Long Run Cost

UNIT 9 LONG RUN COST ANALYSIS Analysis

Structure

9.0 Objectives
9.1 Introduction
9.2 Long-run Cost Functions
9.3 Economies and Diseconomies of Scale
9.4 Learning Curve
9.5 Economies of Scope
9.6 Cost Function and its Determinants
9.7 Estimation of Cost Function
9.8 Empirical Estimates of Cost Function
9.9 Managerial Uses of Cost Function
9.10 Let Us Sum Up
9.11 Terminal Questions

9.0 OBJECTIVES
After studying this unit, you should be able to:

 analyze the behavior of costs i n long run;

 comprehend the different sources of economies of scale;
 explain various functional forms of production and costs;
 understand empirical determination of these theoretical functions; and
 identify managerial uses of such empirical estimates.

9.1 INTRODUCTION
In unit 8, you have learnt about different cost concepts used by managers in
decision- making process, the relationship between these concepts, and the
distinction between accounting costs and economic costs, and short run cost
analysis and its applications in managerial decision making. We will continue
the analysis of costs in this unit also, long term cost analysis will be
discussed.

In the process of decision-making, a manager should understand clearly the

relationship between the inputs and output on one hand and output and costs
on the other. Estimation of cost curves will help production manager in
understanding the nature and shape of cost curves and taking useful
decisions. Both short run cost function and the long run cost function must
be estimated, since both sets of information will be required for some vital
decisions. Knowledge of the short run cost functions allows the decision
makers to judge the optimality of present output levels and to solve decision
problems of production manager. Knowledge of long run cost functions is
important when considering the expansion or contraction of plant size, and 189
Production and Cost for confirming that the present plant size is optimal for the output level that is
Analysis being produced. In the present Unit, we will discuss different approaches to
examination of cost functions, analysis of some empirical estimates of these
functions, and managerial uses of the estimated functions.

9.2 LONG-RUN COST FUNCTIONS

In the long run, all inputs are variable, and a firm can have a number of
alternative plant sizes and levels of output that it wants. There are no fixed
cost functions (total or average) in the long run, since no inputs are fixed. A
useful way of looking at the long run is to consider it a planning horizon. The
long run cost curve is also called planning curve because it helps the firm in
future decision-making process.

Figure 9.1: Short-Run and Long Run Average Cost Curves

The long run cost output relationship can be shown with the help of a long
run cost curve. The long run average cost curve (LRAC) is derived from
short run average cost curves (SRAC). Let us illustrate this with the help of a
simple example. A firm faces a choice of production with three different
plant sizes viz. plant size-1 (small size), plant size-2 (medium size), plant
size-3 (large size), and plant size-4 (very large size). The short run average
cost functions shown in Figure 9.1 (SRAC1, SRAC2, SRAC3, and SRAC4) are
associated with each of these plants discrete scale of operation. The long run
average cost function for this firm is defined by the minimum average cost of
each level of output. For example, output rate Q1 could be produced by the
plant size-1 at an average cost of C1 or by plant size-2 at a cost of C2.

Clearly, the average cost is lower for plant size-1, and thus point a is one
point on the long run average cost curve. By repeating this process for various
rates of output, the long run average cost is determined. For output rates of
zero to Q2 plant size-1is the most efficient and that part of SRAC1 is part of
the long run cost function. For output rates of Q2 to Q3 plant size-2 is the
most efficient, and for output rates Q3 to Q4, plant size-3 is the most
190
efficient. The scallop-shaped curve shown in bold face in Figure 9.1 is the Long Run Cost
Analysis
long run average cost curve for this firm. This bold faced curve is called an
envelope curve (as it envelopes short run average cost curves). Firms plan to
be on this envelope curve in the long run. Consider a firm currently operating
plant size-2 and producing Q1 units at a cost of C2 per unit. If output is
expected to remain at Q1, the firm will plan to adjust to plant size-1, thus
reducing average cost to C1.

Most firms will have many alternative plant sizes to choose from, and there is
a short run average cost curve corresponding to each. A few of the short run
average cost curves for these plants are shown in Figure 9.2, although many
more may exist. Only one point of a very small arc of each short run cost
curve will lie on the long run average cost function. Thus, long run average
cost curve can be shown as the smooth U-shaped curve. Corresponding to
this long run average cost curve is a long run marginal cost (LRMC) curve,
which intersects LRAC at its minimum point a, which is also the minimum
point of short run average cost curve 4 (SRAC4). Thus, at a point a and only
at a point a, the following unique result occurs:

SRAC = SRMC when LRAC = LRMC

Figure 9.2 : Short – Run and Long – Run Average Cost and Marginal
Cost Curves

LRAC

The long run cost curve serves as a long run planning mechanism for the
firm. It shows the least per unit cost at any output can be produced after the
firm has had time to make all appropriate adjustments in its plant size. For
example, suppose that the firm is operating on short run average cost curve
SRAC3 as shown in Figure 9.2, and the firm is currently producing an output
of Q*. By using SRAC3, it is seen that the firm’s average cost is C2. Clearly,
if projections of future demand indicate that the firm could expect to continue
selling Q* units per period at the market price, profit could be increased 191
Production and Cost significantly by increasing the scale of plant to the size associated with short
Analysis
run average cost curve SRAC4. With this plant, average cost for an output
rate of Q* would be C2 and the firm’s profit per unit would increase by C2–
C1.Thus, total profit would increase by (C2–C1)*Q*.

The U-shape of the LRAC curve reflects the laws of returns to scale.
According to these laws, the cost per unit of production decreases as plant
size increases due to the economies of scale, which the larger plant sizes
make possible. But the economies of scale exist only up to a certain size of
plant, known as the optimum plant size where all possible economies of scale
are fully exploited. Beyond the optimum plant size, diseconomies of scale
arise due to managerial inefficiencies. As plant size increases beyond a limit,
the control, the feedback of information at different levels and decision-
making process becomes less efficient. This makes the LRAC curve turn
upwards. Given the LRAC in Figure 9.2, we can say that there are increasing
returns to scale up to Q* and decreasing returns to scale beyond Q*.
Therefore, the point Q* is the point of optimum output and the corresponding
plant size-4 is the optimum plant size. If you have long run average cost of
producing a given output, you can readily derive the long run total cost
(LRTC) of the output, since the long run total cost is simply the product of
long run average cost and output. Thus, LRTC = LRAC *Q.

Figure 9.3 shows the relationship between long run total cost and output.
Given the long run total cost function you can readily derive the long run
marginal cost function, which shows the relationship between output and the
cost resulting from the production of the last unit of output, if the firm has
time to make the optimal changes in the quantities of all inputs used.

Figure 9.3 : Long Run Total Cost Function

192
Activity 1 Long Run Cost
Analysis
1. Explain why short run marginal cost is greater than long run marginal
cost beyond the point at which they are equal?

2. Explain why short run average cost can never be less than long run
average cost?

3. Why are all costs variable in the long run?

4. Why is the long run average cost curve called an “envelope curve”?
Why cannot the long run marginal cost curve be an envelope as well?

5. What do you understand by “cost-efficiency”? Draw a long run cost

diagram and explain.

6. Economists frequently say that the firm plans in the long run and
operates in the short run. Explain.

9.3 ECONOMIES AND DISECONOMIES OF

SCALE

We have seen in the preceding section that larger plant will lead to lower
average cost in the long run. However, beyond some point, successively
larger plants will mean higher average costs. Exactly, why is the long run
average cost (LRAC) curve U-shaped? What determines the shape of LRAC
curve? This point needs further explanation.

It must be emphasized here that the law of diminishing returns is not

applicable in the long run as all inputs are variable. Also, we assume that
resource prices are constant. What then, is our explanation? The U-shaped
LRAC curve is explainable in terms of what economists call economies of
scale and diseconomies of scale.

Economies and diseconomies of scale are concerned with behaviour of

average cost curve as the plant size is increased. If LRAC declines as output
increases, then we say that the firm enjoys economies of scale. If, instead, the
LRAC increases as output increases, then we have diseconomies of scale.
Finally, if LRAC is constant as output increases, then we have constant
returns to scale implying we have neither economies of scale nor
diseconomies of scale. Economies of scale explain the down sloping part of
the LRAC curve. As the size of the plant increases, LRAC typically declines
over some range of output for a number of reasons. The most important is
that, as the scale of output is expanded, there is greater potential for
specialization of productive factors. This is most notable with regard to
193
Production and Cost labour but may apply to other factors as well. Other factors contributing to
Analysis
declining LRAC include ability to use more advanced technologies and more
efficient capital equipment; managerial specialization; opportunity to take
advantage of lower costs (discounts) for some inputs by purchasing larger
quantities; effective utilization of by products, etc.

But, after sometime, expansion of a firm’s output may give rise to

diseconomies, and therefore, higher average costs. Further expansion of
output beyond a reasonable level may lead to problems of overcrowding of
labour, managerial in efficiencies, etc., pushing up the average costs.

The economies of scale and diseconomies of scale are sometimes called as

internal economies of scale and internal diseconomies of scale
respectively. This is because the changes in long run average costs result
solely from the individual firm’s adjustment of its output. On the other hand,
there may exist external economies of scale. The external economies also
help in cutting down production costs. With the expansion of an industry,
certain specialized firms also come up for working up the by-products and
waste materials. Similarly, with the expansion of the industry, certain
specialized units may come up for supplying raw material, tools, etc., to the
firms in the industry. Moreover, they can combine together to undertake
research etc., whose benefit will accrue to all firms in the industry. Thus, a
firm benefits from expansion of the industry as a whole. These benefits are
external to the firm, in the sense that these have arisen not because of any
effort on the part of the firm but have accrued to it due to expansion of
industry as a whole. All these external economies help in reducing production
costs.

Economies of scale are often measured in terms of cost- output elasticity,

Ec.

Ec is the percentage change in the average cost of production resulting from a

one percent increase in output:

= (∆TC/TC) / (∆ / ) = (∆TC/∆ ) / (TC/Q) = MC/AC

Clearly, Ec is equal to one when marginal and average costs are equal. This
means costs increase proportionately with output, and there are neither
economies nor diseconomies of scale. When there are economies of scale MC
will be less than AC (both are declining) and Ec is less than one. Finally,
when there are diseconomies of scale, MC is greater than AC, and Ec is
greater than one.

194
ECONOMIES OF SCALE Long Run Cost
Analysis

Internal economies

Real and Pecuniary are two types of internal economies. When quantity of
inputs used decrease for a particular level of output, it gives rise to real
economies. When large quantities of input are bought and large quantities of
output are sold, there are savings in the cost of inputs and distribution costs
due to bulk buying and selling, these savings are known as pecuniary
economies.

A) REAL ECONOMIES OF SCALE

1. Production economies

Production economies arise from different factors of production such

as :-

 Labour Economies
Large scale of production leads to division of labour and
specialization, leading to reduction in costs and time. Due to
large scale production, technical personnel acquire significant
experience and this ‘cumulative volume’ has positive effect on
production and costs, leading to high productivity and lower
costs for large level of outputs.

 Technical Economies
Technical economies are related to fixed capital which includes
machinery and equipments. Specialization and indivisibility of
machines and equipments leads to reduction in per unit costs.
Machines have a property of indivisibility so, when large
production (maximum capacity of machine) is achieved, machine
cost is divided between large units.

In large size firms, there are large machines which perform

different continuous automatic processes which saves time and
cost of labour as different machines for different set-ups are not
required. And with increase in scale, general purpose machinery
is left to set up more which reduces its set up costs.

 Inventory economies
The main aim of inventories is to meet random fluctuations in
supply and demand of inputs & output respectively. When size of
firm increases, these fluctuations are eased out due to large
quantity of resources.
195
Production and Cost 2. Marketing economies
Analysis
With increase in output, advertising, R&D (such as developing new
models and designs) expenditures etc. are spread over and
expenditure per unit decreases considerably.

3. Managerial economies

Managerial economies arise due to various reasons, most important

of them are specialization, decentralization, team work experience
and modern managerial techniques. When scale of operations rises,
division of managerial tasks (production, sales, finance etc.) is done
and this leads to specialization as same task is performed again and
again. Team work experience helps in improving decision making
ability of managers and with decentralization decision making
becomes faster leading to managerial efficiency.

4. Transport and storage economies

Storage costs decrease with increase in the size of output. But

transportation costs keep falling for some extent and then they
become constant, making a L shaped curve.

B) PECUNIARY ECONOMIES OF SCALE

These economies include all the savings and discounts obtained by firm
because of its large size. Few examples of these are:

 Raw material prices become competitive when there is bulk buying.

 Banks offer lower rates of interest to large firms, ultimately it comes

down to lower cost of capital.

 Large firms have need of large-scale advertising, they are offered better
prices.

 Transportation costs turn out lower for bulk transportation.

 Labour costs can be saved by large firms, if they attain a position,

which gives them monopsony power due to large size or prestige in
market.

EXTERNAL ECONOMIES

External economies are those which are not particular to one particular firm
rather these are shared by all firms operating in a particular industry. These
are external to the firm as they do not arise due to efforts of any one
particular firm, they arise when whole industry expands. These can be
economies of information, economies of concentration, economies of
disintegration etc. These external economies also help in reduction of
production costs just like internal economies.
196
DISECONOMIES OF SCALE Long Run Cost
Analysis

Diseconomies of scale occur, at a level of output where one unit increase in

output leads to increase in marginal costs. At this level, diminishing returns
are there and economies of scale are ruled out by diseconomies of scale.
Diseconomies of scale generally arise due to human and behavioural
problems instead of technical factors.

There are several reasons for diseconomies of scale, some of them have been
listed below:

Morale and motivation problems

When the size of firm increases more and more employees join the
organization which reduces personal connection with owners and
management which leads to reduction in motivation among employees.
Reduction in motivation leads to reduction in productivity as well.

Communication problems

Effective and properly defined communication channels are very important in

any business organization. When a firm increases its size, there are increased
layers of command, it may create problems in communication and a message
can be distorted or lost. So, the formal communication of objectives and
goals will also suffer in this scenario which will lead to reduction in
productivity.

In short, it can be concluded that diseconomies of scale will come into picture
when with increase in size, management faces tough challenges in regards to
communication, motivation & morale of employees etc. and they are not able
to overcome those challenges.

197
Production and Cost
Analysis

198
Activity 2 Long Run Cost
Analysis
1. Distinguish between internal and external economies of scale. Give
examples.

2. Distinguish between real and pecuniary economies of scale.

3. Explain the reasons of diseconomies of scale with examples.

9.4 LEARNING CURVE

Learning curve denotes the relationship between labour cost and additional units of
output. It basically revolves around the concept that, with practice workers improve
and ultimately, cost per unit of producing one more units of output decreases.
Learning curve effect is this reduction in cost due to learning process of employees
over a period of time.

9.5 ECONOMIES OF SCOPE

According to the concept of economies of scale, cost advantages follow the
increase in volume of production or what is called the scale of output. On the
other hand, according to the concept of economies of scope, such cost
advantages may follow from a variety of output. For example, many firms
produce more than one product and the products are closely related to one
another — an automobile company produces scooters and cars, and a
university produces teaching and research. A firm is likely to enjoy
production or cost advantages when it produces two or more products. These
advantages could result from the joint use of inputs or production facilities,
joint marketing programs, or possibly the cost savings of a common
administration. Examples of joint products are mutton and wool, eggs and
chicken, fertilizer, etc.

Therefore, economies of scope exist when the cost of producing two (or
more) products jointly is less than the cost of producing a single product. To
measure the degree to which there are economies of scope, we should know
what percentage of the cost of production is saved when two (or more)
products are produced jointly rather than individually. The following
equation gives the degree of economies of scope (SC) that measures the
savings in cost:

( )+ ( )− ( + )
=
( + )

Here, C (Q1) represents the cost of producing output Q1, C (Q2) the cost of
producing output Q2, and C (Q1, Q2) the joint cost of producing both outputs
(Q1 +Q2).
199
Production and Cost For example, a firm produces 10000 TV sets and 5000 Radio sets per year at
Analysis a cost of Rs.8.40 crores, and another firm produces 10000 TV sets only, then
the cost would be Rs.10.00 crores, and if it produced 5000 Radio sets only,
then the cost would be Rs. 0.50 crores. In this case, the cost of producing
both the TV and Radio sets is less than the total cost of producing each
separately. Thus, there are economies of scope. Thus,

10.00 + 0.50 − 8.40

= = 0.25
8.40
Which means that there is a 25% saving of cost by going for joint
production.

With economies of scope, the joint cost is less than the sum of the individual
costs, so that SC is greater than 0. With diseconomies of scope, SC is
negative. In general, the larger the value of SC, the greater is the economies
of scope.

Activity 3

1. Distinguish between economies of scale and economies of scope using

examples.

9.6 COST FUNCTION AND ITS DETERMINANTS

Cost function expresses the relationship between cost and its determinants
such as the size of plant, level of output, input prices, technology, managerial
efficiency, etc. In a mathematical form, it can be expressed as,

C = f (S, O, P, T, E….)

Where, C = cost (it can be unit cost or total cost)

S = plant size

O = output level

P = prices of inputs used in production

T = nature of technology

E = managerial efficiency

Determinants of Cost Function

The cost of production depends on many factors and these factors vary from
one firm to another firm in the same industry or from one industry to another
industry. The main determinants of a cost function are:

a) plant size
b) output level
200 c) prices of inputs used in production,
d) nature of technology Long Run Cost
Analysis
e) managerial efficiency

We will discuss briefly the influence of each of these factors on cost.

a) Plant size: Plant size is an important variable in determining cost.

The scale of operations or plant size and the unit cost are inversely
related in the sense that as the former increases, unit cost decreases,
and vice versa. Such a relationship gives downward slope of cost
function depending upon the different sizes of plants taken into
account. Such a cost function gives primarily engineering estimates of
cost.

b) Output level: Output level and total cost are positively related, as the
total cost increases with increase in output and total cost decreases
with decrease in output. This is because increased production requires
increased use of raw materials, labour, etc., and if the increase is
substantial, even fixed inputs like plant and equipment, and
managerial staff may have to be increased.

c) Price of inputs: Changes in input prices also influence cost,

depending on the relative usage of the inputs and relative changes in
their prices. This is because more money will have to be paid to those
inputs whose prices have increased and there will be no simultaneous
reduction in the costs from any other source. Therefore, the cost of
production varies directly with the prices of production.

d) Technology: Technology is a significant factor in determining cost.

By definition, improvement in technology increases production
leading to increase in productivity and decrease in production cost.
Therefore, cost varies inversely with technological progress.
Technology is often quantified as capital-output ratio. Improved
technology is generally found to have higher capital-output ratio.

e) Managerial efficiency: This is another factor influencing the cost of

production. More the managerial efficiency less the cost of
production. It is difficult to measure managerial efficiency
quantitatively. However, a change in cost at two points of time may
explain how organizational or managerial changes within the firm
have brought about cost efficiency, provided it is possible to exclude
the effect of other factors

9.7 ESTIMATION OF COST FUNCTION

Several methods exist for the measurement of the actual cost-output relation
for a particular firm or a group of firms, but the three broad approaches -
accounting, engineering and econometric – are the most important and
commonly used. 201
Production and Cost Accounting Method
Analysis
This method is used by the cost accountants. In this method, the cost-output
relationship is estimated by classifying the total cost into fixed, variable and
semi-variable costs. These components are then estimated separately. The
average variable cost, the semi-variable cost which is fixed over a certain
range of output, and fixed costs are determined on the basis of inspection and
experience. The total cost, the average cost and the marginal cost for each
level of output can then be obtained through a simple arithmetic procedure.

Although, the accounting method appears to be quite simple, it is a bit

cumbersome as one has to maintain a detailed breakdown of costs over a
period to arrive at good estimates of actual cost-output relationship. One must
have experience with a wide range of fluctuations in output rate to come up
with accurate estimates.

Engineering Method

The engineering method of cost estimation is based directly on the physical

relationship of inputs to output, and uses the price of inputs to determine
costs. This method of estimating real world cost function rests clearly on the
knowledge that the shape of any cost function is dependent on: (a) the
production function and (b) the price of inputs.

We have seen earlier in Unit – 7 while discussing the estimation of

production function that for a given the production function and input prices,
the optimum input combination for a given output level can be determined.
The resultant cost curve can then be formulated by multiplying each input in
the least cost combination by its price, to develop the cost function. This
method is called engineering method as the estimates of least cost
combinations are provided by engineers.

The assumption made while using this method is that both the technology and
factor prices are constant. This method may not always give the correct
estimate of costs as the technology and factor prices do change substantially
over a period of time. Therefore, this method is more relevant for the short
run. Also, this method may be useful if good historical data is difficult to
obtain. But this method requires a sound understanding of engineering and a
detailed sampling of the different processes under controlled conditions,
which may not always be possible.

Econometric Method

This method is also sometimes called statistical method and is widely used
for estimating cost functions. Under this method, the historical data on cost
and output are used to estimate the cost-output relationship. The basic
technique of regression is used for this purpose. The data could be a time
series data of a firm in the industry or of all firms in the industry or a cross-
section data for a particular year from various firms in the industry.
202
Depending on the kind of data used, we can estimate short run or long run Long Run Cost
cost functions. For instance, if time series data of a firm whose output Analysis

capacity has not changed much during the sample period is used, the cost
function will be short run. On the other hand, if cross-section data of many
firms with varying sizes, or the time series data of the industry as a whole is
used, the estimated cost function will be the long run one.

The procedure for estimation of cost function involves three steps. First, the
determinants of cost are identified. Second, the functional form of the cost
function is specified. Third, the functional form is chosen and then the basic
technique of regression is applied to estimate the chosen functional form.

Functional Forms of Cost Function

The following are the three common functional forms of cost function in
terms of total cost function (TC).

Linear cost function: TC = a1 +b1Q

Quadratic cost function: TC = a2 + b2Q + c2Q2

Cubic cost function: TC = a3 + b3Q + c3Q2 +d3Q3

where, a1, a2, a3, b1, b2, b3, c2, c3, d3 are constants.

When all the determinants of cost are chosen and the data collection is
complete, the alternative functional forms can be estimated by using
regression software package on a computer. The most appropriate form of the
cost function for decision-making is then chosen on the basis of the principles
of economic theory and statistical inference.

Once the constants in the total cost function are estimated using regression
technique, the average cost (AC) and marginal cost (MC) functions for
chosen forms of cost function will be calculated. The TC, AC and MC cost
functions for different functional forms of total cost function and their typical
graphical presentation and interpretation are explained below:

A. Linear cost function

TC = a1 + b1Q
AC=(TC)/Q= (a1/Q) +b1
( )
MC = = b1

The typical TC, AC, and MC curves that are based on a linear cost function
are shown in Figure 9.5. These cost functions have the following properties:
TC is a linear function, where AC declines initially and then becomes quite
flat approaching the value of MC as output increases and MC is constant at b1.

B. Quadratic cost function

TC = a2 + b2Q + c2Q2
203
Production and Cost AC = (TC/Q) = (a2/Q)+ b2 + c2Q
Analysis
( )
MC = = b2+ 2c2Q

The typical TC, AC, and MC curves that are based on a quadratic cost
function are shown in Figure 9.6. These cost functions have the following
properties: TC increases at an increasing rate; MC is a linearly increasing
function of output; and AC is a U-shaped curve.

C. Cubic cost function

TC = a3 + b3Q + c3Q2 +d3Q3
AC = (TC/Q) = (a3/Q) +b3+c3 Q+d3Q2
( )
MC = = = b3+ 2c3Q + 3d3 Q2

The typical TC, AC, and MC curves that are based on a cubic cost function
are shown in Figure 9.7. These cost functions have the following properties:
TC first increases at a decreasing rate up to output rate Q1 in the Figure 9.7
and then increases at an increasing rate; and both AC and MC cost functions
are U shaped functions.

The linear total cost function would give a constant marginal cost and a
monotonically falling average cost curve. The quadratic function could yield
a U-shaped average cost curve but it would imply a monotonically rising
marginal cost curve. The cubic cost function is consistent both with a U-
shaped average cost curve and a U-shaped marginal cost curve. Thus, to
check the validity of the theoretical cost-output relationship, one should
hypothesize a cubic cost function.

Figure 9.5: Cost Curves Based on Linear Cost Function

TC = a1+ b1 Q
TC

204 Output (Q)

 Long Run Cost
Analysis

AC = (a1/Q) + b1

MC = b1

Figure 9.6: Cost Curves Based on Quadratic Cost Function

Output (Q)

Output (Q) 205

Production and Cost Figure 9.7 : Cost curves Based on Cubic Cost Function
Analysis

TC = a3 + b3 Q+C3 Q2+d3Q3

Q1 Output (Q)

An example of using estimated cost function:

Using the output-cost data of a chemical firm, the following total cost
function was estimated using quadratic function:

TC = 1016 – 3.36Q + 0.021Q2

a) Determine average and marginal cost functions.

b) Determine the output rate that will minimize average cost and the per unit
cost at that rate of output.

c) The firm proposed a new plant to produce nitrogen. The current market
price of this fertilizer is Rs 5.50 per unit of output and is expected to
remain at that level for the foreseeable future. Should the plant be built?
206
Solution: Long Run Cost
Analysis

a) The average cost function is:

AC = (TC/Q) = (a2/Q) + b2 + c2Q = (1016/Q) – 3.36 + 0.021Q

and the marginal cost function is:

( )
MC = = b2 + 2c2Q = –3.36 + 2(0.021) Q = –3.36 + 0.042Q

b) The output rate that results in minimum per unit cost is found by taking
the first derivative of the average cost function, setting it equal to zero,
and solving for Q.

( ) 1016
= + =− + 0.021 = 0

1016
= 0.021; 0.021 = 1016; = 48381; = 220

To find the cost at this rate of output, substitute 220 for Q in AC equation and
solve it.

AC = (1016/Q) – 3.36 + 0.021Q = (1016/220) – 3.36 + (0.021 * 220)

Rs. 5.88 per unit of output.

c) Because the lowest possible cost is Rs. 5.88 per unit, which is Rs. 0.38
above the market price (Rs.5.50), the plant should not be constructed.

Short Run and Long Run Cost Function Estimation

The same sorts of regression techniques can be used to estimate short run cost
functions and long run cost functions. However, it is very difficult to find
cases where the scale of a firm has changed but technology and other relevant
factors have remained constant. Thus, it is hard to use time series data to
estimate long run cost functions. Generally, regression analysis based on
cross section data has been used instead. Specially, a sample of firms of
various sizes is chosen, and a firm’s TC is regressed on its output, as well as
other independent variables, such as regional differences in wage rates or
other input prices.

207
Production and Cost Figure 9.8: Typical Long Run Average Cost Curve
Analysis

Many studies of long run cost functions that have been carried out found that
there are very significant economies of scale at low output levels, but that
these economies of scale tend to diminish as output increases, and that the
long run average cost function eventually becomes close to horizontal axis at
high output levels. Therefore, in contrast to the U-shaped curve in Figure 9.1,
which is often postulated in micro economic theory, the long run average
cost curve tends to be L-shaped, as shown in Figure 9.8.

Problems in Estimation of Cost Function

We confront certain problems while attempting to derive empirical cost

functions from economic data. Some of these problems are briefly discussed
below.

1. In collecting cost and output data we must be certain that they are
properly paired. That is, the cost data is applicable to the
corresponding data on output.

2. We must also try to obtain data on cost and output during a time
period when the output has been produced at relatively even rate.
If for example, a month is chosen as the relevant time period over
which the variables are measured, it would not be desirable to have
wide weekly fluctuations in the rate of output. The monthly data in
such a case would represent an average output rate that could
disguise the true cost- output relationship. Not only should the
output rate be uniform, but it also should be a rate to which the firm
is fully adjusted. Furthermore, there should be no disruptions in the
208 output due to external factors such as power failures, delays in
 receiving necessary supplies, etc. To generate the data necessary for Long Run Cost
Analysis
a meaningful statistical analysis, the observations must include a wide
range of rates of output. Observing cost-output data for the last 24
months, when the rate of output was the same each month, would
provide little information concerning the appropriate cost function.

3. The cost data is normally collected and recorded by accountants for

their own purposes and in a manner that it makes the information less
than perfect from the perspective of economic analysis. While
collecting historical data on cost, care must be taken to ensure that all
explicit as well as implicit costs have been properly taken into
account, and that all the costs are properly identified by time period in
which they were incurred.

4. For situations in which more than one product is being produced with
given productive factors, it may not be possible to separate costs
according to output in a meaningful way. One simple approach of
allocating costs among various products is based on the relative
proportion of each product in the total output. However, this may not
always accurately reflect the cost appropriate to each output.

5. Since prices change over time, any money value cost would therefore
relate partly to output changes and partly to price changes. In order to
estimate the cost-output relationship, the impact of price change on
cost needs to be eliminated by deflating the cost data by price indices.
Wages and equipment price indices are readily available and
frequently used to ‘deflate’ the money cost.

6. Finally, there is a problem of choosing the functional form of equation

or curve that would fit the data best. The usefulness of any cost
function for practical application depends, to a large extent, on
appropriateness of the functional form chosen. There are three
functional forms of cost functions, which are popular, viz., linear,
quadratic and cubic. The choice of a particular function depends upon
the correspondence of the economic properties of the data to the
mathematical properties of the alternative hypotheses of total cost
function.

The accounting and engineering methods are more appropriate than the
econometric method for estimating the cost function at the firm level, while
the econometric method is more suitable for estimating the cost function at
the industry or national level. There has been a growing application of the
econometric method at the macro level and there are good prospects for its
use even at the micro level. However, it must be understood that the three
approaches discussed above are not competitive, but are rather
complementary to each other. They supplement each other. The choice of a
209
Production and Cost method therefore depends upon the purpose of study, time and expense
Analysis considerations.

9.8 EMPIRICAL ESTIMATES OF COST

FUNCTION
A number of studies using time series and cross-section data have been
conducted to estimate short run and long run cost behavior of various
industries. Table 9.1 lists a number of well-known studies estimating short
run average and marginal cost curves. These and many other studies point
one conclusion: in the short run a linear total variable cost function with
constant marginal cost is the relationship that appears to describe best the
actual cost conditions over the “normal” range of production. U-shaped
average cost (AC) and marginal cost (MC) curves have been found, but are
less prevalent than one might expect.

Table 9.1: Number of well-known studies estimating short run average

and marginal cost curves

Name Type of Industry Findings

Dean (1936) Furniture Constant MC which failed to rise

Dean (1941) Leather belts No significant increases in MC

Dean (1941) Hosiery Constant MC which failed to rise

Dean (1942) Department store Declining or constant MC, depending on

the department within the store

Ezekiel and Wylie (1941) Steel Declining MC but large variation

Hall and Hitch (1939) Manufacturing Majority have decreasing MC

Johnston (1960) Electricity, multi “Direct” cost is a linear function of output,

product function and MC is constant
food processing

Johnston (1960) Electricity Average total cost falls, then flattens,

tending toward constant MC up to
capacity

Mansfield and Wein (1958) Railways Constant MC

Yntema (1940) Steel Constant MC

Source: A.A. Walters, “Production and Cost Functions: An Econometric Survey”, Econometrica, January-
February 1963, PP.49-54
210
Table 9.2 lists a number of well known, long run average cost studies. In Long Run Cost
some industries, such as light manufacturing (of baking products), economies Analysis

of size are relatively unimportant and diseconomies set in rather quickly,

implying that a small plant has cost advantages over a large plant. In other
industries, such as meat packing or the production of household appliances,
the long run average cost curve is found to be flat over an extended range of
output, there by indicating that a variety of different plant sizes are all more
or less equally efficient. In some other industries such as electricity or metal
(aluminum and steel) production, substantial economies of size are found,
thereby implying that a large plant is most efficient. Rarely are substantial
diseconomies of size found in empirical studies, perhaps because of firms
recognizing that production beyond a certain range leads to sharply rising
costs. Therefore, they avoid such situations if all possible by building
additional plants.

Table 9.2: Number of well known, long run average cost studies

Name Type of Industry Findings

Alpert (1959) Metal Economies of scale up to some level of
output per month; constant returns to
scale and horizontal LRAC thereafter
Bain (1956) Manufacturing Small economies of scale for multi-plant
firms
Gribbin (1953) Gas (Great Britain) LRAC of production declines as output
rises
Holton (1956) Retailing LRAC L-shaped
Johnston (1960) Life Assurance LRAC declines
Johnston (1960) Road passenger transport LRAC either falling or constant
(Great Britain)
Johnston (1960) Electricity (Great Britain) LRAC of production declines as output
rises
Lomax (1951) Gas (Great Britain) LRAC of production declines as output
rises
Lomax (1952) Electricity (Great Britain) LRAC of production declines as output
rises
Moore (1959) Manufacturing Economies of scale prevail quite
generally
Nerlove (1961) Electricity (U.S.) LRAC (excluding transmission costs)
declines and then shows signs of
increasing
Gupta (1968) * Manufacturing (India) L-shaped in 18 industries,
U-shaped in 5 industries, and linear in 6
industries
Source: A.A. Walters, “Production and Cost Functions: An Econometric Survey”, Econometrica,
January-February 1963, PP.49-54.

*Vinod K. Gupta, "Cost Functions Concentration and Barriers to entry in twenty-nine Manufacturing
Industries of India." Journal of Industrial Economics, November 1, 1968, 59-60
211
Production and Cost Activity 4
Analysis
1. Pradeep Company’s total variable function is as follows: TVC = 50Q –
10Q2 +Q3

Where Q is the number of units of output produced:

a) What is the output level where marginal cost is a minimum?

b) What is the output level where average variable cost is a minimum?

c) What is the value of average variable cost and marginal cost at the
output specified in the answer to part (b)?

2. How would you reconcile the findings of Yntena with those of Ezekiel and
Wylie?

3. How would you explain the findings of Johnston (Electricity) in short run
and long run?

4. Production is related to costs. In fact, cost function can be derived from

estimated production function. In view of empirical determination of
production function, can you think of some limitations of statistical
analysis relating to cost function?

5. Despite the above limitations listed by you, an estimated cost function is

useful to a manager. Can you think of some points to support this
contention?

6. Some empirical studies have suggested that the marginal cost function is
approximately horizontal, but conventional cost theory suggests that the
marginal cost curve is U-shaped. Provide an explanation for this apparent
inconsistency.

7. The ABC Manufacturing Company’s short-run average cost function in

the year 2000 is AC=3+4Q

Where AC is the firm’s average cost (in Rs. per unit of the product), and Q is
the output rate.

a) Obtain the firm's short-run total cost function.

b) Does the firm have any fixed costs? Explain.

c) If the price of the firm’s product is Rs. 3 per unit, is the firm making
profits or losses? Explain.

d) Derive the firm's marginal cost function.

212
 Long Run Cost
9.9 MANAGERIAL USES OF COST FUNCTION Analysis

The estimated cost function can help managers to take meaningful decisions
with regard to:

1. determination of optimum plant size,

2. determination of optimum output for a given plant, and

3. determination of a firm’s supply curve.

The optimum plant size, as discussed earlier, is defined in terms of minimum

costs per unit of output. In other words, an optimum plant is given by that
value of K (plant size) for which the average cost is minimum. If the long
run total cost curve is a cubic function, the resultant long run average cost
curve will be a conventional U-shaped curve. The plant level at which the
long run average cost is minimum will be of optimum size.

For a given plant, the optimum output level will be achieved at a point where
the average cost is the least. This condition can be easily verified from the
short run total cost function.

The level of output that a firm would like to supply to the market will depend
on the price that it can charge for its product. In other words, a firm’s supply
is a positive function of the product price. To get the firm’s supply schedule,
one needs to know the firm's cost function and its objectives.

Activity 5

1. Can you list some more managerial uses of cost function other than given
in section 9.9?

9.10 LET US SUM UP

In the long run, all inputs to the production process are variable. Thus, in the
long run, total costs are identical to variable costs. The long run average cost
function shows the minimum cost for each output level when a desired scale
of plant can be built. The long run average cost curve is important to
managers because it shows the extent to which larger plants have cost
advantages over smaller ones. Economies or diseconomies of scale arise
either due to the internal factors pertaining to the expansion of output by a
firm, or due to the external factors such as industry expansion. In contrast,
economies of scope result from product diversification. Thus, the scale-
economies have reference to an increase in volume of production, whereas
the scope-economies have reference to an improvement in the variety of
products from the existing plant and equipment.

We have also discussed three forms of cost functions viz. linear cost function,
quadratic cost function, and cubic cost function and their empirical estimates.
Though, empirical estimates of both production functions and cost functions 213
Production and Cost have a lot of use for managerial decision making. There are conceptual and
Analysis statistical problems in estimating such functions. But we understand that it
will be sufficient for the manager if he knows how to interpret the estimates
based on empirical research in her/his decision-making process.

9.11 TERMINAL QUESTIONS

1. Explain the various economies of scale?
2. Explain the determinants of cost function?
3. Explain the econometric method of estimating cost function? Why is this
method more popular than the other two methods (accounting and
engineering) of costs estimation?
4. What are the common problems you encounter while attempting to derive
empirical cost functions from economic data?
5. The total cost function for a manufacturing firm is estimated as :
C=128+6Q+2Q2
Determine the optimum level of output Q to be produced.
6. Suppose that for a XYZ corporation’s total cost function is as follows :

TC=300+3Q+0.02Q2
Where TC is the total cost, Q is the output.
a. What is the corresponding fixed cost function, average fixed cost
function, and variable cost function, average variable cost function?
b. Calculate the average total cost function and marginal cost function.
7. Based on a consulting economist’s report, the total and marginal cost
functions for an ABC company are
TC = 200 + 5Q – 0.04Q2 + 0.001Q3
MC = 5 – 0.08Q + 0.003Q2
The president of the company decides that knowing only these equations
is inadequate for decision making. You have been directed to do the
following.
a. Determine the level of fixed cost (if any) and equations for average
total cost, average variable cost, and average fixed cost.
b. Determine the rate of output that results in minimum average variable
cost.
c. If fixed costs increase to ` 500, what output rate will result in
minimum average variable cost?
8. Given the total cost function for Laxmi Enterprises Co.
TC = 100Q – 3Q2 + 0.1Q3
214
 a. Determine the average cost function and the rate of output that will Long Run Cost
Analysis
minimize average cost.
b. Determine the marginal cost function and the rate of output that will
minimize marginal cost.

FURTHER READINGS
Adhikary, M. (1987). Managerial Economics (3rd ed.).Khosla Publishers,
Delhi.

Maddala, G. S., & Miller, E. M. (1989). Micro Economics: Theory and

Applications. McGraw-Hill, NewYork.

Maurice, S. C., Smithson, C. W., & Thomas, C. R.(2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw- Hill
Publishing.

Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:

Concepts and Cases. Tata McGraw-Hill, New Delhi.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

Lewis, W.C., Jain, S. K., & Peterson, H. C. (2005). Managerial Economics

(4th ed.). Pearson.

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Production and Cost
Analysis

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