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) Revenue from sales £1,000,000

Materials Wages £200,000

Materials £300,000
Other Others £1000,00
Total VC
Total VC 600,000
Fixed Costs
Fixed costs (FC)
Rent
Rent 50,000
Managerial salaries 60,000
Interest on loans 90,000
Depreciation allowance 50,000

Total FC 250,000

Total FC Total Costs (FC+VC) 850,000

Profit (revenue less total costs) £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 -£100,000
Risk Premium -£40,000

Pure or economic rent £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 Total Product Average Product Marginal Product

Labour (L) (TP) (AP) (MP)

(1) (2) (3) (4)

1 43 43 43
2 160 80 117
3 351 117 191
4 600 150 249
5 875 175 275
6 1152 192 277
7 1375 196 220
8 1536 192 164
9 1656 184 120
10 1750 175 94
11 1815 165 65
12 1860 155 45
 Total, average and marginal product curves

2100
300

Average product [AP] and marginal product [MP]

Point of diminishing
TP marginal returns
1800
250
Total product [T/P]

1500
200
1200 AP
150
900 Point of diminishing
average returns
100
600 MP

50
300

0 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
 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 Total Cost Average Cost

Capital Labour Output Fixed Variable Total Fixed Variable Total Marginal
[L] [q] [TFC] [TVC] [TC] [AFC] [AVC] [ATC] 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

 Total, Average and Marginal Cost Curves

280 TC

240 TVC 0.70

0.60

Cost per unit [[£]

200
Cost [£]

0.50
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 Output
average cost curves
 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 E0 LRAC

c1 E1
Attainable levels of cost
Cost per unit

Unattainable levels of cost

q0 q1 qm
0 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
Cost per unit

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 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.
Cost per unit
The Envelope Long-run Average Cost Curve

LRAC

Output per period

 The Envelope Long-run Average Cost Curve
Cost per unit

SRATC

LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve
Cost per unit

SRATC

LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve
Cost per unit

SRATC
SRATC
LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve
Cost per unit

SRATC
SRATC
LRAC

c0

q0

Output per period

 The Envelope Long-run Average Cost Curve
Cost per unit

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.