GROUP 5 Managerial Economics CBET-01-102E

Leader: Jam Cruz

Members:
Jinky Barceta
Rose Ada
Abegail Quinto
Lorence Reyes

Cost Function
The cost function, C(Q), represents the minimum cost required to produce
a given output (Q) using the most efficient combination of inputs. It reflects
the relationship between production and cost and accounts for the prices of
inputs (e.g., labor and capital).

Example:

• Suppose a firm produces 100 units of output using P3,000 worth of labor
and P2,000 worth of capital.
• C(1,000) = P5,000.

Short-run cost function

-A function that defines the
minimum possible cost of
producing each output
level when variable factors
are employed in the cost minimizing way.

• Fixed Costs (FC): Costs that do not change with output (e.g., rent,
equipment).

• Variable Costs (VC): Costs that vary with output (e.g., wages for labor).

• Total Cost (TC): Sum of fixed and variable cost.

Average Cost and Marginal Cost

Average Fixed Cost (AFC):

-fixed costs divided by the
number of units of output.

• AFC decreases as output increases because fixed costs are spread over
more units.

Average Variable Cost (AVC):

-variable costs divided by
the number of units of
output.

• AVC initially decreases due to efficiency, then increases due to diminishing

returns.

Average Total Cost (ATC):

-total cost divided by the
number of units of output.

Marginal cost (MC)

-it is the additional cost of producing one more unit of output.

-it is calculated as the change in costs arising fro

Relations Among Cost

The relations among cost refer to how different types of costs (such as
total cost, average cost, marginal cost, and variable cost) interact and
influence decision-making within a firm. These relationships are crucial for
understanding how a firm's costs change as it adjusts its level of output, and
they help managers make efficient production and pricing decisions.

The shapes of the curves indicate the relation between the marginal and
average costs presented in those tables. These relations among the cost
curves, also depicted in Figure 5-12, are very important.
The first thing to notice is that the marginal cost curve intersects the ATC
and AVC curves at their minimum points. This implies that when marginal
cost is below an average cost curve, average cost is declining, and when
marginal cost is above average cost, average cost is rising.

For example:
If your grade on an exam is below your average grade, the new grade
lowers your average grade. If the grade you score on an exam is above your
average grade, the new grade increases your average. In essence, the new
grade is the marginal contribution to your total grade. When the marginal is
above the average, the average increases; when the marginal is below the
average, the average decreases. The same principle applies to marginal and
average costs.

This part of the report discusses the difference between the concepts
of fixed cost and sunk cost and their relevance/irrelevance in making
managerial decisions, as well as the algebraic forms of cost functions.

Fixed and Sunk Cost

Fixed cost is a cost that does not change when output changes,
regardless whether a business produces more or less, or even nothing at all,
these costs remain the same. While sunk cost is a cost that is lost forever
once it has been paid.
In the example given, the $10,000 lease for the railcar is a fixed cost
because it is constant regardless of whether it transports 10 tons or 10,000
tons of coal. While the sunk cost would be $10,000 also if the lease terms
does not permit to recoup any of the amount paid. However, If the lease
states that you will be refunded $6,000 once you do not need the railcar,
then only $4,000 of the $10,000 in fixed costs is a sunk cost. Thus, sunk cost
is the amount of these fixed costs that cannot be recouped.
Irrelevance of Sunk Costs
A decision maker should ignore sunk costs because they are costs
that have already been incurred and cannot be recovered, regardless of
future actions. Including this cost can prevent you in making a better
decision, when the goal is to maximize future profit or minimize future
losses.
To illustrate, suppose you paid a nonrefundable amount of $10,000 to
lease a railcar for one month, but immediately after signing the lease, you
realize that you do not need it—the demand for coal is significantly lower
than you expected. A farmer approaches you and offers to sublease the
railcar from you for $2,000. If the terms of your lease permit you to sublease
the railcar, should you accept the farmer’s offer?
Your answer should be yes. To minimize losing $10,000, you should
sublease the railcar for $2,000 to at least get a revenue. In making the
decision, you don’t have to consider the sunk cost ($10,000) because the
goal is to increase the cash flow. However, even if the sunk cost is irrelevant
in making future decisions. it is still crucial in computing the business total
profits.

Algebraic Forms of Cost Functions

-are mathematical expression that shows how the cost varies with the
variables in a given situation. There are types of cost functions, such as
linear, quadratic, exponential, logistic regression and etc. but we will focus
on cubic cost function. The cost function is typically denoted as C(Q), where
Q represents the quantity of output, and C(Q) represents the total cost
incurred when producing that quantity.
In the case of a cubic cost function, the cost function has the following
form:
C(Q) = f + aQ + bQ2 + cQ3
Whereas:
 f is a fixed cost that does not depend on the level of output Q.
 aQ is a linear term.
 bQ2 is a quadratic term.
 cQ3 is a cubic term.
a, b, c, and f are constants.
Given an algebraic form of the cubic cost function, we may directly
calculate the marginal cost function.
Marginal cost (MC) is defined as the derivative of the total cost
function with respect to the quantity Q. In other words, it measures how the
total cost changes when the quantity produced changes by one additional
unit.

To illustrate, given the cost function: C(Q)= 100 + 5Q + 3Q 2 + 2Q3

Step 1: Differentiate Each Term
 f = 100, so derivative is 0.

 aq = 5Q, so derivative is 5.
 bQ =3Q2, so derivative is 6Q.
 cQ3 = 2Q3 so derivative is 6Q2.
Marginal Cost Function:
MC(Q)=5+6Q+6Q2
Interpretation:
 If Q=1, the marginal cost is 5 + 6(1) + 6(1) 2 = 17

 If Q=2, the marginal cost is 5 + 6(2) + 6(2) 2 = 41. As you can see, as Q
increases, the marginal cost increases, and it increases at an
accelerating rate because of the quadratic and cubic terms.

This part will discuss long run cost and how it relates to short run cost, we
will also discuss economic scale, driven cost function and the reminders
about economic cost and accounting cost.

Long - run costs

In the long run, all costs are variable because the manager is free to adjust
the levels of all inputs.
*recall for short run cost
In Figure 5-13, the short-run average cost curve ATC0 is drawn under the
assumption that there are some fixed factors of production. The average
total cost of producing output level Q0, given the fixed factors of production,
is ATC0(Q0). In the short run, if the firm increases output to Q1, it cannot
adjust the fixed factors, and thus average costs rise to ATC0(Q1).

In the long run, however, the firm can adjust the fixed factors. Let ATC1 be
the average cost curve after the firm adjusts the fixed factors in an optimal
manner. Now the firm can produce Q1 with average cost curve ATC1. If the
firm produced Q1 with average cost curve ATC0, its average costs would be
ATC0(Q1). By adjusting the fixed factors in a way that optimizes the scale of
operation, the firm economizes in production and can produce Q1 units of
output at a lower average cost, ATC1(Q1). Notice that the curve labeled

The long-run average cost curve, denoted LRAC in Figure 5-13, defines
the mini- mum average cost of producing alternative levels of output,
allowing for optimal selection of all variables of production (both fixed and
variable factors).

The long-run average cost curve is the lower envelope of all the
short-run average cost curves. This means that the long-run average
cost curve lies below every point on the short-run average cost curves,
except that it equals each short-run average cost curve at the points where
the short-run curve uses fixed factors optimally.
Economies of Scale

Notice that the long-run average cost curve in Figure 5-14(a) is U-shaped.
This implies that initially an expansion of output allows the firm to produce at
lower long-run average cost, as is shown for outputs between 0 and ".
● economies of scale
Exist whenever long-run average costs decline as output increases.
● diseconomies of scale
Exist whenever fang-run average costs increase as output increases.
● constant returns to scale
Exist when long-run average costs remain constant as output is
increased.

Data-Driven Cost Functions

Just as with the case of production functions, it is also possible to use

regression analysis to estimate a cost function. The cubic cost function,
written as

C(Q) = f + aQ + b * Q ^ 2 + c * Q ^ 3

fits squarely within the multiple regression framework discussed in Chapter

1. In order to determine nine useful cost metrics such as marginal cost,
average total cost, and so forth, a manager needs to have values for f. a. b,
and e

A Reminder: Economic Costs versus Accounting Costs

● -Accounting Costs: Explicit, easily measurable costs appearing on

financial statements (e.g., wages, rent, materials). These are the costs
a firm directly pays.
 ● Economic Costs: Include accounting costs plus opportunity costs.
Opportunity costs represent the potential benefits a firm forgoes by
choosing one course of action over another (e.g., the profit from
producing a different product). This represents the true cost of a
decision.

Multiple – Output Cost Functions

Cost Functions
Shows how much it costs to produce a product baswd on how many
units you make.
Multiple – output cost Functions
When a company makes more than one product like, Honda, Nissan,
Subaru, Isuzu where they make cars and trucks.

Example: Think of Honda, they make cars and motorcycles, the cost
functions tells us how much it costs to make a certain amount of cars and
motorcycles together.

Economies of Scope
This Happens when it’s cheaper to produce two products together than
producing each one separately.
Example 1: If you run one garage or workshop where you do PMS or
Preventive Maintenance Service and Modify Cars, it is cheaper because you
only need one place, one set of staff, etc etc.
Example 2: if you had two garage where the other one does the PMS and the
other one does the Modifications, you would need two place, two set of staff
etc etc which is more expensive.

Now mathematically

The left side is the costs of service separately

The right side is the costs of service together

If the right side is smaller, you have economies of scope

Sample with the formula would be
If the garage 1 we do PMS and Modifying cars, that costs around let’s say
100,000 pesos combined.
Now cost of garage 2 PMS ( 80,000 pesos) and garage 3 modifying cars
( 50,000 pesos) youll have a total costs of 130,000 now put it into the
formula

130,000 > 100,000

Right side is smaller you have economies of scope
Cost Complementarity
This is where producing more of one product lowers the cost of producing
another product.

Example
Making doughnuts and munchkins or doughnut holes together is cheaper
because you use the leftover dough from doughnuts that has holes and
those holes are made into munchkins.
If you make them separately it would need more dough, more time and more
effort.

Mathematically:

Now Dunkin Donuts make 100 donuts a day, the marginal cost of each
doughnut is 2 Pesos. The shop doesn’t make any munchkin yet so Q 2 = 0
Now let’s introduce the munchkins the shop decides to use the leftover
dough from the doughnuts to make munchkins, the marginal costs of making
each munchkin is 1 pesos because they are using the leftover dough and the
labor required to make them is minimal.
Now they make 100 munchkins per day in addition to the 100 doughnuts
earlier. The Marginal costs of Doughnuts also decreases because of the
shared resources. (dough, workers and equipment)
MC1 is marginal costs of making doughnuts
Q2 is the quantity of munchkins made
The costs of making doughnuts lets say drops to 1.50 pesos, this is because
using the leftover dough reduces the cost of producing more doughnuts.
Change in MC1 = 1.50 – 2 = 0.50 pesos (decrease in cost)
Change in Q2 = 100 (Quantity of Munchkins)

Quadratic Cost Functions

This is just a way of writing the cost functions using math symbols, Fancier?
Yes, but the idea is the same
It has corresponding marginal cost functions

and to examine whether the economies of

scope exist in here, recall that theres economies of scope if

This Condition may be rewritten as this

Or can be simplified to