1. Technology, Production, and Costs
Chapter 6
Technology, Production, and Costs

2. Learning Objectives
Define technology and give examples of technological change.
Distinguish between the economic short run and the economic long run.
Understand the relationship between the marginal product of labour and the average product of labour.

3. Learning Objectives
Explain and illustrate the relationship between marginal cost and average total cost.
Graph average total cost, average variable cost, average fixed cost, and marginal cost.
Understand how firms use the long-run average cost curve to plan.

4. Computers, diminishing returns and virtualisation
IBM launched its highly promising Virtualisation Engine in 2007.
Virtualisation allows one piece of hardware to look like multiple independent machines and thus run several operational systems at the same time.

5. Technology: An Economic Definition
LEARNING OBJECTIVE 1
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.

6. The Short Run and the Long Run
LEARNING OBJECTIVE 2
The Short Run and the Long Run
Short run: The period of time during which at least one of the firm’s inputs is fixed.
Long run: A period of time long enough to allow a firm to vary all of its inputs, to adopt new technology, and to increase or decrease the size of its physical plant.

7. Improving Inventory Control at Bunnings
MAKING THE CONNECTION
6.1
Improving Inventory Control at Bunnings
Better inventory controls have helped reduce the firm’s costs.
Inventories are an input into Bunnings’s output sold to consumers. Holding inventories is costly, so firms have an incentive to hold as few inventories as possible and turn over their inventories as rapidly as possible by ensuring that goods do not remain on the shelves long.
In recent years, many firms have adopted just-in-time inventory systems in which firms accept shipments from suppliers as close as possible to the time they will be needed. Bunnings actively manages its supply chain stretching from the manufacturers of the goods it sells to its retail stores.
Technological change has been a key to Bunnings’ becoming one of the largest retailers in Australia.

8. The difference between fixed costs and variable costs
LEARNING OBJECTIVE 2
The Short Run and the Long Run
The difference between fixed costs and variable costs
Total cost: The cost of all the inputs a firm uses in production.
Variable costs: Costs that change as the quantity of output changes.
Fixed costs: Costs that remain constant as quantity of output changes.
Total Cost = Fixed Cost + Variable Cost
TC = FC + VC

9. 6.2 Fixed costs in the publishing industry
MAKING THE CONNECTION
The salaries of editors are considered a fixed cost by publishers
6.2
Fixed costs in the publishing industry
COST
AMOUNT
($)
Salaries and Benefits
Rent
Utilities
Supplies
Postage
Travel
Subscriptions, etc.
Miscellaneous
Total
75 000
20 000
6000
4000
8000
5000
Academic publishers hire editors, designers, and production and marketing managers who help prepare books for publication. Because these employees work on several books simultaneously, the number of people the company hires will not go up and down with the quantity of books the company publishes during any particular year. Therefore, their salaries are considered a fixed cost by publishers.

10. The Short Run and the Long Run
LEARNING OBJECTIVE 2
The Short Run and the Long Run
Implicit versus explicit cost
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 non-monetary opportunity cost.

11. Cost per year of setting up a photocopying business: Table 6.1
Costs Per Year
Paper
$20 000
Wages
48 000
Lease payment for photocopier machines
10 000
Electricity
6 000
Lease payment for store
24 000
Foregone salary
40 000
Foregone interest
3 000
Economic depreciation
Total
Explicit costs
Table 6.1– Julie Johnson’s costs per year. Explicit costs (accounting costs) are in the red colour and implicit costs are in the blue colour.
Implicit costs
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

12. The Short Run and the Long Run
LEARNING OBJECTIVE 2
The Short Run and the Long Run
Production function: The relationship between the inputs employed by the firm and the maximum output it can produce with those inputs.

13. Short-run production and costs at a photocopying store: Table 6.2
Table 6.2 – Short-run production and cost at Julie Johnson’s photocopying store.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

14. The Short Run and the Long Run
LEARNING OBJECTIVE 2
The Short Run and the Long Run
A first look at the relationship between production and cost
Average total cost: Total cost divided by the quantity of output produced.

15. Graphing total cost and average total cost at the photocopying store: Figure 6.1
Figure 6.1 – Graphing total cost and average total cost at Julie Johnson’s photocopying store.
We can use the information from Table 6.2 to graph the relationship between the quantity of photocopies Julie produces and her total cost and average total cost. Panel (a) shows that total cost increases as the level of output increases. In panel (b) we see that the average total cost is roughly U-shaped: as output increases from low levels, average cost falls before rising at higher levels of output. To understand why average cost has this shape we must look more closely at the technology of producing photocopies, as shown by the production function.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

16. The Marginal Product of Labour and the Average Product of Labour
LEARNING OBJECTIVE 3
The Marginal Product of Labour and the Average Product of Labour
Marginal product of labour: The additional output a firm produces as a result of hiring one more worker.
Law of diminishing returns: The principle that, at some point, adding more of a variable input, such as labour, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline.

17. The marginal product of labour at a photocopying store: Table 6.3
Table 6.3 – The marginal product of labour at Julie Johnson’s photocopying store
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

18. Total output and the marginal product of labour: Figure 6.2
Figure 6.2 – Total output and the marginal product of labour
In panel (a) output increases as more workers are hired, but the increase in output does not occur at a constant rate. Because of specialisation and the division of labour, output will at first increase at an increasing rate, with each additional worker hired causing output to increase by a greater amount than did the hiring of the previous worker. After the third worker has been hired, hiring more workers while keeping the amount of machinery constant results in diminishing returns. Once the point of diminishing returns has been reached, output increases at a decreasing rate. Each additional worker hired after the third worker causes output to increase by a smaller amount than did the hiring of the previous worker. In panel (b) the marginal product of labour is the additional output produced as a result of hiring one more worker. The marginal product of labour rises initially because of the effects of specialisation and division of labour, and then falls due to the effects of diminishing returns.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

19. The Marginal Product of Labour and the Average Product of Labour
LEARNING OBJECTIVE 3
The Marginal Product of Labour and the Average Product of Labour
The relationship between marginal and average product
Average product of labour: The total output produced by a firm divided by the number of workers, or, output per worker.
= ( ) / 3
Average product of labour for three workers
Marginal product of labour for the first worker
Marginal product of labour for the second worker
Marginal product of labour for the third worker

20. The Relationship Between Short-Run Production and Short-Run Cost
LEARNING OBJECTIVE 4
The Relationship Between Short-Run Production and Short-Run Cost
Marginal cost: The change in a firm’s total cost from producing one more unit of a good or service. D TC MC = D Q

21. Marginal cost and average total cost of producing copies: Figure 6.3
Figure 6.3 – Julie Johnson’s marginal cost and average total cost of producing copies
We can use the information in the table to calculate Julie’s marginal cost and average total cost of producing copies. For the first three workers hired, the marginal product of labour is increasing. This increase causes the marginal cost of production to fall. For the last three workers hired, the marginal product of labour is falling. This causes the marginal cost of production to increase. Therefore, the marginal cost curve falls and then rises—has a U-shape—because the marginal product of labour rises and then falls. As long as marginal cost is below average total cost, average total cost will be falling. When marginal cost is above average total cost, average total cost will be rising. The relationship between marginal cost and average total cost explains why the average total cost curve also has a U-shape.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

22. The relationship between marginal cost and average cost
LEARNING OBJECTIVE 4
The relationship between marginal cost and average cost
Nigel Brown is the owner of a grape juice company, says “I currently produce 50 kilolitres of juice a day at a total cost of $ If I am to produce 51 kilolitres, my total cost would be $ Therefore, my marginal cost and average total cost must be increasing too”.
Is Nigel right? Draw a graph to illustrate your answer.
INSTRUCTOR NOTES -: This problem is designed to help students understand the interaction between marginal cost and average total cost of production. Moreover, it assists students to learn and appreciate graphic solutions to economic problems.

23. The relationship between marginal cost and average cost
LEARNING OBJECTIVE 4
The relationship between marginal cost and average cost
Solving the problem:
STEP 1: Review the chapter material. The problem requires understanding the relationship between marginal and average cost, so you may like to review the section ‘The relationship between marginal cost and average cost’ on p.170.
STEP 2: Calculate average total cost and marginal cost. Average total cost is total cost divided by total output. In this case initial average total cost is $60 000/50 = $ Marginal cost is:
$ $60 000=$ New average total cost is $61 710/51 = $1 210.

24. The relationship between marginal cost and average cost
LEARNING OBJECTIVE 4
The relationship between marginal cost and average cost
STEP 3: Use the relationship between marginal cost and average total cost to answer the question.
When marginal cost is greater than average total cost, marginal cost must be increasing. Since, in Step 2 we found that MC>ATC, then Nigel is right.
When marginal cost is above average total cost, average total cost will rise. As we have seen in Step 2, it is indeed the case. Therefore, Nigel is right here too.
STEP 4: Draw the graph.

25. The relationship between marginal cost and average cost
LEARNING OBJECTIVE 4
The relationship between marginal cost and average cost
Cost
(dollars
per litre) MC
ATC
$1710
$1210 51
Quantity
(kilolitres per day)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

26. Graphing Cost Curves ATC = AFC + AVC
LEARNING OBJECTIVE 5
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.
Average total cost = ATC = TC/Q
Average fixed cost = AFC = FC/Q
Average variable cost = AVC = VC/Q
ATC = AFC + AVC

27. Graphing Cost Curves Relationships between MC, ATC, AVC and AFC
LEARNING OBJECTIVE 5
Graphing Cost Curves
Relationships between MC, ATC, AVC and AFC
The MC, ATC and AVC curves are all U-shaped, and the marginal cost curve intersects the average variable cost and average total cost curves at their minimum points.
As output increases, AFC gets smaller and smaller.
As output increases, the difference between average total cost, and average variable cost decreases.

28. Costs at the photocopying store: Figure 6.4
Figure 6.4 – Costs at Julie Johnson’s photocopying store
Julie’s costs of making copies are shown in the table and plotted in the graph. Notice three important facts about the graph:
The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all U-shaped, and the marginal cost curve intersects both the average variable cost curve and average total cost curve at their minimum points.
As output increases, average fixed cost (AFC) becomes smaller and smaller.
(3) As output increases, the difference between average total cost and average variable cost decreases. Make sure you can explain why each of these three facts is true. You should spend time becoming familiar with this graph, because it is one of the most important graphs in microeconomics.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

29. Costs in the Long Run Economies of scale
LEARNING OBJECTIVE 6
Costs in the Long Run
Economies of scale
Long-run average cost curve: A curve showing the lowest cost at which the firm is able to produce a given quantity of output in the long run, when no inputs are fixed.
Economies of scale: Economies of scale exist when a firm’s long-run average costs fall as it increases scale of production and the quantity of output it produces.

30. LEARNING OBJECTIVE 6
Costs in the Long Run
Constant returns to scale: Constant returns to scale exist when a firm’s long-run average costs remain unchanged as it increases its scale of production and the quantity of output.
Minimum efficient scale: The level of output at which all economies of scale have been exhausted. It is the minimum point on the long run average cost curve.
Diseconomies of scale: Exist when a firm’s long-run average costs rise as it increases its scale of production and the quantity of output.

31. The relationship between short-run and long-run average costs: Figure 6.5
Figure 6.5 – The relationship between short-run average cost and long-run average cost
If a bookshop expects to sell only 1000 books per month, the small store represented by the ATC curve on the left of the figure will allow it to sell this quantity of books at the lowest average cost, which would be $22 per book. A larger bookshop, Dymocks, will be able to sell books per month at a lower cost of $18 per book. A bookshop selling books per month and a bookshop selling books per month will experience constant returns to scale and have the same average cost. A bookshop selling books per month will have reached minimum efficient scale. Very large bookshops will experience diseconomies of scale, and their average costs will rise as sales increase beyond books per month.

32. Is it possible for a factory to be too big?
MAKING THE CONNECTION
The Colossal River Rouge: Diseconomies of Scale at the Ford Motor Company
6.3
Is it possible for a factory to be too big?
Henry Ford, the founder of Ford Motor Company, introduced two new ideas that allowed him to take advantage of economies of scale in his workshops. First, he used interchangeable parts so that unskilled workers could be used to assemble cars. Second, instead of having groups of workers moving from one stationary car to the next, he had the workers remain stationary while the cars moved along an assembly line. These ideas helped Ford to produce his Model T at an average cost well below his competitors.
Ford believed that a larger plant would help him to take advantage of economies of scales even further. Unfortunately, Ford’s massive River Rouge plant was too large and suffered from diseconomies of scale. Ford’s managers could not coordinate well the production of cars in such a large plant and average costs of production were too high.

33. A summary of definitions of cost: Table 6.4
Table 6.4 – A summary of definitions of cost
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

34. An Inside Look
Economies of scale in electronics production

35. An Inside Look
Figure 1: Long-run average cost of pocket calculators
Insert Figure 1 from page 181 – as large as possible while remaining clarity

36. An Inside Look
Figure 2: The effect of technological change on the long-run average cost of calculators
Insert Figure 2 from page 181 – as large as possible while remaining clarity

37. Key Terms Long run average cost curve Average fixed cost
Marginal cost
Marginal product of labour
Minimum efficient scale
Opportunity cost
Production function
Short run
Technological change
Technology
Total cost
Variable costs
Average fixed cost
Average product of labour
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

38. Get Thinking!
In 2009, the Western Australian Government announced a comprehensive plan for structural reform of local governments which basically meant that small ‘unsustainable’ local councils would be forced to amalgamate into larger ‘more efficient’ councils . Similar reforms were earlier implemented in NSW, Victoria and Queensland. The major argument put forward in favour of amalgamation was the assumption that larger councils will capture the benefits of economies of scale.
Do you think the WA Government is right? Do you believe the public sector can capture economies of scale? If so, which local government functions are likely to bring most benefits of economies of scale?
It is extremely difficult to judge whether the WA government is right or not. On the one hand, there are no reasons why the public sector should be any different from the private sector in terms of ability to capture benefits of economies of scale. On the other hand, the existing empirical research is inadequate to make a well-justified judgement call whether economic benefits of amalgamation are large enough to compensate for the substantial costs of reforms. Neither NSW nor Victorian governments undertook comprehensive post-hoc studies to prove that their amalgamation experiments were justified.
Since local councils provide a wide range of services, it is likely that some services are more likely than others to bring the benefits of economies of scale. See, for example, Dollery, Byrnes and Allan (2007) review for the survey in NSW.

39. Check Your Knowledge
Q1. Which of the following are sometimes called accounting costs?
a. Economic costs.
b. Implicit costs.
c. Explicit costs.
d. Total variable costs.

40. Check Your Knowledge
Q1. Which of the following are sometimes called accounting costs?
a. Economic costs.
b. Implicit costs.
c. Explicit costs.
d. Total variable costs.

41. Check Your Knowledge
Q2. Refer to the graph below. During the trajectory of the curve from point A to point B, which of the following is more likely to occur?
a. Specialisation.
b. Diminishing returns.
c. Division of labour.
d. None of the above.

42. Check Your Knowledge
Q2. Refer to the graph below. During the trajectory of the curve from point A to point B, which of the following is more likely to occur?
a. Specialisation.
b. Diminishing returns.
c. Division of labor.
d. None of the above.

43. Check Your Knowledge
Q3. Refer to the graph below. How much is the value of total fixed cost? a b
5 800
Total fixed
cost cannot be
computed using this graph.

44. Check Your Knowledge
Q3. Refer to the graph below. How much is the value of total fixed cost? a b
5 800
Total fixed
cost cannot be
computed using this graph.

45. Check Your Knowledge
Q4. When does the law of diminishing returns apply?
a. When there are diseconomies of scale.
b. In the short run only.
c. In the long run only.
d. In both the short run and the long run.

46. Check Your Knowledge
Q4. When does the law of diminishing returns apply?
a. When there are diseconomies of scale.
b. In the short run only.
c. In the long run only.
d. In both the short run and the long run.