The Analysis of Cost

2
Readings
Hirschey: Economics for Managers, 2009 (Fifth Indian
Reprint), South-Western Cengage Learning Chapter 9
Hubbard & OBrian: Microeconomics (First Edition), Pearson
Education India Chapter 10

Mansfield, Allen, Doherty and Weigelt: Managerial
Economics: Theory, Applications and Cases (Seventh
Edition), Viva-Norton Student Edition Chapter 5
Thomas and Maurice: Managerial Economics: Concepts and
Applications (Eighth Edition), Tata McGraw-Hill Chapters 8
& 9
Session Objectives:
Explain and illustrate the relationship between
marginal cost and average total cost in the short run
Graph average total cost, average variable cost,
average fixed cost, and marginal cost.
Understand how firms use the long-run average cost
curve to plan.
What are economies of scope and Learning
Curve?



3
From the Production Function to the
Total-Cost Curve
Recollect the farmers story in Production Theory

A farmer grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.

Farmer must pay Rs.1000 per month for the land,
regardless of how much wheat he grows.
The market wage for a farm worker is Rs.2000 per
month.
So the farmers costs are related to how much wheat
he produces.
4
From the Production Function to the
Total-Cost Curve
L
(no. of
workers)
Q
(bushels
of wheat)
cost of
land
cost of
labor
Total
Cost
11,000
9,000
7,000
5,000
3,000
1,000
10,000
8,000
6,000
4,000
2,000
0
1,000
1,000
1,000
1,000
1,000
1,000 0
1000
1800
2400
2800
3000
0
1
2
3
4
5
5
The Farmers Total-Cost Curve
Q
(bushels
of wheat)
Total
Cost
0 1,000
1000 3,000
1800 5,000
2400 7,000
2800 9,000
3000 11,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
0 1000 2000 3000
T
o
t
a
l

c
o
s
t
Quantity of wheat
6
The Various Types of Costs in Short Run

Costs of production may be divided into fixed costs and variable costs.

Fixed costs (FC) are those costs that do not vary with the quantity
of output produced.
For the farmer, FC = Rs.1000 for his land

Other examples:
cost of equipment, loan payments, rent, property taxes

Variable costs (VC) are those costs that do vary with the quantity
of output produced. They go up as the firms output rate rises,
since higher output rates require higher variable inputs, which
means bigger variable costs.
For the farmer, VC = wages he pays workers

Other example: cost of materials the larger the product of a woolen
mill, the larger the quantity of wool that must be used, and the higher
the total cost of wool
7
The Various Types of Costs in Short Run
Total Costs in Short Run
Total Fixed Costs (FC)
Total Variable Costs (VC)
Total Costs (TC)
TC = FC + VC

8
The Average Costs

Average costs can be determined by dividing the
firms costs by the quantity of output it produces.
The average cost is the cost of each typical unit of
product.
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC
9
The Average Costs
Fixed cost
Quantity
FC
AFC
Q

Variable cost
Quantity
VC
AVC
Q

Total cost
Quantity
TC
ATC
Q

10
Marginal Costs
Marginal cost (MC) measures the increase in total cost that
arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of
output?
MC is the slope of the total cost curve

(change in total cost)
(change in quantity)
TC
MC
Q

11
Marginal Costs
Why is MC important?
In the earlier example, the farmer is rational and wants to
maximize his profit. To increase profit, should he produce
more wheat, or less?
To find the answer, the farmer needs to think at the margin.
If the cost of additional wheat (MC) is less than the revenue he
would get from selling it, then farmers profits rise if he
produces more.
12
The Various Measures of Cost: A
Hypothetical Example
13
Shapes of Cost Curves
14
Shapes of Cost Curves
Average fixed cost (AFC) is always downward sloping. Since
AFC= F / Q and F is constant, as Q increases, AFC decreases.

Also, AFC x Q = F, a constant. So AFC curve is a rectangular hyperbola.
As output increases, AFC gets smaller and smaller. Firms often refer to
this process of lowering average fixed cost by selling more output as
spreading the overhead. By overhead they mean fixed costs.

IF AVC is the average variable cost, VC total variable cost, Q is
the quantity of output, L is the quantity of labour (variable
input), and w is the price of the variable input (wage rate); then

AVC = VC / Q = wL / Q = w / AP
L


If the firm is the price taker in the input market, then the shape
of AP
L
determines the shape of AVC. Since AP
L
generally rises
and then falls with increases L (and hence increase in output),
AVC must decrease and then go up with increases in output.




15
Shapes of Cost Curves
Average total Cost (AC) is the total cost divided by output. AC
also equals AFC plus AVC.

For those levels of output where both average fixed cost and average
variable cost decrease, average total cost must decrease too. However,
average total cost reaches its minimum after average variable cost,
because the increases in average variable cost are for a time more than
offset by decreases in average fixed cost

Marginal cost is the addition to total cost resulting from the
addition of the last unit of output.

MC= TVC/Q = w L / Q = w / MP
L


If the firm is the price taker in the input market, then the shape
of MP
L
determines the shape of MC. Since MP
L
generally rises
and then falls with increases L (and hence increase in output),
MC must decrease and then go up with increases in output.

16
Shapes of Cost Curves
Relationship between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total
cost is falling.
Whenever marginal cost is greater than average total cost, average
total cost is rising.
The marginal cost curve crosses the average cost curve at the
minimum point of the average cost curve, i.e., at the efficient scale.
Efficient scale is the quantity that minimizes average total cost.
Summary:
Marginal cost eventually rises with the quantity of output
The average-total-cost curve is U-shaped.
The marginal-cost curve crosses the average-total-cost curve at the
minimum of average total cost.

17
Shapes of Cost Curves
Shapes of Total Variable Cost and Total Cost Curve
Marginal cost is the slope of total variable cost curve and total cost
curve.
Given that MC is U-shaped, it follows that total variable cost increases
at a decreasing rate upto a certain output rate (in our example, 1.5
units of output, denoted by point G on the TVC curve); beyond that
output, total variable costs increase at an increasing rate.
This later characteristic of total variable cost function follows from the
law of diminishing marginal returns. At small levels of output,
increases in the employment of variable inputs may result in increases
in their productivity, so the total variable costs increase with output at
a decreasing rate. Once diminishing returns set in, though, variable
costs increase with output at an increasing rate.
Finally, total costs are the sum of TFC and TVC. TC curve is derived by
adding the total fixed costs to the total variable costs at each level of
output. The total cost curve and total variable cost curve have the
same shape, since they differ by only a constant amount, which is
total fixed cost.


18
Quick Activity - 1

(a) Consider the total cost function of an engineering firm:

TC = 100 + 50Q 11Q
2
+ Q
3


Comment on the shapes of the TFC, TVC, AFC, AVC, AC and MC
curves.
(b) Examine the validity of the following statement: I am
currently producing 10,000 copies per day at a total cost of
Rs.500. If I produce 10,001 copies my total cost will rise to
Rs.500.11. Therefore, my marginal cost of producing copies
must be increasing.
19
Short Run and Long Run
Short run: Some inputs are fixed (e.g., factories, land). The costs of
these inputs are FC.

Long run: All inputs are variable (e.g., firms can build more factories,
or sell existing ones). The only costs are VC.

While operating in the short run, the firm must continually be planning
ahead and deciding its strategy in the long-run. Its decision
concerning the long run determine the sort of short-run position that
the firm will occupy in the future.

For example, before the IBM Corporation makes the decision to add a
new type of product to its line, the firm is in a long-run situation, since
it can choose among a wide variety of types and sizes of equipment to
produce the new product. But once the investment is made, IBM is
confronted with a short-run situation, since the type and size of
equipment are, to a considerable extent, frozen.

20
Long Run Average Cost
Q
AC
AC
M
AC
S
AC
L
Firm can choose from 3 plant
sizes: S, M, L. Each size has
its own SAC curve.
The firm can change to a
different plant size in the long
run, but not in the short run.
In the short run, given the
level of plant size (K), the firm
is stuck to one of these
curves. However, in the long
run, the firm is free to choose
the level of K that minimizes
the cost for a particular level
of output.
21
Long Run Average Cost
Q
AC
AC
M
AC
S
AC
L
In the long run, the firm could
decide to operate on any of
these plants, but which scale
would be most profitable?

If the firm wants to produce
where the average cost is
minimum, the answer
obviously depends on how
much the firm wants to
produce in the long run.

To produce less than Q
A
, firm will
choose size S in the long run. To
produce between Q
A
and Q
B
, firm
will choose size M in the long run.
To produce more than Q
B
, firm will
choose size L in the long run.
Q
A
Q
B
LAC

22
Long Run Average Cost
LAC

Q
AC
In the real world, plants come in
many sizes, each with its own SAC
curve.
The long-run AC (LAC) curve is
constructed tangent to each short-
run average cost curve. At each
point of tangency, the related scale
of plant is optimal; no other plant
can produce that particular level of
output at so low a total cost.
A typical LAC curve looks like an
envelope of several SAC curves..
As such LAC curve is called an
envelope curve. It is also called a
planning curve, since it reflects
firms decision to whether continue
production with the existing plant, or
shift to a higher capacity plant.
23
Quick Activity - 2

Suppose that a firm is thinking of buying a printer for one of its
employees. It can choose between an inkjet printer which costs
Rs.5000 or a laser printer which costs Rs.8000. The per page
printing cost for an inkjet is Rs.1.80 and that for a laser printer
is Rs.1.50. Which one should the firm buy?
24
Answer

If q denotes the number of pages printed, the total costs will be

C
ij
= 5000 + 1.8q
C
L
= 8000 + 1.5q

The average cost curves are given by
AC
ij
= 5000/q + 1.8
AC
L
= 8000/q + 1.5

It can be seen that AC
L
- AC
ij
= 3000/q 0.3, and therefore, for
q>10,000, AC
L
< AC
ij
.
Whether the firm should buy the inkjet printer or the laser printer will
then depend on its expected rate of printing of pages. If, for example,
only 10 pages are to be printed every day, then it will take 1000 days
(almost three years) before the laser printer becomes cost-effective.
On the other hand, if the expected rate of usage is (say) 100 pages
per day, then the laser-printer will become cost-effective after 100
days.


25
Long-Run Average Cost Curve
The law of returns to scale determine the shape of long-run average
cost curve (LAC).

LAC = C/q = (wL + rK)/q = w(L/q) + r(K/q)

Case 1: Under CRS
Any proportionate change in L and K results in equiproportionate changes in
q, leaving (L/q) & (K/q) unchanged. Thus LAC does not change despite
change in output.

Case 2: Under IRS (Economies of Scale)
Any proportionate change in L and K results in more than proportionate
changes in q; (L/q) & (K/q) falls with increase in output. Thus LAC declines
as output increases.

Case 3: Under DRS (Diseconomies of Scale)
Any proportionate change in L and K results in less than proportionate
changes in q; (L/q) & (K/q) rises with increase in output. Thus LAC rises as
output increases.



26
Long Run Average Cost
LRATC

Q
ATC
Economies of scale:
ATC falls as Q
increases.
Constant returns to
scale: ATC stays the
same as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
27
Long Run Average Cost
Economies of scale occur when increasing production allows greater
specialization and division of labour. The workers more efficient when
focusing on a narrow task.

To the extent that these efficiencies exist and can be exploited, the
long-run average-cost function declines as output climbs. The range
over which the average cost function declines varies from industry to
industry, and it can change from time to time in response to the advent
of new technology.

Diseconomies of scale are due to coordination problems in large
organizations. More and more responsibility and power must be given
to lower-level employees. Coordination becomes more difficult. Red
tape increases. Flexibility can be reduced. Management becomes
stretched, cant control costs.

It is not easy to determine just when these diseconomies of scale begin
to offset the economies of scale already cited. Empirical studies seem
to indicate that long-run average cost can be constant over a
considerable range of output. Economists generally expect, however,
that the LAC will eventually begin to rise.
28
29
Various Shapes of LAC
Minimum Efficient Scale
In general, the empirical studies have found that there are very
significant economies of scale at low output levels, but that
these economies of scale tend to diminish as output increases,
and that the long-run average cost function eventually
becomes close to horizontal at high output levels.

Given that this is the case, managers and others are
particularly interested in estimating the minimum efficient scale
(MES) of plant or firm in a particular industry. The MES of plant
is defined as the smallest output at which LAC is a minimum.

One reason why managers are interested in the MES is that
plants below this size are at a competitive disadvantage, since
their costs are higher than those of their larger rivals.
30
Application - 1
Economies of Scale in Nursing Homes in US
A long-un average cost (LAC) curve is important for practical
decision making by managers because it shows whether, and to
what extent, larger plants have cost advantages over small
ones. In cases in which this occurs, we often say that there are
economies of scale.

To illustrate, consider nursing homes, which are a huge
industry with annual sales of over $70 billion. Based on Texas
data, if a nursing home provides only 10,000 patient-days of
service per year, the cost per patient-day is almost $29; if it
provides about 50,000 patient-days of service per year, the
cost per patient-day is under $26.

For nursing homes with under 60,000 patient-days, there seem
to be substantial economies of scale.
31
Application - 1
What could be the plausible reason for such economies of scale?
In many industries, firms can operate more than one plant, and there
may be economies of scale at the firm (in contrast to the plant) level.
This seems to be true in the nursing home industry. Because of
advantages due to centralized purchasing of inputs and a more
sophisticated staff, firms with many nursing homes seem to have
lower costs than those with only one nursing home.
Beyond nursing homes, other examples of economies of scale exist.
Mergers are happening in many industries. The oil industry has
recently seen mergers with BP Amoco and ExxonMobil, among others.
Renault and Nissan and GM and Fiat are among numerous automobile
company mergers.
While there are many reasons for firms to merge, one may be
economies of scale by becoming larger, average costs may become
smaller.

32
Application - 2
The Crosby Corporation: A Numerical Example
To illustrate the relationship between a firms long-run and short-run
cost functions, consider the Crosby Corporation, a hypothetical
producer of flashlights. Crosbys engineers have determined that the
firms production function is
Q = 4(KL)
0.5
,
where Q is output (in thousands of flashlights per month), K is the
amount of capital used per month (in thousands of units), and L is the
number of hours of labour employed per month (in thousands).
Because Crosby must pay $8 per hour for labour and $2 per unit for
capital, its total cost (in thousands of dollars per month) equals
TC = 8L + 2K = Q
2
/2K + 2K [since L = Q
2
/16K]
In the short run, which is a time period so brief that a firm cannot
vary the quantity of its plant and equipment, K is fixed. Suppose the
Crosby Corporation has a plant size of 10 thousand square foot, K=10.
33
Application - 2
Substituting 10 for K, the short-run cost function is

TC
s
= Q
2
/20 + 20

Thus the short-run average total cost function is AC
s
= Q/20 + 20/Q

and short-run marginal cost function is MC
s
= Q/10

In the long run, no input is fixed. To determine the optimal amount of
capital input to be used to produce an output of Q units per month,
Crosbys managers should minimize total cost, i.e., set dTC/dK = 0.
This implies that the cost-minimizing value of K is K* = Q/2.

We see that the long-run cost function is TC
L
= 2Q; long-run average
cost equals $2 per flashlight. Because LAC is constant, the Crosby
Corporation exhibits CRS in the long run

34
Application - 3
Should US Continue to Make Autos from Steel?
In recent years, automakers have begun to substitute synthetic
materials for steel. Engineers at the Materials Systems
Laboratory of the Massachusetts Institute of Technology have
made careful studies of the costs of producing an automobile
fender.
Assuming that the annual production volume of the fender is
1,00,000, the average cost of a fender is as shown below if
sheet steel or four alternative plastics fabrication technologies
are used to make the fender.
35
Application - 3
36
Cost Steel
Sheet
Injection
Moulding
Compression
Moulding
Reaction
Injection
Moulding
Thermo-
plastic
sheet
Materials $4.25 $8.50 $4.84 $4.89 $5.75
Labour 0.24 0.42 0.63 0.83 0.52
Capital 0.66 2.62 1.57 1.40 2.18
Tooling 2.57 0.86 0.71 0.57 0.71
Total
a
$7.71 $12.39 $7.75 $7.70 $9.17
a
Figures do not sum to totals because of rounding errors

If the annual production is 2,00,000 rather than 1,00,000, the cost
per fender, if sheet metal is used in its production, is less than $7
and less than the cost if any of the plastics are used at this production
volume.
Application - 3
Questions:
If 10,000 fenders are made per year, does the cost per fender
differ significantly if sheet steel is used from the cost if reaction
moulding (or compression moulding) is used?
Compared with reaction injection moulding (or compression
moulding), sheet steel uses less (or less costly) materials,
labour and capital. Why then doesnt it have lower average
total costs?
If sheet steel is used, are there economies of scale in fender
production?
Steel is commonly thought to be the most advantageous
material for high-volume production of auto fenders. Does this
seem to be true?
37
Application - 3
Answers:
No. The cost is $7.71 for sheet steel versus $7.70 for reaction
injection moulding (and $7.75 for compression moulding).
Sheet steel has much higher tooling costs per fender than does
reaction injection moulding (or compression moulding).
Yes. Whereas the cost per fender is $7.71 when 1,00,000
fenders are produced per year, it is less than $7 when 2,00,000
are produced per year.
Yes. For a production volume of 2,00,000 per year, sheet steel,
according to the figures quoted, has a lower average cost than
any of the plastics fabrication techniques.
38
Economies of Scope
Firms commonly produce more than one product. Oil firms like
Exxon Mobil and BP Amoco produce both petroleum and
chemical products; drug firms like Merck and Smith-Kline
Beecham produce both vaccines and tranquilizers; and
publishers like Oxford and Penguin produce both mysteries and
biographies.

In many cases, a firm obtains production or cost advantages
when it produces a combination of products rather than just
one.

These advantages sometimes arise because certain production
facilities used to make one product can also be used to make
another product; or because by-products resulting from the
making of one product are useful in making other products.
39
Economies of Scope
40
A firm will produce products that are complimentary when
producing them together is more efficient than producing them
individually.
Economies of scope arise
from complementarities in
the production or distribution
of distinct goods or services
Economies of Scope
Economies of Scope can be measured as




41
) ( ) (
) , ( ) ( ) (
2 1
2 1 2 1
Q C Q C
Q Q C Q C Q C
SC

where C(Q
1
,Q
2
) is the cost of jointly producing goods 1 and 2 in
the respective quantities; C(Q
1
) is the cost of producing good 1
alone, and similarly for C(Q
2
).
If there are economies of scope, SC is greater than zero because
the cost of producing both products together - C(Q
1
,Q
2
) is less
than the cost of producing each alone - C(Q
1
) + C(Q
2
).
Clearly, SC measures the percentage saving as a result of
producing them jointly rather than individually.
Economies of Scope
Example 1:
Suppose that the Martin Company produces 1,000 milling
machines and 500 lathes per year at a cost of $15 million,
whereas if a firm produced 1,000 milling machines only, the
cost would be $12 million, and if it produced 500 lathes only,
the cost would be $6 million.
In this case, the cost of producing both the milling machines
and the lathes is less than the total cost of producing each
separately. Thus, there are economies of scope.
In the case of the Martin Company, SC = 0.20, which means
that there is a 20 percent saving of this sort.
42
Economies of Scope
Example 2:
Suppose that a regional airline offers regularly scheduled
passenger service between midsize city pairs and that there is
modest local demand for air parcel and small-package delivery
service.
A small airline may find that its regularly scheduled passenger
service can be profitably supplemented by providing cargo
services, since the cost of flying both passengers and cargo is
much less than that of specializing in either passenger or cargo
services.
43
Exploiting Scope Economies

Economies of scope are important because they permit a firm
to translate superior skill in a given product line into unique
advantages in the production of complementary products.
Effective competitive strategy often emphasizes product lines
related to a firms current stars, or areas of recognized strength
For example, PepsiCo, Inc., has long been leader in the soft
drink market. Over time, the company has gradually broadened
its product line to include various brands of regular and soft
diet drinks, Tropicana, Fritos and Doritos chips, Grandmas
Cookies, and other snack foods.
PepsiCo can no longer be considered just a soft drink
manufacturer. It is a widely diversified beverages and snack
food company for whom well over one-half of total current
profits come from non-soft drink lines.
44
Exploiting Scope Economies

PepsiCos snack foods and sport drink product line extension
strategy is effective because it capitalizes on the distribution
network and marketing expertise developed in the firms soft
drink business.
In this case, for PepsiCo, soft drinks, snack foods, and sports
beverages are a natural fit and a good example of how a firm
has been able to take the skills gained in developing one star
(soft drinks) and use them to develop others (snack foods,
sport drinks).
45
Learning Curve
46
The learning curve embodies the (inverse) relationship between
average production cost and cumulative output, i.e., the total
amount of output produced since the introduction of the product.
The experience of the workforce tends to increase with
cumulative outputthus workers are more familiar with the
production process and have their movements/activities
become routinized or a matter of habit.
There are usually several ways to do a task, and it takes time
and experimentation to find the best way.
Quality control for inputs and outputs needs time to identify
potential problem areas. For example, there may be a number
of defective items which makes it possible to identify the
source of a problem and correct it quickly.
R a t e o f O u t p u t ( p e r M o n t h )
A v e r a g e C o s t
1 , 0 0 0 1 , 5 0 0
L A C ( y e a r 2 )
L A C ( y e a r 1 )
I n c r e a s i n g
r e t u r n s
L e a r n i n g
Learning is manifested
by a downward shift of
the LAC function
Learning Curve

In the figure, start with an output of 1,000. The firms average cost
curve is LAC (year 1). If the firm expands its output to 1,500, its
average cost would fall on the same AC curve.
However, if it continues to produce 1,500, then the average cost curve
falls to LAC (year 2) because of the learning by doing effect.
Managers, economists, and engineers often use the learning curve to
represent the extent to which the average cost of producing an item
falls in response to increases in its cumulative total output.
The learning curve is expressed as: C = aQ
b
, where C is the input cost
of the Q
th
unit of output produced. If this relationship holds exactly, a
is the cost of the first unit produced. The value of b is negative, since
increases in cumulative total output reduce total cost. If the absolute
value of b is large, cost falls more rapidly with increases in cumulative
total output than it would if the absolute value of b were small.
48
Application - 4
Many firms have adopted pricing strategies based on the learning
curve. Consider the case of Texas Instruments, a major producer of
semiconductor chips and other electronic products.

When the semiconductor industry was relatively young, Texas
Instruments priced its products at less than its then-current average
costs in order to increase its output rate and its cumulative total
output.

Believing that the learning curve was relatively steep, it hoped that
this would reduce its average costs to such an extent that its product
would be profitable to produce and sell at this low price.

This strategy was extremely successful. As Texas Instruments
continued to cut price, its rivals began to withdraw from the market,
its output continued to grow up, its (average) costs were further
reduced, and its profits rose.
49