By Prof. Dr. Sami Fethi: FALL 2016-17

Department of Business Administration
FALL 2016-17
Cost Theory and Estimation
by
Prof. Dr. Sami Fethi
CH 7: Cost Theory
The Nature of Costs
C = aQb ln C = ln a + b ln Q
2
Managerial Economics in a Global Economy © Dominick Salvatore; ed. 2007;2011, 2014/15, Sami Fethi, EMU, All Right Reserved.
CH 7: Cost Theory
The Nature of Costs
• Costs are incurred as a result of

production.
• Costs are the sum of all expenditures

incurred in producing a given volume of
output.
• Costs are the amount of money spent on

the production of different levels of a good.
3
CH 7: Cost Theory
The Nature of Costs
 Explicit Costs
 Accounting Costs
 Economic Costs
 Implicit Costs
 Alternative or Opportunity Costs
 Relevant Costs
 Incremental Costs
 Sunk Costs are Irrelevant
4
CH 7: Cost Theory
The Nature of Costs
• Economists define cost in terms of

opportunities that are sacrificed when a
choice is made. Therefore, economic costs
are simply benefits lost.
• Accountants define cost in terms of

resources consumed. Accounting costs
reflect changes in stocks (reductions in
good things, increases in bad things) over
a fixed period of time.
5
CH 7: Cost Theory
Explicit Costs
 Explicit costs are actual expenditures of

the firm to hire, rent, or purchase the
inputs it requires in production.
 These includes the wages to hire labor, the
rental price of capital, equipment, and
buildings, and the purchase price of raw
materials and semi finished products.
6
CH 7: Cost Theory
Implicit Costs
 Implicit costs refers to the value of the

inputs that are owned and used by the firm
in its own production activity.
 These includes the highest salary that the
entrepreneur could earn in his or her best
alternative employment and the highest
return that the firm could receive from
investing its capital in the most rewarding
alternative use or renting its land and
buildings to the highest bidder.
7
CH 7: Cost Theory
Economic Costs
 Economic cost refers the sum of explicit and

implicit costs. These costs must be
distinguished from accounting costs, which
refer only to the firm’s actual expenditures,
or explicit cost, incurred for purchased or
hired inputs.
8
CH 7: Cost Theory
Alternative or Opportunity Costs
 The cost to the firm of using a purchased or

owned input is equal to what the input could
earn in its best alternative use.
• The firm must include the alternative or
opportunity costs because the firm cannot
retain a hired input if it pays a lower price for
the input than another firm.
9
CH 7: Cost Theory
Relevant and Irrelevant Costs
 Relevant Costs: The costs that should be

considered in making a managerial decision;
economic or opportunity costs.
Incremental costs: the total increase in
costs for implementing a particular
managerial decision.
• Irrelevant or Sunk Costs: The cost that are
not affected by a particular managerial
decision.
10
CH 7: Cost Theory
Short-Run Cost Functions
 In short-run period, some of the firm’s

inputs are fixed and some are variable, and
this leads to fixed and variable costs.
 Total costs is the cost of all the productive

resources used by the firm. It can be
divided into two separate costs in the short
run.
11
CH 7: Cost Theory
Total fixed and variable costs
 Total Fixed Costs: The total obligations of

the firm per time period for all the fixed
inputs the firm uses.
 Total Variable Costs: The total obligations

of the firm per time period for all the
variable inputs the firm uses.
12
CH 7: Cost Theory
Total Cost = TC = f(Q)

Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC
13
CH 7: Cost Theory
Average Costs
 Average total cost (also called average cost)

equals total cost per unit of output produced
ATC = TC/Q
 Average fixed cost equals fixed cost divided
by quantity produced
AFC = FC/Q
 Average variable cost equals variable cost
divided by quantity produced
AVC = VC/Q
14
CH 7: Cost Theory
Average Costs and Marginal Cost
 Average total cost is also the sum of average fixed

cost and average variable cost.
ATC = AFC + AVC
 Marginal (incremental) cost is the increase in total

cost resulting from a one-unit increase in output.
Marginal decisions are very important in
determining profit levels.
MC = ΔTC/ΔQ
15
CH 7: Cost Theory
•The marginal cost curve, average variable

cost curve and average total cost curves are
generally U-shaped.
•The U-shape in the short run is attributed to
increasing and diminishing returns from a fixed-
size plant, because the size of the plant is not
variable in the short run.
16
CH 7: Cost Theory
•The marginal cost and average cost curves are

related
When MC exceeds AC, average cost must
be rising
When MC is less than AC, average cost
must be falling
•This relationship explains why marginal cost
curves always intersect average cost curves at
the minimum of the average cost curve.
17
CH 7: Cost Theory
Graphical Presentation
$ MC will intersect the AVC at the

minimum of the AVC [always].
ATC
AVC
ATC* R MC will intersect the ATC
at the minimum of the ATC.
AVC* TC = ATC* x Q** J The vertical distance between
TVC = AVC* x Q* ATC and AVC at any output is
the AFC. At Q** AFC is RJ.
Q* Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.
18
CH 7: Cost Theory
Relationship Between Marginal and Average Costs
If MC > ATC, then ATC is rising

If MC = ATC, then ATC is at its minimum
If MC < ATC, then ATC is falling
If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum
If MC < AVC, then AVC is falling
19
CH 7: Cost Theory
Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
20
CH 7: Cost Theory
Short-Run Cost Functions-Example
Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q
21
CH 7: Cost Theory
Graphical Presentation
22
CH 7: Cost Theory
Average Cost Curves-Graphical meaning
• The average fixed cost curve slopes

down continuously.
• The average total cost curve is the
vertical summation of the average fixed
cost curve and the average variable cost
curve
The ATC curve is always higher than
AFC and AVC curves
• While output gets big and AFC decline
to zero, the AVC curve approaches the
ATC curve.
23
CH 7: Cost Theory
Wage Rate
Average Variable Cost

AVC = TVC/Q = w/APL
Marginal Cost
TC/Q = TVC/Q = w/MPL
24
CH 7: Cost Theory
Long-Run Cost Curves
•The long run is the period of time during which:

Technology is constant
All inputs and costs are variable
The firm faces no fixed inputs or costs
The long run period is a series of short run
periods. [For each short run period there is a
set of TP, AP, MP, MC, AFC, AVC, ATC, TC,
TVC & TFC for each possible scale of plant].
25
CH 7: Cost Theory
Long-Run Total Cost = The minimum total

costs of producing various levels of output
when the firm can build any desired scale
of plant: LTC = f(Q)
Long-Run Average Cost = The minimum
per-unit cost of producing any level of
output when the firm can build any desire
scale of plant: LAC = LTC/Q
Long-Run Marginal Cost = The change in
long-run total costs per unit change in
output: LMC = LTC/Q
26
CH 7: Cost Theory
Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q
27
CH 7: Cost Theory
Derivation of Long-Run Cost Curves
From point A on
the expansion path
in the first panel
with w=$ 10 and
r=$ 10, the firm
uses 4 units of
labor 4L and 4
units of capital 4k
and the minimum
totalcost producing
1Q is $80. This is
shown as point A’
and A’’ on the long-
run total cost curve
in the middle panel
and bottom panel.
28
Relationship Between Long-Run and Short- CH 7: Cost Theory
Run Average Cost Curves The top panel of the
figure is based on the
assumption that the
firm can build only
four scales of plant
SAC1 etc.., while the
bottom panel is based
on the assumption
that the firm can build
many more or an
infinite number of
scales of plant. At A’’
min av cost of
producing o/p is $80.
At B* the firm can
produce 1.5Q at an av
cost of $70 by using
either SAC1 or SAC2
and so on..
29
CH 7: Cost Theory
Possible Shapes of the LAC Curve
The left panel shows a U-shaped LAC curve which

indicates first decreasing and then increasing
returns to scale. The middle panel shows a nearly L-
shaped LAC curve which shows that economies of
scale quickly give way to constant returns to scale or
gently rising LAC. The right panel shows an LAC
curve that declines continuously, as in the case of
natural monopolies. 30
CH 7: Cost Theory
Learning Curves
The learning curve shows the decline in the

average input cost of production with rising
cumulative total outputs over time. The learning
curve also shows that the average cost is about $
250 for producing the 100th unit at point F etc..
31
CH 7: Cost Theory
Learning Curves
Average Cost of Unit Q = C = aQb
Estimation Form: log C = log a + b Log Q
The Learning curve can be express algebraically as follows:
(C is cost of the Qth unit of output)
ln C = ln a + b ln Q
Linearized version, can be easily estimated and interpreted.
ln C = 3 – 0.3 ln Q
If Q increases by 1%, then unit (average) costs decrease by 0.3%.
Useful to make predictions for the future: how much does the
average cost for the 100th unit as well as 200th:
lnC =3 – 0.3ln100 = 2.4 ==> C = antilog of (2.4) =$251.19

lnC =3 – 0.3ln200 =2.31==>C =antilog of (2.31) =$204.03
32
CH 7: Cost Theory
Total cost in the short and long run
CH 7: Cost Theory
Cost-Volume-Profit Analysis
• Cost-volume-profit or breakeven analysis examines the

relationship among the TR, TC, and total profits of the firm
at various levels of o/p.
• This technique is often used by business executives to
determine the sales volume required for the firm to break
even and the total profits and losses at other sales levels.
The analysis uses a cost-volume-profit chart in which the
TR and TC curves are represented by straight lines and
the break-even o/p (QB) is determined at their
intersection.
34
CH 7: Cost Theory
The slope of the total
revenue TR curve
refers to the product
price of $10 per unit.
The vertical intercept
of the total cost of
(TC) curve refers
TFC of $200, and the
slope of the TC
curve to the AVC of
$5. The break-even
with TR=TC $400 at
the output (Q) of $40
units per time period
at the point B.
35
CH 7: Cost Theory
Total Revenue = TR = (P)(Q)
Total Cost = TC = TFC + (AVC)(Q)

Breakeven Volume TR = TC
(P)(Q) = TFC + (AVC)(Q)
QBE = TFC/(P - AVC)
36
CH 7: Cost Theory
Break-even o/p
QBE = TFC/(P - AVC)

P = 40
TFC = 200
AVC = 5
QBE = 40
37
CH 7: Cost Theory
Operating Leverage and the other concepts
Operating leverage: The ratio of the firm’s total

fixed costs to its total variable costs.
Contribution margin per unit: The excess of the
selling price of the product over the average
variable costs of the firm (i.e. P-AVC) that can be
applied to cover the fixed costs of the firm and to
provide profits.
Degree of operating leverage (DOL): The
percentage change in the firm’s profits divided by
the percentage change in output or sales; the
sales elasticity of profits.
38
CH 7: Cost Theory
Operating Leverage
Operating Leverage = TFC/TVC
Degree of Operating Leverage = DOL
% Q( P  AVC )
DOL  
%Q Q( P  AVC )  TFC
 A leverage ratio is any one of several financial measurements
that look at how much capital comes in the form of debt (loans),
or assesses the ability of a company to meet financial
obligations.
39
CH 7: Cost Theory
Operating Leverage
The intersection of TR and TC

defines the break even quantity
of QB=40. With TC’, the break
even quantity increases to
QB’=45.
TC’ has a higher DOL than TC
and therefore a higher QBE
40
CH 7: Cost Theory
Empirical Estimation Data Collection Issues
 Opportunity Costs Must be Extracted

from Accounting Cost Data
 Costs Must be Apportioned Among
Products
 Costs Must be Matched to Output Over
Time
 Costs Must be Corrected for Inflation
41
CH 7: Cost Theory
Empirical Estimation
Functional Form for Short-Run Cost Functions

Theoretical Form Linear Approximation
TVC  aQ  bQ2  cQ3 TVC  a  bQ
TVC a
AVC   a  bQ  cQ 2
AVC   b
Q Q
MC  a  2bQ  3cQ2 MC  b
42
CH 7: Cost Theory
Empirical Estimation
Theoretical Form Linear Approximation
43
CH 7: Cost Theory
Empirical Estimation Long-Run Cost Curves
 Regression Analysis for cost estimation
44
CH 7: Cost Theory
Empirical Estimation-Example
 A computer company wants to estimate the

average variable cost fuction of producing
hard disks. The firm believes that AVC varies
with the level of output and wages. An analyst
collects the monthly data over the past two
years and deflates the variables using the
relevant price indexes. Finally, he regresses
TVC fuction on output and wages as follows:
 LnTVC=0.14+0.80LnQ+0.036LnW
(2.8) (3.8) (3.3) t-values

‾ R²=0.92 DW=1.9 F=125.8
45
CH 7: Cost Theory
Empirical Estimation-Example
 Suppose W= $10, drive the AVC and MC.
 What are the shapes of the AVC and MC

curves of the firm?
 Why did the analyst fit a linear rather than

quadratic or cubic TVC function?
 Was this application the right choice? Why?
46
CH 7: Cost Theory
Empirical Estimation-Example-Answers
 Suppose W= $10, drive the AVC and MC.

(a) What are the shapes of the AVC and MC
curves of the firm?
Substituting W = 10 into the estimated regression
equation, we get
TVC = 0.5 + 0.8Q

Thus, the TVC function is a straight line with a vertical
intercept of $0.50. The AVC function is then
AVC=TVC/Q = (0.5/Q)+ 0.8
The MC function is the slope of the TVC curve. That is,
MC = 0.8
47
CH 7: Cost Theory
Empirical Estimation-Example-Answers
 (b) Why did the analyst fit a linear rather

than quadratic or cubic TVC function?
The AVC curve declines rapidly and gets closer and
closer to the horizontal MC curve.
 (c) Was this application the right choice?

Why?
He fit a linear TVC function to the data because he was
aware that most empirical studies found that the linear
formulation fit the data better than the quadratic or
cubic forms.
48
CH 7: Cost Theory
The End
Thanks
49

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Department of Business Administration

Cost Theory and Estimation

The Nature of Costs

The Nature of Costs

• Costs are incurred as a result of

• Costs are the sum of all expenditures

• Costs are the amount of money spent on

The Nature of Costs

The Nature of Costs

• Economists define cost in terms of

• Accountants define cost in terms of

 Explicit costs are actual expenditures of

 Implicit costs refers to the value of the

 Economic cost refers the sum of explicit and

Alternative or Opportunity Costs

 The cost to the firm of using a purchased or

Relevant and Irrelevant Costs

 Relevant Costs: The costs that should be

Short-Run Cost Functions

 In short-run period, some of the firm’s

 Total costs is the cost of all the productive

Total fixed and variable costs

 Total Fixed Costs: The total obligations of

 Total Variable Costs: The total obligations

Short-Run Cost Functions

Total Cost = TC = f(Q)

 Average total cost (also called average cost)

Average Costs and Marginal Cost

 Average total cost is also the sum of average fixed

 Marginal (incremental) cost is the increase in total

Average Costs and Marginal Cost

•The marginal cost curve, average variable

Average Costs and Marginal Cost

•The marginal cost and average cost curves are

$ MC will intersect the AVC at the

Relationship Between Marginal and Average Costs

If MC > ATC, then ATC is rising

If MC > AVC, then AVC is rising

Short-Run Cost Functions

Average Total Cost = ATC = TC/Q

Short-Run Cost Functions-Example

Q TFC TVC TC AFC AVC ATC MC

• The average fixed cost curve slopes

Average Variable Cost

Long-Run Cost Curves

•The long run is the period of time during which:

Long-Run Cost Curves

Long-Run Total Cost = The minimum total

Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

The left panel shows a U-shaped LAC curve which

The learning curve shows the decline in the

lnC =3 – 0.3ln100 = 2.4 ==> C = antilog of (2.4) =$251.19

Total cost in the short and long run

• Cost-volume-profit or breakeven analysis examines the

Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC/(P - AVC)

QBE = TFC/(P - AVC)

Operating Leverage and the other concepts

Operating leverage: The ratio of the firm’s total

Operating Leverage = TFC/TVC