CHAPTER 8:

Firms, Cost, and Profits

FIGURE TEXT
 Table 8.1: 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.
 Table 8.2: 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.
 Figure 8.1: 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.
 Figure 8.3 (i): Total 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.
Figure 8.3 (ii): Average and marginal cost
curves

 The total cost curves in Figure 8.3 (i) 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.
Figure 8.4: 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
q 1.
 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.
 Figure 8.5: Long-run average cost and short-
run average total 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.
 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.
Figure 8.6: 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.