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ECONOMICS
ELEVENTH EDITION

LIPSEY & CHRYSTAL

Chapter 6
THE COST STRUCTURE OF FIRMS

Slides by Alex Stojanovic

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Learning Outcomes
Real-world firms can adopt one of several different legal structures, but for most of the analysis in the book firms are assumed to have a very simple structure There is a difference between economists measure of profit and accountants measure of profit For economists, profit is the difference between total cost and total revenue, where total cost includes the cost of capital The production function relates physical quantities of inputs to the quantity of output Cost curves show the money cost of producing various levels of output

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Learning Outcomes
The short-run cost curve is U-shaped because some inputs are being held constant and the law of diminishing returns applies to these that are allowed to vary The long-run cost curve can take on various shapes depending on the scale effects when all inputs are allowed to vary at once Costs in the very long run are altered by technical change

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Profit and Loss Account for XYZ Company For the Year Ending 31 Dec. 1999
Expenditure
Variable Costs Wages Materials Other Total VC Fixed Costs Rent Managerial salaries Interest on loans Depreciation allowance Total FC Total Costs Profit 50,000 60,000 90,000 50,000 250,000 850,000 150,000 200,000 300,000 100,000 600,000

Income
Revenue from sales 1,000,000

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A simplified profit and loss account

Costs are divided between variable and fixed. Total revenue minus total costs as measured by the firm give profits in the sense used by firms. To the firm, profits include the opportunity cost of its capitalwhat it must earn to induce it to keep its capital in its present use.

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Calculation of Pure Profits

Profits as reported by the firm

Opportunity cost of capital Pure return on the firms capital Risk Premium Pure or economic rent

150,000

-100,000 -40,000 10,000

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Calculation of pure profits

The economists definition of profits does not include the opportunity cost of capital. To arrive at this figure the opportunity cost of capital must be deducted from what the firm regards as its capital.

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Total, Average and Marginal Products in the Short Run

Quantity of labour [L] [1] 1 2 3 4 5 6 7 8

Total Product [TP]

[2] 43 160 351 600 875 1152 1375 1536

Average Product [AP] [3] 43 80 117 150 175 192 196 192

Marginal Product [MP] [4] 43 117 191 249 275 277 220 164

9
10 11 12

1656
1750 1815 1860

184
175 165 155

120
94 65 45

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Total, average and marginal product curves

2100 1800 TP 250

300

Point of diminishing marginal returns

Total product [T/P]

1500 200 1200 150 900 600 300 100

Point of diminishing average returns

AP

MP 50

10

12

Quantity of labour [i] Total Product

4 6 8 10 Quantity of Labour

12

[ii] Average and Marginal Product

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Total, average and marginal product curves

(i): Total product curve The TP curve shows the total product steadily rising, first at an increasing rate, then at a decreasing rate.

(ii): Average and marginal product curves The marginal product curves rise at first and then decline. Where AP reaches its maximum. MP = AP.

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Variation of Costs With Capital Fixed and Labour Variable

Inputs
Capital Labour [L] [2]

Total Cost
Output [q]
[3]

Average Cost
Fixed [AFC]
[7]

Fixed [TFC]
[4]

Variable Total [TVC] [TC]

[5] [6]

Variable [AVC]
[8]

Marginal Total [ATC] Product [MP]

[9] [10]

[1]

10 10 10

1 2 3

43 160 351

100 100 100

20 40 60

120 140 160

2,326 0.625 0.285

0.465 2,791 0.250 0.171 0.875 0.456

0.465 0.171 0.105

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Total, Average and Marginal Cost Curves

TC
TVC 0.70 0.60 0.50

280
240 200 Cost [] 160

MC 0.40

120 80 40

TFC

0.30 0.20 0.10 AFC ATC AVC

300

600

900

1200 1500 1800

2100

300 600 900 1200 1500 1800 2100 Output [ii] Marginal and average cost curves

Output [i] Total cost curves

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Total, Average and Marginal Cost Curves

Total fixed cost does not vary with output. Total variable cost and the total of all costs, TC, (= TVC + TFC) rise with output, first at a decreasing rate, then at an increasing rate. The total cost curves in the figure give rise to the average and marginal curves in this figure. Average fixed cost (AFC) declines as output increases. Average variable cost (AVC) and average total cost (ATC) decline and then rise as output increases. Marginal cost (MC) does the same, intersecting the AVC and ATC curves at their minimum points. Capacity output is defined as the minimum point of the ATC curve, which is an output of 1,500 in this example.

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A Long-run Average Cost-curve

LRAC Attainable levels of cost

Unattainable levels of cost

qm

Output per period

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A Long-run Average Cost-curve

c0

E0 Attainable levels of cost

LRAC

Unattainable levels of cost

q0

qm

Output per period

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A Long-run Average Cost-curve

c2

c0
c1

E0
E1 Attainable levels of cost

LRAC

Unattainable levels of cost

q0

q1

qm
Output per period

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A Long-run Average Cost-curve The long-run average cost (LRAC) curve is the boundary between attainable and unattainable levels of cost. Since the lowest attainable cost of producing q0 is c0 per unit, the point E0 is on the LRAC curve. Suppose a firm producing at E0 desires to increase output to q1. In the short run, it will not be able to vary all factors, and thus unit costs above c1, say c2, must be accepted. In the long run a plant that is the optimal size for producing output q1 can be built and costs of c1 can be attained. At output qm the firm attains its lowest possible perunit cost of production for the given technology and factor prices.

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Long-run Average Cost and Short-run Average Cost Curves

qm
Output per period

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Long-run Average Cost and Short-run Average Cost Curves

SRATC c0

LRAC

q0

qm
Output per period

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Long-run Average Cost and Short-run Average Cost Curves

The short-run average total cost (SRATC) curve is tangent to the long-run average cost (LRAC) curve at the output for which the quantity of the fixed factors is optimal. The curves SRATC and LRAC coincide at output q0 where the fixed plant is optimal for that level of output. For all other outputs, there is too little or too much plant and equipment, and SRATC lies above LRAC. If some output other than q0 is to be sustained, costs can be reduced to the level of the long-run curve when sufficient time has elapsed to adjust the size of the firms fixed capital. The output qm is the lowest point on the firms long-run average cost curve. It is called the firms minimum efficient scale (MES), and it is the output at which long-run costs are minimized.

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The Envelope Long-run Average Cost Curve

LRAC

Output per period

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The Envelope Long-run Average Cost Curve

SRATC LRAC c0

q0 Output per period

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The Envelope Long-run Average Cost Curve

SRATC LRAC c0

q0 Output per period

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The Envelope Long-run Average Cost Curve

SRATC

SRATC LRAC

c0

q0 Output per period

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The Envelope Long-run Average Cost Curve

SRATC

SRATC LRAC

c0

q0 Output per period

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The Envelope Long-run Average Cost Curve

SRATC

SRATC LRAC

c0

q0 Output per period

qm

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The Envelope Long-run Average Cost Curve

Each short-run curve shows how costs vary if output varies, with the fixed factor held constant at the level that is optimal for the output at the point of tangency with LRAC. As a result, each SRATC curve touches the LRAC curve at one point and lies above it at all other points. This makes the LRAC curve the envelope of the SRATC curves.

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CHAPTER 6: THE COST STRUCTURE OF FIRMS

Firms in Practice and Theory

Production is organised either by private sector firms, which take four main forms - sole traders, ordinary partnerships, limited partnerships, and joint-stock companies - by state-owned enterprises called public corporations and by non-profit units, mostly government owned bodies, that distribute goods and services free or below cost . Modern firms finance themselves by selling shares, reinvesting their profits, or borrowing from lenders such as banks. Firms are in business to make profits, which they define as the difference between what they earn by selling their output and what it costs them to produce that output. This is the return to owners capital.

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CHAPTER 6: THE COST STRUCTURE OF FIRMS

Production, Costs and Profits The production function relates inputs of factor services to outputs. In addition to what firms count as their costs, economists include the imputed opportunity costs of owners capital. This includes the pure return, what could be earned on a riskless investment,and a risk premium, what could be earned over the pure return on an equally risky investment. Pure or economic profits are the difference between revenues and all these costs. Pure profits play a key role in resource allocation. Positive pure profits attract resources into an industry; negative pure profits induce resources to move elsewhere.

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CHAPTER 6: THE COST STRUCTURE OF FIRMS

Costs in the Short Run Short run variations in output are subject to the law of diminishing returns: equal increments of the variable input sooner or later produce smaller and smaller additions to total output and, eventually, a reduction in average output per unit of variable input. Short-run average and marginal cost curves are Ushaped, the rising portion reflecting diminishing average and marginal returns. The marginal cost curve intersects the average cost curve at the latters minimum point, which is called the firms capacity output. There is a family of short-run average and marginal cost curves, one for each amount of the fixed factor.

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CHAPTER 6: THE COST STRUCTURE OF FIRMS Costs in the Long Run In the long run, the firm can adjust all inputs to minimize the cost of producing any given level of output. Cost minimization requires that the ration of an inputs marginal product to its price be the same for all inputs. The principle of substitution states that, when relative input prices change, firms will substitute relatively cheaper inputs for relatively more expensive ones. Long-run cost curves are often assumed to be Ushaped, indicating decreasing average costs (increasing returns to scale) followed by increasing average costs (decreasing returns to scale). The long-run cost curve may be thought of as the envelope of the family of short-run curves, all of which shift when factor prices shift.

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CHAPTER 6: THE COST STRUCTURE OF FIRMS

The Very Long Run

In the very long run, innovations introduce new methods of production that alter the production function. These innovations of the occur as response to changes in economic incentives such as variations in the prices of inputs and outputs. These cause cost curves to shift downwards.