Production
and Cost
CHAPTER OUTLINE
Chapter
12
I. Explain how economists measure a firm’s cost of production and profit.
A. The Firm’s Goal
B. Accounting Cost and Profit
C. Opportunity Cost
1. Explicit Costs and Implicit Costs
D. Economic Profit
2. Explain the relationship between a firm’s output and labor employed in
the short run.
A. The Short Run: Fixed Plant
B. The Long Run: Variable Plant
C. Total Product
D. Marginal Product
1. Increasing Marginal Returns
2. Decreasing Marginal Returns
E. Average Product
3. Explain the relationship between a firm’s output and costs in the short
run.
A. Total Cost
B. Marginal Cost
C. Average Cost
D. Why the Average Total Cost Curve is U-Shaped
E. Cost Curves and Product Curves
F. Shifts in the Cost Curves
1. Technology
2. Prices of Factors of Production
4. Derive and explain a firm’s long-run average cost curve.
A. Plant Size and Cost
1. Economies of Scale
2. Diseconomies of Scale
3. Constant Returns to Scale
B. The Long-Run Average Cost Curve
1. Economies and Diseconomies of Scale
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Part 4 . A CLOSER LOOK AT DECISION MAKERS
 What’s New in this Edition?
Chapter 12 is slightly rewritten to improve clarity.
 Where We Are
In this chapter, we define economic costs and profits. We examine the relationship between inputs, costs, and production. This chapter lays the groundwork for the profitmaximizing decisions that are made by firms, which we
study in the next several chapters.
 Where We’ve Been
We defined what economics means in terms of scarcity, opportunity cost, choice, and efficient use of resources. We’ve
explored the interactions of supply and demand that bring
about the efficient use of resources by equating marginal
benefit to marginal cost. We’ve discussed the rationale behind the downward-sloping demand curve using marginal
utility analysis.
 Where We’re Going
After this chapter, we look at the demand and marginal revenue curves for firms in different industry structures. By
combining the cost, demand, and revenue curves, we will
see the profit-maximizing operating decisions made by these
firms.
IN THE CLASSROOM
 Class Time Needed
You can complete this chapter in two to three class sessions. However, this is a
very important chapter, so do not short change it. If you judge from your class’s
reaction that you need more time, take it!
An estimate of the time per checkpoint is:

12.1 Economic Cost and Profit—15 to 25 minutes

12.2 Short-Run Production—45 to 65 minutes

12.3 Short-Run Cost—45 to 65 minutes

12.4 Long-Run Cost—30 to 40 minutes
Chapter 12 . Production and Cost
299
CHAPTER LECTURE
12.1
Economic Cost and Profit
The Firm’s Goal

The firm’s goal is to maximize profit.
Accounting Cost and Profit versus Opportunity Cost


Accountants measure revenue and cost using accounting conventions in order to ensure
that the firm pays the proper amount of tax and to give creditors information. But the
costs as measured by accountants are the firm’s opportunity costs.
The decisions the firm makes to maximize its profit respond to opportunity cost and economic profit. The opportunity cost of a firms use of resources is the highest-valued alternative forgone. Opportunity costs include both explicit costs and implicit costs.
 An explicit cost is a cost paid in money. Explicit costs are opportunity costs.
 An implicit cost is an opportunity cost incurred by a firm when it uses a factor of
production for which it does not make a direct money payment.
Normal Profit and Economic Profit


A firm’s owner supplies entrepreneurship by organizing the business and bearing the
risk of running it.
 Normal profit is the return to entrepreneurship.
 Normal is part of a firm’s opportunity cost because it is the cost of persuading the entrepreneur of not running another business.
Economic profit is a firm’s total revenue minus its total opportunity cost. An economic
profit is a profit over and above the normal profit.
12.2
Short-Run Production
A firm owner’s decisions can be categorized as short run decisions and long run decisions.
 The short run is a time frame in which the quantities of some resources are fixed. The
fixed resources include the firm’s management organization structure, level of technology, buildings and large equipment. These factors are called the firm’s plant.
 The long run is a time frame in which the quantities of all resources can be varied. Longrun decisions are not easily reversed so usually a firm must live with the plant size that it
has created for some time.
Help the students to understand that the difference between the long run and short run is not
related to calendar time. Compare the street vendor, who is a firm owner operating out of a food
truck, to the giant automaker firm, General Motors. Ask them how long it would take for the food
vendor to double the size of his or her plant (truck, oven, etc.) versus GM to double its plant size
(factory buildings covering multiple blocks, sophisticated computerized assembly lines and robotics, etc.). They will realize that the length of time covered by the long run differs among firms.
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300
To increase its output in the short run, a firm must increase the quantity of labor employed. There
are three relationships between the quantity of labor and the firm’s output.
Product Schedules







The total product is the total quantity of a good produced in a given period.
The marginal product (MP) of labor is the
Total
Marginal
increase in total product that results from a
Labor
product
product
one-unit increase in the quantity of labor
0
0
employed with all other inputs remaining
10
the same.
1
10
The average product of labor is equal to the
20
total product of labor divided by the quanti2
30
ty of labor.
6
The table to the right has examples of these
3
36
product schedules.
Average
product
10
15
12
The marginal product curve shows the additional output generated by each additional
unit of labor. The figure shows a typical marginal product of labor curve (MP), with an
upside-down U shape. The shape reflects the
point that marginal product has increasing
marginal returns initially and decreasing
marginal returns eventually.
 Increasing marginal returns occurs
when the marginal product of an additional worker exceeds the marginal
product of the previous worker. The
marginal product curve has a positive
slope. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows
large gains from specialization. Eventually these gains become small or nonexistent and decreasing marginal returns set in.
 Decreasing marginal returns occur when the marginal product of an additional
worker is less than the marginal product of the previous worker. The marginal product curve has a negative slope. The law of decreasing returns states that as a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.
The average product curve shows the average product that is generated by labor at each
level of labor. The average product of labor curve (AP) has an upside-down U shape.
As the figure shows, the marginal product curve and the average product curve are related: when the marginal product of labor exceeds the average product of labor, the aver-
Chapter 12 . Production and Cost
301
age product of labor increases; when the marginal product of labor is less than the average
product of labor, the average product of labor decreases; and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum.
12.3
Short-Run Cost
Labor
0
Output
0
1
10
2
30
3
36
Fixed
Variable
Average
Average
Average Marginal
cost
cost
Total cost fixed cost variable cost total cost
cost
(dollars) (dollars) (dollars)
(dollars)
(dollars)
(dollars) (dollars)
50
0
50
10.00
50
100
150
5.00
10.00
15.00
5.00
50
200
250
1.66
6.67
8.33
16.67
50
300
350
1.39
8.33
9.72
The table above continues the previous product schedule table and shows different costs.
Total Cost

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost
(TFC) is the cost of the firm’s fixed factors of production—the cost of land, capital, and
entrepreneurship. Total variable cost (TVC) is the cost of the firm’s variable inputs—the
cost of labor. Total cost is the sum of total fixed cost plus total variable cost:
TC = TFC + TVC.
Marginal Cost and Average Costs

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in
output.

Average fixed cost (AFC) is total fixed
cost per unit of output. The value of
AFC falls as output increases.

Average variable cost (AVC) is total
variable costs per unit of output. At low
levels of output, AVC falls as output increases but at higher levels of output,
AVC rises as output increases.

Average total cost (ATC) is the total
cost per unit of output. ATC = AFC +
AVC. At low levels of output, ATC falls
as output increases but at higher levels
of output, ATC rises as output increases.

The figure illustrates typical MC, AFC,
AVC, and ATC curves. As the figure
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302
shows, the MC curve, the AVC curve, and the ATC curve are all U-shaped. There are other additional important points about this figure:
 The vertical distance between the AVC curve and the ATC curve is the AFC. Because
the AFC decreases as output increases, these curves become closer to each other as
output increases.
 The MC curve intersects the AVC curve and ATC curve at their minimums.
Cost Curves and Product Curves

The shape of the cost curves is related to the shape of the productivity curves.
 The shape of the AVC curve is determined by the shape of the AP curve. Over the
range of output for which the AP curve is rising, the AVC curve is falling and over
the range of output for which the AP curve is falling, the AVC curve is rising.
 The shape of the MC curve is determined by the shape of the MP curve. Over the
range of output for which the MP curve is rising, the MC curve is falling and over the
range of output for which the MP curve is falling, the MC curve is rising.
Shifts in the Cost Curves

The cost curves shift with changes in technology or changes in resource prices.
 An increase in technology that allows more output to be produced from the same resources shifts the cost curves downward. If the technology requires more capital, a
fixed input, then the average total cost curve shifts upward at low levels of output
and downward at higher levels of output.
 A fall in the price of the fixed factor of production shifts the AFC and ATC curves
downward but leaves the AVC and MC curves unchanged. A fall in the price of a
variable factor of production shifts the AVC, ATC, and MC curves downward but
leaves the AFC curve unchanged.
12.4
Long-Run Cost
In the long run, a firm can vary the quantity of both labor and capital, so in the long run all costs
are variable costs.
Plant Size and Cost

In the long run, when a firm changes its plant size, its average total cost might rise, fall,
or not change


Economies of scale occur when a firm increases its plant size and labor employed by
the same percentage, its output increases by a larger percentage, so its average total
cost decreases. The main source of economies of scale is greater specialization of both
labor and capital.
Diseconomies of scale occur when a firm increases its plant size and labor employed
by the same percentage, its output increases by a smaller percentage, so its average
total cost increases. Diseconomies of scale arise from the difficulty of coordinating
and controlling a large business.
Chapter 12 . Production and Cost

303
Constant returns to scale occur when a firm increases its plant size and labor employed
by the same percentage, its output increases by the percentage, so its average total cost
does not change.
Long-Run Costs

In the long run, a firm can use different
plant sizes. Each plant size has a different short-run ATC curve. Each short-run
ATC curve is U-shaped and the larger
the plant size, the greater is the output
at which the average total cost is a minimum.

The figure illustrates three average total
cost curves for three plant sizes. ATC1
pertains to the smallest plant size and
ATC3 to the largest.

The long-run average cost curve,
LRAC, is the curve that shows the lowest average total cost at which it is possible to produce each output when the
firm has sufficient time to change both
its plant size and labor employed. This curve is derived from the short-run average total
cost curves. It shows the lowest average total cost to produce a given level of output. In
the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.

The LRAC slopes downward when the firm has economies of scale, is horizontal when
the firm has constant returns to scale, and slopes upward when the firm has diseconomies of scale.
Point out to the students that the long-run average cost curve yields the lowest average cost of
production possible when plant size is free to change. Once a firm commits to a specific plant
size, it is locked into a specific short run cost curve configuration. Any significant departure from
the range of output per period that best suits that configuration means the firm will incur higher
short-run average total costs than it would have had it chosen a more appropriate plant size. If
the firm’s competitors chose their plant size more wisely, the firm might have a tough time surviving! This observation explains why successful firms often spend much money on long run
market analysis.
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 Lecture Launchers
1.
This chapter is incredibly important because it serves as the basis for the
next three chapters. You know this fact, I know this fact, but your students
don’t know this fact. You must tell them this fact because without it you
will definitely lose some of the class. How so? They won’t realize that this
chapter is critical until they are unable to grasp the next three chapters. At
that point, several possibilities exist, all unpleasant: These students flunk
the course, these students drop the course, or these students camp out in
your office. Most likely no one would be happy with any of these outcomes,
so launch your lecture by motivating your students with the important information that Chapter 12 is truly a key to Chapters 13, 14, and 15!
2.
This chapter has a plethora of definitions. Students must learn the definitions, but they are secondary to the concepts they define and the insights
they bring. Focus on why productivity measures and cost measures are useful for decision making. Managers must frequently make quick decisions
with little information. If managers have knowledge of a useful relationship
between input measures and production cost measures they can use their
understanding of this link to make inferences about how production costs
might behave when the firm’s output must change to accommodate market
changes.
3.
This chapter is one more place where an in-class experiment has a huge
payoff and is definitely recommended. The experiment teaches students
about the product curves, and a related assignment that we describe later
teaches them about the short-run cost curves. Allow 30 to 40 minutes for
this production experiment. This experiment motivates the students to go
beyond memorizing the cost and productivity definitions by getting them
directly involved with generating their own data and productivity and cost
measures. This is a fun exercise that will illustrate the concept of diminishing returns to labor, as well as how short run productivity measures and
cost measures are related. Students genuinely enjoy and learn from this exercise, even though it might seem childish. You have two inputs:
Capital: A table (of which the class must have an unobstructed view),
some tear-off scratch pads with about 500 sheets of paper, a fully loaded
stapler, and a back-up stapler (also fully loaded).
Labor: Provided by your students.
The capital and labor are used to produce “widgets.” A widget is a piece
of paper, torn from a pad, folded twice very carefully so that the corners of
the paper align, and stapled. The first fold bisects the paper along its long
side and the second fold is at right angles to the first. Once folded, a staple
Chapter 12 . Production and Cost
is used to hold the folds in place. A widget is fragile and breaks if it falls off
the table.
Start the experiment by hiring a manager from your class and appointing
an auditor. Get the manager to hire a quality controller, an accountant, and
some workers. Tell the manager that he or she must produce widgets as efficiently as possible and that he or she can discuss the process with his
workers and with the class.
Start the experiment by defining that a day lasts for 1 minute. Get the
class to keep time. On day 1, have 1 worker produce widgets. On day 2,
have 2 workers, and so on. You’ll probably run for 10 to 12 days before you
get to almost zero marginal product. Record the inputs and outputs in a table on the board. Have some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and partly made widgets
don’t get used in a subsequent day. Each day must start clean.
Now comes the assignment (Stage 1): Get the students to calculate marginal
product and average product from the total product numbers that you’re
recorded on the board. Get them to make graphs of the total product, marginal product, and average product curves. Get them to describe the curves
and to explain their similarities with and differences to the curves for
smoothies in the textbook.
The first assignment covers only production. If you want, you can extend
the experiment with another assignment (Stage 2): Use the data from your
widget production experiment. Tell the students the cost of the capital and
the wage rate of a worker. (Make up the numbers. Any will do.) Tell the
students to calculate total cost, marginal cost, and average cost. Get them to
make graphs of the total cost, marginal cost, and average cost curves. Get
them to describe the curves and to explain their similarities with and differences to the curves for smoothies in the textbook. This assignment and the
previous one make an outstanding assignment for credit or extra credit.
4.
Though perhaps this suggestion is more of a lecture closer than launcher, be
sure that your students see the big picture. There are two big ideas:
First, a firm’s long-run production costs depend on the freedom to choose
all inputs. Long-run flexibility enables firms to produce at a lower cost than
is possible in the short run when some inputs are fixed.
Second, in the short run, with one or more fixed inputs, production costs
vary with output in a predictable way because they are directly linked to input
productivity.
 Land Mines
1.
If you do not create your own data using the experiment described above,
be sure that when you draw the curves in this chapter you use numeric ex-
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Part 4 . A CLOSER LOOK AT DECISION MAKERS
amples. Either make up your own numbers or use the table the text provides, but make sure to provide your students with two things: a preprinted table with the columns labeled (but not filled in) and preprinted
handouts with graphs on which the axes are labeled. If you can, draw the
points (not the actual curves) on the graphs that will correspond to the data
in the tables.
The table should provide a complete spreadsheet, with labor employment, capital employment, output, AP, MP, TC, TFC, TVC, ATC, AFC, AVC,
and MC. Work through the first part of the table (capital and labor inputs,
output, fixed, variable and total costs). Label and draw these graphs. Then
turn back to the table, completing the data for the average and marginal
cost columns. Finally draw and explain the graphs that relate to these data.
This exercise allows students to listen to the intuition and follow the example without being distracted trying to get the layout of the table and graphs
correct. You’ll also be able to cover more material this way because you
won’t be waiting for students to catch up.
2.
Watch out for persistent confusion between economic profit and accounting
profit. You can avoid some of this by thoroughly drilling them in opportunity cost, so that they understand that non-money cost is still cost.
3.
Students are introduced to more graphs in this chapter. When summing up
the day’s lecture, the clearest way to show the differences (especially with
respect to the variables on the axes) is to graph each of the curves on the
board at the same time. Suggest that students practice graphing each of the
curves many times noting the maximum points, minimum points, and intersections. Tell your students that it is important to draw the ATC curve
and MC curve correctly, that is, so that the MC curve intersects the ATC
curve when the ATC is at its minimum.
4.
Distinguish between decreasing marginal product in the short run versus
diseconomies of scale in the long run. Decreasing returns occur when additional units of labor are combined with a fixed amount of capital. Diseconomies of scale do not occur for the same reason, because in the long run
both labor and capital can change. Diseconomies of scale occur because of
chaos, organizational overloads, etc.
5.
The grade point average versus marginal grade example in the text is outstanding to use in class to describe how the marginal product and marginal
cost curves relate to the average product and average cost curves. Once
students can tell a story using the same intuition, they find drawing those
curves much easier. While you have the curves drawn on the board or
overhead, physically pull the average cost curves down (while marginal
cost is below) or pull them up (when the marginal cost curve rises above).
Use theatrics: raise your hands over your head and “pull down the curves.”
Chapter 12 . Production and Cost
If you have a more sports-oriented class, you can try using a batting average percentage and at-bat outcome example (if you had a .300 batting average and you struck out at your next at-bat [the marginal factor], your batting average is pulled down).
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Part 4 . A CLOSER LOOK AT DECISION MAKERS
ANSWERS TO CHECKPOINT EXERCISES
 CHECKPOINT 12.1 Economic Cost and Profit
1a. Explicit costs are the $1,500 for the lease of a Web server and $1,750 for
high-speed Internet service. The total explicit costs are $3,250.
The implicit costs are the $20,000 in wages forgone, the $4,000 in rent forgone, the $100 in forgone interest payments on the savings, the $55,000 in
normal profit, and the $1,500 in economic depreciation for the computer.
The total implicit costs are $80,600.
1b. The economic profit equals total revenue minus total opportunity costs,
which is $45,000  ($3,250 + $80,600) = $38,850. Toni incurred an economic
loss of $38,850 for the year.
 CHECKPOINT 12.2 Short-Run Production
1a. The marginal product of the fourth student is the change in total product
that results from hiring the fourth student. The total product with 3 students is 9 houses painted a week and the total product with 4 students is 12
houses painted a week. So the marginal product of the fourth student is 12
houses painted a week minus 9 houses painted a week, which equals 3
houses painted a week.
1b. The average product equals total product divided by the number of students. When 4 students are hired, average product is 12 houses painted a
week divided by 4 students, which equals 3 houses painted a week.
1c. The marginal product decreases between 4 and 6 students.
1d. When the marginal product, though decreasing, exceeds the average product the average product increases as more workers are hired. Eventually as
the marginal product decreases it becomes less than the average product.
When the marginal product is less than the average product, the average
product decreases as more workers are hired.
 CHECKPOINT 12.3 Short-Run Cost
1a. Assuming
a 5-day
workweek, the total
cost schedules are in
the table to the right.
Output
Total
Total
(houses
fixed cost variable cost Total cost
Labor
painted
(dollars
(dollars
(dollars
(students) per week) per week) per week) per week)
0
0
500
0
500
1
2
500
250
750
2
5
500
500
1,000
3
9
500
750
1,250
4
12
500
1,000
1,500
5
14
500
1,250
1,750
6
15
500
1,500
2,000
Chapter 12 . Production and Cost
b.
The
average
cost
schedules are in the table to the right.
309
Output
Average
Average
Average
(houses
fixed cost variable cost total cost
Labor
painted (dollars per (dollars per (dollars per
(students) per week)
house)
house)
house)
0
0
xx
xx
xx
1
2
250.00
125.00
375.00
2
5
100.00
100.00
200.00
3
9
55.56
83.33
138.89
4
12
41.67
83.33
125.00
5
14
35.71
89.29
125.00
6
15
33.33
100.00
133.33
c.
The marginal cost schedule is in the table to the
right.
d. The difference between the total cost and total
variable cost is the same at all levels of output
and is equal to total fixed cost. This difference is
always equal to the total fixed cost because total
cost equals total variable cost plus total fixed
cost.
Labor
(students)
0
1
2
3
4
5
6
Output
Marginal
(houses
cost
painted (dollars per
per week)
house)
0
125.00
2
83.33
5
62.50
9
83.33
12
125.00
14
250.00
15
 CHECKPOINT 12.4 Long-Run Cost
a.
b.
If Lizzie doubles her inputs, and her output less than doubles, Lisa experiences diseconomies of scale. Average total cost rises so that her long-run
average cost curve slopes upward.
The source of her diseconomies of scale could be management problems
when she hires more students and leases more equipment. Trying to organize more equipment and more students across different houses in different
areas of the town requires more communication and coordination. If she is
unable to manage the larger firm as efficiently as she was able to manage
the smaller firm, her average total cost increases.
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Part 4 . A CLOSER LOOK AT DECISION MAKERS
ANSWERS TO CHAPTER CHECKPOINT EXERCISES
1a. Joe’s explicit costs are $2,000 rent he pays the airport and $200 in interest he
pays on his credit card. So Joe’s total explicit costs are $2,200.
1b. Joe’s implicit costs are $10,000 of normal profit for running a shoeshine
stand and $500 depreciation for his capital equipment, the chair, polishes,
and brushes. So Joe’s total implicit costs are $10,500.
1c. Joe’s economic profit equals his total revenue minus his total opportunity
costs. Joe’s total revenue is $15,000. His total opportunity costs are the sum
of his explicit costs, $2,200, and his implicit costs, $10,500. Joe’s total opportunity costs are $12,700 so his economic profit is $15,000 minus $12,700,
which is $2,300.
2a. Sonya’s explicit costs are $10,000 for cards, $5,000 for rent, and $1,000 for
utilities. So Sonya’s explicit costs are $16,000.
2b. Sonya’s implicit costs are $25,000 in forgone income as a real estate agent,
$14,000 normal profit, $60 in forgone interest, and $400 in economic depreciation on the cash register, for a total of $39,460.
2c. Sonya’s economic profit equals her total revenue, $58,000, minus her total
opportunity costs or $55,640, which is the sum of her explicit and implicit
costs. Sonya’s economic profit is
Total
Average
Marginal
$58,000  $55,640, which equals
Labor
product
product
product
$2,360.
0
0
xx
20
3a. The marginal product and average
1
20
20.0
product schedules are in the table to
24
the right.
2
44
22.0
16
3
60
20.0
12
4
72
18.0
8
5
80
16.0
4
6
84
14.0
2
7
86
12.3
3b. Marginal returns increase for the first 2 workers.
3c. Marginal returns decrease after the second worker is hired.
Chapter 12 . Production and Cost
4a. The table to the right has Yolanda’s
total product, marginal product, and
average product schedules.
4b. Marginal returns increase for the 2nd
and 3rd workers.
4c. After the third worker is hired, marginal returns decrease.
5a. The variable costs are the
costs of labor; the fixed costs
are the costs of the shaping
board equipment. Assuming
a 5-day work week, the total
cost schedules per day are in
the table to right.
311
Labor
0
Total
product
0
Average
product
xx
1
1,000
1,000
2
2,000
1,000
3
4,000
1,333
4
5,000
1,250
Marginal
product
1,000
1,000
2,000
1,000
Total
Total
Total
Total
product
fixed cost variable cost cost
Labor (body boards) (dollars)
(dollars) (dollars)
0
0
60
0
60
1
20
60
200
260
2
44
60
400
460
3
60
60
600
660
4
72
60
800
860
5
80
60
1,000
1,060
6
84
60
1,200
1,260
7
86
60
1,4000
1,460
5b. Total cost minus total variable cost always equals $60. The difference between total cost and total variable cost equals total fixed cost, which does
not change with the
Total
Average
Average
level of output.
product
fixed
cost
variable
cost
5c. The average cost
Labor (body boards) (dollars)
(dollars)
schedules are in the
0
0
xx
xx
table to the right.
1
20
3.00
10.00
2
3
4
5
6
7
44
60
72
80
84
86
1.36
1.00
.83
.75
.71
.70
9.09
10.00
11.11
12.50
14.29
16.28
Average
total cost
(dollars)
xx
13.00
10.45
11.00
11.94
13.25
15.00
16.98
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Part 4 . A CLOSER LOOK AT DECISION MAKERS
Total
Marginal
5d. The marginal cost schedule is in the table to the right.
Labor
product
cost
5e. Len’s average total cost is at a minimum between 44
0
0
and 60 body boards a day.
10.00
5f. Len’s average variable cost is at a minimum between
1
20
8.33
44 and 60 body boards a day.
2
44
5g. Though the range of output over which the minimum
12.50
average total cost and average variable cost occur is
3
60
16.67
the same, we know that the average variable cost
4
72
equals its minimum at a lower level of output than
25.00
the average total cost. The average total cost equals
5
80
50.00
the average variable cost plus the average fixed cost.
6
84
The average fixed cost constantly falls as output in100.00
creases. So as output increases after the average vari7
86
able cost reaches a minimum and starts to rise, the
average total cost continues to fall for a while because
the average fixed cost falls and this fall dominates the rise in the average
variable cost. Eventually the rise in the average variable cost is greater than
the fall in the average fixed cost and at that level of output, the average total
cost begins to rise as output increases.
6a. The variable costs are the
Total
Total
Total
costs of labor; the fixed costs
Labor
Output fixed cost variable cost
cost
are the costs of the equip0
0
1,000
0
1,000
1
1,000
1,000
500
1,500
ment. The total cost sched2
2,000
1,000
1,000
2,000
ules are in the table to right.
3
4,000
1,000
1,500
2,500
6b. Total cost minus total varia4
5,000
1,000
2,000
3,000
ble cost always equals
$1,000. The difference between total cost and total variable cost equals total fixed cost, which does
not change with the level
Average
Average
Average
of output.
Labor
Output fixed cost variable cost total cost
6c. The average cost sched0
0
xx
xx
xx
1
1,000
1.00
.50
1.50
ules are in the table to the
2
2,000
.50
.50
1.00
right.
3
4,000
.25
.38
.63
4
5,000
.20
.40
.60
Chapter 12 . Production and Cost
313
6d. The marginal cost schedule is in the table to the right.
Marginal
6e. From the numbers in the average cost table, YolanLabor
Output
cost
da’s average total cost is at a minimum when she
0
0
.50
produces 5,000 bullfrogs a week.
1
1,000
6f. Yolanda’s average variable cost is at a minimum
.50
when she produces 4,000 bullfrogs a week.
2
2,000
.25
6g. Average total cost equals average variable cost plus
3
4,000
.50
average fixed cost. Average fixed cost constantly falls
5
5,000
as output increases. So as output increases after average variable cost reaches a minimum and starts to
rise, average total cost continues to fall for a while because average fixed cost falls and this fall dominates the rise in average variable cost. Eventually, the rise in average variable cost is greater than the
fall in average fixed cost and at that level of output, average total cost begins to rise as output increases.
7.
The completed table
L
TP
TVC
TC
AFC
AVC
ATC
MC
is to the right.
0
0
0
100
xx
xx
xx
13.50
1
10
35
135
10.00
3.50
13.50
2.50
2
24
70
170
4.17
2.91
7.08
2.50
3
38
105
205
2.63
2.76
5.39
5.83
4
44
140
240
2.27
3.18
5.45
11.67
5
47
175
275
2.13
3.72
5.85
8.
9.
A = $1,050. Calculate A using TVC = TC  TFC. Total cost is given in the
row. For total fixed cost, TFC, note that TFC = TC  TVC. Use the information in the top row to get TFC = $500. So A = $1,550  $500, which
equals $1,050.
B = $1,200. Calculate B by adding TVC + TFC, with TFC from part (a) as
$500. Then B = $700 + $500, which equals $1,200.
C = $5. Calculate C by calculating TFC  TP, which is $500  100 = $5.
D = $8.50. Calculate D by calculating TC  TP, which is $850  100= $8.50.
E = $2.50. Calculate E as the change in TC divided by the change in TP,
which is ($1,550  $1,200)  (380  240) = $2.50.
The long-run average cost curve, LRAC, shows the lowest average total
cost of producing any level of output when the firm has had sufficient
time to change both its plant size and labor employed. To construct the
314
Part 4 . A CLOSER LOOK AT DECISION MAKERS
LRAC curve, calculate the ATC curve for each plant size. The ATC that is
the lowest for each level of output is the LRAC for that level of output.
10.
A firm that is producing at the lowest average cost might be able to lower its average
cost further by increasing its production.
Figure 12.1 shows an example. If the firm is
producing at point A, the firm can increase
its production by hiring more labor and increasing the size of its plant and move to
point B. At point B the average cost is lower
than at point A. Between point A and point
B, the firm enjoys economies of scale.
11.
The sources of economies to scale are specialization of labor and capital. The sources
of diseconomies of scale are difficulties of
management coordination and communication. In Figure 12.2, economies of scale occur
up to point A, 45,000 units of output a day,
because the long-run average cost (generally) falls as output increases. Diseconomies of
scale occur at output levels greater than
45,000 units a day because the long-run average cost (generally) rises as output increases.
12.
Your students’ answers will differ, but economies of scale occur in industries that are high tech and in agriculture. High tech industries, such as
Chapter 12 . Production and Cost
server farms, can service thousands of customers in one location. The ATM
example in the book provides a good example.
In agriculture, large, commercial farms can hire many workers to specialize
in the many specific tasks that are required. For instance, on a dairy farm
many tasks are required: breeding cows, growing feed, milking, selling, and
delivering milk. A large corporate farm can hire specialists for all these
tasks, versus a single farmer trying to do all of the jobs on a farm.
13.
Your students’ answers will differ from these answers. Diseconomies of
scale probably occur in large conglomerate companies such as General Electric, Tyco, or TimeWarner. Managing these types of companies is very
complex because the different business often can have little in common. For
example, General Electric produces light bulbs, locomotives, and CNBC.
Management is already struggling to run these disparate divisions, so if the
company increases still more in size, it is probable that the added complexity results in average cost rising.
Diseconomies of scale also occur in the electricity industry. We see electrical
utilities buying electricity from other suppliers during extreme weather that
occurs infrequently. If the utility had built a plant to meet demand on these
very cold or very hot days, it would experience diseconomies of scale. As a
result, the utility uses a smaller plant size that minimizes average total cost
on normal days (the vast majority of days), but it must buy additional power during extreme weather.
315
316
Part 4 . A CLOSER LOOK AT DECISION MAKERS
 Critical Thinking
14.
The cost of the fiber-optic system is a long-run cost. It also is a sunk cost.
It is a sunk cost because it has already been paid.
15a.
The cost of the human teller is primarily the cost of labor, a variable cost,
with only a slight amount of capital cost. The cost of the ATM is primarily
the cost of the capital, a fixed cost, with only a small amount of labor cost.
So the cost of an ATM shows substantial economies of scale whereas the
cost of a human teller reaches its minimum at a lower scale of transactions and then starts to rise.
As long as the bank forecasts a reasonably large number of transactions at
a location, with the low cost of an ATM, it makes sense for the bank to locate an ATM at that location.
Branches of banks that are located in very small towns and that have relatively few customers will not have ATMs.
For two reasons, ATMs are not as common in China as in the United
States. First, the cost of capital is higher in China and the cost of labor is
lower. So, ATMs do not enjoy as large a cost advantage in China as they
do in the United States. Second, the demand for bank services is lower in
China than in the United States. So, ATMs are less likely to achieve the
large scale of transactions necessary for them to be less expensive than
human tellers.
15b.
15c.
15d.
16a.
16b.
The cost of using human tellers does not change. The cost of using ATMs
increases, so the average total cost curve for ATMs shifts upward.
The tax increases the scale at which it is less expensive to use an ATM
instead of a human teller. As a result, banks hire more human tellers and
create fewer ATMs.
Chapter 12 . Production and Cost
 Web Exercises
17a. The marginal cost of growing larger frogs probably increases because the
price of larger frogs exceeds the price of smaller frogs. The marginal cost of
growing additional numbers of similar sized frogs does not appear to increase because any number of similar sized frogs can be purchased for the
same price.
17b. A firm’s cost and production curves are such that when the marginal cost is
increasing, then the marginal product is decreasing. Because the marginal
cost of growing larger frogs seems to be increasing, then bull frog farming
displays decreasing marginal returns.
17c. For some people, the value from a larger frog is worth the additional cost
over a smaller frog. Depending on what the consumer does with the bull
frog, larger frogs might have significantly better survival rates (though, of
course, all frogs croak in the end), might be able to jump farther, or might
have noticeably more meat on their legs.
18a. The survivor technique measures economies of scale over the long run by
observing the evolution of the surviving firms. If surviving firms grow over
time while small firms decline, then economies of scale must be present.
18b. The survivor technique works because firms whose costs are higher than
others do not survive—they go bankrupt or are purchased by survivors.
18c. These survivor technique indicates that significant economies of scale exist
in the banking industry and that economies of scale are available at low asset levels. Banks with assets of $300 million or more appear to have a cost
advantage over smaller banks.
18d. Figure 12.3 illustrates a long-run average cost
that is consistent with what is found using the
survivor technique.
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318
Part 4 . A CLOSER LOOK AT DECISION MAKERS
19a. The costs fall into 5 categories: 1) land preparation; 2) planting;
3) fertilization; 4) fungicide-insecticide applications; and, 5) harvest costs.
Details of what these costs include are in answer (b) below.
19b. The issue of what is a fixed cost and what is a variable cost depends on
when the costs are being considered, so your students’ answers might vary.
Assume we are studying a farmer who, in the spring, is determining what
to grow on an acre of soil. So the farmer has already prepared the ground
but has not yet purchased any seed. In this case, the land preparation cost,
$72.36 an acre, is a fixed cost; the planting cost, $313.38 an acre and which
includes the seed and actual planting, is a variable cost; the fertilization
cost, $166 an acre, is a variable cost; the pest control cost, $744.85 per acre, is
a variable cost; and, the harvesting cost, $291 an acre, is a variable cost. Any
cost to rent the land is a fixed cost and was not specifically given on the
web page.
19c. Your students’ answers will vary, depending
on the assumptions they make. The web page
mentions 5 ton, 8 ton, and 10 ton crops. The assumption I make is that if the farmer does not
fertilize or spray, the harvest is 5 tons; if the
farmer fertilizes 1/3 the recommended amount
and does 1/3 the recommended spraying, the
harvest is 8 tons; and if the farmer fertilizes the
recommended amount and does all the recommended spraying, the harvest is 10 tons.
With these assumptions, for 5 tons, TFC is $72,
TVC is $604, TC is $676, AFC is $14, AVC is
$121, and ATC is $135. For 8 tons, TFC is $72,
TVC is $907, TC is $979, AFC is $9, AVC is $113,
and ATC is $122. For 10 tons, TFC is $72, TVC
is $1,513, TC is $1,585, AFC is $7, AVC is $151,
and ATC is $158. The MC between 5 and 8 tons
is $101 a ton and between 8 and 10 tons is
$303. These data are illustrated in Figure 12.4.
19d. The minimum point on the AVC curve is at about 7 tons of pumpkins and
the minimum point on the ATC curve is at about 8 tons of pumpkins.
Chapter 12 . Production and Cost
319
ADDITIONAL EXERCISES FOR ASSIGNMENT
 Questions
 CHECKPOINT 12.1 Economic Cost and Profit
1. In 2005, Roma was a schoolteacher and earned $40,000. But she enjoys creating cartoons, so at the beginning of 2006, Roma quit teaching and set to
work as a cartoonist. She stopped renting out her basement for $5,000 a
year and began to use it as her office. She used $5,000 from her savings account to buy a new computer, and she leased a printer for $150 a year. During 2006, Roma paid $1,250 for paper, utilities, and postage; the bank paid 5
percent a year on savings account balances; and Roma sold $50,000 of cartoons. Normal profit is $3,000 a year. At the end of 2006, Roma was offered
$4,000 for her computer. For 2006, calculate Roma's:
1a. Explicit costs.
1b. Implicit costs.
1c. Economic profit.
 CHECKPOINT 12.2 Short-Run Production
2. Lisa has a lawn-mowing business. Lisa hires
Labor
Total product
students to mow the lawns. The table sets out
(students per day) lawns cut per day)
0
0
Lisa's total product schedule.
1
20
2a. Calculate the marginal product of the fourth
2
44
student.
3
70
2b. Calculate the average product of four stu4
94
dents.
5
114
6
120
2c. Over what numbers of students does marginal product decrease?
2d. When marginal product decreases, compare average product and marginal
product.
3.
Create some hypothetical short-run production data for a firm’s labor employment and output. Calculate the firm’s average product and marginal
product schedule. Carefully graph the data. What happens at the minimum
of the average product curve?
 CHECKPOINT 12.3 Short-Run Cost
4. Lisa has a lawn-mowing business. Lisa hires
students at $40 a day to mow lawns. Lisa
leases 5 lawn mowers for $200 a day. The table gives the daily output.
4a. Construct the total variable cost and total
cost schedules.
Labor
Total product
(students per day) (lawns cut per day)
0
0
1
. 20
2
44
3
70
4
94
5
114
6
120
320
Part 4 . A CLOSER LOOK AT DECISION MAKERS
4b. Construct the average fixed cost, average variable cost, and average total
cost schedules.
4c. Construct the marginal cost schedule.
4d. Check that the gap between total cost and total variable cost is the same at
all outputs. Explain why.
5.
Create hypothetical short-run production data for a firm’s labor employment, amount of capital, and output. Select wages and the cost of the capital and then calculate the total cost, marginal cost, average fixed cost, average variable cost, and average total cost schedules and curves.
 Answers
 CHECKPOINT 12.1 Economic Cost and Profit
1a. Explicit costs are the $150 printer lease and $1,250 for paper, utilities, and
postage. So explicit costs are $1,400.
1b. Implicit costs are $40,000 in wages forgone, $5,000 in rent forgone, $3,000 in
normal profit, $250 in forgone interest payments on the savings, and $1,000
in economic depreciation on the computer. So implicit costs are $49,250.
1c. Economic profit equals total revenue minus total opportunity cost, which is
the sum of the explicit costs and implicit costs. So Roma’ economic profit is
$50,000  ($1,400 + $49,250), which equals $650. Roma incurs an economic
loss of $650 for the year.
 CHECKPOINT 12.2 Short-Run Production
2a. The total product with 3 workers is 70 lawns mowed and the total product
with 4 workers is 94 lawns mowed. So, the marginal product of the fourth
student is 24 lawns.
2b. The average product of four students is (94 lawns)  (4 students), which is
23.5 lawns.
2c. The marginal product decreases between 4 and 6 students.
2d. When marginal product decreases, eventually it become less than average
product. Before it is less than average product (that is, when marginal
product, though decreasing, exceeds average product) average product increases as more workers are hired. When marginal product is less than average product, average product decreases as more workers are hired.
3.
Students will have individual answers. Make sure their average product
curve is U-shaped and that the marginal product curve intersects the average product curve at the minimum of the average product curve. Also
make sure that the axes are labeled correctly.
Chapter 12 . Production and Cost
 CHECKPOINT 12.3 Short-Run Cost
4a. The total costs are in the table
to the right.
Labor
0
1
2
3
4
5
6
4b. The average costs are
in the table to the
right.
Labor
0
1
2
3
4
5
6
Output
0
20
44
70
94
114
120
Output
0
20
44
70
94
114
120
Average
fixed cost
xx
10.00
4.55
2.86
2.13
1.75
1.67
4c. The marginal cost is in the table to the right.
4d. The gap between total cost and total variable cost is
the same at all levels of output because total cost
minus total variable cost equals total fixed cost.
Note in the answer to part (a), that the difference between total variable cost and total cost is always
$200, the amount of total fixed cost.
5.
Total
fixed cost
200
200
200
200
200
200
200
321
Total
variable cost
0
40
80
120
160
200
240
Average
variable cost
xx
2.00
1.82
1.71
1.70
1.75
2.00
Labor
0
Output
0
1
20
2
44
3
70
4
94
5
114
6
120
Students will have individual answers. Make sure
graphs and axes are labeled correctly. By generating their own data, students learn the interaction of output and different costs.
Total
cost
200
240
280
320
360
400
440
Average
total cost
xx
12.00
6.37
4.57
3.83
3.50
3.67
Marginal
cost
2.00
1.67
1.54
1.67
2.00
6.67
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Part 4 . A CLOSER LOOK AT DECISION MAKERS
USING EYE ON THE U.S. ECONOMY
 The ATM and the Cost of Getting Cash
The article provides interesting data and ATC curves for ATMs. The story and
curves clearly show why large banks do a lot of their business via ATMs as a result of a large customer base. Smaller banks, on the other hand, face a small client
base and so it is not efficient (cost-effective) for them to provide ATMs to this
small number. It is cheaper for the small banks to use tellers.
Ask your students if they think that smaller banks and credit unions would
be less likely to charge their own customers for using other banks’ ATM machines. You can conduct a quick poll of the class to determine if any of the students have actual experience with this question. The point is that by not charging
its customers for using other bank’s ATMs, the smaller bank can increase its scale
without having to actually change its plant size. The answer to the question depends, in part, on the charges the smaller bank has to pay to allow its customers
to be part of the larger network.