COST THEORY

Cost theory is related to production theory, they are often used together. However, the
question is usually how much to produce, as opposed to which inputs to use. That is,
assume
that we use production theory to choose the optimal ratio of inputs (eg. 2 fewer
engineers
than technicians), how much should we produce in order to minimize costs and/or
maximize
profits? We can also learn a lot about what kinds of costs matter for decisions made by
managers, and what kinds of costs do not.
I What costs matter?
A Opportunity Costs
Remember from Section (IV) of the Introduction, that in addition to accounting profit,
managers must consider the cost of inputs supplied by the owners (owners capital and
labor).
Definition 16 Explicit Costs: Accounting Costs, or costs that would appear as costs in
an accounting statement.
Definition 17 Opportunity Costs: The value of all inputs to a firms production in their
most valuable alternative use.
Recall the example from Section (IV), where the decision was whether or not to buy
the kitchen. the opportunity costs were the $24,000 per year the money could be
earning
elsewhere, and the owners time cost of $40,000, which exceeded the accounting profit
of
$60,000.
B Fixed costs, variable costs, and sunk costs
Some inputs vary with the amount produced and others do not. The firms computer
sys-
tem and accountants may be able to handle a large volume of sales without increasing
the
number of computers or accountants, for example. Inputs that do not vary with the
amount
produced, like accountants and computers, are called fixed inputs.
Most inputs are fixed only for a certain range of production. A medical office may be
able to handle many additional patients without adding and office assistant or extra
phones.
The phones and office assistants are fixed inputs. But, if the number of extra patients is
large enough, the firm needs extra office staff.
Reasons for fixed costs:
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1. Salaried workers. Salaried workers are a fixed input if the worker can work overtime
without additional compensation (doctors paid a fee for service are variable inputs,
salaried medical staff are fixed inputs).
2. Fixed hours at work. An hourly worker sometimes cannot be sent home early if not
enough work is available. Therefore, workers may not be busy and be able to handle
extra work without additional hours.
3. Time to adjust. Some inputs, like machines, take time to purchase and install.
Conversely, unskilled labor may be adjusted more quickly through overtime, temps,
etc. Therefore, by necessity the firm may only be able to vary production by increasing
labor in the short run.
Definition 18 Total Variable Cost The total cost of all inputs that change with the
amount produced (all variable inputs).
Definition 19 Total fixed costs The total cost of all inputs that do not vary with the
amount produced (all fixed inputs).
Consider the Thompson machine company. The firm uses 5 machines to make machine
parts. Because of the time to adjust, machines are a fixed cost, while the number of
workers
varies with the amount produced. Labor is a variable cost.
Definition 20 Sunk costs Are costs that have been incurred and cannot be reversed.
Any costs incurred in the past, or indeed any fixed cost for which payment must be
made regardless of the decision is irrelevant for any managerial decision. Suppose you
hire
an executive with a $100,000 signing bonus, plus $200,000 salary. After hiring, you may
find the executive does not live up to expectations. However, if the executives marginal
revenue product is $200,001, the executive still generates $1 in profits relative to his
salary
and therefore should be retained. But if his MRP is $199,999, the firm loses an extra $1
each
year they keep him, so he should be let go. The bonus is a sunk cost and does not
affect the
retention decision.
The principle of sunk costs is equivalent to the saying dont throw good money after
bad.
Sometimes a decision can be made to recover part of a fixed cost. Perhaps one could
sell
a factory and recover part of the fixed costs. Then only the difference is sunk. For
example,
if we can sell a building for which we paid $500,000 for $300,000, then only $200,000 is
sunk.
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Sunk costs are perhaps one of the most psychologically difficult things to ignore. Exam-
ples:
1. Finance. Studies show investors let sunk costs enter their decision making. What
price the stock was purchased at is sunk and therefore irrelevant. What matters is
only whether or not this stock offers the best return for the risk. Yet, investors are
reluctant to sell stocks whose price has gone down.
2. Capital investment. I watched the world series of poker. In one instance, the odds
of drawing a flush (and almost for sure winning the hand) was 1 in 5. The pot was
about $200,000. So the player should call any bet less than or equal to $40,000. Yet
the commentator advised that the player should call regardless of the bet, because he
already had so much money in the pot (sunk costs).
3. Cut your losses? Consider the war in Afghanistan. We have sunk billions, but that
should not enter our decision about whether or not to stay.
4. Pricing in high rent districts. Consider restaurants in a high rent district (say
an airport). Should they take the rent into account when setting prices? No. In fact,
prices are high not because of the rent, but typically because of the lack of competitors.
II Short run costs
We use short run costs primarily to compute how much to produce while maximizing
profits.
We use long run costs to answer questions like should the firm expand, contract,
merge, etc.
Definition 21 Average Costs: Costs divided by output.
Definition 22 Marginal Costs: The cost of one additional unit of an input.
Here is the notation:
Type of Cost Total Cost equals Variable Costs Plus Fixed Costs
Total TC = TV C +TFC
Average ATC = TC
Q = AV C = TV C
Q +AFC = TFC
Q
Marginal MC = dTC
dQ = _TC
_Q
Properties of cost functions in the short run:
1. Total costs of increase with Q, the quantity produced.
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2. Average Costs decline with Q, but eventually rise. The fixed costs are spread over
many
more units of production at high Q, reducing average costs. All of the extra workers
required for producing additional units when the factory is near capacity starts to
increase average costs eventually.
3. Marginal costs usually decline then increase, but must eventually increase. At first,
producing one additional unit is may cheaper than the last unit, due to specialization.
However, eventually diminishing returns sets in and the workers just get in each others
way. Then a very large number of additional workers might be needed to produce an
additional unit.
Here is a graph of the cost curves.
0 1 2 3 4 5 6 7 8 9 10
0
50
100
150
200
250
300
350
400
450
500
Q
Cost ($)
Total Cost Functions
Total Costs
Total Fixed Costs
Total Variable Costs
Figure 5: Typical short total cost curves.
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0 1 2 3 4 5 6 7 8 9 10
0
20
40
60
80
100
120
Q
Costs per unit ($)
Short Run Cost Functions
Average Total Costs
Average Fixed Costs
Average Variable Costs
Marginal Costs
Figure 6: Typical short run average and marginal cost curves.
III Examples using short run cost curves.
A Profit maximization with perfect competition
Let us suppose that you are a hypothetical manager of a group of cruise ships. Using
data
from previous years, you estimate the short run cost function is (we will see how to do
this
estimation below):
TC = 60 +
Q2
20
(71)
Here Q is the number of cruises the ship takes (not the number of passengers). The
cost
of the ship is $60 million, which is sunk. Notice in equation (71) that the cost of the ship
does not depend on the number of cruises the ship takes. Suppose further that each
cruise
generates revenue of $3 million.
Maximize profits:
max _ = TR TC = 3Q 60
Q2
20
(72)
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Take the derivative to get the slope and set the slope equal to zero:
3
Q
10
= 0 ! Q = 30. (73)
Notice that the fixed costs have dropped out. The math agrees: fixed costs do not
matter
for our decision. In general, to maximize profits we set marginal revenue (here $3) equal
to
marginal costs (here Q/10).
MR = MC. (74)
In a competitive industry, firms have no ability to influence the price. Examples include
market makers in stock markets, commodities, and large food markets. For example, an
individual farmer may produce as much corn as desired and sell the corn on the
commodities
markets with no change in price. Regardless of the amount produced by an individual
firm,
the price is unchanged and MR = P. So in competitive industries, we set:
P = MC. (75)
The firm should produce one more unit if we can sell it for more than it costs to produce.
The firm makes profits in this case. In the next set of notes, we will do the case where
firms
have pricing power.
Using a table:
Cruises (Q) Total variable costs (TV C) Marginal costs (MC)
0 0
20 = (202)/20 = 20 = (20 0)/(20 0) = 1
25 = (252)/20 = 31.25 = (31.25 20)/(25 20) = 2.25
30 45 2.75
35 61.25 3.25
40 80 3.75
Table 6: Variable costs on a cruise ship.
The marginal revenue is the price of the cruise, equal to $3 million. We can see that
marginal revenue equals marginal costs somewhere between 30 and 35 cruises.2
Producing the 30th cruise gives us $3 of revenue, enough to cover the costs of
producing
the 30th cruise, which (using table 6) is approximately $2.75. However, the 35th cruise
loses
2The table is an approximation, however. In fact, using the true marginal cost of the 30th cruise is
MC = dTC/dQ = Q/10 = 3.
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money. The table estimates that cruise would cost $3.25, and since revenues are $3,
the
cruise would lose an estimated $0.25 million.
The fixed costs are irrelevant here. When considering the fixed costs, the firm has
negative
profits regardless of how many cruises the firm takes. The maximum profits occurs at 30
cruises:
_ = TR TC = 3 30 _60 +
302
20 _ = $15. (76)
We have already paid the fixed costs, so we might as well lose as little as possible.3
B Break Even Analysis
An important consideration when deciding whether to continue operations in a particular
market, expand into a market, or start a new business is a break even analysis. We can
do
a break even analysis with a cost function.
In a break even analysis, the question is: how much profit is required to exactly pay off
all fixed costs? Alternatively, how much revenue is required to pay off the average
variable
costs and the fixed costs:
_ = 0 = TR TC (77)
0 = P Q TFC TV C (78)
0 = P Q TFC AV C Q (79)
Q =
TFC
P AV C
(80)
Here I have assumed linear total costs, so that average variable cost is constant. One
could
assume (more realistically) that average variable costs depend on Q, and use a table to
get
the break even point.
3Note that it is irrelevant how the ship is financed. Interest and principle payments are also sunk costs.
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C Average Costs
Often average cost data is easy to get. It is relatively easy to measure total costs and
the
quantity sold to get average costs. However, many managers then incorrectly base
decisions
on average costs.
Consider the following data:
Typical Data Calculate this!
Gas Produc-
tion (Q)
Total costs
(TC)
Average Total
costs (ATC)
Marginal Costs
(MC)
Profits (_)
20 1271 = 1271/20 = 63.6 89
22 1359 61.8 = (1359 1271)/
(22 20) = 44.0
137
24 1456 60.7 48.5 176
26 1562 60.1 53.0 206
28 1675 59.8 56.5 229
30 1797 59.9 61.0 243
32 1928 60.3 65.5 248
34 2067 60.8 69.5 245
36 2214 61.5 73.5 234
38 2370 62.4 78.0 214
40 2534 63.4 82.0 186
42 2707 64.5 86.5 149
44 2888 65.6 90.5 104
46 3077 66.9 94.5 51
48 3275 68.2 99.0 -11
Table 7: Average and marginal costs in the gas industry.
The first 3 columns of table 7 give a typical data set one might have in a real business
situation. For example, a gas refinery might produce different quantities monthly
depending
on variations in the price of gas and demand. Suppose the price of gas is currently $68.
How much gas should be produced? Setting price equal to average cost (48 units)
actually
produces a loss. We could try to minimize average costs, which occurs at 28 units. Still,
this is not the maximum profits. The maximum profits occurs when price equals
marginal
costs, about 32-34 units. The key is that given the first 3 columns, one can easily
calculate
the marginal costs and calculate the profit maximizing quantity.
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IV Long Run Costs
We use long run costs to decide scale issues, for example mergers, but also the optimal
size
of our operations (e.g. optimal plant size). The long run is when all costs are variable.
In the long run, we can build any size factory we wish, based on anticipated demand,
profits, and other considerations. Once the plant is built, we move back to the short run
as described above. Therefore, it is important to forecast the anticipated demand. Too
small a factory and marginal costs will be high as the factory is stretched to over
produce.
Conversely too large a factory results in large fixed costs (eg. air conditioning, or taxes).
A Definition
Definition 23 Long Run Average Costs: The minimum cost per unit of producing a
given output level when all costs are variable.
Average
cost ($/unit)
Long Run Average
Costs
Short Run Average
Costs
Q
small plant small plant
Qd
Cost of making
size plant
medium
plant
small
Qd with a
Cost of making
Qd with a
Figure 7: Long run average cost curve.
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Think of each short run average cost curve as a factory of different size. We build the
factory, and then operate within the short run average cost curve for the factory that is
built. For each size factory, average total costs are initially decreasing as the fixed costs
are spread over more and more units. Eventually, however, average total costs rise as
the
factory becomes over crowded. Suppose we forecast demand at Qd on the graph. Then,
from
the graph, we create a small sized factory, as that is the cheapest way to build Qd units.
Therefore, we must have that the long run average cost curve is tangent to the
minimum of
the short run average cost curves.
B Deriving a long run average cost curve: Example
Suppose we can build plants of three sizes:
Cost Type Plant Size
AV C Small Medium Large
Labor $3.70 $2.50 $1.10
Materials $1.80 $1.40 $0.90
Other $2.00 $2.60 $3.00
TFC $25,000 $75,000 $300,000
Capacity 50,000 100,000 200,000
Table 8: Plant size and LRAC.
What type of plant produces 100,000 units at the lowest long run average costs? We
can
build either two small plants, 1 medium sized plant, or one large plant. The average
costs
of two small plants are:
ATC = AV C +
TFC
Q
, (81)
ATC = $3.70 + $1.80 + $2.00 +
$25, 000 2
100, 000
= $8. (82)
Here, the fixed costs of the small plant is multiplied by two since we need two plants.
For a
single medium sized plant:
ATC = $2.50 + $1.40 + $2.60 +
$75, 000
100, 000
= $7.25. (83)
The medium sized plant is cheaper. Although the factory is more expensive to build
than
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two small factories, it can produce units at lower average variable cost. A large plant
has:
ATC = $1.10 + $0.90 + $3.00 +
$300, 000
100, 000
= $8.00. (84)
The large plant can produce at a very low average variable cost of $5 per unit, but is
just
too expensive to build.
So for Q = 100, 000 units, we build a single, medium sized factory. The point on the
long
run average cost curve for Q = 100, 000 is LRAC = $7.25.
Suppose instead expected demand is Q = 200, 000 units. We can build 1 large, two
medium, or 4 small plants. The cost of these options (per unit) are: $6.50, $7.25, and
$8,
respectively. The large plant is the cheapest, and LRAC = $6.50 for Q = 200, 000. We
could also build 1 medium and two small factories, but then the costs would be an
average
of $7.25 and $8, which is still worse than a large plant.
Finally long run average costs are minimized when we dont have to build any small or
medium sized plants, at Q = 200,000, 400,000, and so on.
C Factors that affect long run average costs
Long run average costs may be decreasing and then increasing, but also may be strictly
decreasing. Here are some LRAC curves for some industries.
1. Nursing Homes have decreasing LRAC. Nursing homes have many fixed man-
agement costs. Further, larger nursing homes are able to negotiate lower prices for
many raw materials.
2. Cruise Ships have decreasing LRAC. Huge cruise ships have lower average costs
than small cruise ships, economizing on many services provided on the ships.
3. Hospitals have U-shaped LRAC. Cowing and Holtmann (1983) in fact found many
hospitals in New York should in the long run reduce both capital and physicians to
lower average costs.
When the LRAC curve is decreasing, it is in the interest of the industry to consolidate.
A merger with another firm can increase the customer base but reduce the cost per unit,
thus increasing profits.
Reasons for decreasing long run average costs:
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1. Specialization of labor. Producing more units requires more workers. Workers can
then specialize in different parts of the production process, and produce more units.
2. Indivisibilities. A firm may require one accountant, even if there is less than 40 hours
of work to do. But then the firm can increase units produced without increasing the
size of the accounting staff.
3. Pricing Power. Large firms buy in bulk and therefore negotiate lower prices for
inputs.
Notice the reasons are similar to increasing returns to scale.
Reasons for increasing costs:
1. Regulation may exempt smaller firms.
2. Coordination and information problems. In a large firm, many individuals do
not meaningfully affect profits and thus have the wrong incentives. Smaller operations
may know their customers and production processes better.
With decreasing returns, spin-offs and divestments may be optimal.
A compromise is franchising. Nationalize just the parts for which increasing returns
works.
D Long run competitive equilibrium
In the long run, firms can enter and exit the market, or grow or shrink in size. As long as
economic profits are positive, new entrants arrive as the industry gives higher profits
than
alternatives. New entrants increases competition and pushes down the price until
economic
profits are zero. Therefore, in the long run:
_ = TR TC = 0, (85)
P Q = TC, (86)
P =
TC
Q
= LRAC. (87)
Now at the firm level, we set P = LRMC. But since also P = LRAC, marginal and
average costs are equal in the long run. We can therefore minimize long run average
costs
and in the long run, we will have P = LRMC = LRAC.
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V Application of long run average costs: Banking mergers
Consider two banks. The first bank services Q = 15 customers and the second (smaller)
bank services Q = 5 customers. The long run average cost function in the industry is:
LRAC = 700 40Q + Q2 (88)
Price is constant at $300 dollars of revenue per customer.
Should these two firms merge? The size of the customer base (Q) which minimizes long
run average costs is:
min LRAC = 700 40Q + Q2 (89)
40 + 2Q = 0 ! Q = 20 (90)
Costs per unit fall until Q = 20. Thus these two firms can reduce costs by merging from
two
firms of size Q = 15 and Q = 5) into one firm with Q = 20.
Profit per unit in each case are:
_ = 300 700 40Q + Q2_ = 400 + 40Q Q2 (91)
_ (Q = 15) = 400 + 40 15 152 = 25 (92)
_ (Q = 5) = 400 + 40 5 + 52 = 225 (93)
_ (Q = 20) = 400 + 40 20 202 = 0 (94)
Individually, the two banks lose money but together they have zero economic profits. At
zero economic profits, no incentive exists for firms to enter or exit the market. The
choice is
essentially to merge and get bigger or exit the market.
VI Measuring Cost Functions
We use the same procedure as with production functions: Obtain data on total costs
and
quantity produced, and use Excel to fit the data. Both total cost and total quantity
produced
may appear to be easier to obtain than input data. However, one must remember that
costs
40
represent opportunity costs, which are not always straightforward.
Some additional issues:
A Choice of Cost Function
One choice is whether to use a linear, quadratic, or cubic function:
TC = a + bQ (95)
TC = a + bQ + cQ2 (96)
TC = a + bQ + cQ2 + dQ3 (97)
Under most circumstances, the linear cost function does a reasonable job over a narrow
range of Q (for example in the short run), but the quadratic and cubic terms must matter
theoretically, especially for a wider range of Q. A good strategy might therefore be to
estimate the cubic or quadratic.
If the t-stats are low for the quadratic and cubic terms, then predictions are likely to be
unreliable for Q that falls outside the data. This indicates using some caution before, for
example, committing to large mergers. The following graph illustrates the problem.
1 2 3 4 5 6 7
60.5
61
61.5
62
62.5
63
63.5
64
Q
Cost ($)
Possible Problem Estimating Cost Functions: Data is to homogeneous
Estimate is inaccurate here
Estimate is accurate here
data
True Cost Function
Estimated Cost Function
Figure 8: Cost estimation problems.
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B Data issues
Some problems with the data that often need correcting:
1. Definition of cost: as mentioned earlier, we use opportunity costs not accounting
costs.
2. Price level changes: Historical data is likely to be inaccurate if the price of some
inputs
or outputs have changed dramatically.
3. What costs vary with output: Some costs have a very limited relationship with output.
For example, the number of professionals required may vary in some limited way with
output. A firm with $1 million in sales may have two accountants. The firm can
obviously increase output to some degree without needing more accountants (so the
cost would be fixed). But for larger Q additional accountants are needed (like a variable
cost).
4. The cost data needs to match the output data. Often the cost of producing some
output may be accounted for in some other period.
5. The firms technology may change over time.
When estimating long run costs, it is usually preferable to use a cross section of firms
across an industry. An individual firm is unlikely to have changed size significantly
enough
to generate data for a wide range of Q.
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In economics, the cost-of-production theory of value is the theory that the price of an object or
condition is determined by the sum of the cost of the resources that went into making it. The cost
can comprise any of the factors of production (including labor, capital, or land) and taxation.
The theory makes the most sense under assumptions of constant returns to scale and the
existence of just one non-produced factor of production. These are the assumptions of the so-
called non-substitution theorem
[clarification needed]
. Under these assumptions, the long-run price of a
commodity is equal to the sum of the cost of the inputs into that commodity, including interest
charges.