Transcript No Slide Title

The Cost Structure
of Firms
Chapter 6
LIPSEY & 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)
Materials Wages
Materials
Other
Others
Total VC
Total VC
Fixed Costs
Fixed costs (FC)
Rent
Revenue from sales
£200,000
£300,000
£1000,00
600,000
Rent
Managerial salaries
Interest on loans
Depreciation allowance
50,000
60,000
90,000
50,000
Total FC
250,000
Total FC Total Costs (FC+VC)
850,000
Profit (revenue less total costs)
£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
£150,000
Opportunity cost of capital
Pure return on the firm’s capital
Risk Premium
Pure or economic rent
-£100,000
-£40,000
£10,000
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 of
Labour (L)
Total Product
(TP)
Average Product
(AP)
Marginal Product
(MP)
(1)
(2)
(3)
(4)
1
2
3
4
5
6
7
8
9
10
11
12
43
160
351
600
875
1152
1375
1536
1656
1750
1815
1860
43
80
117
150
175
192
196
192
184
175
165
155
43
117
191
249
275
277
220
164
120
94
65
45
Total, average and marginal product curves
2100
300
Point of diminishing
marginal returns
TP
Total product [T/P]
1800
250
1500
200
AP
1200
150
900
Point of diminishing
average returns
100
600
MP
50
300
0
2
[i] Total Product
4
6
8
Quantity of labour
10
12
2
4
6
8
Quantity of Labour
[ii] Average and Marginal Product
10
12
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
Total Cost
Labour
[L]
Output
[q]
Average Cost
Fixed Variable Total
[TFC]
[TVC]
[TC]
[6]
Marginal
Total
[ATC] Product [MP]
Fixed
[AFC]
Variable
[AVC]
[7]
[8]
[9]
[1]
[2]
[3]
[4]
[5]
[10]
10
1
43
£100
£20
£120
£2,326
£0.465
£2,791
£0.465
10
2
160
100
40
140
0.625
0.250
0.875
0.171
10
3
351
100
60
160
0.285
0.171
0.456
0.105
Total, Average and Marginal Cost Curves
280
TC
TVC
240
0.60
200
Cost [£]
0.70
0.50
160
MC
0.40
120
TFC
0.30
80
0.20
40
0.10
AVC
ATC
AFC
300
600
[i] Total cost curves
900
1200 1500 1800
Output
2100
300
600
900 1200 1500 1800 2100
[ii] Marginal and
average cost curves
Output
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.
A Long-run Average Cost-curve
c2
c0
LRAC
E0
E1
c1
Attainable levels of cost
Unattainable levels of cost
0
q0
q1
qm
Output per period
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.
Long-run Average Cost and Short-run Average Cost Curves
SRATC
LRAC
c0
q0
qm
Output per period
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 Shortrun 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 longrun 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.
The Envelope Long-run Average Cost Curve
LRAC
Output per period
The Envelope Long-run Average Cost Curve
SRATC
LRAC
c0
q0
Output per period
The Envelope Long-run Average Cost Curve
SRATC
LRAC
c0
q0
Output per period
The Envelope Long-run Average Cost Curve
SRATC
SRATC
LRAC
c0
q0
Output per period
The Envelope Long-run Average Cost Curve
SRATC
SRATC
LRAC
c0
q0
Output per period
The Envelope Long-run Average Cost Curve
SRATC
SRATC
LRAC
c0
q0
qm
Output per period
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.