Handout 4 (Technology, Production, Costs)
We will now begin studying the behavior of firms. Before we understand the
behavior of firms (i.e. how do firms decide what level of output to produce at and
what price to charge), we must study what affects a firm’s decision. Namely, we
need to study the concepts of technology, production, and costs.
For simplicity and for examples throughout this handout, let’s focus on one specific
firm: a pizza store on Franklin Street.
Technology ->
Technological Change ->
Short Run ->
Long Run ->
Example for short run vs long run:
Types of costs
1. Variable Cost (VC)
a. Definition:
b. Example:
2. Fixed Cost (FC)
a. Definition:
b. Example:
*Costs in the long run?
3. Total Cost (TC)
a. Definition:
4. Implicit Costs
a. Definition:
b. Example:
5. Explicit Costs
a. Definition:
b. Example:
6. Economic Costs
Average Total Cost (ATC) =
Average Fixed Cost (AFC) =
Average variable cost (AVC) =
Marginal Cost (MC) =
What is a production function?
Let’s look at an example for our pizza restaurant on Franklin.
Is this a short-run or long-run production function? Why?
Quantity Quantity Quantity
of
of Pizza of pizzas
Workers Ovens
per week
0
1
2
3
4
5
6
2
2
2
2
2
2
2
0
200
450
550
600
625
640
Cost of
Pizza
Ovens
(________
Cost)
800
800
800
800
800
800
800
Cost of
Workers
(_________
Cost)
Total Cost Marginal Cost
Per Week Cost
Per
Pizza
(ATC)
0
650
1300
1950
2600
3250
3900
Marginal Product of Labor (MPL)
Definition:
Marginal Product of Capital (MPK)
Definition:
Let’s look at an example:
Quantity of
Quantity of Pizza
Workers
Ovens
0
2
1
2
2
2
3
2
4
2
5
2
6
2
Law of Diminishing Returns ->
Quantity of Pizzas Marginal Product
Produced
of Labor
0
200
450
550
600
625
640
Cost minimization for the firm
Goal for the firm:
We can derive a very similar cost-minimization rule for firms as we did for
consumers (Recall: Consumers optimally consume to maximize their utility by
choosing the combination of goods where __________________________________)
Cost minimization principle for the firm->
Let’s look at an example from our pizza restaurant. Suppose you are given the
following information about the pizza restaurant (whose owner’s name is Tom):
 Marginal Product of Capital – 3000 pizzas per oven
 Marginal Product of Labor – 1200 pizzas per worker
 Wage rate – $300 per week
 Price of Ovens – $600 per week
Is Tom minimizing costs? If she is not minimizing costs, explain whether she should
buy more ovens and hire fewer workers or buy fewer ovens and hire more workers.
Exercises
1. Which of the following are examples of a firm experiencing positive
technological change?
a. A firm is able to cut each worker’s wage rate by 10 percent and still
produce at the same level of output
b. A training program makes a firm’s workers more productive
c. An exercise program makes a firm’s workers more healthy and
productive
d. A firm cuts its workforce and is able to maintain its initial level of
output
e. A firm rearranges the layout of its factory and finds that by using its
initial set of inputs, it can produce exactly as much as before
2. Go back to the example of the pizza restaurant. Explain whether each of the
following is a fixed cost or a variable cost.
a. The payment she makes on her fire insurance policy
b. The payment she makes to buy pizza dough
c. The wages she pays her workers
d. The lease payment she makes to the landlord who owns the building
where her store is located
e. The $300-per-month payment she makes to her local newspaper for
running her weekly advertisements
3. Suppose the total cost of producing 10,000 tennis balls is $30,000 and the
fixed cost is $10,000.
a. What is the variable cost?
b. When output is 10,000, what are the average variable cost and
average fixed cost?
4. Consider the following information for the Franklin St Pizza Restaurant:
 Marginal product of capital -> 4000
 Marginal product of labor -> 100
 Wage Rate -> $10
 Price of ovens ->
Is the restaurant minimizing costs? If it is not, explain how the restaurant could
reallocate between ovens and workers.