Microeconomics ECON 2302 May 2011 Marilyn Spencer, Ph.D. Professor of Economics Chapter 10

10 Technology, Production, and Costs CHAPTER Technology, Production, and Costs Technological change leads to new products and lower production costs. How do firms take costs into account when setting prices?

10 Technology, Production and Costs CHAPTER Technology, Production and Costs Chapter Outline and Learning Objectives 10.1 Technology: An Economic Definition Define technology and give examples of technological change. 10.2 The Short Run and the Long Run in Economics Distinguish between the economic short run and the economic long run. 10.3 The Marginal Product of Labor and the Average Product of Labor Understand the relationship between the marginal product of labor and the average product of labor.

Chapter Outline and Learning Objectives, cont. 10.4 The Relationship between Short-Run Production and Short-Run Cost Explain and illustrate the relationship between marginal cost and average total cost. 10.5 Graphing Cost Curves Graph average total cost, average variable cost, average fixed cost, and marginal cost. 10.6 Costs in the Long Run Understand how firms use the long-run average cost curve in their planning Chapter Outline and Learning Objectives, cont.

Technology: An Economic Definition 10.1 LEARNING OBJECTIVE Define technology and give examples of technological change. 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.

Making the Connection Improving Inventory Control at Wal-Mart Improvements in inventory control meet the economic definition of positive technological change because they allow firms to produce the same output with fewer inputs. Better inventory controls have helped reduce firms’ costs.

10.2 LEARNING OBJECTIVE Distinguish between the economic short run and the economic long run. 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.

TC = FC + VC Total Cost = Fixed Cost + Variable Cost The Short Run and the Long Run in Economics: The Difference between Fixed Costs & Variable Costs – The Short Run 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. Total Cost = Fixed Cost + Variable Cost TC = FC + VC

Publishers consider the salaries of editors to be a fixed cost. Making the Connection Fixed Costs in the Publishing Industry COST AMOUNT Salaries and benefits $437,500 Rent 75,000 Utilities 20,000 Supplies 6,000 Postage 4,000 Travel 8,000 Subscriptions, etc. Miscellaneous 5,000 Total $559,500 Publishers consider the salaries of editors to be a fixed cost.

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.

The Short Run and the Long Run in Economics: Implicit Costs versus Explicit Costs 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 depreciation Total $151,000

The Short Run and the Long Run in Economics: The Production Function Table 10-2 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) 2 $800 $0 — 1 200 800 650 1,450 $7.25 450 1,300 2,100 4.67 3 550 1,950 2,750 5.00 4 600 2,600 3,400 5.67 5 625 3,250 4,050 6.48 6 640 3,900 4,700 7.34

Short Run & Long Run in Economics: 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 (ATC) Total cost (TC) divided by the quantity (Q) of output produced. TC /Q = ATC

Short Run and Long Run in Economics: First Look at the Relationship between Production & Cost FIGURE 10-1 Graphing Total Cost and Average Total Cost at Jill Johnson’s Restaurant The info from Table 10-2 in the graph shows the relationship between the Q of pizzas and Jill’s TC and ATC. Panel (a) shows that TC increases as the level of production increases. Panel (b), shows that the ATC is roughly U-shaped: As production increases from low levels, ATC falls before rising at higher levels of production.

Marginal Product of Labor & Average Product of Labor 10.3 LEARNING OBJECTIVE Understand the relationship between the marginal product of labor and the average product of labor. Marginal Product of Labor & Average Product of Labor Marginal product of labor The additional output a firm produces as a result of hiring one more worker. Table 10-3 The Marginal Product of Labor at Jill Johnson’s Restaurant QUANTITY OF WORKERS QUANTITY OF PIZZA OVENS QUANTITY OF PIZZAS MARGINALPRODUCT OF LABOR 2 — 1 200 450 250 3 550 100 4 600 50 5 625 25 6 640 15

Marginal Product of Labor & Average Product of Labor 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.

Marginal Product of Labor & Average Product of Labor FIGURE 10-2 Total Output & Marginal Product of Labor In panel (a), Q increases as more workers are hired, but the increase in Q does not occur at a constant rate. Each additional worker hired after the 3rd worker causes production to increase by a smaller amount than did the hiring of the previous worker. In panel (b), the marginal product of labor is the additional Q produced as a result of hiring 1 more worker. MPL rises initially because of the effects of specialization and division of labor, and then it falls due to the effects of diminishing returns.

Making the Connection Adam Smith’s Famous Account of the Division of Labor in a Pin Factory The gains from division of labor and specialization are as important to firms today as they were in the eighteenth century, when Adam Smith first discussed them.

Marginal Product of Labor & Average Product of Labor Relationship between Marginal and Average Product Average product of labor The total output produced by a firm divided by the quantity of workers.

The Marginal Product of Labor and the Average Product of Labor An Example of Marginal and Average Values: College Grades FIGURE 10-3 Marginal and Average GPAs The relationship between marginal and average values for a variable can be illustrated using GPAs. We can calculate the GPA Paul earns in a particular semester (his “marginal GPA”), and we can calculate his cumulative GPA for all the semesters he has completed so far (his “average GPA”).

The Relationship between Short-Run Production and Short-Run Cost 10.4 LEARNING OBJECTIVE Explain and illustrate the relationship between marginal cost and average total cost. 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.

Relationship between Short-Run Production & Short-Run Cost: Why Are the Marginal and Average Cost Curves U Shaped? FIGURE 10-4 Jill Johnson’s MC and ATC of Producing Pizzas We can use the info in the table to calculate Jill’s MC and ATC of producing pizzas. For the first 2 workers hired, the MPL increases. This increase causes the MC of production to fall. For the last 4 workers hired, the MPL falls. This causes the MC of production to go up. Thus, the MC curve falls and then rises - that is, has a U shape -because the MPL rises and then falls. When MC is below ATC, average total cost falls. When MC is above ATC, average total cost rises. The relationship between MC and ATC explains why the ATC curve also has a U shape.

Solved Problem 10-4 The Relationship between Marginal Cost and Average Cost When marginal cost is greater than average total cost, marginal cost must be increasing.

ATC = AFC + AVC Graphing Cost Curves 10.5 LEARNING OBJECTIVE Graph average total cost, average variable cost, average fixed cost, and marginal cost. 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 = Average fixed cost = AFC = Average variable cost = AVC = ATC = AFC + AVC

Graphing Cost Curves FIGURE 10-5 Costs at Jill Johnson’s Restaurant Jill’s costs of making pizzas are shown in the table & in the graph. Notice 3 important facts about the graph: (1) MC, ATC, and AVC curves are all U-shaped, and the MC curve intersects both the AVC curve and ATC curve at their minimum points. (2) As output increases, AFC gets smaller and smaller. (3) As output increases, the difference between ATC and AVC decreases.

Graphing Cost Curves Understand the following three key facts about Figure 10-5: MC, ATC, and AVC curves are all U-shaped, and the MC curve intersects the AVC and ATC curves at their minimum points. When MC is < either AVC or ATC, it causes each of them to decrease. When MC is > AVC or ATC, it causes each of them to increase. Therefore, when MC = AVC or ATC, they must be at their minimum points. As Q increases, AFC gets smaller and smaller. This happens because in calculating AFC, we are dividing something that gets larger and larger - Q - into something that remains constant - TFC. Firms often refer to this process of lowering AFC by selling more Q as “spreading the overhead” (where “overhead” refers to fixed costs). As Q increases, the difference between ATC and AVC decreases. This happens because the difference between ATC and AVC is AFC, which gets smaller as output increases.

Costs in the Long Run Economies of Scale 10.6 LEARNING OBJECTIVE Understand how firms use the long-run average cost curve in their planning. Costs in the Long Run Economies of Scale 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.

FIGURE 10-6 If a small bookstore expects to sell only 1,000 books/ mo., then it will be able to sell that Q of books at the lowest average cost of $22/book if it builds the small store represented by the ATC curve on the left of the figure. A larger bookstore will be able to sell 20,000 books/ mo. at a lower cost of $18/book. A bookstore selling 20,000 books/mo. and a bookstore selling 40,000 books/mo. will experience constant returns to scale and have the same ATC. A bookstore selling 20,000 books/mo. will have reached minimum efficient scale. Very large bookstores will experience diseconomies of scale, and their average costs will rise as sales increase beyond 40,000 books/mo. The Relationship between Short-Run Average Cost and Long-Run Average Cost

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.

Solved Problem 10-6 Using Long-Run Average Cost Curves to Understand Business Strategy Both firms will still be short of minimum efficient scale after the trade, although their average costs will have fallen.

Making the Connection The Colossal River Rouge: Diseconomies of Scale at Ford Motor Company Smaller factories produced the Model A at a lower average cost than was possible at the River Rouge plant. Was Ford’s River Rouge plant too big?

Costs in the Long Run Don’t Let This Happen to YOU! Don’t Confuse Diminishing Returns with Diseconomies of Scale

Conclusion Table 10-4 A Summary of Definitions of Cost TERM DEFINITION SYMBOLS AND EQUATIONS Total cost The cost of all the inputs used by a firm, or fixed cost plus variable cost TC Fixed costs Costs that remain constant when a firm’s level of output changes FC Variable costs Costs that change when the firm’s level of output changes VC Marginal cost Increase in total cost resulting from producing another unit of output Average total cost Total cost divided by the quantity of output produced Average fixed cost Fixed cost divided by the quantity of output produced Average variable cost Variable cost divided by the quantity of output produced Implicit cost A nonmonetary opportunity cost ― Explicit cost A cost that involves spending money

AN INSIDE LOOK >> Sony Gambles on the Future Cost of the Next Generation of TVs Economies of scale will result in a lower average total cost of production in 2013 if Sony can sell 2.8 million OLED TVs.

KEY TERMS Average fixed cost Average product of labor 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 Long-run average cost curve Marginal cost Marginal product of labor Minimum efficient scale Opportunity cost Production function Short run Technological change Technology Total cost Variable costs

Reality Check Assignment to for Chapter 11: Pre-read Ch. 11, including: Review Questions: 3rd ed., pg 394 1.1, 1.2, 1.3; pg 305 2.2; pg 395, 3.2; pg 398 5.1, 5.2, 5.3 pg 399 6.1 (2nd ed., pg 404; 1.1, 1.2 & 1.3; pg 406; 3.2; pg 405; 2.2; pg 407; 4.1; pg 408; 5.1, 5.2 & 5.3; pg 409; 6.1; 1st edition: 1 - 10 on pp. 380-381), Problems and Applications: 3rd ed., pg 394 1.4; p 396 3.7; pg 397 4.3; pg 398 5.4, 5.9 (2nd ed., p. 404, 1.4; p. 406, 3.7; p. 407, 4.3; p. 408, 5.4 & 5.9); and this application: The following is an excerpt from a newspaper story on the state of the lettuce market in the spring of 2002: “The shortage [of lettuce] began with freezing weather that cut per- acre yields by more than half in parts of California, where more than half of the nation’s supply is grown. At the same time, many farmers grew less lettuce, fearing a drop in demand after Sept. 11 [2001] because many people dined out less. (continued on next slide)

Reality Check Assignment to for Ch. 11, continued: The result has been high prices. In some parts of the country, iceberg lettuce has topped $3 per head at grocery stores, up from the regular $1 to $2. Prices are expected to drop to their usual levels in the next two to three weeks as new supplies catch up to demand,” said Ashraf Zaki, a market price reporter for the Agriculture Department in Forest Park, Ga. Use a demand-and-supply graph to illustrate the changes in the lettuce market described in this story. Briefly explain any shifts of the demand and supply curves in your graph. Why was the market prices reporter for the Agriculture Department confident that prices would drop “to their usual levels”? (1st edition: 1, 3, 7, 14, 20 & 21 on pp. 381-384).