Microeconomics
ECON 2302
May 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
Improving Inventory
Connection Control at Wal-Mart
the
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 The cost of all the inputs a firm uses in
production.
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
Fixed Costs in the
Connection 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
$20,000
Wages
48,000
Interest payments on loan to buy pizza ovens
10,000
Electricity
6,000
Lease payment for store
24,000
Foregone salary
30,000
Foregone interest
Economic depreciation
Total
3,000
10,000
$151,000
The Short Run and the Long Run in
Economics:
The Production Function
Table 10-2
QUANTITY
OF WORKERS
QUANTITY
OF
PIZZA OVENS
Short-Run Production and Cost at Jill Johnson’s Restaurant
QUANTITY OF
PIZZAS
PER WEEK
COST OF
PIZZA OVENS
(FIXED COST)
COST PER
COST OF
TOTAL COST
PIZZA
WORKERS
OF PIZZAS
(AVERAGE
(VARIABLE COST) PER WEEK TOTAL COST)
0
2
0
$800
$0
$800
—
1
2
200
800
650
1,450
$7.25
2
2
450
800
1,300
2,100
4.67
3
2
550
800
1,950
2,750
5.00
4
2
600
800
2,600
3,400
5.67
5
2
625
800
3,250
4,050
6.48
6
2
640
800
3,900
4,700
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 Ushaped: 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
QUANTITY
OF PIZZA OVENS
QUANTITY
OF PIZZAS
MARGINALPRODUCT
OF LABOR
0
2
0
—
1
2
200
200
2
2
450
250
3
2
550
100
4
2
600
50
5
2
625
25
6
2
640
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 3rd 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. MPL 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
MC 
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
MPL increases. This increase causes
the MC of production to fall.
For the last 4 workers hired, the
MPL 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 MPL
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 Fixed cost divided by the quantity of
output produced.
Average variable cost Variable cost divided by the quantity
of output produced.
TC
Average total cost = ATC =
Q
FC
Average fixed cost = AFC =
Q
VC
Average variable cost = AVC =
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.
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.
3.
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 The Colossal River Rouge: Diseconomies of Scale
at Ford Motor Company
Connection
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
SYMBOLS AND
EQUATIONS
TERM
DEFINITION
Total cost
The cost of all the inputs used by a firm, or
fixed cost plus variable cost
TC
Fixed costs
Costs that remain constant when a firm’s
level of output changes
FC
Variable costs
Costs that change when the firm’s level of
output changes
VC
TC
Q
TC
ATC 
Q
MC 
Marginal cost
Increase in total cost resulting from
producing another unit of output
Average total cost
Total cost divided by the quantity of output
produced
Average fixed cost
Fixed cost divided by the quantity of output
produced
Average variable cost
Variable cost divided by the quantity of
output produced
Implicit cost
A nonmonetary opportunity cost
―
Explicit cost
A cost that involves spending money
―
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: 3rd 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 (2nd 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;
1st edition: 1 - 10 on pp. 380-381),
Problems and Applications: 3rd ed., pg 394 1.4; p 396 3.7; pg 397 4.3;
pg 398 5.4, 5.9 (2nd 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 peracre 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”?
(1st edition: 1, 3, 7, 14, 20 & 21 on pp. 381-384).