Cubic Cost Function

Related terms:

Economics, Subadditivity, Cost Model, Decreasing Rate, Input Price, Marginal Cost
Curve

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The Theory of Natural Monopoly

Monica Greer, in Electricity Cost Modeling Calculations, 2011

Average cost
Certainly, declining average cost throughout the relevant range of outputs is an
indicator that the cost function is subadditive and it is more efficient for one firm
to supply the entire industry output; that is, a natural monopoly. What this requires,
however, is that the marginal cost also declines throughout a subset of this range of
outputs. And necessary for this is a twice-differentiable cost function, which yields
the appropriately shaped average and marginal cost curves. Such a cost function is
displayed in Figure 2.1.

Figure 2.1. Total cost curve generated by a cubic cost function

A cubic cost function yields the appropriately shaped average and marginal cost
curves. For Y < Y*, cost increases at a decreasing rate. In this range, both marginal
and average cost decline. However, once diminishing returns set in, costs begin to
increase at an increasing rate; it is in this range that marginal costs begin to rise and
total cost increases at an increasing rate, which causes average cost to begin rising
and yields the U-shaped average cost curve displayed in Figure 2.2.

Figure 2.2. Average and marginal cost curves generated by cubic total cost function

A cubic cost function generates this particular shape and is of the general form

(2.3)

so that average cost is given by

(2.4)

where AC(Y) = C(Y)/Y. And marginal cost is given by

(2.5)

Note: As long as a, b, and d > 0, and c < 0, the total cost curve is as displayed in
Figure 2.1, which yields appropriately shaped (U-shaped, due to diminishing returns)
average and marginal cost curves; that is, as displayed in Figure 2.2.

The cubic cost function just described generates the average (AC) and marginal (MC)
cost curves displayed in Figure 2.2. For Y < Y*, marginal cost declines and pulls
average cost down with it; this is the region of the total cost curve in which cost
rises at a decreasing rate. Once diminishing returns set in, marginal costs rise and
eventually cause average cost to rise as well, which occurs at Y*, when total costs
begin to increase at an increasing rate.

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The Theory of Natural Monopoly and

Literature Review
Monica Greer Ph.D, in Electricity Marginal Cost Pricing, 2012

Average Cost
Certainly, declining average cost throughout the relevant range of outputs is an
indicator that the cost function is subadditive and that it is more efficient for
one firm to supply the entire industry output, that is, a natural monopoly. What
this requires, however, is that marginal cost also declines throughout a subset of
this range of outputs. And necessary for this is a twice-differentiable cost function,
which yields the appropriately shaped average and marginal cost curves. Such a cost
function is displayed in Figure 2.1.

Figure 2.1. Total cost curve generated by a cubic cost function.

A cubic cost function yields the appropriately shaped average and marginal cost
curves. For Y < Y*, cost increases at a decreasing rate. In this range, both marginal
and average costs are declining. However, once diminishing returns set in, costs
begin to increase at an increasing rate; it is in this range that marginal costs begin
to rise and total cost increases at an increasing rate, which causes average cost to
begin rising and yields the U-shaped average cost curve displayed in Figure 2.2.

Figure 2.2. Average and marginal cost curves generated by cubic total cost function.

A cubic cost function generates this particular shape and is of the general form:
(2.3)

so that average cost is given by

(2.4)

where AC(Y) = C(Y)/Y and marginal cost is given by

(2.5)

Note: As long as a, b, and d > 0, and c < 0, then the total cost curve is as displayed in
Figure 2.1, which yields appropriately (U-shaped, due to diminishing returns) shaped
average and marginal cost curves; that is, as displayed in Figure 2.2.

The cubic cost function described earlier generates the average (AC) and marginal
(MC) cost curves displayed in Figure 2.2. For Y < Y*, marginal cost declines and pulls
the average cost down with it; this is the region of the total cost curve in which cost
is rising at a decreasing rate. Once diminishing returns set in, marginal costs rise
and eventually cause the average cost to rise as well, which occurs at Y* when total
costs begin to rise at an increasing rate.

> Read full chapter

The Economics (and Econometrics) of

Cost Modeling
Monica Greer, in Electricity Cost Modeling Calculations, 2011

Cubic cost models

It is a well-established fact that total cost functions are cubic in nature; that is, there
is a region of increasing returns, constant returns, and decreasing returns to scale,
which yield the classic “hook shaped” marginal cost and U-shaped average cost
curves as displayed in Figure 4.6.
Figure 4.6. Average and marginal cost curves for cubic total cost function

Also displayed in Chapter 2, the cubic cost function generates the average (AC) and
marginal (MC) cost curves displayed in Figure 4.6. For Y < Y*, marginal cost declines
and pulls average cost down with it; this is the region of the total cost curve in which
cost is rising at a decreasing rate, which generates increasing returns to scale. Once
diminishing returns set in, marginal costs rise and eventually cause average cost to
rise as well, which occurs at Y*, when total costs begin to increase at an increasing
rate.

That is, the total cost increases at a decreasing rate (i.e., marginal cost declines
with output), then increases at an increasing rate (i.e., marginal cost increases with
output), thus causing average cost to rise. This is also analogous to Figure 4.3.

These are the classic “textbook” examples that all principles of economics students
are taught: Marginal cost declines in the increasing returns to scale portion of the
total cost curve, which causes average cost to decline; when decreasing returns to
scale set in, marginal cost begins to rise, thus causing average cost to rise (recall
that marginal cost cuts the average cost curve at its minimum), which results in the
classic U-shaped average cost curve.

> Read full chapter

The Economics (and Econometrics) of

Cost Modeling
Monica Greer Ph.D, in Electricity Marginal Cost Pricing, 2012

Cubic Cost Models

It is a well-established fact that total cost functions are cubic in nature; that is, there
is a region of increasing returns, constant returns, and decreasing returns to scale,
which yield the classic “hook-shaped” marginal cost and U-shaped average cost
curves displayed in Figure 4.6.

Figure 4.6. Average and marginal cost curves for cubic total cost function.

Also displayed in Chapter 2, the cubic cost function generates the average (AC) and
marginal (MC) cost curves displayed in Figure 4.6. For Y < Y*, marginal cost declines
and pulls average cost down with it; this is the region of the total cost curve in which
cost is rising at a decreasing rate, which generates increasing returns to scale. Once
diminishing returns set in, marginal costs rise and eventually cause average cost to
rise as well, which occurs at Y* when total costs begin to increase at an increasing
rate.

That is, total cost increases at a decreasing rate (marginal cost declines with output)
and then increases at an increasing rate (marginal cost increases with output), thus
causing average cost to rise. This is also analogous to Figure 4.3.

These are the classic “textbook” examples that all principles of economics students
are taught: marginal cost declines in the increasing returns-to-scale portion of the
total cost curve, which causes average cost to decline; when decreasing returns to
scale set in, marginal cost begins to rise, thus causing average cost to rise (marginal
cost cuts the average cost curve at its lowest point), which results in the classic
U-shaped average cost curve.

As stated in Chapter 2, the cubic form of the cost equation is the appropriate spec-
ification for generating average and marginal cost curves that accord to economic
theory. The author has began experimenting with the cubic form of her quadratic
cost model, which is given by

(4.87)

for outputs Y1 and Y2. This cost model is the subject of a case study presented in
Chapter 6.
> Read full chapter

Case Study1
Monica Greer Ph.D, in Electricity Marginal Cost Pricing, 2012

Literature Review
Few studies employ the cubic functional form to model costs, especially in mul-
tiproduct industries. Prior to this study, Martins and colleagues (2006) employed
such a specification to examine the cost structure of the Portuguese water industry.
Like similar studies (i.e., cost estimation) for public utilities, their objective was to
estimate economies of scale and scope and, ultimately, to test for whether the electric
industry is a natural monopoly. Their model is given by

(6.1)

However, and unlike this chapter, Martins et al. (2006) do not include input prices
into their cost model, which violates a basic tenet of cost functions, which, by
definition:

A cost function measures the minimum cost of producing a given level of output (Y)
for some fixed factor price (w). As such, and at the very least, a cost model is given
by(6.2)(Varian, 1992).

Laband and Lentz (2005) employ a cubic cost function to estimate higher-education
costs and the production of extension, which is often important in agriculture-relat-
ed studies. Following Baumol et al. (1982), they specify a flexible fixed cost equation
of the form:

(6.3)

where Ci are total expenditures by the higher-education institution i in 1996 and

Yi,j are outputs: undergraduate education, graduate education, and research and
extension.7

Creedy et al. (2003) also studied the cost of higher-education costs in Australia. They
specify the form

(6.4)

where L is the number of students and D is the student share of a discipline group.
Again, no input prices are included.
The only paper the author has found that uses a cubic function in the electric utility
industrial is that of Yoo (1988). Estimating a two-output (electricity and gas) cost
model of the form

(6.5)

Yoo found that in 1983 product-specific economies of scale for electricity were
prevalent up to 10 GWh (the coefficient on the cubed output term is not statistically
different from zero). Nonetheless, appropriately shaped average and marginal cost
curves result. However, again no input prices are included, as his is a long-run
model, which, as stated previously, does not accord with economic theory.

This chapter is unique in its contribution to the literature, offering a theoretically

sound and properly specified multiproduct cost function in which outputs enter
cubically and, as such, generate the appropriately shaped average and marginal cost
curves, as displayed in Figure 6.2. This is a necessary condition for the efficient
pricing of services (i.e., prices are equal to the marginal cost of providing service),
which in turn is necessary to properly signal and incentivize consumers to make
appropriate investments in energy efficiency and conservation in general in the
consumption of electricity.

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Cost Models
Monica Greer Ph.D, in Electricity Marginal Cost Pricing, 2012

Cubic Cost Models

Another form is that of the cubic cost equation in which outputs enter linearly, as
quadratics, and to the third degree. Not often used in the economics literature,
this form of the equation is actually the most correct because it yields appropriately
shaped average and marginal cost curves. These are displayed in Figures 5.2 and 5.3.
Figure 5.2. An appropriately shaped total cost function. A cost function that is cubic
in output (Y) yields regions of increasing, constant, and decreasing returns to scale.
Y* denotes the inflection point, which is the point at which returns to scale go from
being increasing to decreasing.

Figure 5.3. Average and marginal cost curves. At output levels Y &lt; Y*, increasing
returns to scale are indicated by declining average costs [AC = f(Y)]. At Y = Y*, returns
to scale are constant (and average cost = marginal cost). Beyond this level of output,
Y &gt; Y*, diminishing returns to production set in (i.e., marginal cost increases with
output) and decreasing returns to scale are experienced.

The reason that this is important is that economic theory dictates that efficiency
occurs when price is equal to marginal cost, as this results in optimal allocation of
resources, and resources are devoted to their best output (i.e., productive efficiency-
). In the case of electricity (and energy services in general), the only way to reduced
greenhouse gases (and other emissions) is to price it efficiently and with a rate
structure that recovers fixed costs via fixed charges and variables via variable charges.
Also known as marginal cost pricing, the concept has been gaining favor in recent
years and is the subject of Chapter 8.

In general, a single-output cubic cost function is given by

(5.70)

where Y is output (distributed electricity) and wi are input prices (again capital, labor,
and purchased power).

Example 5.7

We could estimate the parameters of this model and test for economies of scale, etc.
Using data contained in Coops97, which contains panel data from 1997 to 2001. For
the year 1998, the results are obtained and displayed in Table 5.10.

Table 5.10. Estimation Results for Cubic Cost Model, 1998 Data
Variable Estimated Coefficient t Statistic
Intercept −15.4932 −4.89
Y 0.059066 9.47

Y2 4.47E-06 0.61

Y3 −2.18E-09 −1.74

Pp 0.297248 6.58

Pk 0.426449 1.23

Pl 0.283252 2.84

A Priori Expectations
Before we review the results, let us first review a priori expectations concerning
estimated coefficients in the model. In general terms, let the total cost function
be given by

(5.71)

For this to have the appropriate shape (as displayed in Figure 5.2), it is necessary to
impose certain restrictions on the parameters a, b, and c.

Equivalently, we know that the marginal cost curve should be positive throughout.
In this case, marginal cost is given by

(5.72)

For this to be positive throughout (as in Figure 5.3), it must be U-shaped with its
minimum also greater than zero. In this case, we can ensure this by solving for the
level of output that satisfied the first-order condition:

(5.73)

which implies that

(5.74)

(This minimizes marginal cost because

(5.75)

as long as we restrict a > 0.)

What about other parameter restrictions? Substituting Y* into the MC function yields
 (5.76)

or

(5.77)

which implies that

(5.78)

Because we have already restricted that a > 0, the aforementioned implies that c > 0.
(What about b? Is it necessary to impose that b < 0? Why or why not?)

Back to the Example at Hand

Given the earlier discussion, it is clearly the case that

(5.79)

(Of course, the coefficients, i, on the input price variables must be positive to
accord with theory.) Do the results obtained accord with Equation (5.79)? Estimation
results are displayed in Table 5.10.

Discussion
Despite a rather high adjusted R2 of 0.93, estimation results do not accord with a
priori expectations. The quadratic and cubic terms in output are of the wrong sign.
Clearly, this particular equation is not well suited to underlying data, which could be
due to the functional form itself or another issue, such as an omitted variable (see
Example 4.4 on omitted variable bias in Chapter 4).

Another option is to specify a log-linear model to see if that improves the estimation
results. In an exercise you will do this, that is, using the same data as before, to
specify a model of the form:

(5.80)

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