545103604510520153515460801401520353556013519512273955

TFC

Short-Run Cost FunctionsAverage Variable CostAVC = TVC/Q = w/APL

Marginal CostTC/Q = TVC/Q = w/MPL

Long-Run Cost CurvesLong-Run Total Cost = LTC = f(Q)Long-Run Average Cost = LAC = LTC/QLong-Run Marginal Cost = LMC = LTC/Q

Derivation of Long-Run Cost Curves

Relationship Between Long-Run and Short-Run Average Cost Curves

Possible Shapes of the LAC Curve

Learning CurvesAverage Cost of Unit Q = C = aQbEstimation Form: log C = log a + b Log Q

Minimizing Costs InternationallyForeign Sourcing of InputsNew International Economies of ScaleImmigration of Skilled LaborBrain Drain

Architecture of Ideal FirmCore CompetenciesOutsourcing of Non-Core TasksLearning OrganizationEfficiency and FlexibilityLocation Near MarketsAgility in Responding to Market Forces

Cost-Volume-Profit AnalysisTotal Revenue = TR = (P)(Q)Total Cost = TC = TFC + (AVC)(Q)Breakeven Volume TR = TC(P)(Q) = TFC + (AVC)(Q)QBE = TFC/(P - AVC)

Cost-Volume-Profit AnalysisP = 10TFC = 200AVC = 5QBE = 40

Operating LeverageOperating Leverage = TFC/TVCDegree of Operating Leverage = DOL

Operating LeverageTC has a higher DOL than TC and therefore a higher QBE

Empirical EstimationData Collection IssuesOpportunity Costs Must be Extracted from Accounting Cost DataCosts Must be Apportioned Among ProductsCosts Must be Matched to Output Over TimeCosts Must be Corrected for Inflation

Empirical EstimationFunctional Form for Short-Run Cost FunctionsTheoretical FormLinear Approximation

Empirical EstimationTheoretical FormLinear Approximation

Empirical EstimationLong-Run Cost Curves

Cross-Sectional Regression AnalysisEngineering MethodSurvival Technique

Empirical EstimationActual LAC versus empirically estimated LAC