The Cost Structureof Firms

Chapter 6LIPSEY & CHRYSTAL

ECONOMICS 12e

Introduction

• The firm is the most important agent in the economy that makes decisions about production of the specific goods or services in which it specializes.

• The firms’ options are affected by the market structure in which they operate.

• They also have to make supply decisions in the light of their costs of production.

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.

• 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.

Firms in Practice and Theory

• Production is organised either by private sector firms, which may take the following forms:

• Sole traders • Ordinary partnerships• Limited partnerships• Joint-stock companies• Public corporations • Non-profit units

• 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 owner’s capital.

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.

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 U-shaped, the rising portion reflecting diminishing average and marginal returns.

• The marginal cost curve intersects the average cost curve at the latter’s minimum point, which is called the firm’s capacity output.

• There is a family of short-run average and marginal cost curves, one for each amount of the fixed factor.

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 input’s 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 U-shaped, 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.

The Very Long Run

• In the very long run, innovations introduce new methods of production that alter the production function.

• These innovations 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.

Profit and Loss Account for XYZ Company For the Year Ending 31 Dec. 20XX

Variable costs (VC)

WagesMaterialsOthers

Total VC

Fixed costs (FC)

RentManagerial salariesInterest on loansDepreciation allowance

Total FC

Total Costs (FC+VC)

Profit (revenue less total costs)

Other

Total VC

Materials

Total FC

Rent

Fixed Costs

£200,000£300,000£1000,00

600,000

50,00060,00090,00050,000

250,000

850,000

Revenue from sales £1,000,000

£150,000

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 capital - what it must earn to induce it to keep its capital in its present use.

Calculation of Pure Profits

Profits as reported by the firm

Opportunity cost of capital

Pure return on the firm’s capital

Pure or economic rent

Risk Premium

-£100,000

-£40,000

£10,000

£150,000

Calculation of pure profits

· The economist’s 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.

Total, Average and Marginal Products in the Short Run

Quantity ofLabour (L)

(1)

123456789

101112

Total Product(TP)

(2)

431603516008751152137515361656175018151860

Average Product(AP)

(3)

4380117150175192196192184175165155

Marginal Product(MP)

(4)

43117191249275277220164120946545

Total, average and marginal product curves

[i] Total Product

2

300

4

600

6

900

8 10

1500

1200

1800

2100

12

Quantity of labour

Tota

l pro

duct

[T

/P]

TP

0 2 4 6 8 10 12

50

100

150

200

250

300

Point of diminishing average returns

AP

MP

Ave

rage

pro

duc t

[A

P]

and

mar

gina

l pro

d uct

[M

P]

Quantity of Labour[ii] Average and Marginal Product

Point of diminishing marginal returns

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.

Variation of Costs With Capital Fixed and Labour Variable

Inputs

Capital Labour [L]

10

10

210

£1001

100

100

£20

40

60 160

Average Cost

Fixed Variable Total [AFC] [AVC] [ATC]

Output [q]

Total Cost

Fixed Variable Total [TFC] [TVC] [TC]

[1] [2] [3] [4] [8]

43

160

351

£120

140

£2,326

0.625

0.285

£0.465 £2,791

0.250 0.875 0.171

0.4560.171

£0.465

0.105

Marginal Product [MP]

[5] [6] [7] [9] [10]

3

300

40

600

80

900

120

1200 1500

200

160

240

280

1800

Total, Average and Marginal Cost Curves

Output

Cos

t [£]

TC

300 600 900 1200 1500 1800

0.10

0.20

0.30

0.40

0.50

0.60

Cos

t per

uni

t [[£

]

Output[i] Total cost curves [ii] Marginal and average cost curves

0.70

2100

MC

TFC

TVC

2100

AFC

AVC

ATC

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.

LRAC

Attainable levels of cost

Unattainable levels of cost

Output per period0

c1

E0

E1

Cos

t p

er u

nit

c0

c2

q1qmq0

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 per-unit cost of production for the given technology and factor prices.

A Long-run Average Cost-curve

LRAC

Output per period

Cos

t p

er u

nit

qm

SRATC

q0

c0

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.

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

· 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 firm’s fixed capital.

· The output qm is the lowest point on the firms long-run average cost curve.

· It is called the firm’s minimum efficient scale (MES), and it is the output at which long-run costs are minimized.

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

LRAC

Output per period

The Envelope Long-run Average Cost CurveC

ost

per

un

it

LRAC

Output per period

SRATC

c0

Cos

t p

er u

nit

q0

The Envelope Long-run Average Cost Curve

LRAC

Output per period

Cos

t p

er u

nit

SRATC

c0

q0

The Envelope Long-run Average Cost Curve

LRAC

Output per period

SRATC

c0

SRATC

Cos

t p

er u

nit

q0

The Envelope Long-run Average Cost Curve

LRAC

Output per period

SRATC

c0

SRATC

Cos

t p

er u

nit

q0

The Envelope Long-run Average Cost Curve

LRAC

Output per period

qm

SRATC

q0

c0

SRATC

Cos

t p

er u

nit

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.

The Envelope Long-run Average Cost Curve