Lipsey Ch06

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6- 1

THE COST STRUCTURE OF

FIRMS

Slides by

Alex Stojanovic

Chapter 6

ECONOMICSELEVENTHEDITION

LIPSEY &

CHRYSTAL

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6- 2 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 simplestructure

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 ofinputs to the quantity of output

Cost curves show the money cost of producing

various levels of output

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6- 3 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 allowedto 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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6- 4 Profit and Loss Account for XYZ Company For the Year Ending 31 Dec. 1999

Expenditure

Variable Costs

Wages

Other

Total VC

Materials

Total FC

Rent

Managerial salaries

Fixed Costs

Depreciation allowance

Interest on loans

200,000

300,000

100,000

600,000

150,000

850,000

Income

50,000

60,000

90,000

50,000

250,000

Revenue from sales 1,000,000

Total Costs

Profit

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6- 5 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 ofits capitalwhat it must earn to induce it to keep

its capital in its present use.

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6- 6 Calculation of Pure Profits

Profits as reported by the firm

Opportun i ty cost of capi tal

Pure return on the firms capital

Pure or economic rent

Risk Premium

-100,000

-40,000

10,000

150,000

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6- 7 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 ofcapital must be deducted from what the firm

regards as its capital.

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6- 8 Total, Average and Marginal Products in the Short Run

Quantity of

labour [L]

175

1

3

4

2

10

6

7

5

9

8

43

80

117

150

175

Marginal

Product [MP]

192

196

1750

192

184

11

12

Total

Product [TP]

Average

Product [AP]

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

43

160

351

600

875

1152

1375

1536

1656

1815

1860

165

155

117

191

249

275

277

220

164

120

94

65

43

45

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6- 9

2 4 6 8 10 12

50

100

150

200

250

300

Point of diminishing

average returns

AP

MP

Quantity of Labour

[i] Total Product [ii] Average and Marginal Product

Point of diminishing

marginal returns

2

300

4

600

6

900

8 10

1500

1200

1800

2100

12

Quantity of labour

Tota

lproduct[T/P]

TP

0

Total, average and marginal product curves

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6- 10 Total, average and marginal product curves

(i): Total product curve The TPcurve 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.

WhereAPreaches its maximum. MP = AP.

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6- 11 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

2

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6- 12

300

40

600

80

900

120

1200 1500

200

160

240

280

1800

Total, Average and Marginal Cost Curves

Output

Cost[]

TC

300 600 900 1200 1500 1800

0.10

0.20

0.30

0.40

0.50

0.60

Output

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

0.70

2100

MC

TFC

TVC

2100

AFC

AVC

ATC

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6- 13 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 theAVC andATC curves at their minimum points.

Capacity output is defined as the minimum point of the

ATCcurve, which is an output of 1,500 in this example.

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6- 14

LRAC

Attainable levels of cost

Unattainable levels of cost

Output per period

0qm

A Long-run Average Cost-curve

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6- 15

LRAC



Output per period

0

E0c0

qmq0


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6- 16

LRAC



Output per period

0

c1

E0

E1

c0

c2

q1qmq0


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6- 17

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 c0per unit, the point E0is 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 q1can 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.


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6- 18 Long-run Average Cost and Short-run Average Cost Curves

Output per period

qm

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6- 19

LRAC

Output per period

qm

SRATC

q0

c0

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

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6- 20

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 q0where

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 SRATClies above LRAC. If some output other than q0is 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-runaverage cost curve.

It is called the firmsminimum 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

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6- 21

LRAC

Output per period

The Envelope Long-run Average Cost Curve

C C

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6- 22

LRAC

Output per period

SRATC

c0

q0


Th E l L A C t C

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6- 23

LRAC

Output per period

SRATC

c0

q0


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Th E l L A C t C

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6- 25

LRAC

Output per period

SRATC

c0

SRATC

q0


Th E l L A C t C

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6- 26

LRAC

Output per period

qm

SRATC

q0

c0

SRATC


Th E l L A C t C

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6- 27

Each short-run curve shows how costs vary ifoutput 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 SRATCcurve touches the LRACcurve at one point and lies above it at all other

points.

This makes the LRAC curve the envelope of the

SRATCcurves.


CHAPTER 6: THE COST STRUCTURE OF FIRMS

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6- 28

Firms in Practice and Theory

Production is organised either by private sector firms,

which take four main forms - sole traders, ordinarypartnerships, 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 freeor 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 ownerscapital.

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6 31 CHAPTER 6: THE COST STRUCTURE OF FIRMS

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6- 31 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 relativelycheaper 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.

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6- 32 CHAPTER 6: THE COST STRUCTURE OF FIRMS

The Very Long Run

In the very long run, innovations introduce newmethods of production that alter the production

function.

These innovations of the occur as response to

changes in economic incentives such asvariations in the prices of inputs and outputs.

These cause cost curves to shift downwards.

Documents

Lipsey Ch06