Estimation of Cost Function

There are three main approaches to measure the actual cost-output relation for a particular firm or a group of firms, namely

(a)     Engineering method

(b)     Statistical method

(c)     Accounting method

Physical relationships of a particular product expressed in the production function are taken into account to estimate a production function under engineering method. Optimum input combination for producing any given quantity of output is estimated from the production function and input prices. The cost curve is then formulated by multiplying each input in the obtained least cost combination by its price and then adding to develop the cost function. This method is useful when historical data is not available. But the method requires knowledge of production technology and factor prices.

Under statistical method, statistical techniques are applied on historical data on cost and its determinants. The data could be a time-series data for a particular firm in the industry or of all firms in the industry or a cross-section data for a particular year from various firms in the industry. If time-series data is used, then we generally obtain a short run cost function. On the other hand, if cross-section data of many firms whose, size vary substantially, or time-series data of the industry as a whole whose output has expanded enormously during the sample period, were used, the estimated cost function would be a long run one.

Accounting method requires classification of data into various categories, like fixed, variable and semi variable. Then cost observations are taken at the extreme and various intermediate levels. Next, the output levels and the corresponding costs are plotted on a graph to obtain the cost function. The cost functions may be linear or non-linear.

After the list of cost determinants is collected and the functional form is selected the cost fun

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