Microeconomics ECON 2302 Spring 2011

Marilyn Spencer, Ph.D.

Professor of Economics

Chapter 10

CHAPTER 10

Technology, Production, and Costs

Technological change leads to new products and lower production costs. How do firms take costs into account when setting prices?

CHAPTER 10

Technology, Production and Costs Chapter Outline

and

Learning Objectives 10.1

Technology: An Economic Definition

Define technology and give examples of technological change.

10.2

The Short Run and the Long Run in Economics

Distinguish between the economic short run and the economic long run.

10.3

The Marginal Product of Labor and the Average Product of Labor

Understand the relationship between the marginal product of labor and the average product of labor.

Chapter Outline

and

Learning Objectives, cont. 10.4

The Relationship between Short-Run Production and Short-Run Cost

Explain and illustrate the relationship between marginal cost and average total cost.

10.5

Graphing Cost Curves

Graph average total cost, average variable cost, average fixed cost, and marginal cost.

10.6 Costs in the Long Run

Understand how firms use the long-run average cost curve in their planning

10.1 LEARNING OBJECTIVE

Define technology and give examples of technological change.

Technology: An Economic Definition

Technology

The processes a firm uses to turn inputs into outputs of goods and services.

Technological change

A change in the ability of a firm to produce a given level of output with a given quantity of inputs.

Making the Connection

Improving Inventory Control at Wal-Mart

Improvements in inventory control meet the economic definition of positive technological change because they allow firms to produce the same output with fewer inputs.

Better inventory controls have helped reduce firms’ costs.

10.2 LEARNING OBJECTIVE

Distinguish between the economic short run and the economic long run.

The Short Run and the Long Run in Economics

Short run

The period of time during which at least one of a firm’s inputs is fixed.

Long run

The period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant.

The Short Run and the Long Run in Economics:

The Difference between Fixed Costs & Variable Costs – The Short Run

Total cost

production.

The cost of all the inputs a firm uses in

Variable costs

Costs that change as output changes.

Fixed costs

Costs that remain constant as output changes.

Total Cost = Fixed Cost + Variable Cost

TC = FC + VC

Making the Connection

Fixed Costs in the Publishing Industry

Publishers consider the salaries of editors to be a fixed cost.

COST

Salaries and benefits Rent Utilities Supplies Postage Travel Subscriptions, etc.

Miscellaneous Total

AMOUNT

$437,5 00 75,000 20,000 6,000 4,000 8,000 4,000 5,000 $559,5 00

The Short Run and the Long Run in Economics: Implicit Costs versus Explicit Costs

Opportunity cost

The highest-valued alternative that must be given up to engage in an activity.

Explicit cost

A cost that involves spending money.

Implicit cost

A nonmonetary opportunity cost.

The Short Run and the Long Run in Economics: Implicit Costs versus Explicit Costs

Table 10-1 Jill Johnson’s Costs per Year

Pizza dough, tomato sauce, and other ingredients Wages Interest payments on loan to buy pizza ovens Electricity Lease payment for store Foregone salary Foregone interest Economic depreciation Total $20,000 48,000 10,000 6,000 24,000 30,000 3,000 10,000 $151,000

The Short Run and the Long Run in Economics: The Production Function

Table 10-2 Short-Run Production and Cost at Jill Johnson’s Restaurant QUANTITY OF WORKERS

0 1 2 3 4 5 6

QUANTITY OF PIZZA OVENS

2 2 2 2 2 2 2

QUANTITY OF PIZZAS PER WEEK

0

COST OF PIZZA OVENS (FIXED COST) COST OF WORKERS (VARIABLE COST) TOTAL COST OF PIZZAS PER WEEK COST PER PIZZA (AVERAGE TOTAL COST)

$800 $0 $800 — 200 450 550 600 800 800 800 800 650 1,300 1,950 2,600 1,450 2,100 2,750 3,400 $7.25

4.67

5.00

5.67

625 640 800 800 3,250 3,900 4,050 4,700 6.48

7.34

Short Run & Long Run in Economics: The Production Function

Production function

The relationship between the inputs employed by a firm and the maximum output it can produce with those inputs.

A First Look at the Relationship between Production and Cost

Average total cost (ATC)

Total cost (TC) divided by the quantity (Q) of output produced.

TC /Q = ATC

Short Run and Long Run in Economics:

First Look at the Relationship between Production & Cost FIGURE 10-1 Graphing Total Cost and Average Total Cost at Jill Johnson’s Restaurant

The info from Table 10-2 in the graph shows the relationship between the Q of pizzas and Jill’s TC and ATC.

Panel (a) shows that TC increases as the level of production increases. Panel (b), shows that the ATC is roughly U shaped: As production increases from low levels, ATC falls before rising at higher levels of production.

10.3 LEARNING OBJECTIVE

Understand the relationship between the marginal product of labor and the average product of labor.

Marginal Product of Labor & Average Product of Labor

Marginal product of labor

The additional output a firm produces as a result of hiring one more worker.

Table 10-3 The Marginal Product of Labor at Jill Johnson’s Restaurant QUANTITY OF WORKERS

0 1 2 3 4 5 6

QUANTITY OF PIZZA OVENS

2 2 2 2 2 2 2

QUANTITY OF PIZZAS

0 200 450 550 600 625 640

MARGINALPRODUCT OF LABOR

— 200 250 100 50 25 15

Marginal Product of Labor & Average Product of Labor The Law of Diminishing Returns

Law of diminishing returns

The principle that, at some point, adding more of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline.

Marginal Product of Labor & Average Product of Labor

FIGURE 10-2 Total Output & Marginal Product of Labor

In panel (a), Q increases as more workers are hired, but the increase in Q does not occur at a constant rate. Each additional worker hired after the 3 rd worker causes production to increase by a

smaller

amount than did the hiring of the previous worker. In panel (b), the

marginal product of labor

is the additional Q produced as a result of hiring 1 more worker. MP L rises initially because of the effects of specialization and division of labor, and then it falls due to the effects of diminishing returns.

Making the Connection

Adam Smith’s Famous Account of the Division of Labor in a Pin Factory

The gains from division of labor and specialization are as important to firms today as they were in the eighteenth century, when Adam Smith first discussed them.

Marginal Product of Labor & Average Product of Labor

Relationship between Marginal and Average Product

Average product of labor

The total output produced by a firm divided by the quantity of workers.

The Marginal Product of Labor and the Average Product of Labor An Example of Marginal and Average Values: College Grades FIGURE 10-3 Marginal and Average GPAs

The relationship between marginal and average values for a variable can be illustrated using GPAs. We can calculate the GPA Paul earns in a particular semester (his “marginal GPA”), and we can calculate his cumulative GPA for all the semesters he has completed so far (his “average GPA”).

10.4 LEARNING OBJECTIVE

Explain and illustrate the relationship between marginal cost and average total cost.

The Relationship between Short-Run Production and Short-Run Cost

Marginal Cost

Marginal cost

The change in a firm’s total cost from producing one more unit of a good or service.

ΔTC ΔQ

Relationship between Short-Run Production & Short-Run Cost: Why Are the Marginal and Average Cost Curves U Shaped?

FIGURE 10-4 Jill Johnson’s MC and ATC of Producing Pizzas

We can use the info in the table to calculate Jill’s MC and ATC of producing pizzas. For the first 2 workers hired, the MP L increases. This increase causes the MC of production to fall. For the last 4 workers hired, the MP L falls. This causes the MC of production to go up. Thus, the MC curve falls and then rises - that is, has a U shape -because the MP L rises and then falls.

When MC is below ATC, average total cost falls. When MC is above ATC, average total cost rises. The relationship between MC and ATC explains why the ATC curve also has a U shape.

Solved Problem 10-4

The Relationship between Marginal Cost and Average Cost

When marginal cost is greater than average total cost, marginal cost must be increasing.

10.5 LEARNING OBJECTIVE

Graph average total cost, average variable cost, average fixed cost, and marginal cost.

Graphing Cost Curves

Average fixed cost

output produced.

Fixed cost divided by the quantity of

Average variable cost

of output produced.

Variable cost divided by the quantity Average total cost = Average fixed cost =

ATC AFC

= = Average variable cost =

AVC

=

TC Q FC Q VC Q ATC = AFC + AVC

Graphing Cost Curves FIGURE 10-5 Costs at Jill Johnson’s Restaurant

Jill’s costs of making pizzas are shown in the table & in the graph. Notice 3 important facts about the graph: (1)

MC, ATC,

and

AVC

curves are all U-shaped, and the MC curve intersects both the AVC curve and ATC curve

at their minimum points

. (2) As output increases,

AFC

gets smaller and smaller.

(3) As

output increases, the difference between ATC and AVC decreases.

Graphing Cost Curves

Understand the following three key facts about Figure 10-5: 1.

MC,

ATC

, and

AVC

curves are all U-shaped, and the MC curve intersects the AVC and ATC curves at their minimum points. When MC is < either AVC or ATC, it causes each of them to decrease. When MC is > AVC or ATC, it causes each of them to increase. Therefore, when MC = AVC or ATC, they must be at their minimum points.

2.

3.

As Q increases, AFC gets smaller and smaller. This happens because in calculating AFC, we are dividing something that gets larger and larger - Q - into something that remains constant - TFC. Firms often refer to this process of lowering AFC by selling more Q as “spreading the overhead” (where “overhead” refers to fixed costs).

As Q increases, the difference between ATC and AVC decreases. This happens because the difference between ATC and AVC is AFC, which gets smaller as output increases.

10.6 LEARNING OBJECTIVE

Understand how firms use the long-run average cost curve in their planning.

Costs in the Long Run Economies of Scale

Long-run average cost curve

A curve showing the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed.

Economies of scale

The situation when a firm’s long-run average costs fall as it increases output.

If a small bookstore expects to sell only 1,000 books/ mo., then it will be able to sell that Q of books at the lowest average cost of $22/book if it builds the small store represented by the

ATC

curve on the left of the figure. A larger bookstore will be able to sell 20,000 books/ mo. at a lower cost of $18/book. A bookstore selling 20,000 books/mo. and a bookstore selling 40,000 books/mo. will experience

constant returns to scale

and have the same ATC. A bookstore selling 20,000 books/mo. will have reached

minimum efficient scale

. Very large bookstores will experience

diseconomies of scale

, and their average costs will rise as sales increase beyond 40,000 books/mo.

FIGURE 10-6 The Relationship between Short-Run Average Cost and Long-Run Average Cost

Costs in the Long Run

Long-Run Average Total Cost Curves for Bookstores

Constant returns to scale

The situation when a firm’s long-run average costs remain unchanged as it increases output.

Minimum efficient scale

The level of output at which all economies of scale are exhausted.

Diseconomies of scale

The situation when a firm’s long-run average costs rise as the firm increases output.

Solved Problem 10-6

Using Long-Run Average Cost Curves to Understand Business Strategy

Both firms will still be short of minimum efficient scale after the trade, although their average costs will have fallen.

Making the Connection

The Colossal River Rouge: Diseconomies of Scale at Ford Motor Company

Smaller factories produced the Model A at a lower average cost than was possible at the River Rouge plant.

Was Ford’s River Rouge plant too big?

Costs in the Long Run

Don’t Let This Happen to YOU!

Don’t Confuse Diminishing Returns with Diseconomies of Scale

Conclusion

Table 10-4 A Summary of Definitions of Cost TERM

Total cost Fixed costs Variable costs Marginal cost Average total cost Average fixed cost Average variable cost Implicit cost Explicit cost

DEFINITION

The cost of all the inputs used by a firm, or fixed cost plus variable cost Costs that remain constant when a firm’s level of output changes Costs that change when the firm’s level of output changes Increase in total cost resulting from producing another unit of output Total cost divided by the quantity of output produced Fixed cost divided by the quantity of output produced Variable cost divided by the quantity of output produced A nonmonetary opportunity cost A cost that involves spending money

SYMBOLS AND EQUATIONS

TC FC MC

 

VC TC



Q ATC



TC Q AFC



FC Q AVC



VC Q ― ―

AN INSIDE

LOOK >> Sony Gambles on the Future Cost of the Next Generation of TVs

Economies of scale will result in a lower average total cost of production in 2013

if

Sony can sell 2.8 million OLED TVs.

KEY TERMS

Average fixed cost Average product of labor Average total cost Average variable cost Constant returns to scale Diseconomies of scale Economies of scale Explicit cost Fixed costs Implicit cost Law of diminishing returns Long run Long-run average cost curve Marginal cost Marginal product of labor Minimum efficient scale Opportunity cost Production function Short run Technological change Technology Total cost Variable costs

Reality Check Assignment to for Chapter 11:

Pre-read Ch. 11, including:

Review Questions: 3 rd ed., pg 394 1.1, 1.2, 1.3; pg 305 2.2; pg 395, 3.2; pg 398 5.1, 5.2, 5.3 pg 399 6.1 (

2 nd ed., pg 404; 1.1, 1.2 & 1.3; pg 406; 3.2; pg 405; 2.2; pg 407; 4.1; pg 408; 5.1, 5.2 & 5.3; pg 409; 6.1; 1 st edition: 1 - 10 on pp. 380-381),

Problems and Applications: 3 rd pg 398 5.4, 5.9

(2 nd

ed., pg 394 1.4; p 396 3.7; pg 397 4.3;

ed., p. 404, 1.4; p. 406, 3.7; p. 407, 4.3; p. 408, 5.4 & 5.9); and this application: The following is an excerpt from a newspaper story on the state of the lettuce market in the spring of 2002: “The shortage [of lettuce] began with freezing weather that cut per acre yields by more than half in parts of California, where more than half of the nation’s supply is grown. At the same time, many farmers grew less lettuce, fearing a drop in demand after Sept. 11 [2001] because many people dined out less.

(continued on next slide)

Reality Check Assignment to for Ch. 11,

continued:

The result has been high prices. In some parts of the country, iceberg lettuce has topped $3 per head at grocery stores, up from the regular $1 to $2. Prices are expected to drop to their usual levels in the next two to three weeks as new supplies catch up to demand,” said Ashraf Zaki, a market price reporter for the Agriculture Department in Forest Park, Ga. Use a demand-and-supply graph to illustrate the changes in the lettuce market described in this story. Briefly explain any shifts of the demand and supply curves in your graph. Why was the market prices reporter for the Agriculture Department confident that prices would drop “to their usual levels”? (1 st edition: 1, 3, 7, 14, 20 & 21 on pp. 381-384).