Question

Do theoretical cost functions have relevance in business decision making?

Context

Although not a universal statement, undergraduate studies tend to focus on the theory while graduate work moves from the theory to critique and dissection of the theory in real world application. As business decision makers, we need to discern which theory to apply, critique individual situations and determine proper courses of action. This assignment moves us to that graduate perspective.

Assignment Background

Cost theory; fixed, variable and marginal costs in the short and long run have been taught in UG economics for years. However, empirical evidence seems to refute the use of cost theory in real world decision making and misunderstanding of marginal cost and production concepts.

Consider the research question in the title, “Do theoretical cost functions have relevance in business decision making?’

Write a 2-3 page opinion piece that includes a synopsis of a research paper. Do you think there is enough information to support the notion that business decision makers do not use cost theory in making decisions related to production, factors of production and cost.  

Answer 1

The study of business behaviour concentrates on the production process—the conversion of inputs into outputs—and the relationship between output and costs of production.

We have already studied a firm’s production technology and how inputs are combined to produce output. The production function is just a starting point for the supply decisions of a firm. For any business decision, cost considerations play a great role.

Cost function is a derived function. It is derived from the production function which captures the technology of a firm. The theory of cost is a concern of managerial economics. Cost analysis helps allocation of resources among various alternatives. In fact, knowledge of cost theory is essential for making decisions relating to price and output.

Whether production of a new product is a wiser one on the part of a firm greatly depends on the evaluation of costs associated with it and the possibility of earning revenue from it. Decisions on capital investment (e.g., new machines) are made by comparing the rate of return from such investment with the opportunity cost of the funds used.

The relevance of cost analysis in decision-making is usually couched in terms of short and long periods of time by economists. In all market structures, short run costs are crucial in the determination of price and output. This is due to the fact that the basis for cost function is production and the prices of inputs that a firm pays.

On the other hand, long run cost analysis is used for planning the optimal scale of plant size. In other words, long run cost functions provide useful information for planning the growth as well as the investment policies of a firm. Growth of a firm largely depends on cost considerations.