Costs: a key concept in Economics
Downloadable (with restrictions)! The purposes of this study are twofold. First, it extends production risk from a production function to a more general cost. importance of the relationship between school inputs and student achie .. production function estimates in other sectors, where market prices are used to. The contribution of this paper is to estimate the substitution relationship elasticities obtained from fexible functional forms cost or production functions, the .
If quality improvements have taken place and have not been accounted forthe cost-output relation will be biased. Specific criticisms of the long-run cost studies: The following additional criticisms have been directed against studies of long-run costs: Friedman argued that the empirical findings from cross-section data of firms are not surprising, since all firms in equilibrium have equal costs they produce at the minimum point of their LAC irrespective of their size.
This argument would be valid if the firms worked in pure competition. However, in manufacturing industries pure competition does not exist as we will see in Part Two of this book. Clearly accountants do not include these items in their cost figures.
Yet their cost figures show constant cost at large scales of output.
The cross-section data assume: In short, there are too many inter-firm differences which cannot be assumed randomly distributed to different plant sizes. Hence, the measured cost function is not the true cost function of economic theory.
This criticism is basically a valid one. Thus, the cost data of firms which apply standard costing methods, if used for the estimation of statistical cost functions, will impart a bias towards linearity. The most known and debated study in this group is the one conducted by Eiteman and Guthrie.
The researchers attempted to draw inferences about the shape of the cost curves by the method of questionnaires.
Empirical estimation of production risk using a cost function with panel data
Selected firms were presented with various graphs of costs and were asked to state which shape they thought their costs were. Most of the firms reported that their costs would not increase in the long run, while they remain constant over some range of output. This is the same evidence as that provided by the statistical cost functions.
Engineering cost studies The Eiteman-Guthrie study has been criticised on the grounds that the authors did not ask the appropriate questions and did not interpret their results correctly.
The engineering method is based on the technical relationships between inputs and output levels included in the production function. These technically-optimal input combinations are multiplied by the prices of inputs factors of production to give the cost of the corresponding level of output. The cost function includes the cost of the optimal least-cost methods of producing various levels of output. To illustrate the engineering method we will use L.
The first stage in the engineering method involves the estimation of the production function, that is, the technical relation between inputs and output. In the case of crude-oil trunk-lines output X was measured as barrels of crude oil per day.
The production function relating X, H and D will depend on several factors such as the density of the crude oil carried through the pipes, the wall thickness of pipe used, and so forth. The above production function was computed by the use of a hydraulic formula for computing horse-powers for various volumes of liquid flow in pipes adjusted with appropriate constants for the crude oil of Mid-Continent type.
The second stage in the engineering method is the estimation of the cost curves from the technical information provided by the engineering production function. From the production function it is seen that a given level of output can be technically produced with various combinations of the D and H inputs. In order to compute the long-run cost curve Cookenboo proceeded as follows. For each level of output he estimated the total cost of all possible combinations of H and D, and he chose the least expensive of these combinations as the optimum one for that level of output.
The long-run cost curve was then formed by the least-cost combinations of inputs for the production of each level of output included in his study. The costs of pipe diameter D: The costs of horse-power H: These are the annual expenditures for electric power, labour and maintenance required to operate the pumping stations. Cookenboo included in this category the initial cost of pumping stations costs of raw materials and labour costs.
These include the initial costs of storing-tank capacity, surveying the right- of-way, damages to terrain crossed, a communications system, and the expenses of a central office force. Cookenboo assumes that these costs are proportional to output or to the length of pipeswith the exception of the last item expenses of the central office forcewhich, however, he considers as unimportant: There are no significant per-barrel costs of a pipe line which change with length.#20, Production function, types of products (Micro economics-Class 11 and 12)
The only such costs are those of a central office force; these are inconsequential in relation to total. Hence, it is possible to state that other costs per barrel-mile for a mile trunk line are representative of costs per barrel-mile of any trunk line. The derived long-run average-cost curve from the engineering production function is shown in figure 4. From his study Cookenboo concluded that the LR costs fall continuously over the range of output covered by his study.
Given their nature, their findings are not surprising and cannot seriously challenge the U-shaped LR curve of the traditional theory. The existence of technical economies in large-scale plants has not been questioned. Indeed, by their design large-scale plants have a lower unit cost, otherwise firms would not be interested in switching to such production techniques as their market increased; they would rather prefer to expand by duplicating smaller-size plants with whose operations their labour force and their administrative staff is familiar.
What has been questioned is the existence of managerial diseconomies at large scales of output.
Furthermore, by their nature, they provide ex ante information about the cost-output relation, as economic theory- requires. Another shortcoming of engineering cost studies is the underestimation of costs of large-scale plants obtained from extension of the results of the studies to levels of output outside their range.
Usually engineering cost studies are based on a small-scale pilot plant. Engineers next project the input-output relations derived from the pilot plant to full-scale large production plants. It has often been found that the extension of the existing engineering systems to larger ranges of output levels grossly underestimates the costs of full-scale, large-size operations.
Finally, engineering cost studies are applicable to operations which lend themselves readily to engineering analysis. This is the reason why such studies have been found useful in estimating the cost functions of oil-refining, chemical industrial processes, nuclear-power generation.
Another source of evidence about the returns to scale are the statistical studies of production functions. Most of these studies show constant returns to scale, from which it is inferred that the costs are constant, at least over certain ranges of scale.
Like the statistical cost functions, statistical production functions have been attacked on various grounds. Their discussion goes beyond the scope of this book. The interested reader is referred to A. This technique has been developed by George Stigler. It is based on the Darwinian doctrine of the survival of the fittest.
Empirical Evidence on the Shape of Costs
The method implies that the firms with the lowest costs will survive through time: The basic postulate of the survivor technique is that competition of different sizes of firms sifts out the more efficient enterprises. Therefore by examining the development of the size of firms in an industry at different periods of time one can infer what is the shape of costs in that industry.
In applying the survivor technique firms or plants in an industry are classified into groups by size, and the share of each group in the market output is calculated over time. If the share of a given group class falls, the conclusion is that this size is relatively inefficient, that is, it has high costs decreasing returns.
The firms have been grouped into seven classes according to their percentage market share. From the data shown in table 4. Thus Stigler concluded that the small and the large firms are inefficient have high costs. The medium-size firms increased or held their market share, so they constitute, according to Stigler, the optimum firm size for the steel industry in the U. Over a wide range of outputs there is no evidence of net economies or diseconomies of scale. In the case of an exporteran example of sunk costs could be the costs of analysing the market and of exploring opportunities and seeking commercial partners.
Sergio Bruno in " The economics of ex-ante coordination ". High sunk costs makes an investment irreversible, what, couple with uncertainty about the future, impacts the level of investment by industry, as this empirical analysis points out.
A narrative example of sunk costs in a real-world situation is given here. Profitability and shut down rules In one period of time, total profits are given by total revenue less total costs. If they are negative, the firm will look into the future and see whether there is a possible reversal of this situation. Perhaps it is carrying out investments that are large now but that can produce effects later on.
Empirical Evidence on the Shape of Costs
But it can also take into consideration the possibility of shut down operations and exit the market. It will, for instance, evaluate the average variable costs and the current price. If the price is lower, then for every units of production the price doesn't recover even the direct costs.
A very critical situation. But exiting a market is a strategic decision that cannot be taken wholehearted and it should be put into the more larger picture of industrial dynamicswhere exit dynamics is related to more than just cost considerations, as for instance empirically demonstrated in this paper. To see the balance between entry and exit in a market where fixed costs and variable costs are firm-specific see this paper and the related software.
In particular, cashflow and debt problems play a crucial role in increasing the risk of default, because firms take credit to fund both current business activities and investment e. The availability of credit depends on creditworthinesswhich in turn is linked to real and perceived risk in the specific market and country-wide.
In other terms, bankruptcy can happen even if the price cover the costs, but the firm has become, for other reasons, unreliable and nobody provides necessary credit. In a less drammatic condition, multiproduct firms selling more than one product might decide to sell some of its products at a price lower than unitary cost or of marginal costrecovering the losses by selling more of the others.
This is very common for large retailers and supermarkets which promote temporarily or permanently their overall sales by demonstrating exceptionally cheap some reference products be they well known industrial brands or phantasy brands of their own.
Far from being a critical situation, this competitive strategy is a sign of strength. Indeed, if below-cost prices are used to eliminate competitors for which the product at hand represents a very substantial share in salesthis predatory price strategy is effective in two versions: Is refusal to sell a marginal cost issue? The neoclassical theory of costs assumes that marginal costs are rising and that producers will refuse to sell a further unit after the equilibrium quantity because the price does not cover the larger marginal cost it requires.
Empirical estimation of production risk using a cost function with panel data
An exploration of this case and of realistic reasons to refuse to sell is here. Spatial differentiation of production costs The cost of production can be widely different in geopolitical areas where the labour costthe energy cost, the land cost, interest ratesand other prices are different thus violating the Purchasing Parity theory. In principle quantities should be the same material input needed, intermediate goods, hours of labour, etc.
In fact, the productivity of people and machine is largely dependent on historical reasons, with path dependency and place-dependency, to the effect that also quantities can widely vary across areas.
Some simple relations between marginal costs and average costs If to an average of 5, you add a 6, the new average will be higher than 5. If the cost of a further unit is higher than the average cost of all preceding units, the average cost will rise.
If marginal costs are higher than average costs, the "average cost curve" will be upward sloping.