1. The Cost Structure of Firms Chapter 6
LIPSEY & CHRYSTAL
ECONOMICS 12e

2. 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.

3. 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.

4. 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.

5. 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.

6. 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

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. Profit and Loss Account for XYZ Company For the Year Ending 31 Dec
Profit and Loss Account for XYZ Company For the Year Ending 31 Dec. 20XX
Variable costs (VC)
Wages
Materials
Others
Total VC
Fixed costs (FC)
Rent
Managerial salaries
Interest on loans
Depreciation allowance
Total FC
Total Costs (FC+VC)
Profit (revenue less total costs)
£200,000
£300,000
£1000,00
600,000
50,000
60,000
90,000
250,000
850,000
Revenue from sales £1,000,000
£150,000
Materials
Other
Total VC
Fixed Costs
Rent
Total FC

16. 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.

17. Calculation of Pure Profits
Profits as reported by the firm
£150,000
Opportunity cost of capital
Pure return on the firm’s capital
-£100,000
Risk Premium
-£40,000
Pure or economic rent
£10,000

18. 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.

19. Total, Average and Marginal Products in the Short Run
Quantity of
Labour (L)
(1) 1 2 3 4 5 6 7 8 9 10 11 12
Total Product
(TP)
(2) 43
160
351
600
875
1152
1375
1536
1656
1750
1815
1860
Average Product
(AP)
(3) 43 80
117
150
175
192
196
184
165
155
Marginal Product
(MP)
(4) 43
117
191
249
275
277
220
164
120 94 65 45

20. Total, average and marginal product curves
2100
300
Point of diminishing
marginal returns TP
1800
250
1500
200
Total product [T/P]
1200 AP
150
Average product [AP] and marginal product [MP]
900
Point of diminishing
average returns
100
600 MP 50
300 2 4 6 8 10 12 2 4 6 8 10 12
Quantity of Labour
[i] Total Product
Quantity of labour
[ii] Average and Marginal Product

21. 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.

22. Variation of Costs With Capital Fixed and Labour Variable
Inputs
Capital Labour
[L]
Total Cost
Fixed Variable Total [TFC] [TVC] [TC]
Average Cost
Fixed Variable Total
[AFC] [AVC] [ATC]
Output
[q]
Marginal
Product [MP]
[1] [2]
[3]
[4]
[5]
[6]
[7]
[8]
[9]
[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

23. Total, Average and Marginal Cost Curves
280 TC
TVC
0.70
240
0.60
200
0.50
Cost [£]
Cost per unit [[£]
160 MC
0.40
120
TFC
0.30
AVC 80
0.20
ATC 40
0.10
AFC
300
600
900
1200
1500
1800
2100
300
600
900
1200
1500
1800
2100
[i] Total cost curves
Output
[ii] Marginal and
average cost curves
Output

24. 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.

25. A Long-run Average Cost-curve
LRAC c0 E0 E1 c1
Attainable levels of cost
Cost per unit
Unattainable levels of cost qm q0 q1
Output per period

26. 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.

27. Long-run Average Cost and Short-run Average Cost Curves
Cost per unit
SRATC
LRAC c0 q0 qm
Output per period

28. 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.

29. 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.

30. The Envelope Long-run Average Cost Curve
Cost per unit
LRAC
Output per period

31. The Envelope Long-run Average Cost Curve
SRATC
Cost per unit
LRAC c0 q0
Output per period

32. The Envelope Long-run Average Cost Curve
SRATC
Cost per unit
LRAC c0 q0
Output per period

33. The Envelope Long-run Average Cost Curve
SRATC
Cost per unit
SRATC
LRAC c0 q0
Output per period

34. The Envelope Long-run Average Cost Curve
SRATC
Cost per unit
SRATC
LRAC c0 q0
Output per period

35. The Envelope Long-run Average Cost Curve
SRATC
Cost per unit
SRATC
LRAC c0 q0 qm
Output per period

36. 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.