Cost functions contain all the necessary information on production process, information that is essential to planners and regulators. Without this information, decisions on pricing may lead to suboptimal results. The researcher has to decide on the methodology used to analyse the cost structure of a transport company. As explained in this chapter, there are two methodologies (accounting and statistical), of which the statistical method is the most popular in the applied transport economics literature. The theory on cost functions has progressed considerably, and a number of different (flexible) specifications are available, of which the researcher has to choose the form which best fits the problem. A calibrated Cobb-Douglas function may meet the demands posed by economic theory, it also puts severe restrictions on the specification of production technology. A flexible form on the other hand puts no limits on technology, but may not meet the theoretical demands (e.g., the global curvature condition). Statistical tests are available on all restrictions on the cost functions; usually these are parameter restrictions. Starting with an unrestricted, flexible form one can include more and more restrictions until a statistically satisfying specification is found (that can also be interpreted from economic theory). It is not possible to say what is the best specification; each has its advantages and drawbacks. The translog specification is most commonly used in the applied transport economies literature.
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