Cost estimates and cost overrun
When developing a business plan for a new company, product, or project, planners typically make cost estimates in order to assess whether revenues/benefits will cover costs (see cost-benefit analysis). This is done in both business and government. Costs are often underestimated resulting in cost overrun during implementation. Main causes of cost underestimation and overrun are optimism bias and strategic misrepresentation (Flyvbjerg et al. 2002). Reference class forecasting was developed to curb optimism bias and strategic misrepresentation and arrive at more accurate cost estimates.
Cost Plus, is where the Price = Cost plus or minus X%, where x is the percentage of built in overhead or profit margin.
Cost curve
In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics.
The Short Run average total cost curve (SATC or SAC)
The average total cost curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialisation and no further opportunities for decreasing costs exist. This is usually not U shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the right.Example: Q=2K.5L.5 STC=Pk(K)+Pw(Q2/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)
The long-run average cost curve (LRAC)
The long-run average cost curve depicts the per unit cost of producing a good or service in the long run when all inputs are variable. The curve is created as an envelope of an infinite number of short-run average total cost curves. The envelope is based on the point of each short-run ATC curve that provides the lowest possible average cost for each quantity of output.
The LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In this case productive efficiency occurs at the optimum scale of output where all the possible economies of scale have been enjoyed and the firm is not large enough to experience diseconomies of scale. This at output level Q2 in the diagram.
The marginal cost curve (MC)
A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the short-run product of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant.
The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, declines, reaches a minimum value, then rises.
The marginal cost is shown in relation to marginal revenue, the incremental amount of sales that an additional product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns - Diminishing returns).
Combining cost curves
You can combine cost curves to provide information about firms. In this diagram for example, we are assuming that the firm is in a perfectly competitive market. The marginal cost curve will cut the average cost curve at its lowest point. In a perfectly competitive market a firm's profit maximising price would be above the price at which the average cost curve cuts the marginal cost curve. If the marginal revenue is above the average total cost price the firm is deriving an economic profit.
The shutdown point
The shutdown point is a point where firms stop producing temporarily.
When a firm is making a loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different total costs levels and whether the firm is operating in the short run or in the long run.
If the firm is in the short run, and is making a loss whereby:
Total costs (TC) is greater than total revenue (TR)
and whereby total revenue is equal to total variable cost (TVC)
it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advised to close down so that the only costs the firm will have to pay will be the fixed costs.
Even if the firm stop producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and increase total revenue, thus making profits. This can be done by:
Increasing productivity. The most obvious methods involve automation and computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.
In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line representing market price should be above the minimum point of the ATC curve.
If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the short run shut down case because in long run there's no longer a fixed cost (everything is variable).
Examples
Some agricultural markets, with numerous suppliers and almost perfectly substitutable products have been suggested as approximations for the perfect-competition model. The extent of its applicability may be dependent on the market in question. Agricultural policies in many countries undermine the requirements for complete Pareto efficiency to apply.
Perhaps the closest thing to a perfectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. By design, a stock exchange resembles this, not as a complete description (for no markets may satisfy all requirements of the model) but as an approximation. The flaw in considering the stock exchange as an example of Perfect Competition is the fact that large institutional investors (e.g. investment banks) may solely influence the market price. This, of course, violates the condition that "no one seller can influence market price".
eBay auctions can be often be seen as perfectly competitive. There are very low barriers to entry (anyone can sell a product, provided they have some knowledge of computers and the Internet), many sellers of common products and many potential buyers.
Cost Plus, is where the Price = Cost plus or minus X%, where x is the percentage of built in overhead or profit margin.
Cost curve
In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics.
The Short Run average total cost curve (SATC or SAC)
The average total cost curve is constructed to capture the relation between cost per unit and the level of output, ceteris paribus. A productively efficient firm organizes its factors of production in such a way that the average cost of production is at lowest point and intersects Marginal Cost. In the short run, when at least one factor of production is fixed, this occurs at the optimum capacity where it has enjoyed all the possible benefits of specialisation and no further opportunities for decreasing costs exist. This is usually not U shaped, it is a checkmark shaped curve. This is at the minimum point in the diagram on the right.Example: Q=2K.5L.5 STC=Pk(K)+Pw(Q2/4K) SATC or SAC= (Pk(K)/Q)+Pw(Q/4K)
The long-run average cost curve (LRAC)
The long-run average cost curve depicts the per unit cost of producing a good or service in the long run when all inputs are variable. The curve is created as an envelope of an infinite number of short-run average total cost curves. The envelope is based on the point of each short-run ATC curve that provides the lowest possible average cost for each quantity of output.
The LRAC curve is U-shaped, reflecting economies of scale when negatively-sloped and diseconomies of scale when positively sloped. In the long run, when all factors of production can be changed, the scale of the enterprise can be increased. In this case productive efficiency occurs at the optimum scale of output where all the possible economies of scale have been enjoyed and the firm is not large enough to experience diseconomies of scale. This at output level Q2 in the diagram.
The marginal cost curve (MC)
A marginal cost that graphically represents the relation between marginal cost incurred by a firm in the short-run product of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables, like technology and resource prices, constant.
The marginal cost curve is U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, declines, reaches a minimum value, then rises.
The marginal cost is shown in relation to marginal revenue, the incremental amount of sales that an additional product or service will bring to the firm. This shape of the marginal cost curve is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns - Diminishing returns).
Combining cost curves
You can combine cost curves to provide information about firms. In this diagram for example, we are assuming that the firm is in a perfectly competitive market. The marginal cost curve will cut the average cost curve at its lowest point. In a perfectly competitive market a firm's profit maximising price would be above the price at which the average cost curve cuts the marginal cost curve. If the marginal revenue is above the average total cost price the firm is deriving an economic profit.
The shutdown point
The shutdown point is a point where firms stop producing temporarily.
When a firm is making a loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different total costs levels and whether the firm is operating in the short run or in the long run.
If the firm is in the short run, and is making a loss whereby:
Total costs (TC) is greater than total revenue (TR)
and whereby total revenue is equal to total variable cost (TVC)
it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advised to close down so that the only costs the firm will have to pay will be the fixed costs.
Even if the firm stop producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and increase total revenue, thus making profits. This can be done by:
Increasing productivity. The most obvious methods involve automation and computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.
In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line representing market price should be above the minimum point of the ATC curve.
If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the short run shut down case because in long run there's no longer a fixed cost (everything is variable).
Examples
Some agricultural markets, with numerous suppliers and almost perfectly substitutable products have been suggested as approximations for the perfect-competition model. The extent of its applicability may be dependent on the market in question. Agricultural policies in many countries undermine the requirements for complete Pareto efficiency to apply.
Perhaps the closest thing to a perfectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. By design, a stock exchange resembles this, not as a complete description (for no markets may satisfy all requirements of the model) but as an approximation. The flaw in considering the stock exchange as an example of Perfect Competition is the fact that large institutional investors (e.g. investment banks) may solely influence the market price. This, of course, violates the condition that "no one seller can influence market price".
eBay auctions can be often be seen as perfectly competitive. There are very low barriers to entry (anyone can sell a product, provided they have some knowledge of computers and the Internet), many sellers of common products and many potential buyers.