Chapter 8 discusses the theory and estimation of costs in managerial economics, covering definitions and types of costs, short-run and long-run relationships between production and costs, and the impact of input prices on cost curves. Key concepts include average total cost, marginal cost, and the learning curve, along with their significance in production cost analysis. The chapter highlights the importance of understanding cost structures for effective managerial decision-making.

1. Chapter 8Chapter 8
The Theory
and
Estimation of
Cost
Managerial Economics:
Economic Tools for Today’s
Decision Makers, 4/e By Paul
Keat and Philip Young

2. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
Before We Start…Group Presentation
• So popular?
Q = aL
b
K
1-borc
• b+c > 1 IRTS
• b+c = 1 CRTS
• b+c < 1 DRTS
• Short Run Analysis: MPK = c Q/K
& MPL = b Q/L
• b & c are elasticities of K & L
factors
• LogQ=loga+blogL+clogK + dlogT
where T  technology

3. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Theory and
Estimation of Cost
• Definition of Cost
• The Short Run Relationship Between
Production and Cost
• The Short Run Cost Function
• The Long Run Relationship Between
Production and Cost
• The Long Run Cost Function
• The Learning Curve

4. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
Definition of Cost
• A cost is relevant if it is affected by a
management decision.
• Historical cost is incurred at the time of
procurement
• Replacement cost is necessary to replace
inventory
• Are historical costs relevant?

5. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
Definition of Cost
• There are two types of cost associated
with economic analysis
• Opportunity cost is the value that is
forgone in choosing one activity over the
next best alternative
• Out-of-pocket cost is actual transfer of
value that occur
• Which cost is relevant?

6. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
Definition of Cost
• There are two types of cost associated
with time
• Incremental cost varies with the range
of options available in the decision
making process.
• Sunk cost does not vary with decision
options.
• Is sunk cost relevant?

7. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• A firm’s cost structure is related to its
production process.
• Costs are determined by the production
technology and input prices.
• Assuming that the firm is a “price taker” in
the input market.

8. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• Total variable cost
(TVC) is associated
with the variable
input
• Assume w=$500
per unit (price-
taker)
Total
Input
(L) Q (TP) MP
TVC
(wL)
0 0 0
1 1,000 1,000 500
2 3,000 2,000 1,000
3 6,000 3,000 1,500
4 8,000 2,000 2,000
5 9,000 1,000 2,500
6 9,500 500 3,000
7 9,850 350 3,500
8 10,000 150 4,000
9 9,850 -150 4,500

9. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• TP and TVC are mirror images of
each other
Kings Dominion
Example

10. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• Total cost (TC) is the cost associated
with all of the inputs. It is the sum of
TVC and TFC.
• TC=TFC+TVC
• Marginal Costs
• Average Costs
Tool Set for
Production Cost
Analysis
vs.
Production Process
Analysis

11. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• Marginal cost (MC) is the change in
total cost associated a change in output.
Q
TC
MC
∆
∆
=
Q
TVC
Q
TVC
Q
TFC
Q
TVCTFC
Q
TC
MC
∆
∆
+=
∆
∆
+
∆
∆
=
∆
+∆
=
∆
∆
= 0
)(

12. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• Add marginal
cost to the
table
Total
Input
(L) Q MP
TVC
(wL) MC
0 0 0
1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500

13. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• Observe that:
• When MP is
increasing,
MC is
decreasing.
• When MP is
decreasing,
MC is
increasing.
Total
Input
(L) Q MP
TVC
(wL) MC
0 0 0
1 1,000 1,000 500 0.50
2 3,000 2,000 1,000 0.25
3 6,000 3,000 1,500 0.17
4 8,000 2,000 2,000 0.25
5 9,000 1,000 2,500 0.50
6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500

14. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
SR Relationship Between
Production and Cost
• The relationship between MP and
MC is
MP
w
MP
w
Q
L
w
Q
Lw
Q
TVC
MC =•=
∆
∆
•=
∆
ƥ
=
∆
∆
=
1
Law of diminishing returns implies that
MC will eventually increase! Why?

15. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Average total cost (ATC) is the
average per-unit cost of using all of the
firm’s inputs (TC/Q)
• Average variable cost (AVC) is the
average per-unit cost of using the firm’s
variable inputs (TVC/Q)
• Average fixed cost (AFC) is the average
per-unit cost of using the firm’s fixed
inputs (TFC/Q)

16. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Add ATC = AFC + AVC to the table

17. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• ATC = AFC + AVC

18. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Production cost graph or map is

19. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Important Map Observations
• AFC declines steadily over the range of
production. Why?
• In general, ATC is u-shaped. Why?
• MC intersects the minimum point (q*) on
ATC. Why?

20. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Important Map Observations
• What is the economic significance of q*?

21. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Average total cost (ATC) is the
average per-unit cost of using all of the
firm’s inputs (TC/Q)
• At Q* - ATC is minimized or inputs
are used most efficiently given the
production function
Going at 55 MPH

22. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• A change in input
prices will shift the
cost curves.
• If fixed input costs
are reduced then
ATC will shift
downward. AVC
and MC will remain
unaffected. Computer Chip
Case

23. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• A change in input
prices will shift
the cost curves.
• If variable input
costs are reduced
then MC, AVC,
and AC will all
shift downward.
Airline Industry
Case

24. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Short Run Cost Function
• Yahoo Group
Discussion
• What is different
about dot.com
businesses?
Irrational
Exuberance

25. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The LR Relationship Between
Production and Cost
• In the long run, all inputs are variable.
• What makes up LRAC?

26. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Long-Run Cost Function
• LRAC is made up
for SRACs
• SRAC curves
represent various
plant sizes
• Once a plant size is
chosen, per-unit
production costs are
found by moving
along that particular
SRAC curve

27. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Long-Run Cost Function
• The LRAC is the lower envelope of all
of the SRAC curves.
• Minimum efficient scale is the lowest
output level for which LRAC is
minimized
Is LRAC a function of market size?
What are implications?

28. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Long-Run Cost Function
• Reasons for Economies of Scale…
Increasing returns to scale
Specialization in the use of labor and capital
• Economies in maintaining inventory
• Discounts from bulk purchases
• Lower cost of raising capital funds
• Spreading promotional and R&D costs
Management efficiencies

29. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Long-Run Cost Function
• Reasons for Diseconomies of Scale…
 Decreasing returns to scale
 Input market imperfections
 Management coordination and control
problems

30. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Learning Curve
• Measures the
percentage decrease in
additional labor cost
each time output
doubles.
• An “80 percent” learning
curve implies that the
labor costs associated
with the incremental
output will decrease to
80% of their previous
level.

31. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
The Learning Curve
• A downward slope in the learning
curve indicates the presence of the
learning curve effect
• Why? Workers improve their
productivity with practice
• The learning curve effect shifts the
SRAC downward

32. 2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
Production Cost Homework
• Page 378
• Problem 10