Chapter 12
Production and Cost
12.1 Economic Cost and Profit
1) Jake opens a pig farm in Idaho. To start his farm, he uses his entire $50,000 of savings from
his savings account. The bank was paying him $2,500 interest on his saving. Explain why
the $2,500 is one of Jake's costs.
Answer: When Jake provides the $50,000 to finance his farm's operations, he forgoes the
$2,500 in interest. Thus the opportunity cost of the $50,000 is the interest income
forgone and so the $2,500 is an implicit cost of running the farm.
Topic: Implicit cost
Skill: Level 2: Using definitions
Objective: Checkpoint 12.1
Author: PH
2) What is a normal profit? Is it part of the firm's opportunity costs, total revenue, or neither?
Answer: The normal profit is the return to entrepreneurship. It is part of the firm's
opportunity costs.
Topic: Normal profit
Skill: Level 2: Using definitions
Objective: Checkpoint 12.1
Author: SB
3) What is the difference between a normal profit and an economic profit?
Answer: A normal profit is the return to entrepreneurship and is part of the opportunity cost
of operating a business. An economic profit is the difference between the firm's total
revenue and its total opportunity cost. Because the normal profit is part of the firm's
opportunity cost, an economic profit is a profit above and beyond a normal profit. If
the firm earns an economic profit, the entrepreneur running the firm receives the
normal profit plus the economic profit.
Topic: Economic profit
Skill: Level 2: Using definitions
Objective: Checkpoint 12.1
Author: MR
240
Bade/Parkin œ Foundations of Economics, Third Edition
4) Professor Rush decided to quit teaching economics and opens a shoe store out at the mall.
He gave up an annual income of $50,000 to open the store. A year after opening the shoe
store, the total revenue for the year was $200,000. Rush's expenses were $30,000 for labor,
rent was $18,000, and utilities were $1,200. He also had to purchase new shoes from
manufacturers, at a cost of $60,000, which was financed by cashing in his savings of $60,000
that had been in a bank earning 8 percent per year. The normal profit from operating a shoe
store in the mall is $20,000. Determine Professor Rush's explicit costs, implicit costs, and
economic profit.
Answer: The explicit costs are the cost of labor, the rent, the utilities, and the cost of the shoes.
Thus the explicit cost equals $30,000 + $18,000 + $1,200 + $60,000 = $109,200. The
implicit costs are the forgone income from the job he quit, the forgone interest, and
the normal profit. The forgone interest is (8 percent) ˛ ($60,000) = $4,800, so the total
implicit costs equals $50,000 + $4,800 + $20,000 = $74,800. The economic profit equals
the total revenue minus the total opportunity cost and the total opportunity cost
equals the sum of the explicit and implicit costs. Therefore the total opportunity cost
is $109,200 + $74,800 = $184,000. Thus the economic profit = $200,000 - $184,000 =
$16,000.
Topic: Costs and economic profit
Skill: Level 3: Using models
Objective: Checkpoint 12.1
Author: TS
5) Jessica is a young doctor who has just started her own practice. Her previous position paid
her $80,000 a year. For office space, she uses a building which she owns and which she has
rented in the past for $40,000 a year. Her total revenue from her new practice is $250,000.
She pays $50,000 to other firms for materials and supplies, and she pays $40,000 in wages to
her office nurse. Assume that Jessica's building and equipment do not depreciate and that
her normal profit is $20,000.
a. Which of Jessica's costs are explicit costs and what is their total?
b. Which of Jessica's costs are implicit costs and what is their total?
c. What is the opportunity cost of all factors of production employed by Jessica?
d. What is Jessica's economic profit?
Answer: a. Jessica's explicit costs are the wages and the amount she paid to other firms for
material and supplies. Hence her explicit costs equal $40,000 + $50,000 = $90,000.
b. Jessica's implicit costs are her forgone wages, the forgone rent on her building,
and her normal profit. Hence her implicit costs equal $80,000 + $40,000 + $20,000 =
$140,000.
c. The opportunity cost equals the sum of explicit costs plus implicit costs, so
Jessica's opportunity cost equals $90,000 + $140,000 = $230,000.
d. Economic profit equals total revenue minus total opportunity cost, or $250,000 $230,000 = $20,000.
Topic: Costs and economic profit
Skill: Level 3: Using models
Objective: Checkpoint 12.1
Author: SB
Chapter 12 Production and Cost
241
12.2 Short-Run Production
1) What resources can a firm change in the short run? In the long run?
Answer: In the short run, the firm can change its variable inputs. These would be inputs such
as labor. The firm cannot change its fixed inputs, such as its capital stock. The inputs
the firm cannot change are called its plant. In the long run, the firm can change all of
its inputs. Indeed, the long run is defined as the period of time long enough so that
the firm can change all of its inputs.
Topic: Short run and long run
Skill: Level 2: Using definitions
Objective: Checkpoint 12.2
Author: WM
2) What do economists mean when they say that a firm's plant is fixed?
Answer: The phrase that a "firm's plant is fixed" refers to the fact that, in the short run, there
are some resources that are fixed, that is, the quantity employed cannot be changed.
These resources, which include factors such as the firm's capital, are collectively
referred to as the firm's plant.
Topic: Short run, plant
Skill: Level 1: Definition
Objective: Checkpoint 12.2
Author: SB
3) What is the difference between decreasing marginal returns and negative marginal returns?
Answer: Decreasing marginal returns occur when the marginal product of an additional
worker is less than the marginal product of the previous worker. In this case, if the
marginal product of the new worker is positive, the additional worker adds to total
product, but adds less than did the previous worker. Negative marginal returns
occurs when an additional worker actually decreases total product.
Topic: Marginal returns
Skill: Level 2: Using definitions
Objective: Checkpoint 12.2
Author: CD
4) What does the average product of labor equal?
Answer: The average product of labor equals the total product (the total output) divided by
the quantity of labor.
Topic: Average product
Skill: Level 1: Definition
Objective: Checkpoint 12.2
Author: PH
242
Bade/Parkin œ Foundations of Economics, Third Edition
5) "If the marginal product of labor curve slopes downward, then the average product of labor
curve necessarily must slope downward." Explain whether the previous statement is correct
or incorrect?
Answer: The statement is incorrect. The relationship between the marginal product and
average product of labor is that when the marginal product of labor exceeds the
average product of labor, the average product of labor curve slopes upward and
when the marginal product of labor is less than the average product of labor, the
average product of labor curve slopes downward. So, even if the marginal product of
labor curve slopes downward, as long as it is above the average product of labor
curve, the average product of labor curve slopes upward.
Topic: Marginal product and average product
Skill: Level 2: Using definitions
Objective: Checkpoint 12.2
Author: JC
Chapter 12 Production and Cost
Quantity of labor
(workers)
0
1
2
3
4
5
Total product
(lawns mowed
per day)
0
3
8
15
20
21
6) The above table has the total product schedule for Jesse's Lawn Service.
a. In the figure, label the axes and then graph the total product curve.
b. Find the average product for the different amounts of employment.
243
244
Bade/Parkin œ Foundations of Economics, Third Edition
Answer:
a. The figure graphs the total product curve.
b. The average product when 1 worker is employed is 3 lawns mowed per day;
when 2 workers are employed, it is 4 lawns per day; when 3 workers are employed,
it is 5 lawns per day; when 4 workers are employed, it is 5 lawns per day; and when
5 workers are employed, it is 4.2 lawns per day.
Topic: Total product
Skill: Level 3: Using models
Objective: Checkpoint 12.2
Author: SB
Chapter 12 Production and Cost
Quantity of labor Total
(workers)
product
0
0
1
24
2
50
3
74
4
94
5
110
6
122
7
130
8
134
9
134
Average
product
xx
___
___
___
___
___
___
___
___
___
245
Marginal
product
___
___
___
___
___
___
___
___
___
___
7) Ajax Manufacturing has a fixed scale of plant with the levels of total product given in the
table for different levels of labor. Complete the table by calculating the average product and
marginal product.
Answer:
Quantity of labor Total
(workers)
product
0
0
1
24
2
50
3
74
4
94
5
110
6
122
7
130
8
134
9
134
The completed table is above.
Topic: Short-run production
Skill: Level 3: Using models
Objective: Checkpoint 12.2
Author: TS
Average
product
xx
24.0
25.0
24.7
23.5
22.0
20.3
18.6
16.8
14.9
Marginal
product
24
26
24
20
16
12
8
4
0
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Bade/Parkin œ Foundations of Economics, Third Edition
Quantity of labor
Total product
(workers)
(hair stylings per day)
0
0
1
10
2
25
3
45
4
60
5
70
8) The above table shows the total product schedule for Hair Today, a hair styling salon.
a. What is the first worker's marginal product? The second worker? The third worker?
The fourth worker? The fifth worker?
b. Over what range of workers is there increasing marginal returns? Over what range is
there decreasing marginal returns?
Answer: a. The first worker's marginal product is 10 hair stylings. The second worker's
marginal product is 15 hair stylings. The third worker's marginal product is 20 hair
stylings. The fourth worker's marginal product is 15 hair stylings. The fifth worker's
marginal product is 10 hair stylings.
b. There are increasing marginal returns for the first 3 workers. After the third
worker, there are decreasing marginal returns.
Topic: Marginal product
Skill: Level 3: Using models
Objective: Checkpoint 12.2
Author: WM
12.3 Short-Run Cost
1) Jake is a corn farmer in Nebraska. He rents his land on a long-term lease for $250,000 a
year. He pays his farm hands $128,000 a year. Is his rent a fixed cost or a variable cost? Are
the wages he pays his workers a fixed cost or a variable cost? Briefly explain your answers.
Answer: Jake's rent is a fixed cost. He is renting his land on a long-term lease and so the land
is a fixed input. The wages Jake pays are a variable cost. Labor is a variable input so
the wages are a variable cost.
Topic: Fixed cost, variable cost
Skill: Level 2: Using definitions
Objective: Checkpoint 12.3
Author: JC
Chapter 12 Production and Cost
247
2) "In the short run, even when output is zero, the firm still has some variable costs it must
pay." Is the statement correct or incorrect? Briefly explain your answer.
Answer: The statement is incorrect. When output is zero, there are no variable costs because
there are no variable inputs being employed. However, in the short run there might
be fixed resources, in which case the firm would still have some fixed costs it must
pay.
Topic: Fixed cost, variable cost
Skill: Level 2: Using definitions
Objective: Checkpoint 12.3
Author: TS
3) When plotted against the total output, what does the total fixed cost curve look like?
Answer: The total fixed cost curve is a horizontal straight line, indicating that at any level of
output the total fixed cost does not change as output changes.
Topic: Fixed cost curve
Skill: Level 1: Definition
Objective: Checkpoint 12.3
Author: JC
4) Downsizing is the practice of laying off workers in an attempt to decrease average total
cost. Can laying off workers decrease average total cost? Is it possible for the firm to
downsize and have its average total cost increase? Explain your answer.
Answer: Yes, downsizing by laying off workers can decrease the firm's average total cost. And
it is possible for a firm to downsize and increase its average total cost. Suppose that
the firm initially is producing more output than the level that minimizes average
total cost. In this case, downsizing by laying off workers decreases the amount of
output the firm produces and the firm can move along its average total cost curve to
a lower average total cost. However, the firm can lay off too many workers. If it lays
off too many workers, it decreases its output so much that it moves along its average
total cost curve enough that its average total costs wind up higher than they were
initially.
Topic: Average total cost curve
Skill: Level 4: Applying models
Objective: Checkpoint 12.3
Author: JC
248
Bade/Parkin œ Foundations of Economics, Third Edition
5) How do we calculate average fixed cost and why does average fixed cost fall as output
increases?
Answer: Average fixed cost is calculated by dividing total fixed cost by the quantity of output.
Because total fixed cost stays the same for all levels of output, as the quantity
produced increases, the average fixed cost decreases.
Topic: Average fixed cost
Skill: Level 2: Using definitions
Objective: Checkpoint 12.3
Author: SA
6) The average total cost curve is U-shaped. At the quantity of output where average total cost
is at its minimum, is the marginal cost curve above the average total cost curve, below the
average total cost curve, or intersecting the average total cost curve?
Answer: When the average total cost is at its minimum, the average total cost equals the
marginal cost. Therefore at the quantity of output where the average total cost is at
its minimum, the marginal cost curve intersects the average total cost curve.
Topic: Marginal cost and average total cost curve
Skill: Level 1: Definition
Objective: Checkpoint 12.3
Author: SA
7) Which average cost curves are U-shaped?
Answer: Both the average total cost and the average variable cost curves are U-shaped. The
only average cost curve that is not U-shaped is the average fixed cost curve.
Topic: Why the average total cost curve is U-shaped
Skill: Level 1: Definition
Objective: Checkpoint 12.3
Author: SA
Chapter 12 Production and Cost
249
8) What is the relationship between the marginal product of labor and the marginal cost?
Answer: Initially, as each additional unit of labor is employed, the marginal product of labor
increases. The cost of each worker is the same--the wage rate. Because each worker's
cost is the same, but each additional worker produces more output than the previous
worker, the cost of producing an additional unit of output decreases. The cost of
producing an additional unit of output is the marginal cost. Therefore when the
marginal product of labor is increasing, the marginal cost is decreasing. At some
point, the marginal product of labor will reach a peak, at which level of output
marginal cost is minimized. After that amount of output, the marginal product of an
additional worker starts to decrease. When the marginal product decreases, the
marginal cost increases; each worker costs the same to hire, but an additional worker
produces less output than the previous worker. Therefore when the marginal
product of labor is decreasing, the marginal cost is increasing.
Topic: MP and MC
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: JC
9) Explain how new technologies, which increase productivity, affect the average variable
cost, average total cost, and marginal cost curves.
Answer: A technological change that increases productivity shifts the total product, average
product, and the marginal product curves upward. Because the new technologies
enable existing inputs to produce more output, this effect means that the average
variable cost, average total cost, and marginal cost curves shift downward, reflecting
the decrease in average and marginal costs. However, the new technologies often
need to use more capital and less labor. In this case, the firm's fixed cost increases
and its variable cost decreases. The increase in fixed cost leads to an increase in total
cost while the decrease in variable cost leads to a decrease in total cost. Although the
net effect is ambiguous, generally the total cost increases at low levels of output and
decreases at higher levels of output. In this case, the average total cost curve shifts
upward at lower levels of output and shifts downward at higher levels of output.
Topic: Shifts in the cost curves, technology
Skill: Level 2: Using definitions
Objective: Checkpoint 12.3
Author: PH
250
Bade/Parkin œ Foundations of Economics, Third Edition
10) When the Rent-A-Limo Company negotiates its new labor contract it finds that the wages
it must pay drivers have increased. How does this wage hike affect the Rent-A-Limo
Company's average fixed cost, average variable cost, average total cost, and marginal cost?
Answer: The drivers' wages are a variable cost because the number of drivers needed varies
with how many limousines are rented. The increase in wages will have no effect on
the average fixed cost but the average variable cost will increase. The increase in
average variable cost leads to an increase in the average total cost and an increase in
the marginal cost.
Topic: Shifts in the cost curves, prices of factors of production
Skill: Level 2: Using definitions
Objective: Checkpoint 12.3
Author: PH
Chapter 12 Production and Cost
Quantity of labor Total product
(workers)
(widgets per day) TFC
0
0
__
1
5
__
2
15
__
3
35
__
4
50
__
5
60
__
6
65
__
TVC
__
__
__
__
__
__
__
TC
__
__
__
__
__
__
__
AFC
xx
__
__
__
__
__
__
AVC
xx
__
__
__
__
__
__
ATC
xx
__
__
__
__
__
__
251
MC
xx
__
__
__
__
__
__
11) The table above has the total product schedule for an imaginary good called a widget. Each
unit of labor costs $25 and the total cost of capital is $100.
a. Use this information to complete the table. In the table, TFC is the total fixed cost, TVC
is the total variable cost, TC is the total cost, AFC is the average fixed cost, AVC is the
average variable cost, ATC is the average total cost, and MC is the marginal cost.
Quantity of labor Total product
(workers)
(widgets per day) TFC
0
0
__
1
5
__
2
15
__
3
35
__
4
50
__
5
60
__
6
65
__
TVC
__
__
__
__
__
__
__
TC
__
__
__
__
__
__
__
AFC
xx
__
__
__
__
__
__
AVC
xx
__
__
__
__
__
__
ATC
xx
__
__
__
__
__
__
MC
xx
__
__
__
__
__
__
b. Suppose that labor becomes twice as expensive (so that one unit of labor now costs $50)
but nothing else changes. Complete the above table with the new cost schedules. If you
plotted the cost curves, how would the increased wage rate affect the cost curves?
252
Bade/Parkin œ Foundations of Economics, Third Edition
Answer:
Quantity of Total product
labor
(widgets per
(workers)
day)
0
0
1
5
2
15
3
35
4
50
5
60
6
65
a.
TFC TVC TC AFC AVC
0
100
xx
xx
100
100 25 125 20.00 5.00
100 50 150 6.67 3.33
100 75 175 2.86 2.14
100 100 200 2.00 2.00
100 125 225 1.67 2.08
100 150 250 1.54 2.31
ATC
xx
25.00
10.00
5.00
4.00
3.75
3.85
MC
xx
5.00
2.50
1.25
1.67
2.50
5.00
The completed table is above. All the costs in dollars.
Quantity of labor Total product
(workers)
(widgets per day)
0
0
1
5
2
15
3
35
4
50
5
60
6
65
TFC
100
100
100
100
100
100
100
TVC
0
50
100
150
200
250
300
TC AFC AVC ATC MC
100
xx
xx
xx
xx
150 20.00 10.00 30.00 10.00
200 6.67 6.67 13.33 5.00
250 2.86 4.29 7.14 2.50
300 2.00 4.00 6.00 3.33
350 1.67 4.17 5.83 5.00
400 1.54 4.62 6.15 10.00
b. The completed table is above. All the costs are in dollars. There would be no
change in the total fixed and average fixed cost curves because the fixed cost did not
change. The total cost, total variable cost, average total cost, average variable cost,
and marginal cost curves would all shift upward.
Topic: Short-run costs
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: SB
Chapter 12 Production and Cost
253
12) This month, the local widget factory produced 100 widgets. The total variable cost of
production was $500 and the average total cost of production was $8.
a. What is the total cost?
b. What is the total fixed cost?
c. What is the average fixed cost?
d. What is the average variable cost?
Answer: a. Total cost can be calculated as average total cost times output, which is $8 ˛ 100 =
$800.
b. Total fixed cost equals total cost minus total variable cost. The total cost from
part (a) is $800. The total variable cost is $500. Therefore the total fixed cost is $800 $500 = $300.
c. Average fixed cost equals total fixed cost divided by output, which is $300d100 =
$3.
d. Average variable cost equals total variable cost divided by output. The total
variable cost from part (b) is $500, so the average variable cost is $500d100 = $5.
Topic: Short-run costs
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: SB
254
Bade/Parkin œ Foundations of Economics, Third Edition
Rocket shoes
(per day)
0
1
2
3
4
5
6
7
8
9
10
Total cost
(dollars)
$12
$20
$26
$30
$32
$36
$42
$50
$64
$88
$124
TFC
___
___
___
___
___
___
___
___
___
___
___
TVC
___
___
___
___
___
___
___
___
___
___
___
AFC AVC ATC
xx
xx
xx
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
___ ___ ___
13) Acme produces rocket shoes for use by slow coyotes. Acme's total cost schedule is given in
the table above. Acme's total fixed cost is $12. Complete the table. (In the table, TFC is the
total fixed cost, TVC is the total variable cost, AFC is the average fixed cost, AVC is the
average variable cost, and ATC is the average total cost.)
Answer:
Rocket shoes
(per day)
0
1
2
3
4
5
6
7
8
9
10
Total cost
(dollars)
$12
$20
$26
$30
$32
$36
$42
$50
$64
$88
$124
The completed table is above.
Topic: Short-run costs
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: TS
TFC
12.00
12.00
12.00
12.00
12.00
12.00
12.00
12.00
12.00
12.00
12.00
TVC AFC AVC
0.00
xx
xx
8.00 12.00 8.00
14.00 6.00 7.00
18.00 4.00 6.00
20.00 3.00 5.00
24.00 2.40 4.80
30.00 2.00 5.00
38.00 1.71 5.43
52.00 1.50 6.50
76.00 1.33 8.44
112.0 1.20 11.20
ATC
xx
20.00
13.00
10.00
8.00
7.20
7.00
7.14
8.00
9.77
12.40
Chapter 12 Production and Cost
255
14) Rufus runs a skunk-skinning service in West Virginia. He employs skinners at a wage rate
of $240 a week for each one. He leases the shack where his workers work for $200 per week.
The rent is fixed for the next two years. Last week his 10 employees managed to skin a total
of 300 skunks.
a. What is the average product of labor for Rufus's company?
b. What is Rufus' total variable cost per week?
c. What is the average variable cost for Rufus's company?
d. If Rufus adds his brother Jethro to his staff, at a wage rate of $240 a week, and his
company can now skin 310 skunks per week, what is Rufus's new average variable cost?
Answer: a. The average product of labor is 30 skunks skinned per worker.
b. The total variable cost per week is $2,400.
c. The average variable cost is $8 per skunk skin.
d. The new total variable cost is $2,640. Hence the new average variable cost is
$8.52 per skunk skin.
Topic: Short-run costs
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: JC
256
Bade/Parkin œ Foundations of Economics, Third Edition
Output
Total cost
(oil changes per hour) (dollars per hour)
0
10
1
20
2
35
3
50
4
80
15) The above table gives the total cost schedule for oil changes at the local Jiffy Lube.
a. What is Jiffy Lube's total fixed cost?
b. What is the total variable cost of 2 oil changes?
c. What is the average variable cost of 4 oil changes?
d. What is the average fixed cost of 2 oil changes?
e. What is the marginal cost of the 3rd oil change?
Answer: a. The total fixed cost is $10. At zero output, the total variable cost is $0, so the
entire cost, $10, must be the fixed cost.
b. The total variable cost of 2 oil changes is $25. The total cost, TC, is $35 and from
part (a) the total fixed cost, TFC, is $10. The total variable cost, TVC, is equal to TC TFC or $35 - $10 = $25.
c. The average variable cost for 4 oil changes is $17.50. Start similarly to part (b) by
calculating that the total variable cost, TVC, for 4 oil changes is $70. Then, the
average variable cost, AVC, equals the total variable cost divided by output, or TVC d
Q. In this case, the AVC is equal to $70 d 4 = $17.50.
d. The average fixed cost of 2 oil changes is $5. The average fixed cost, AFC, equals
the total fixed cost divided by output, or TFC d Q. From part (a), the total fixed cost is
$10, so the average fixed cost equals $10 d2 = $5.
e. The marginal cost is $15. Marginal cost is defined as the change in the total cost
that results from a one-unit increase in output. The total cost of 2 oil changes is $35
and the total cost of 3 oil changes is $50. Therefore the change in the total cost is $15,
which is the marginal cost.
Topic: Short-run costs
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: SA
Chapter 12 Production and Cost
257
16) Suppose the local newspaper hires students to fold and bag newspapers for delivery and
pays them $20 per shift. Five students can fold and bag 300 newspapers per shift. The
fourth student added 50 newspapers to total output. The cost of the capital the firm uses is
fixed at $50 per shift.
a. Is the newspaper operating in the long run or short run? Why?
b. What is the average product of 5 students?
c. Calculate the total fixed, total variable, and total costs of folding and bagging 300
newspapers.
d. Calculate the average fixed, average variable, and average total costs of folding and
bagging 300 newspapers.
e. What is the marginal cost of one of the 50 newspapers folded and bagged by the fourth
student?
Answer: a. The firm is operating in the short run because its capital cost is fixed.
b. Average product equals 300 d 5 = 60 newspapers per shift.
c. Total fixed cost = $50, total variable cost = 5 ˛ $20 = $100, and so total cost = $50
+ $100 = $150.
d. Average fixed cost = $50 d 300 = $0.17, average variable cost = $100 d 300 =
$0.33, and average total cost = $150 d 300 = $0.50 (alternatively, average total cost =
average fixed cost + average variable cost = $0.17 + $0.33 = $0.50).
e. Marginal cost = change in total cost divided by change in output, or $20 d 50 =
$0.40.
Topic: Production and cost
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: SB
258
Bade/Parkin œ Foundations of Economics, Third Edition
17) Draw an average total cost curve, an average variable cost, and a marginal cost curve all on
the same graph. Make sure to correctly label the axes. What relationship must exist between
the marginal cost curve and the average total cost and average variable cost curves?
Answer:
Typical cost curves are above. The average variable cost curve, AVC, and average
total cost curve, ATC, are U-shaped. The marginal cost curve, MC, intersects the AVC
curve and ATC curve at their minimum points.
Topic: Short-run cost curves
Skill: Level 3: Using models
Objective: Checkpoint 12.3
Author: CD
12.4 Long-Run Cost
1) In the long run all costs are variable costs. Why?
Answer: The long run is defined as the time frame over which all resources can be varied. The
costs of the variable inputs are the variable costs. Taken together, these definitions
imply that in the long run all inputs are variable inputs so all costs are variable costs.
Topic: Long-run costs
Skill: Level 1: Definition
Objective: Checkpoint 12.4
Author: SA
Chapter 12 Production and Cost
259
2) Which curve shows the lowest average total cost at which it is possible to produce each
output when the firm has time to change both its labor force and plant size?
Answer: The long-run average cost curve shows the lowest average total cost at which it is
possible to produce each output when the firm has had time to change all its inputs.
Topic: Long-run average cost curve
Skill: Level 1: Definition
Objective: Checkpoint 12.4
Author: PH
3) What is the long-run average cost curve? What are the three ranges of output and in what
order do they occur? Briefly define each of the three ranges.
Answer: The long-run average cost curve shows the lowest average cost at which it is possible
to produce each output when the firm has time to change both its labor force and its
plant size. The long-run average cost curve is U-shaped and shows three possible
production ranges. In order, these ranges are: economies of scale, constant returns to
scale, and diseconomies of scale. Economies of scale are when a firm increases its
plant size and labor employed by the same percentage and its output increases by a
larger percentage so that its average total cost decreases. Constant returns to scale are
when a firm increases its plant size and labor employed by the same percentage and
its output increases by the same percentage so that its average total cost does not
change. And, diseconomies of scale are when a firm increases its plant size and labor
employed by the same percentage and its output increases by a smaller percentage so
that its average total cost increases.
Topic: Long-run average cost curve
Skill: Level 1: Definition
Objective: Checkpoint 12.4
Author: CD
260
Bade/Parkin œ Foundations of Economics, Third Edition
4) Are the short-run average total cost curve and the long-run average cost both U-shaped
for the same reasons? If so, carefully explain these reasons. If not, explain why each curve is
U-shaped.
Answer: The curves are U-shaped for quite different reasons. In the short run, the firm's
plant, that is, its capital, is fixed. Therefore the only way to increase output is by
increasing the quantity of the variable resource, labor. Initially as labor increases,
there are gains from specialization and division of labor, which leads the marginal
product to rise and the average total cost to fall as more workers are employed.
Eventually, however, the firm runs up against its capital constraint and workers
must share tools and building space. As this happens, decreasing marginal returns
begin and average total cost eventually begins to rise.
In the long run, both labor and capital are variable. As a firm expands its use of
both resources, gains from specialization of both labor and capital cause average total
costs to fall. Eventually, however, the business becomes so large it is difficult to
coordinate and control. When this happens, long-run average total cost begins to
rise.
Thus the short-run average total cost is U-shaped because more workers must
make do with the same amount of plant. The long-run average cost curve is
U-shaped because the very scale of the firm's operations make it difficult to control
efficiently and effectively.
Topic: Long-run and short-run average cost curves
Skill: Level 4: Applying models
Objective: Checkpoint 12.4
Author: SB
5) What are economies of scale? What is the main source of economies of scale?
Answer: Economies of scale are when a firm increases its plant size and labor employed by
the same percentage and its output increases by a larger percentage so that its
average total cost decreases. Economies of scale result because of specialization.
When a firm increases its capital stock, the capital can be more specialized and hence
produce more output than less specialized, more generalized capital. Similarly, when
a firm increases its labor force, it can hire more specialists, each of whom is better at
doing his or her assigned task than a less specialized individual. As a result of
specialization, the firm's average product increases so that its average total cost
decreases.
Topic: Economies of scale
Skill: Level 1: Definition
Objective: Checkpoint 12.4
Author: MR
Chapter 12 Production and Cost
261
6) Explain the difference between increasing marginal returns and economies of scale.
Answer: Increasing marginal returns apply to the case where a firm has increased only the
amount of labor it uses while keeping capital fixed. If increasing marginal returns
occur, an additional worker is more productive than the previous worker hired. In
this case, the marginal product of the new worker exceeds the marginal product of
the previous worker. Economies of scale apply when a firm increases both the
amount of labor it uses and the amount of capital it uses. If there are economies of
scale, when a firm increases labor and capital by the same percentage, its output
increases by a larger percentage.
Topic: Economies of scale, increasing marginal returns
Skill: Level 2: Using definitions
Objective: Checkpoint 12.4
Author: CD
7) What are diseconomies of scale and why might they occur?
Answer: Diseconomies of scale mean that as the firm increases all its inputs by the same
percentage, its output increases by a smaller percentage. As a result, the firm's
long-run average cost rises. Diseconomies of scale can arise from the sheer size of a
firm. As a firm grows larger, it becomes increasingly more difficult to manage.
Communicating information up and down the management hierarchy as well as
communicating between managers and workers on the same level becomes more
costly. In this case the firm experiences diseconomies of scale, that is, its long-run
average cost increases as it expands the scale of its operation by producing yet more
output.
Topic: Diseconomies of scale
Skill: Level 1: Definition
Objective: Checkpoint 12.4
Author: SA
8) A firm increases both its plant and its labor force by the same percentage and its average
total costs remain unchanged. Is the firm experiencing increasing returns to scale, constant
returns to scale, or decreasing returns to scale?
Answer: The firm is experiencing constant returns to scale.
Topic: Constant returns to scale
Skill: Level 2: Using definitions
Objective: Checkpoint 12.4
Author: WM
262
Bade/Parkin œ Foundations of Economics, Third Edition
9) Most banks use ATMs (Automated Teller Machines) to handle banking transactions. These
banks assert that ATMs handle the transactions at a lower average total cost than human
tellers. Some small credit unions employ tellers rather than use ATMs. Why? What has to
happen before these credit unions begin using ATMs?
Answer: The credit unions that use tellers are small. At their smaller scale of operations, the
average cost of a transaction is lower with a teller than a machine. Before ATMs
become economically feasible for these credit unions, the credit union has to expand
its output and move to a different scale of operation. If they do so, they will move
along their long-run average cost curve and experience the benefits of specialization
in their capital resource and thereby produce transactions at a lower average total
cost.
Topic: Eye on the U.S. economy, the ATM and the cost of getting cash
Skill: Level 2: Using definitions
Objective: Checkpoint 12.4
Author: SB
Chapter 12 Production and Cost
Year Total product
1
100
2
240
3
500
4
1,000
5
1,800
6
2,500
263
Total cost Average cost
(dollars)
(dollars)
1,000
____
2,000
____
4,000
____
8,000
____
16,000
____
32,000
____
10) Jones Production started business with a small scale plant. Fortunately for Smith, the owner
of Jones Production, the business grew rapidly. It doubled its plant scale and its labor force
every year for the next six years. The table above gives the total costs and the associated
total products for each year.
a. Complete the table by finding the average cost for each scale.
b. Over what range of total product (output) did Jones Production experience economies
of scale, constant returns to scale, and diseconomies of scale?
Answer:
Year Total product
1
100
2
240
3
500
4
1,000
5
1,800
6
2,500
Total cost Average cost
(dollars)
(dollars)
1,000
10.00
2,000
8.33
4,000
8.00
8,000
8.00
16,000
8.88
32,000
12.80
a. The completed table is above.
b. There are economies of scale from 100 to 500 units of total product, constant
returns to scale from 500 to 1,000 units of total product, and diseconomies of scale
from 1,000 to 2,500 units of total product.
Topic: Long-run average cost
Skill: Level 3: Using models
Objective: Checkpoint 12.4
Author: TS
264
Bade/Parkin œ Foundations of Economics, Third Edition
11) Ayanna grows herbs. Last year she grew 2,000 pounds of herbs in a year while using 250
square feet of land and 1 worker. This year she doubled her land to 500 square feet, doubled
her workers to 2, and grew 4,500 pounds of herbs. She sells her rare, organic herbs for $50 a
pound. She pays her a worker $25,000 a year and rents her land for $100 per square foot for
a year. These are her only costs.
a. What was Ayanna's total cost last year and this year?
b. What was Ayanna's average total cost last year and this year?
c. Did Ayanna experience economies or diseconomies of scale?
Answer: a. Ayanna's total cost last year was $50,000 and her total cost this year is $100,000.
b. Ayanna's average total cost last year was $25 a pound and her average total cost
this year is $22.22 a pound.
c. Ayanna's average total cost decreased so she experienced economies of scale.
Topic: Economies of scale
Skill: Level 3: Using models
Objective: Checkpoint 12.4
Author: WM
Chapter 12 Production and Cost
265
12) The above figure represents the average total cost curves of a wheat farmer.
a. Which average total cost curve has the lowest average total cost of producing 30,000
bushels of wheat?
b. Over what range of output is the farmer experiencing economies of scale?
c. Over what range of output is the farmer experiencing diseconomies of scale?
d. Which average total cost curve has the lowest possible average cost of production?
e. Which average total cost curve represents the largest plant?
Answer: a.
ATC3 has the lowest average total cost to produce 30,000 bushels of wheat.
b. The farmer is experiencing economies of scale between 0 to 30,000 bushels of
wheat.
c. The farmer is experiencing diseconomies of scale for more than 30,000 bushels of
wheat.
d. ATC3 has the lowest possible average total cost, which occurs at 30,000 bushels
of wheat.
e. ATC4 represents the largest plant.
Topic: Long-run average cost curve
Skill: Level 3: Using models
Objective: Checkpoint 12.4
Author: SB