Chapter 34 Cost allocation

Abstract

This chapter discusses the game-theory literature on cost allocation. Cost allocation not only provides internal signals that guide a firm's operations but also may be a response to external competitive pressures. Cost allocation is a kind of game in which costs (and benefits) are shared among different parts of an organization. The organization wants an allocation mechanism that is efficient, equitable, and provides appropriate incentives to its various parts. Cooperative game theory provides the tools for analyzing these issues. Cooperative game theory and cost allocation are closely intertwined in practice. Some of the central ideas in cooperative game theory, such as the core, were prefigured in the early theoretical literature on cost allocation. Others, such as the Shapley value, have long been used implicitly by some organizations. The chapter describes some of the central solution concepts in cooperative game theory. Axioms and conditions that are usually presented in an abstract setting often seem more compelling when interpreted in the cost-allocation framework. Cost allocation is a practical problem in which the salience of the solution depends on contextual and institutional details. The chapter presents various ways of modeling a cost allocation situation.