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1、 Copyright 2014 Pearson Education,Inc.CHAPTER 7 AND APPENDICES THE THEORY AND ESTIMATION OF COST QUESTIONS 1.a.Sunk cost is a cost that is incurred in the past that is not affected by a current decision(except for purposes of taxes and possibly for the“full-cost”pricing of a product).Incremental cos
2、t is a cost that is affected by a current decision.It is measured by the change in cost relative to the change in a particular activity(e.g.,construction of a new building,entry into the market with a new product,development of new software etc.)b.Fixed cost is a cost that does not vary with the lev
3、el of business activity.Variable cost is a cost that does vary with the level of business activity.c.Incremental cost is the cost associated with a particular activity.Marginal cost is the per unit cost associated with a particular activity.For example,incremental cost is TVC,while marginal cost is
4、TVC/Q.d.Opportunity cost is the amount forgone when choosing one activity over the next best alternative.Out-of-pocket cost is the monetary cost associated with the choice of one activity over another.For example,the out-of-pocket cost of leaving ones job to attend school on a full-time basis is the
5、 tuition,books,etc.The opportunity cost is the loss of income from the job.2.Incremental cost,variable cost,and marginal cost are considered“relevant costs”because they are affected by a current decision.Sunk cost is not considered relevant because it is incurred in the past and therefore not affect
6、ed by a current decision.In the short run,fixed cost is also not considered to be relevant because a firm cannot change this amount regardless of its level of production or business activity.In contrast,incremental cost(and its per unit counterpart,marginal cost)and variable cost are considered to b
7、e relevant because they are affected by a current decision.Opportunity cost can also be considered a relevant cost,but it depends on the situation.For example,in the case of the decision to quit ones job to pursue an academic degree full time,the lost income from the job would be considered a releva
8、nt cost.However,suppose after one year of studies,the student considers quitting school(or attending school on a part-time basis)in order to return to work on a full-time basis.The lost income or opportunity cost of that one year in school would have to be considered“sunk.”3.The firms short run cost
9、 function can be considered somewhat akin to a“mirror image”of its production function.As reflected in Figure 7.1 of the chapter,when its marginal product increases,its marginal cost decreases,and when its marginal product decreases(i.e.,when the law of diminishing returns takes effect)its marginal
10、cost starts to increase.(This would always be the case if there were no changes in input prices due to changes in input usage(i.e.,the firm faces a perfectly elastic input supply function);if not,input price changes could offset the inverse relationship between input productivity and input cost.)The
11、 Theory and Estimation of Cost 57 Copyright 2014 Pearson Education,Inc.4.This statement is true.As indicated in the question above,the law of diminishing returns causes a firms marginal cost to increase.This increase in marginal cost eventually causes a firms average variable cost and average cost t
12、o increase(again,this assumes that input prices are constant).5.From the standpoint of the supply side of the market,the short run is time enough only for those sellers already in the market to react to changes in the market by changing inputs(referred to as“variable inputs”).In the long run,firms m
13、ay either enter or leave the market.Moreover,those firms already in the market have enough time to change all their production inputs and processes.6.Economies of scale is the decrease in a firms unit cost of production as it increases all of its inputs(i.e.,its“scale”of production).Economies of sca
14、le can be considered the monetary equivalent of increasing returns to scale.That is,when a firms output increases by a greater proportion than the increase in its inputs,its unit cost of production decreases.The main determinants of economies of scale are summarized in Table 7.4 of the chapter.Instr
15、uctors may wish to divide these factors into the“financial”and the“real.”The financial factors are:a)productive capacity of certain capital equipment rises faster than purchase price b)discounts from bulk purchases c)lower cost of raising capital funds.The other factors listed in the Table can be co
16、nsidered real factors because they relate primarily to the nature of the production process.7.Diseconomies of scale is the increase in a firms unit cost of production as it increases all of its inputs.The main determinants of diseconomies of scale are also listed in Table 8.4.Perhaps the most import
17、ant of these factors are a)management coordination and control problems,b)the disproportionate rise in staff and indirect labor,and c)the upward pressure on input prices as more are purchased.8.Economies of scope refers to the reduction in unit cost resulting from a firms production of two or more p
18、roducts.This type of cost savings is related to economies of scale to the extent that a firm of a larger size is more likely to produce a variety of goods,thereby increasing the probability of experiencing economies of scope.However,economies of scale do not necessarily lead to economies of scope an
19、d economies of scope do not depend on the existence of scale economies.9.The learning curve indicates unit costs on the basis of an accumulation of output.The typical cost function indicates unit cost associated with different levels of output in a given time period.In other words,the cost function
20、is not cumulative.Because the learning curve was not considered explicitly in the neo-classical theory of the firm,we can only suggest that the learning curve phenomenon is more consistent with the long run.This is because,in the short run,we are assuming a certain level of skills,technology,etc.and
21、 are also assuming that the firm is using them to the best of their ability(i.e.,is operating somewhere on the cost line,whatever the level of output).10.As explained in the text,the experience curve is often considered synonymous with the learning curve.However,certain people prefer to consider it
22、in a broader context.The introduction of either the learning curve or the experience curve phenomenon would cause a downward shift in the firms unit cost curves.11.After reading the section“The Long-Run Average Cost Curve as the Envelope of Short-Run Average Cost,”students should agree with this sta
23、tement.As seen in Figure 8.9,for the output level marked by the asterisk on unit cost curve“B,”the firm would be incurring a lower unit cost by using the larger capacity“C”rather than using the smaller capacity“B”at its most efficient point.58 The Theory and Estimation of Cost Copyright 2014 Pearson
24、 Education,Inc.This is because the economies of scale made possible by the larger capacity more than makes up for the fact that this larger capacity is not being run at its point of minimum unit cost.12.Accounting statements,as a rule,do not differentiate between costs and expenses which are relevan
25、t to decision making and those that are not.Included in cost of goods sold can be such items as fixed overhead and depreciation which is time-related(and not production-related).Thus,not all costs included in cost of goods sold are relevant according to the economists definition.Many of the expenses
26、 included in selling,administrative and general,and research and development expenses are fixed,and thus not relevant to decision making.However,there are expenses which vary with quantities.Commissions paid to sales representatives would be an example.Other types of selling and advertising expenses
27、 can also be quantity-related,and thus would be relevant to decision making.13.This person is referring to the spreading out of fixed cost in as short-run situation.Economies of scale are more properly used in a long-run situation in which all inputs can be changed.14.In the economic short-run,at le
28、ast one factor remains fixed.In estimating such cost functions,economists assume that capital is fixed while labor is the variable factor.Thus,the data used in this regression analysis must cover observations where quantities produced and costs change while certain factors remain unchanged.The metho
29、d usually selected is the time-series technique over a period of time.This time period must supply enough observations so that production and cost changes can be observed while the size of plant and its technology remain relatively unchanged.Thus the time period should not be too longfor instance,tw
30、enty-four monthly observations(i.e.,2 years),or possibly 52 weekly observations(i.e.,1 year).15.Some of the problems encountered and for which adjustments must be sought are the following:a.Prices of labor,materials and other variable factors may change over the time period,and must be adjusted to b
31、e consistent.b.Cost should include only those which vary with quantity produced.c.Accounting data are usually employed in cost estimation.Economists would prefer economic costs.If it is possible to include opportunity costs,adjustments of this kind should be made.d.If there are changes in tax rates,
32、social security contributions,or other similar costs,adjustments should be made to make them comparable over time.e.If there has been a change in accounting methods during the period of the study,such change must be adjusted to obtain consistency in the data.f.Some actual cash outlays may be incurre
33、d at discrete intervals and recorded as costs at that time.However,the actual costs are incurred continuously.Overhauls and maintenance are examples.Such costs should be spread over the period in which they are incurred.15.In the economic long run,there are no fixed costs.The economist usually assum
34、es that changes in the size of plant can occur.So,the regression method generally used is the cross-sectional analysis,where observations on output and costs are taken from different plants at one point of time.The Theory and Estimation of Cost 59 Copyright 2014 Pearson Education,Inc.The problems wh
35、ich will be encountered in this analysis and some of the adjustments which may have to be made are:a.Wage rates and other unit costs(e.g.utility bills)may vary from one geographical area to another.Such differences must be adjusted to make these costs consistent from area to area.b.The various plant
36、s may not be operating at an optimal level of technology.Plants in the sample should be carefully selected to include plants which are relatively homogeneous.c.If the different plants in the sample belong to a different firm,there may be differences in accounting methods,and such differences will ha
37、ve to be adjusted,if possible,to make the data consistent.d.Some factors,especially labor,may receive their remuneration differently.For instance,vacation times may differ,or some pay may be in the form of company stock,etc.Again,such differences must be investigated and,where possible,adjusted for
38、consistency.16.a.Engineering costs:based on data developed by experts(engineers),who estimate the optimal quantity of inputs needed to produce various quantities of outputs.The inputs are then added,and total cost for each output is established.Advantages of this method include keeping technology an
39、d output mix constant and avoiding problems caused by inflation.However,the estimates are based on what experts expect them to be,and are not based on actual(historical)data.Associated costs may be omitted.Further,the calculations are based on ideal circumstances and may not consider actual producti
40、on situations.b.Survivorship principle:Plants in an industry are categorized by size,and the proportion of total industry output for each size class is calculated.These computations are repeated over an interval of several years.Then,if a particular size category appears to grow relative to others,i
41、t is concluded that it is more efficient than the others.A long run cost curve can be determined from these observations.A major advantage of this method is that reliance on accounting cost data(and their necessary adjustments)is eliminated.Also,it is a relatively simple method to implement.However,
42、it tells us nothing about actual cost levels;it does not recognize industry changes due to technological advances;it implicitly assumes that competitive circumstances(i.e.cost levels)determine survival rather than industry practices which may not be consistent with competition.60 The Theory and Esti
43、mation of Cost Copyright 2014 Pearson Education,Inc.PROBLEMS 1.Q TC TFC TVC AC AF AVC MC 0 120 120 0 X X X 1 265 120 145 265 120 145 145 2 384 120 264 192 60 132 119 3 483 120 363 161 40 121 99 4 568 120 448 142 30 112 85 5 645 120 525 129 24 105 77 6 720 120 600 120 20 100 75 7 799 120 679 114.1 17
44、.1 97 79 8 888 120 768 111 15 96 89 9 993 120 873 110.3 13.3 97 105 10 1120 120 1000 112 12 100 127 2.Although the numbers are fictitious,this problem is actually based on a study conducted by one of the authors.(See Philip K.Y.Young,“Family Labor,Sacrifice,and Competition:The Case of Korean Greengr
45、ocers in New York City,”Amerasia:The Journal of Asian American Studies,UCLA,Fall/Winter 1983.Mr.Lees opportunity cost of taking the job with the chemical firm is his foregone store profits before taxes of$175,000.)However,in return Mr.Lee will receive the following:Salary plus benefits$95,000 Net re
46、nt($50,000 minus taxes,20,000 insurance,etc.,of$300,000)Interest income(9%of$300,000)27,000 Total$142,000 On the surface,it could be argued that the benefit of taking the job is not sufficient to offset the opportunity cost of giving up his own business.However consider the points below.a.The long h
47、ours of work reduces the attractiveness of owning ones own business.b.The profits have to be shared with his wife and brother.If he takes the job,his wife and brother may then decide to get their own jobs.c.Although the forecast is that the profits in his own business and his salary will increase at
48、 the same rate in the future,each involves its own risks.A downturn in the economy or increasing competition(particularly from other Koreans who open up their own stores)may sharply reduce profits.On the other hand,working for someone else entails the risk of being laid off.Finally,there is always t
49、he argument of the“psychic benefits”that one receives by being his or her own boss.Instructors may wish to discuss this further,particularly in light of the extremely long hours that one work in owning and operating a business.The Theory and Estimation of Cost 61 Copyright 2014 Pearson Education,Inc
50、.3.Instructors should have an interesting time discussing this question.We recommend that this question be answered in class by small groups of students(perhaps 4 to 6).Each group should be allowed a short time to discuss the problem and to reach a consensus about the cost estimate.We have found tha