Different cost concepts are useful for answering different questions about a firm and its activities. This section provides an overview of cost measures that are particularly relevant to price regulation:
Figure 1 shows these cost concepts relate to each other.
Figure 1: Cost Concepts in Regulatory Economics
Historic cost is an accounting cost measure. The historic cost (or embedded cost) of an activity is the sum of the costs the firm actually attributes to providing that activity in a given accounting period. Historic cost reflects what a firm actually pays for capital equipment, its actual costs of operating and maintaining that equipment, and any other costs incurred to provide service during that accounting period.
Sunk cost is an economic cost concept, but like accounting cost concepts, measures costs incurred in the past. Sunk costs are historic costs that are irreversibly spent and independent of the future quantity of service supplied. An example of a sunk cost is the cost of a marketing campaign for a new service. Once spent, this cost cannot be recovered regardless of whether the service continues to be provided.
The economic cost of an activity is the actual forward-looking cost of that activity. This is the cost of accomplishing that activity in the most efficient way possible, given technological, geographical and other real world constraints. Forward-looking costs are the costs of present and future uses of a firm’s (or society’s) resources. Only forward-looking costs are relevant for making pricing, production, and investment decisions in the present, or the future.
Costs can be broken into the fixed costs and variable costs of providing a given service.
Fixed costs do not vary as the volume of a service provided changes. For a firm that provides several services, fixed costs can be split into:
- Service-specific costs: Costs the firm must incur to provide a specific service. A firm supplying any level of the service would incur service-specific fixed costs, but would avoid these costs altogether by ceasing production of the service.
- Shared costs: Costs the firm must incur to provide a group of services. Shared fixed costs do not vary with the level of any individual service in the group, and do not vary with decisions to produce or cease producing any service or subset of services within the group. The firm can avoid shared fixed costs if it no longer provides any of the services in the group.
- Common costs: These are fixed costs are shared by all services produced by the firm. The cost of the president’s desk is a classic example of a fixed cost that is common to all services.
Variable costs vary with the volume of service provided. Two measures of variable costs are incremental cost and marginal cost.
Incremental cost is the additional cost of producing a given increment of output. How much does the firm’s total costs change if the volume of a particular service increases (or decreases) by a given amount?
Marginal cost is the incremental cost of producing one additional unit of output. Marginal cost is a limiting case of incremental cost, where the increment is a single extra unit of service in addition to the amount currently provided.
Incremental cost is usually considered over the long run — long-run incremental cost (LRIC) is the cost of producing a given increment of output, including an allowance for an appropriate return on capital to reflect the costs of financing investment in facilities used for interconnection, as well as the capital costs of those facilities.
Total-service long-run incremental cost (TSLRIC) is a special case of incremental cost, where the relevant increment is the total volume of the service in question, and the time perspective is the long-run. TSLRIC is the additional cost incurred by a firm when adding a new service to its existing lineup of services (holding the quantities of all those other services constant). For an existing service, TSLRIC measures the decrease in costs associated with discontinuing supply of the service entirely, other things being constant. TSLRIC is equivalent to the concept of Total element long-run incremental cost (TELRIC) used in the United States.
Stand-alone cost (SAC) is the cost that a stand-alone firm (producing no other services) would incur to produce a particular service. For a single-service firm, TSLRIC and SAC are equal. For a multiple service firm, SAC will generally be greater than TSLRIC, because SAC incorporates shared fixed costs and common fixed costs.
Firms incur costs in the short run, or the long run. Short run costs are the costs of providing a given service, assuming that the current stock of capital is fixed. Over the long run, firms can vary their stock of capital, for example by investing in new plant. The long run cost of a service therefore includes the cost of the capital plant required to supply that service.
RELATED INFORMATION
Fixed and Variable Costs and Price Setting