Transcript Slide 1

THE COSTS OF PRODUCTION
0
Chapter 13: The Costs of
Production
Econ 2100
THE COSTS OF PRODUCTION
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Course Outline
What; why;
who?
What works in
the public
sector?
How markets
work?
Why are you
hired?
Are markets
good?
How firms
behave?
Chapters 13 - 17
Chapter 13 Outline
Explicit vs Implicit
Costs
Economic vs.
Accounting Profit
Economies &
Diseconomies of
Scale
Production
Function &
Marginal Product
Costs: Short Run
vs. Long Run
Costs and
Relationship to
Output
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Total Revenue, Total Cost, Profit
• We assume that the firm’s goal is to maximize
profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output
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the market
value of the
inputs a firm
uses in
production
4
Costs: Explicit vs. Implicit
• Explicit costs require an outlay of money,
e.g., paying wages to workers.
• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
• Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
• This is true whether the costs are implicit or
explicit. Both matter for firms’ decisions.
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Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = $3000 (5%) interest on the loan
– implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
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Economic Profit vs. Accounting Profit
• Accounting profit
= total revenue minus total explicit costs
• Economic profit
= total revenue minus total costs (including explicit
and implicit costs)
• Accounting profit ignores implicit costs,
so it’s higher than economic profit.
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Chapter 13 Outline
Explicit vs Implicit
Costs
Economic vs.
Accounting Profit
Economies &
Diseconomies of
Scale
Production
Function &
Marginal Product
Costs: Short Run
vs. Long Run
Costs and
Relationship to
Output
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The Production Function
• A production function shows the relationship
between the quantity of inputs used to
produce a good and the quantity of output of
that good.
• It can be represented by a table, equation, or
graph.
• Example 1:
– Farmer Jack grows wheat.
– He has 5 acres of land.
– He can hire as many workers as he wants.
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Example 1: Farmer Jack’s Production Function
Q
(no. of (bushels
workers) of wheat)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
2,000
1,500
1,000
0
1
2
3
4
5
No. of workers
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Marginal Product
• If Jack hires one more worker, his output rises by the
marginal product of labor.
• The marginal product of any input is the increase in
output arising from an additional unit of that input,
holding all other inputs constant.
• Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
• Marginal product of labor (MPL) =
THE COSTS OF PRODUCTION
∆Q
∆L
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EXAMPLE 1: Total & Marginal Product
L
Q
(no. of (bushels
workers) of wheat)
∆L = 1
0
1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
2
3
4
5
0
MPL
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
1000
1800
2400
2800
3000
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EXAMPLE 1: MPL = Slope of Prod Function
Q
(no. of (bushels MPL
workers) of wheat)
0
0
1000
1
1000
800
2
1800
600
3
4
5
2400
2800
3000
400
200
MPL
3,000
Quantity of output
L
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why
500 production
the
function
gets flatter
0
as L0 increases.
1
2
3
4
5
No. of workers
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Why MPL Is Important
• Recall one of the Ten Principles:
Rational people think at the margin.
• When Farmer Jack hires an extra worker,
– his costs rise by the wage he pays the worker
– his output rises by MPL
• Comparing them helps Jack decide whether he would
benefit from hiring the worker.
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Why MPL Diminishes
• Farmer Jack’s output rises by a smaller and smaller
amount for each additional worker. Why?
• As Jack adds workers, the average worker has less land
to work with and will be less productive.
• In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment,
machines, etc.).
• Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
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Think of Einstein’s Bagels
• What happens if 1 person is
working in the place?
How many customers can be served
in a given time period?
• What if 2 are working?
Greater or lesser number of
customers?
• What if 25 are working?
Greater or lesser number of
customers?
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Aircraft Scheduling & Marginal
Product - Simplified
• ORD – LHR 10.5 hrs
• Crew: 4 pilots & 11 FAs
• One Crew – A/C can fly
one way in 24 hrs
• Two Crews – A/C can fly
round trip in 24 hrs
• Three Crews and more –
A/C can only fly round
trip in 24 hrs
747-100
Built 1971
A/C is fixed factor of production
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Chapter 13 Outline
Explicit vs Implicit
Costs
Economic vs.
Accounting Profit
Economies &
Diseconomies of
Scale
Production
Function &
Marginal Product
Costs: Short Run
vs. Long Run
Costs and
Relationship to
Output
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EXAMPLE 1: Farmer Jack’s Costs
• Farmer Jack must pay $1000 per month for the
land, regardless of how much wheat he grows.
• The market wage for a farm worker is $2000
per month.
• So Farmer Jack’s costs are related to how much
wheat he produces….
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EXAMPLE 1: Farmer Jack’s Costs
L
Q
Cost of
(no. of (bushels
land
workers) of wheat)
Cost of
labor
Total
Cost
0
0
$1,000
$0
$1,000
1
1000
$1,000
$2,000
$3,000
2
1800
$1,000
$4,000
$5,000
3
2400
$1,000
$6,000
$7,000
4
2800
$1,000
$8,000
$9,000
5
3000
$1,000 $10,000
$11,000
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EXAMPLE 1: Farmer Jack’s Total Cost Curve
0
$12,000
Total
Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
$10,000
Total cost
Q
(bushels
of wheat)
$8,000
$6,000
$4,000
$2,000
$0
0
1000
2000
3000
Quantity of wheat
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Marginal Cost
• Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q
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EXAMPLE 1: Total and Marginal Cost
Q
(bushels
of wheat)
0
Total
Cost
$1,000
∆Q = 1000
1000
$3,000
∆Q = 800
∆Q = 600
∆Q = 400
∆Q = 200
1800
Marginal
Cost (MC)
$5,000
2400
$7,000
2800
$9,000
3000 $11,000
∆TC = $2000
$2.00
∆TC = $2000
$2.50
∆TC = $2000
$3.33
∆TC = $2000
$5.00
∆TC = $2000
$10.00
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EXAMPLE 1: The Marginal Cost Curve
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$12
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
2800
$9,000
3000 $11,000
$10.00
$0
0
1,000
2,000
3,000
Q
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Relationship Between Marginal Product
and Marginal Cost
How many
Employees?
Employee
Marginal
Product
Per Hour
(Sandwiches)
First
Second
Third
Fourth
10
15
10
5
Total
Product
Per hour
Salary
Per Hour
Marginal
Cost
Per Unit
$10
$10
$10
$10
$1
$0.67
$1
$2
(Sandwiches)
10
25
35
40
25
Why MC Is Important
• Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce more
or less wheat?
• To find the answer, Farmer Jack needs to
“think at the margin.”
• If the cost of additional wheat (MC) is less than
the revenue he would get from selling it,
then Jack’s profits rise if he produces more.
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Fixed and Variable Costs
• Fixed costs (FC) do not vary with the quantity of output
produced.
– For Farmer Jack, FC = $1000 for his land
– Other examples:
cost of equipment, loan payments, rent
• Variable costs (VC) vary with the quantity produced.
– For Farmer Jack, VC = wages he pays workers
– Other example: cost of materials
• Total cost (TC) = FC + VC
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EXAMPLE 2
• Our second example is more general,
applies to any type of firm
producing any good with any types of inputs.
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EXAMPLE 2: Costs
FC
VC
TC
0 $100
$0 $100
1
100
70
170
2
100 120
220
3
100 160
260
4
100 210
310
5
100 280
380
FC
$700
VC
TC
$600
$500
Costs
Q
$800
$400
$300
$200
$100
6
7
100 380
100 520
480
620
$0
0
1
2
3
4
5
6
7
Q
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EXAMPLE 2: Marginal Cost
TC
MC
0 $100
1
2
3
4
5
6
7
170
220
260
310
380
480
620
$70
50
more unit:
70
100
140
$175
$150
$125
$100
$75
$50
40
50
$200
Costs
Q
Recall, Marginal
Cost (MC)
is the change in
total cost from
producing one
MC =
∆TC
∆Q
$25
$0
0
1
2
3
4
5
6
Q
Usually, MC rises as Q rises, due to
diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.)
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7
EXAMPLE 2: Average Fixed Cost
FC
0 $100
1
2
100
100
AFC
n/a
$100
50
3
100 33.33
4
100
25
5
100
20
6
100 16.67
7
100 14.29
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
Costs
Q
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The firm is spreading its fixed
$50
costs over a larger and larger
$25
number
of units.
$0
0
1
2
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3
4
Q
5
6
7
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EXAMPLE 2: Average Variable Cost
VC
AVC
0
$0
n/a
1
70
$70
2
120
60
3
160
53.33
4
210
52.50
5
280
56.00
6
380
63.33
7
520
74.29
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity of output:
$150
Costs
Q
AVC
$125
= VC/Q
$100
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
0
1
2
THE COSTS OF PRODUCTION
3
4
Q
5
6
7
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EXAMPLE 2: Average Total Cost
Q
TC
0 $100
ATC
AFC
AVC
n/a
n/a
n/a
1
170
$170
$100
$70
2
220
110
50
60
3
260 86.67 33.33
53.33
4
310 77.50
25
52.50
5
380
76
20
56.00
6
480
80 16.67
63.33
7
620 88.57 14.29
74.29
Average total cost
(ATC) equals total
cost divided by the
quantity of output:
ATC = TC/Q
Also,
THE COSTS OF PRODUCTION
ATC = AFC + AVC
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EXAMPLE 2: Average Total Cost
TC
0 $100
1
2
170
220
ATC
$200
Usually,
as in this example,
$175
the ATC curve is U-shaped.
n/a
$150
$170
110
Costs
Q
$125
$100
3
260 86.67
4
310 77.50
5
380
76
$25
6
480
80
$0
7
620 88.57
$75
$50
0
1
2
3
4
5
6
7
Q
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EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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EXAMPLE 2: Why ATC Is Usually U-Shaped
As Q rises:
$200
Initially,
falling AFC
pulls ATC down.
$175
Efficient scale:
The quantity that
minimizes ATC.
Costs
Eventually,
rising AVC
pulls ATC up.
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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EXAMPLE 2: ATC and MC
When MC < ATC,
ATC is falling.
$175
$150
ATC is rising.
$125
Costs
When MC > ATC,
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
ATC
MC
$200
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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Chapter 13 Outline
Explicit vs Implicit
Costs
Economic vs.
Accounting Profit
Economies &
Diseconomies of
Scale
Production
Function &
Marginal Product
Costs: Short Run
vs. Long Run
Costs and
Relationship to
Output
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Short-Run Versus Long-Run
• The short run is a period of time for
which two conditions hold:
1. The firm is operating under a fixed scale
(or fixed factor) of production, and
2. Firms can neither enter nor exit the
industry.
But can shut down
39
Short-Run Versus Long-Run
• The long run is a period of time for
which there are no fixed factors of
production. Firms can increase or
decrease scale of operation, and new
firms can enter and existing firms can
exit the industry.
40
Costs in the Short Run & Long Run
• Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
• Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones).
• In the long run, ATC at any Q is cost per unit
using the most efficient mix of inputs for that
Q (e.g., the factory size with the lowest ATC).
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EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose
from 3 factory
sizes: S, M, L.
Each size has its
own SRATC curve.
Avg
Total
Cost
ATCS
The firm can
change to a
different factory
size in the long
run, but not in the
short run.
ATCM
ATCL
Q
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EXAMPLE 3: LRATC with 3 factory Sizes
To produce less
than QA, firm will
choose size S
in the long run.
To produce
between QA
and QB, firm will
choose size M
in the long run.
To produce more
than QB, firm will
choose size L
in the long run.
Avg
Total
Cost
ATCS
ATCM
ATCL
LRATC
QA
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QB
Q
43
A Typical LRATC Curve
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
ATC
LRATC
So a typical
LRATC curve
looks like this:
Q
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Chapter 13 Outline
Explicit vs Implicit
Costs
Economic vs.
Accounting Profit
Economies &
Diseconomies of
Scale
Production
Function &
Marginal Product
Costs: Short Run
vs. Long Run
Costs and
Relationship to
Output
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Weekly Costs Showing Economies of Scale in
Egg Production
JONES FARM
15 hours of labor (implicit value $8 per hour)
Feed, other variable costs
Transport costs
Land and capital costs attributable to egg production
Total output
Average cost
CHICKEN LITTLE EGG FARMS INC.
Labor
Feed, other variable costs
Transport costs
Land and capital costs
Total output
Average cost
TOTAL WEEKLY COSTS
$120
25
15
17
$177
2,400 eggs
$.074 per egg
TOTAL WEEKLY COSTS
$ 5,128
4,115
2,431
19,230
$30,904
1,600,000 eggs
$.019 per egg
$/Egg
.050
.010
.006
.007
$/Egg
.003
.002
.002
.012
46
How ATC Changes as
the Scale of Production Changes
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
Q
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Cost of Complexity
Two Daughters
Admissions
Ag
Admissions
Univ.
Admissions
Ag
Registrar
Student
Univ
Registrar
Bursar
13,000 Students
Registrar/
Bursar
1,800 Students
48
How ATC Changes as
the Scale of Production Changes
• Economies of scale occur when increasing
production allows greater specialization:
workers more efficient when focusing on a
narrow task.
– More common when Q is low.
• Diseconomies of scale are due to coordination
problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
– More common when Q is high.
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Test Bank Questions
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Questions 22 & 28
22.
A firm's opportunity costs of
production are equal to its
a.
b.
c.
d.
explicit costs only.
implicit costs only.
explicit costs + implicit costs.
explicit costs + implicit costs + total
revenue.
28.
An example of an opportunity cost
that is also an implicit cost is
a. a lease payment.
b. the cost of raw materials.
c. the value of the business
owner’s time.
d. All of the above are correct.
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51
Questions 35 & 3
35.
John owns a shoe-shine
business. His accountant most likely
includes which of the following costs on
his financial statements?
3.
Which of the following
statements about a production function is
correct for a firm that uses labor to
produce output?
a.
a. wages John could earn washing
windows
b. dividends John's money was earning in
the stock market before John sold his
stock and bought a shoe-shine booth
c. the cost of shoe polish
d. Both b and c are correct.
b.
c.
d.
The production function depicts
the relationship between the
quantity of labor and the quantity
of output.
The slope of the production
function measures marginal cost.
The quantity of output determines
the maximum amount of labor the
firm will hire.
All of the above are correct.
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Questions 6 & 8
Alyson’s Pet Sitting
Service
6.
Refer to Table 13-1. What is the
marginal product of the second worker?
a.
b.
c.
d.
Number
of
Workers
0
1
2
3
4
15
20
22.5
25
8.
Refer to Table 13-1.
Alyson’s pet sitting service
experiences diminishing marginal
productivity with the addition of the
a.
b.
c.
d.
Output
(number of
pet visits)
0
20
45
60
70
first worker.
second worker.
third worker.
fourth worker.
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53
Question 13 & 8
13.
Which of these assumptions is
often realistic for a firm in the short run?
a. The firm can vary both the size of its
factory and the number of workers it
employs.
b. The firm can vary the size of its factory
but not the number of workers it employs.
c. The firm can vary the number of workers
it employs but not the size of its factory.
d. The firm can vary neither the size of its
factory nor the number of workers it
employs.
8.
Which of the following costs of
publishing a book is a fixed cost?
a
.
b
.
c
.
d
.
author royalties of 5% per book
the costs of paper and binding
shipping and postage expenses
composition, typesetting, and
jacket design for the book
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54
Questions 11 &43
43.
Marginal
cost equals
11.
Suppose Jan started up a small
lemonade stand business last month.
Variable costs for Jan's lemonade stand
now include the cost of
(i)
a
.
b
.
c
.
d
.
building the lemonade stand.
(ii)
hiring an artist to design a
logo for her sign.
lemons and sugar.
(iii)
change in total cost divided by
change in quantity produced.
change in variable cost divided
by change in quantity produced.
the average fixed cost of the
current unit.
a.
b.
c.
d.
All of the above are correct.
THE COSTS OF PRODUCTION
(i) and (ii) only
(ii) and (iii) only
(i) only
(i), (ii), and (iii)
55
Questions 139, 141 and 143
139. Curve A represents which type of cost
curve?
a. marginal cost
b. average total cost
c. average variable cost
d. average fixed cost
Cost
D
11
C
10
B
9
8
141.Curve C represents which type of cost
curve?
a. marginal cost
b. average total cost
c. average variable cost
d. average fixed cost
7
6
5
4
3
2
1
A
1
143. Curve D represents which type of
cost curve?
a.
b.
c.
d.
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2
3
4
5
6
7
8
9
10
11
12 Quantity
marginal cost
average total cost
average variable cost
average fixed cost
56
Questions 3 & 19
3.
When a factory is operating
in the short run,
a. it cannot alter variable costs.
b. total cost and variable cost are
usually the same.
c. average fixed cost rises as
output increases.
d. it cannot adjust the quantity of
fixed inputs.
19.
Economies of scale
arise when
a. an economy is self-sufficient in
production.
b. individuals in a society are
self-sufficient.
c. fixed costs are large relative to
variable costs.
d. workers are able to specialize
in a particular task.
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57
Questions 47, 49 & 50
47. The three average total cost curves
on the diagram labeled ATC1, ATC2, and
ATC3 most likely correspond to three
different
a.
b.
c.
d.
time horizons.
products.
firms.
factory sizes.
49. The firm experiences
diseconomies of scale if it
changes its level of output
from
a. Q1 to Q2.
b. Q2 to Q3.
c. Q3 to Q4.
d. Q4 to Q5.
50. The firm experiences
constant returns to scale if
it changes its level of
output from
a.
b.
c.
d.
THE COSTS OF PRODUCTION
Q1 to Q2.
Q2 to Q4.
Q1 to Q3.
Q4 to Q5.
58