© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 10 Technology, Production, and Costs

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 44 Technology: An Economic Definition Learning Objective 10.1 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.

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 Learning Objective 10.2 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.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 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

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 44 Learning Objective 10.2 Fixed Costs in the Publishing Industry Making the Connection Publishers consider the salaries of editors to be a fixed cost. COSTAMOUNT Salaries and benefits$437,500 Rent75,000 Utilities20,000 Supplies6,000 Postage4,000 Travel8,000 Subscriptions, etc.4,000 Miscellaneous5,000 Total$559,500

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 44 The Short Run and the Long Run in Economics Learning Objective 10.2 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.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 44 The Short Run and the Long Run in Economics Learning Objective 10.2 Table 10-1 Jill Johnson’s Costs per Year Pizza dough, tomato sauce, and other ingredients$20,000 Wages$48,000 Interest payments on loan to buy pizza ovens$10,000 Electricity$6,000 Lease payment for store$24,000 Foregone salary$30,000 Foregone interest$3,000 Economic depreciation10,000 Total$151,000 Implicit Costs versus Explicit Costs

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 44 The Short Run and the Long Run in Economics Learning Objective 10.2 Table 10-2 Short-Run Production and Cost at Jill Johnson’s Restaurant The Production Function 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 COST PER PIZZA (AVERAGE TOTAL COST) 020$800$0$800— ,450$ ,3002, ,9502, ,6003, ,2504, ,9004,

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 44 The Short Run and the Long Run in Economics Learning Objective 10.2 The Production Function Production function The relationship between the inputs employed by a firm and the maximum output it can produce with those inputs. A First Look at the Relationship between Production and Cost Average total cost Total cost divided by the quantity of output produced.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 44 The Short Run and the Long Run in Economics Learning Objective 10.2 FIGURE 10-1 Graphing Total Cost and Average Total Cost at Jill Johnson’s Restaurant A First Look at the Relationship between Production and Cost

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 44 The Marginal Product of Labor and the Average Product of Labor Learning Objective 10.3 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 MARGINALPRODUCT OF LABOR 020— Table 10-3 The Marginal Product of Labor at Jill Johnson’s Restaurant

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 Learning Objective 10.3 The Law of Diminishing Returns 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.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 44 The Marginal Product of Labor and the Average Product of Labor Learning Objective 10.3 Graphing Production FIGURE 10-2 Total Output and the Marginal Product of Labor

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 44 The Marginal Product of Labor and the Average Product of Labor Learning Objective 10.3 The Relationship between Marginal and Average Product Average product of labor The total output produced by a firm divided by the quantity of workers.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 44 The Marginal Product of Labor and the Average Product of Labor Learning Objective 10.3 An Example of Marginal and Average Values: College Grades FIGURE 10-3 Marginal and Average GPAs

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 Short-Run Production and Short-Run Cost Learning Objective 10.4 Marginal Cost Marginal cost The change in a firm’s total cost from producing one more unit of a good or service.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 44 The Relationship between Short-Run Production and Short-Run Cost Learning Objective 10.4 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

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 44 Solved Problem 10-4 The Relationship between Marginal Cost and Average Cost Learning Objective 10.4

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 44 Graphing Cost Curves Learning Objective 10.5 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 =

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 44 Graphing Cost Curves Learning Objective 10.5 FIGURE 10-5 Costs at Jill Johnson’s Restaurant

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 44 Graphing Cost Curves Learning Objective The marginal cost (MC), average total cost (ATC), and average variable cost (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. When marginal cost is less than either average variable cost or average total cost, it causes them to decrease. When marginal cost is above average variable cost or average total cost, it causes them to increase. Therefore, when marginal cost equals average variable cost or average total cost, they must be at their minimum points. 2As output increases, average fixed cost gets smaller and smaller. This happens 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.” By “overhead” they mean fixed costs. 3As output increases, the difference between average total cost and average variable cost decreases. This happens because the difference between average total cost and average variable cost is average fixed cost, which gets smaller as output increases. Understand the following three key facts about Figure 10-5:

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 Learning Objective 10.6 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

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 44 Costs in the Long Run Learning Objective 10.6 FIGURE 10-6 The Relationship between Short-Run Average Cost and Long-Run Average Cost Economies of Scale

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 44 Costs in the Long Run Learning Objective 10.6 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.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 44 Solved Problem 10-6 Using Long-Run Average Cost Curves to Understand Business Strategy Learning Objective 10.6

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 44 Costs in the Long Run Learning Objective 10.6 Don’t Let This Happen to YOU! DON’T CONFUSE DIMINISHING RETURNS WITH DISECONOMIES OF SCALE

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 44 TERMDEFINITION SYMBOLS AND EQUATIONS Total costThe value of all the inputs used by a firm TC Fixed costCosts that remain constant when a firm’s level of output changes FC Variable costCosts that change when the firm’s level of output changes VC Marginal costThe increase in total cost resulting from producing another unit of output Average total costTotal cost divided by the quantity of units produced Average fixed costFixed cost divided by the quantity of units produced Average variable costVariable cost divided by the quantity of units produced Implicit costA nonmonetary opportunity cost― Explicit costA cost that involves spending money― Table 10-4 A Summary of Definitions of Cost Conclusion

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 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

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 44 Isoquants Appendix An Isoquant Graph FIGURE 10A-1 Isoquants Isoquant A curve that shows all the combinations of two inputs, such as capital and labor, that will produce the same level of output.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 44 Isoquants Appendix The Slope of an Isoquant Marginal rate of technical substitution (MRTS) The slope of an isoquant, or the rate at which a firm is able to substitute one input for another while keeping the level of output constant.

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 44 Isocost Lines Appendix Isocost line All the combinations of two inputs, such as capital and labor, that have the same total cost. Graphing the Isocost Line FIGURE 10A-2 An Isocost Line

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 44 Isocost Lines Appendix The Slope and Position of the Isocost Line FIGURE 10A-3 The Position of the Isocost Line

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 44 Choosing the Cost-Minimizing Combination of Capital and Labor Appendix FIGURE 10A-4 Choosing Capital and Labor to Minimize Total Cost

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 44 Choosing the Cost-Minimizing Combination of Capital and Labor Appendix FIGURE 10A-5 Changing Input Prices Affects the Cost-Minimizing Input Choice Different Input Price Ratios Lead to Different Input Choices

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 44 The Changing Input Mix in Walt Disney Film Animation Making the Connection

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 44 Appendix Another Look at Cost Minimization Choosing the Cost-Minimizing Combination of Capital and Labor

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 44 Solved Problem 10A-1 Determining the Optimal Combination of Inputs Marginal product of capital3,000 pizzas Marginal product of labor1,200 pizzas Wage rate$300 per week Rental price of ovens$600 per week

Chapter 10: Technology, Production, and Costs © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 44 Appendix The Expansion Path FIGURE 10A-6 The Expansion Path Expansion path A curve that shows a firm’s cost- minimizing combination of inputs for every level of output.