Cost function

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  • Cost function

    1. 1. ` Cost Analysis and Estimation
    2. 2. What Makes Cost Analysis Difficult? <ul><li>Link Between Accounting and Economic Valuations </li></ul><ul><ul><li>Accounting and economic costs often differ. </li></ul></ul><ul><li>Historical Versus Current Costs </li></ul><ul><ul><li>Historical cost is the actual cash outlay. </li></ul></ul><ul><ul><li>Current cost is the present cost of previously acquired items. </li></ul></ul><ul><li>Replacement Cost </li></ul><ul><ul><li>Cost of replacing productive capacity using current technology. </li></ul></ul>
    3. 3. Opportunity Cost <ul><li>Opportunity Cost Concept </li></ul><ul><ul><li>Opportunity cost is foregone value. </li></ul></ul><ul><ul><li>Reflects second-best use. </li></ul></ul><ul><li>Explicit and Implicit Costs </li></ul><ul><ul><li>Explicit costs are cash expenses. </li></ul></ul><ul><ul><li>Implicit costs are noncash expenses. </li></ul></ul>
    4. 4. Incremental and Sunk Costs in Decision Analysis <ul><li>Incremental Cost </li></ul><ul><ul><li>Incremental cost is the change in cost tied to a managerial decision. </li></ul></ul><ul><ul><li>Incremental cost can involve multiple units of output. </li></ul></ul><ul><ul><ul><li>Marginal cost involves a single unit of output. </li></ul></ul></ul><ul><li>Sunk Cost </li></ul><ul><ul><li>Irreversible expenses incurred previously. </li></ul></ul><ul><ul><li>Sunk costs are irrelevant to present decisions. </li></ul></ul>
    5. 5. Short-run and Long-run Costs <ul><li>How Is the Operating Period Defined? </li></ul><ul><ul><li>At least one input is fixed in the short run. </li></ul></ul><ul><ul><li>All inputs are variable in the long run. </li></ul></ul><ul><li>Fixed and Variable Costs </li></ul><ul><ul><li>Fixed cost is a short-run concept. </li></ul></ul><ul><ul><li>All costs are variable in the long run. </li></ul></ul>
    6. 6. Short-run Cost Curves <ul><li>Short-run Cost Categories </li></ul><ul><ul><li>Total Cost = Fixed Cost + Variable Cost </li></ul></ul><ul><ul><li>For averages, ATC = AFC + AVC </li></ul></ul><ul><ul><li>Marginal Cost, MC = ∂TC/∂Q </li></ul></ul><ul><li>Short-run Cost Relations </li></ul><ul><ul><li>Short-run cost curves show minimum cost in a given production environment. </li></ul></ul>
    7. 7. Short Run Cost Graphs AFC Q Q 1. 2. AVC 3. Q AFC AVC ATC MC MC intersects lowest point of AVC and lowest point of ATC. When MC < AVC, AVC declines When MC > AVC, AVC rises
    8. 8. Relationships Among Cost & Production Functions <ul><li>AP & AVC are inversely related. (ex: one input) </li></ul><ul><li>AVC = WL /Q = W/ (Q/L) = W/ AP L </li></ul><ul><ul><li>As AP L rises, AVC falls </li></ul></ul><ul><li>MP and MC are inversely related </li></ul><ul><li>MC = dTC/dQ = W dL/dQ = W / (dQ/dL) = W / MP L </li></ul><ul><ul><li>As MP L declines, MC rises </li></ul></ul>prod. functions cost functions MP L L MC AP AVC Q Q cost
    9. 13. Long-run Cost Curves <ul><li>Economies of Scale </li></ul><ul><li>Long-run cost curves show minimum cost in an ideal environment. </li></ul>
    10. 14. Long Run Cost Functions <ul><li>All inputs are variable (can adjust) in the long run. </li></ul><ul><li>LAC is long run average cost </li></ul><ul><ul><li>ENVELOPE of SAC curves </li></ul></ul><ul><li>LMC is flatter than SMC curves. </li></ul><ul><li>The optimal plant size for a given output Q 2 is plant size 2. (A SR concept.) </li></ul><ul><li>However, the optimal plant size occurs at Q 3 , which is the lowest cost point overall. (A LR concept.) </li></ul>Q LAC LMC SAC 2 SMC 2 Q 2 Q 3
    11. 15. Long Run Cost Function (LAC) Envelope of SAC curves
    12. 16. Cost Elasticity and Economies of Scale <ul><li>Cost elasticity is ε C = ∂C/C ÷ ∂Q/Q. </li></ul><ul><li>ε C < 1 means falling AC, increasing returns. </li></ul><ul><li>ε C = 1 means constant AC constant returns. </li></ul><ul><li>ε C > 1 means rising AC, decreasing returns. </li></ul>
    13. 17. Long-run Average Costs
    14. 18. Economists think that the LAC is U-shaped <ul><li>Downward section due to: </li></ul><ul><ul><li>Product-level economies which include specialization and learning curve effects. </li></ul></ul><ul><ul><li>Plant-level economies , such as economies in overhead, required reserves, investment, or interactions among products (economies of scope). </li></ul></ul><ul><ul><li>Firm-level economies which are economies in distribution and transportation of a geographically dispersed firm, or economies in marketing, sales promotion, or R&D of multi-product firms. </li></ul></ul>
    15. 19. <ul><li>Flat section of the LAC </li></ul><ul><ul><li>Displays constant returns to scale </li></ul></ul><ul><ul><li>The minimum efficient scale (MES) is the smallest scale at which minimum per unit costs are attained. </li></ul></ul><ul><li>Upward rising section of LAC is due to: </li></ul><ul><ul><li>Diseconomies of scale. These include transportation costs, imperfections in the labor market, and problems of coordination and control by management. </li></ul></ul><ul><ul><li>The maximum efficient scale (Max ES) is the largest scale before which unit costs begin to rise. </li></ul></ul><ul><ul><li>Modern business management offers techniques to avoid diseconomies of scale through profit centers, transfer pricing, and tying incentives to performance. </li></ul></ul>CRS region MES Max ES DRS LAC
    16. 20. Economies of Scope <ul><li>Economies of Scope Concept </li></ul><ul><ul><li>Scope economies are cost advantages that stem from producing multiple outputs. </li></ul></ul><ul><ul><li>Big scope economies explain the popularity of multi-product firms. </li></ul></ul><ul><ul><li>Without scope economies, firms specialize. </li></ul></ul><ul><li>Exploiting Scope Economies </li></ul><ul><ul><li>Scope economics often shape competitive strategy for new products. </li></ul></ul>
    17. 21. Cost-volume-profit Analysis <ul><li>Cost-volume-profit Charts </li></ul><ul><ul><li>Cost-volume-profit analysis shows effects of varying scale. </li></ul></ul><ul><ul><li>Breakeven analysis shows zero profit points of cost coverage. </li></ul></ul>

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