1. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 44 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.

2. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 44 The Short Run and the Long Run in Economics Short run The period of time during which at least one of a firm’s inputs is fixed. Long run The period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant.

3. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 44 The Short Run and the Long Run in Economics Implicit Costs versus Explicit Costs Opportunity cost The highest- valued alternative that must be given up to engage in an activity. Explicit cost A cost that involves spending money. Implicit cost A nonmonetary opportunity cost.

4. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 44 Pizza dough, tomato sauce, and other ingredients$20,000 Wages48,000 Interest payments on loan to buy pizza ovens10,000 Electricity6,000 Lease payment for store24,000 Foregone salary30,000 Foregone interest3,000 Economic depreciation10,000 Total$151,000 Table 11.1 Jill Johnson’s Costs per Year The entries in red are explicit costs, and the entries in blue are implicit costs.

5. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 44 The Short Run and the Long Run in Economics Learning Objective 10.2 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 output changes. Fixed costs Costs that remain constant as output changes. TC = FC + VC Total Cost = Fixed Cost + Variable Cost

6. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 44 CostAmount Salaries and benefits$625,000 Rent75,000 Utilities20,000 Supplies6,000 Postage5,000 Travel9,000 Subscriptions, etc.5,000 Miscellaneous5,000 Total$750,000 Fixed Costs in the Publishing Industry Making the Connection The wages of these workers are a variable cost to the publishers who employ them. An editor at Cambridge University Press gives the following estimates of the annual fixed cost for a medium-size academic book publisher: In contrast, for a company that prints books, the quantity of workers varies with the quantity of books printed.

7. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 44 Table 11.2 Short-Run Production and Cost at Jill Johnson’s Restaurant Quantity of Workers Quantity of Pizza Ovens Quantity of Pizzas per Week Cost of Pizza Ovens (Fixed Cost) Cost of Workers (Variable Cost) Total Cost of Pizzas per Week Cost per Pizza (Average Total Cost) 020$800$0$800— 122008006501,450$7.25 224508001,3002,1004.67 325508001,9502,7505.00 426008002,6003,4005.67 526258003,2504,0506.48 626408003,9004,7007.34 Production function: The relationship between the inputs employed by a firm and the maximum output it can produce with those inputs.

8. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 44 A First Look at the Relationship between Production and Cost We can use the information from Table 11.2 to graph the relationship between the quantity of pizzas Jill produces and her total cost and average total cost. Panel (a) shows that total cost increases as the level of production increases. Figure 11.1a Graphing Total Cost and Average Total Cost at Jill Johnson’s Restaurant

9. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 44 Here we see that the average total cost is roughly U shaped: As production increases from low levels, average total cost falls before rising at higher levels of production. To understand why average total cost has this shape, we must look more closely at the technology of producing pizzas, as shown by the production function. Figure 11.1b Graphing Total Cost and Average Total Cost at Jill Johnson’s Restaurant Average total cost Total cost divided by the quantity of output produced.

10. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 44 Marginal product of labor The additional output a firm produces as a result of hiring one more worker. Quantity of Workers Quantity of Pizza Ovens Quantity of Pizzas Marginal Product of Labor 020— 12200 22450250 32550100 4260050 5262525 6264015 Table 11.3 The Marginal Product of Labor at Jill Johnson’s Restaurant An increase in the marginal product can result from the division of labor and from specialization. Law of diminishing returns The principle that, at some point, adding more of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline.

11. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 44 Adam Smith’s Famous Account of the Division of Labor in a Pin Factory Making the Connection In The Wealth of Nations, Adam Smith uses production in a pin factory as an example of the gains in output resulting from the division of labor. The following is an excerpt from his account of how pin making was divided into a series of tasks: One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a [distinct operation], to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into eighteen distinct operations. This lesson from more than 225 years ago, showing the tremendous gains from division of labor and specialization, remains relevant to most business situations today.

12. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 44 The Marginal Product of Labor and the Average Product of Labor Graphing Production Total Output and the Marginal Product of Labor

13. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 44 The Relationship between Marginal Product and Average Product Average product of labor The total output produced by a firm divided by the quantity of workers. The average product of labor is the average of the marginal products of labor. Using the numbers from Table 11.3, we can find the average product of labor for three workers:

14. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 44 The Relationship between Short-Run Production and Short-Run Cost Marginal Cost Marginal cost The change in a firm’s total cost from producing one more unit of a good or service.

15. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 44 The Relationship between Short-Run Production and Short-Run Cost Why Are the Marginal and Average Cost Curves U Shaped? FIGURE 10-4 Jill Johnson’s Marginal Cost and Average Total Cost of Producing Pizzas

16. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 44 The Relationship between Marginal Cost and Average Cost

17. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 44 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. ATC = AFC + AVC Average fixed cost = AFC = Average variable cost = AVC = Average total cost = ATC =

18. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 44 Graphing Cost Curves FIGURE 10-5 Costs at Jill Johnson’s Restaurant

19. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 44 1.When marginal cost is less than average variable cost or average total cost, it causes them to decrease. When it is greater, it causes them to increase. Therefore, when they are equal, they must be at their minimum points where the marginal cost curve intersects. All three of these curves are U shaped. 2.Average fixed cost gets smaller and smaller as output increases because in calculating average fixed cost, we are dividing something that gets larger and larger—output—into something that remains constant—fixed cost. Firms often refer to this process of lowering average fixed cost by selling more output as “spreading the overhead” (where “overhead” refers to fixed costs). 3.The difference decreases between average total cost and average variable cost because it is representing average fixed cost, which gets smaller as output increases. Three key facts about cost curves:

20. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 44 Costs in the Long Run Long-run average cost curve A curve showing the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed. Economies of scale The situation when a firm’s long-run average costs fall as it increases output. Economies of Scale

21. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 44 Costs in the Long Run The Relationship between Short-Run Average Cost and Long-Run Average Cost Economies of Scale

22. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 44 Costs in the Long Run Long-Run Average Total Cost Curves for Bookstores Constant returns to scale The situation when a firm’s long-run average costs remain unchanged as it increases output. Minimum efficient scale The level of output at which all economies of scale are exhausted. Diseconomies of scale The situation when a firm’s long-run average costs rise as the firm increases output.

23. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 44 TermDefinitionSymbols and Equations Total costThe cost of all the inputs used by a firm, or fixed cost plus variable cost TC Fixed costsCosts that remain constant as a firm’s level of output changes FC Variable costsCosts that change as the firm’s level of output changes VC Marginal costIncrease in total cost resulting from producing another unit of output Average total costTotal cost divided by the quantity of output produced Average fixed costFixed cost divided by the quantity of output produced Average variable cost Variable cost divided by the quantity of output produced Implicit costA nonmonetary opportunity cost― Explicit costA cost that involves spending money― Table 11.4 A Summary of Definitions of Cost

24. Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 44 An Inside LOOK Lower Manufacturing Costs Push Down the Price of Flat-Panel TVs Flat-Panel TVs, Long Touted, Finally Are Becoming the Norm