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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
Attainable levels of cost
Unattainable levels of cost
Output per period
0
E0c0
qmq0
A Long-run Average Cost-curve
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6- 16
LRAC
Attainable levels of cost
Unattainable levels of cost
Output per period
0
c1
E0
E1
c0
c2
q1qmq0
A Long-run Average Cost-curve
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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.
A Long-run Average Cost-curve
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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
The Envelope Long-run Average Cost Curve
Th E l L A C t C
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LRAC
Output per period
SRATC
c0
q0
The Envelope Long-run Average Cost Curve
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Th E l L A C t C
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LRAC
Output per period
SRATC
c0
SRATC
q0
The Envelope Long-run Average Cost Curve
Th E l L A C t C
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6- 26
LRAC
Output per period
qm
SRATC
q0
c0
SRATC
The Envelope Long-run Average Cost Curve
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.
The Envelope Long-run Average Cost Curve
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.
CHAPTER 6: THE COST STRUCTURE OF FIRMS
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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.