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Prepared By Brock Williams

Chapter 5

ProductionTechnology and

Cost

Consider the challenge of providingsafe water to rural families in less

developed countries.

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2/32Copyright 2014 Pearson Education, Inc. All rights reserved. 5-2

1. Define economic cost and economic profit

2. Draw the short-run marginal-cost andaverage-cost curves

3. Draw the long-run marginal-cost andaverage cost curves

4. Provide examples of production costs

Learning Objectives

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economic profitTotal revenue minus economic cost.

economic costThe opportunity cost of the inputsused in the production process; equalto explicit cost plus implicit cost.

economic profit = total revenueeconomic cost

P R I N C I P L E O F O P P O R T U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.

5.1 ECONOMIC COST AND ECONOMICPROFIT

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explicit cost

A monetary payment.

implicit costAn opportunity cost that does notinvolve a monetary payment.

5.1 ECONOMIC COST AND ECONOMICPROFIT (cont.)

TABLE 5.1

Economic Cost versus Accounting Cost

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OPPORTUNITY COST AND ENTREPENEURSHIP

APPLYING THE CONCEPTS #1:What is the opportunity

cost of an entrepreneur?

Whats the opportunity cost of an entrepreneur?

For many entrepreneurs, starting a new business means leaving paid employment.In other words, businesses are started by people with relatively low wages.

After controlling for gender, age, education, marital status, and region, the wage gap

between workers who become entrepreneurs and workers who remain in paidemployment was about 12 percent.

A P P L I C A T I O N 1


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economic cost = explicit cost + implicit cost

accounting cost = explicit cost

accounting profit = total revenue accounting cost

accounting costThe explicit costs of production.

accounting profit

Total revenue minus accounting cost.


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Production and Marginal Product

marginal product of laborThe change in output from oneadditional unit of labor.

diminishing returnsAs one input increases while the otherinputs are held fixed, output increasesat a decreasing rate.

P R I N C I P L E O F D I M I N I S H I N G R E T U R N S

Suppose output is produced with two or more inputs, and we increase one

input while holding the other input or inputs fixed. Beyond some pointcalled

the point of diminishing returnsoutput will increase at a decreasing rate.

5.2 A FIRM WITH A FIXED PRODUCTIONFACILITY: SHORT-RUN COSTS

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Production and Marginal Product

total-product curveA curve showing the relationship

between the quantity of labor andthe quantity of output produced,ceteris paribus.

5.2 A FIRM WITH A FIXED PRODUCTIONFACILITY: SHORT-RUN COSTS (cont.)

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Production and Marginal ProductFIGURE 5.1

Total-Product Curve

The total-product curve shows the relationship between the quantity of labor and the quantity of

output, given a fixed production facility.

For the first two workers, output increases at an increasing rate because of labor specialization.

Diminishing returns occurs for three or more workers, so output increases at a decreasing rate.


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Short-Run Total Cost

fixed cost (FC)Cost that does not vary with thequantity produced.

variable cost (VC)Cost that varies with the quantityproduced.

short-run total cost (TC)The total cost of production when at

least one input is fixed; equal to fixedcost plus variable cost.

TC= FC+ VC


Rent

Security

Contract work

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Short-Run Total Cost

FIGURE 5.2

Short-Run Costs: Fixed Cost, Variable

Cost, and Total Cost

The short-run total-cost curve shows the

relationship between the quantity of outputand production costs, given a fixed

production facility. Short-run total cost equals

fixed cost (the cost that does not vary with

the quantity produced) plus variable cost (the

cost that varies with the quantity produced).


TABLE 5.2

Short-Run Costs

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Copyright 2014 Pearson Education, Inc. All rights reserved. 5-12

Short-Run Average Costs

average fixed cost (AFC)Fixed cost divided by the quantityproduced.

average variable cost (AVC)Variable cost divided by the quantityproduced.


average total cost (ATC)Total cost divided by the quantityproduced.

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FIGURE 5.3


The short-run average-total-cost

curve (ATC) is U-shaped.

As the quantity producedincreases, fixed costs are spread

over more and more units,

pushing down the average total

cost.

In contrast, as the quantity

increases, diminishing returnseventually pulls up the average

total cost.

The gap betweenATCandAVC

is the average fixed cost (AFC).


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short-run average total cost (ATC)Short-run total cost divided by thequantity produced; equal toAFCplusAVC.


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Short-Run Marginal Cost

short-run marginal cost (MC)The change in short-run total cost resultingfrom a one-unit increase in output.


OR

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The Relationship between Marginal Cost and Average Cost

FIGURE 5.4

Short-Run Marginal and

Average Cost

The marginal-cost curve (MC) is

negatively sloped for small

quantities of output, because ofthe benefits of labor

specialization, and positively

sloped for large quantities,

because of diminishing returns.

The MCcurve intersects the

average-cost curve (ATC) at theminimum point of the average

curve.

At this pointATCis neither falling

nor rising.


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Consider the following simple production process. A firm that simply digs holes has afixed amount of capital (10 standard shovels) and can vary the number of workers.

Armed with a standard shovel, a worker requires two hours to dig one hole. To

produce one hole per day, the firm hires a worker and uses only one of its 10shovels.

If the wage is $12 per hour, the marginal cost of the first dug hole is $24. As thequantity of output increases, the firm adds workers and uses more of its shovels, andthe marginal cost remains at $24 for the first 10 holes.

In this case, marginal cost is constant for the first 10 units of output because the firmdoesnt experience diminishing returns.

Idle Capital and Short-Run Marginal Cost

APPLYING THE CONCEPTS #2: Why is the marginal-cost curve

positively sloped?


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The Relationship between Marginal Cost and Average Cost


TABLE 5.3

Marginal Grade and Average Grade

LEGEND:

GPA = Average Cost

Grade for ECO100 = Marginal Cost

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Expansion and Replication

long-run total cost (LTC)The total cost of productionwhen a firm is perfectly flexiblein choosing its inputs.

long-run average cost (LAC)The long-run cost divided by thequantity produced.

5.3 PRODUCTION AND COST IN THELONG RUN

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constant returns to scaleA situation in which the long-runtotal cost increasesproportionately with output, so

average cost is constant.

long-run marginal cost (LMC)The change in long-run costresulting from a one-unitincrease in output.

5.3 PRODUCTION AND COST IN THELONG RUN (cont.)

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FIGURE 5.5

The Long-Run Average-Cost Curve and

Scale Economies

The long-run average-cost curve (LAC) isnegatively sloped for up to 10 paddles per

day, a result of indivisible inputs and the

effects of labor specialization.

If the firm replicates the operation that

produces 10 paddles per day, the long run

average-cost curve will be horizontalbeyond 10 paddles per day.


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Reducing Output with Indivisible Inputs

indivisible inputAn input that cannot be scaleddown to produce a smallerquantity of output.


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Scaling Down and Labor Specialization

Labor specialization makes workers more productive because ofcontinuity and repetition.

When we reduce the workforce each worker will become less specialized,performing a wider variety of production tasks.

The loss of specialization will decrease labor productivity, leading tohigheraverage cost.


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Economies of Scale

economies of scaleA situation in which the long-runaverage cost of productiondecreases as output increases.

minimum efficient scaleThe output at which scaleeconomies are exhausted.


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Diseconomies of Scale

diseconomies of scaleA situation in which the long-runaverage cost of productionincreases as output increases.


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Actual Long-Run Average-Cost Curves

FIGURE 5.6Actual Long-Run Average-Cost

Curves for Aluminum, Truck

Freight, and Hospital Services

5.3 PRODUCTIONAND COST IN THELONG RUN (cont.)

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Short-Run versus Long-Run Average Cost

The difference between the short run and long run is a firmsflexibility in choosing inputs.


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Indivisible Inputs and the Cost of Fake Killer Whales

APPLYING THE CONCEPTS #3: How do indivisibleinputs affect production costs?


Sea lions off the Washington coast eat steelhead and other fish, depleting somespecies threatened with extinction and decreasing the harvest of the commercialfishing industry.

Rick Funk is a plastics manufacturer who has offered to build a life-sized fiberglass

killer whale, mount it on a rail like a roller coaster, and send the whale diving throughthe water to scare off the sea lions, whalesnatural prey.

According to Funk, it would cost about $16,000 to make the first whale, including$11,000 for the mold and $5,000 for labor and materials. Once the mold is made,each additional whale would cost an additional $5,000.

In other words, the cost of producing the first fake killer whale is more than threetimes the cost of producing the second.

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Examples of Production Cost

There are scale economies in the production of electricity from wind becauseelectricity can be generated from turbines of different sizes. Although largewind turbines are more costly than small ones, the higher cost is more thanoffset by greater generating capacity. The scale economies occur because thecost of purchasing, installing, and maintaining a wind turbine increases lessthan proportionately with the turbines generating capacity.

Scale Economies in Wind Power

TABLE 5.5

Wind Turbines and the Average Cost of Electricity

Th A C t f M i

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FIGURE 5.7

Average-Cost Curve for an

Information Good

For an information good such as

a music video, the cost of

producing the first copy is veryhigh, but the marginal cost of

reproduction is relatively low,

and for products distributed

online, the marginal cost is zero.

The Average Cost of a MusicVideo

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Summary

TABLE 5.6The Language and Mathematics of Costs

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C i h 2014 P Ed i I All i h d 5 32

accounting costaccounting profit

average fixed cost (AFC)

average variable cost (AVC)

constant returns to scalediminishing returns

diseconomies of scale

economic cost

economic profit

economies of scale

explicit cost

fixed cost (FC)

implicit costindivisible input

long-run average cost (LAC)

long-run marginal cost (LMC)

long-run total cost (LTC)marginal product of labor

minimum efficient scale

short-run average total cost (ATC)

short-run marginal cost (MC)

short-run total cost (TC)

total-product curve

variable cost (VC)

K E Y T E R M S

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