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Keat/Young
Learning Objectives
Define the cost function and explain the difference between a short-run and a long-run cost function. Explain the linkages between the production function and the cost function. Distinguish between economic cost and accounting cost. Explain how the concept of relevant cost is used in the economic analysis of cost. Define short-run total cost, short-run variable cost, and total fixed cost and explain their relationship to each other.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Learning Objectives
Define average cost, average variable cost, and average fixed cost and explain their relationship to each other in the short run. Do the same for average cost and average variable cost in the long run. Compare and contrast the short-run cost function and the long-run cost function and explain why economies of scale is considered to be a long-run phenomenon. Provide at least four reasons for the existence of economies of scale.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Keat/Young
The Relationship Between Production and Cost Cost function is simply the production function expressed in monetary rather than physical units. Assume the firm is a price taker in the input market.
Keat/Young
Keat/Young
Keat/Young
The Short-Run Cost Function A reduction in the firms fixed cost would cause the average cost line to shift downward. A reduction in the firms variable cost would cause all three cost lines (AC, AVC, MC) to shift.
Keat/Young
Quadratic relationship
As output increases, total cost increases at an increasing rate.
Linear relationship
As output increases, total cost increases at a constant rate.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
The Long-Run Cost Function When a firm experiences increasing returns to scale:
A proportional increase in all inputs increases output by a greater proportion. As output increases by some percentage, total cost of production increases by some lesser percentage.
Keat/Young
The Long-Run Cost Function Economies of Scale: situation where a firms long-run average cost (LRAC) declines as output increases. Diseconomies of Scale: situation where a firms LRAC increases as output increases. In general, the LRAC curve is u-shaped.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Keat/Young
Keat/Young
Yx = Units of factor or cost to produce the xth unit K = Factor units or cost to produce the Kth (usually first) unit x = Product unit (the xth unit) n = log S/log 2 S = Slope parameter
Managerial Economics, 5/e Keat/Young
Economies of Scope Economies of Scope: reduction of a firms unit cost by producing two or more goods or services jointly rather than separately. Closely related to economies of scale.
Keat/Young
Keat/Young
Ways Companies Have Cut Costs to Remain Competitive The Strategic Use of Cost Reduction in Cost of Materials Using Information Technology to Reduce Costs Reduction of Process Costs Relocation to Lower-Wage Countries or Regions Mergers, Consolidation, and Subsequent Downsizing Layoffs and Plant Closings
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young