Principles of Economics - 3e Chapter 7 Cost and Industry Structure

Production , Costs , and FIGURE Amazon is an American international electronic commerce company that sells books , among many other things , shipping them directly to the consumer . Until recently there were no brick and tar Amazon stores . Credit of Amazon Prime Delivery Van ( by Tony Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Explicit and Implicit Costs , and Accounting and Economic Production in the Short Run Costs in the Short Run Production in the Long Run Costs in the Long Run Introduction to Production , Costs , and Industry Structure BRING IT HOME Amazon In less than two decades , has transformed the way consumers sell , buy , and even read . Prior to Amazon , independent bookstores with limited inventories in small retail locations primarily sold books . There were exceptions , of course . Borders and Barnes Noble offered larger stores in urban areas . In the last decade , however , independent bookstores have mostly disappeared , Borders has gone out of business , and Barnes Noble is struggling . Online delivery and purchase of books has overtaken the more traditional business models . How has

158 ' Production , Costs , and Industry Structure Amazon changed the book selling industry ?

How has it managed to crush its competition ?

A major reason forthe giant retailer success is its production model and cost structure , which has enabled Amazon to undercut the competitors prices even when factoring in the cost of shipping . Read on to see how great ( like Amazon ) and small ( like your corner deli ) determine what to sell , at what output , and price . This chapter is the first of four chapters that explores the theory ofthe . This theory explains how behave . What does that mean ?

Let what we mean by the . A ( or producer or business ) combines inputs of labor , capital , land , and raw or component materials to produce outputs . If the is successful , the outputs are more valuable than the inputs . This activity of production goes beyond manufacturing ( making things ) It includes any process or service that creates value , including transportation , distribution , wholesale and retail sales . Production involves a number of important decisions that a behavior . These decisions include , but are not limited to What product or products should the produce ?

How should the produce the products ( what production process should the use ) How much output should the produce ?

What price should the charge for its products ?

How much labor should the employ ?

The answers to these questions depend on the production and cost conditions facing each . That is the subject of this chapter . The answers also depend on the market structure for the product ( in question . Market structure is a multidimensional concept that involves how competitive the industry is . We it by questions such as these How much market power does each in the industry possess ?

How similar is each product to the products of other in the industry ?

How difficult is it for new to enter the industry ?

Do compete on the basis of price , advertising , or other product differences ?

Figure 72 illustrates the range of different market structures , which we will explore in Perfect Competition , and Monopolistic Competition and . Many firms Many firms Few firms One firm I I I I I I I I Identical Similar but Identical or No similar product not identical similar product products products Perfect Monopolistic Oligopoly Monopoly Competition Competition FIGURE The Spectrum of Competition Firms face different competitive situations . At one are all trying to sell identical products . At the other one is product , and this firm faces no competition . Monopolistic competition and Oligopoly fall between the extremes of perfect competition and monopoly . Monopolistic competition is a situation with many selling similar , but not identical products . Oligopoly is a situation with few that sell identical or similar products . Let examine how determine their costs and desired levels . Then we will discuss the origins of cost , both in the short and long run . Private enterprise , which can be private individual or group business ownership , characterizes the economy . In the system , we have the option to organize private businesses as sole ( one owner ) partners ( more than one owner ) and corporations ( legal Access for free at

Explicit and Implicit Costs , and Accounting and Economic 159 entitles separate from the owners . When people think of businesses , often corporate giants like , or General Motors come to mind . However , come in all sizes , as Table shows . The vast majority of American have fewer than 20 employees . As , the Census Bureau counted million with employees in the economy . Slightly less than half of all the workers in private are at the large , meaning they employ more than 500 workers . Another 35 in the economy are at with fewer than 100 workers . These businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses . Table does not include a separate category for the millions of small businesses where a single owner or a few partners are not paid wages or a salary , but simply receive whatever they can earn . Number of Employees Firms ( of total ) Number of Paid Employees ( of total employment ) Total million ( million ( million ( million ( million ( 500 or more ( million ( TABLE Range in Size of Firms ( Source Census , 2010 ) Explicit and Implicit Costs , and Accounting and Economic Profit LEARNING OBJECTIVES By the end of this section , you will be able to Explain the difference between explicit costs and implicit costs Understand the relationship between cost and revenue Each business , regardless of size or complexity , tries to earn a Profit Total Revenue Total Cost Total revenue is the income the generates from selling its products . We calculate it by multiplying the price of the product times the quantity of output sold Total Revenue Price Quantity We will see in the following chapters that revenue is a function of the demand for the products . Total cost is what the pays for producing and selling its products . Recall that production involves the converting inputs to outputs . Each of those inputs has a cost to the . The sum of all those costs is total cost . We will learn in this chapter that short run costs are different from long run costs . We can distinguish between two types of cost explicit and implicit . Explicit costs are costs , that is , actual payments . Wages that a pays its employees or rent that a pays for its are explicit costs . Implicit costs are more subtle , but just as important . They represent the opportunity cost of using resources that the already owns . Often for small businesses , they are resources that the owners contribute . For example , working in the business while not earning a formal salary , or using the ground ofa home as a retail store are both implicit costs . Implicit costs also include the depreciation of goods , materials , and equipment that are necessary for a company to operate . See the Work It Out feature for an extended example .

160 ' Production , Costs , and Industry Structure These two of cost are important for distinguishing between two conceptions of , accounting , and economic . Accounting is a cash concept . It means total revenue minus explicit difference between dollars brought in and dollars paid out . Economic is total revenue minus total cost , including both explicit and implicit costs . The difference is important because even though a business pays income taxes based on its accounting , whether or not it is economically successful depends on its economic . Calculating Implicit Costs Consider the following example . currently works for a corporate law . She is considering opening her own legal practice , where she expects to earn per year once she establishes herself . To run her own , she would need an office and a law clerk . She has found the perfect , which rents for per year . She could hire a law clerk for per year . If these are accurate , would legal practice be ?

Step . First you have to calculate the costs . You can take what you know about explicit costs and total them Office rental Law clerk salary Total explicit costs Step . Subtracting the explicit costs from the revenue gives you the accounting . Revenues Explicit costs Accounting profit However , these calculations consider only the explicit costs . To open her own practice , would have to quit her current job , where she is earning an annual salary of . This would be an implicit cost of opening her own . Step . You need to subtract both the explicit and implicit costs to determine the true economic Economic revenues explicit costs implicit costs per year would be losing per year . That does not mean she would not want to open her own business , but it does mean she would be earning less than if she worked for the corporate . Implicit costs can include other things as well . Maybe values her leisure time , and starting her own would require her to put in more hours than at the corporate . In this case , the lost leisure would also be an implicit cost that would subtract from economic . Now that we have an idea about the different types of costs , let look at cost structures . A cost structure in the long run may be different from that in the short run . We turn to that distinction in the next few sections . Access for free at

Production in the Short Run 161 Production in the Short Run LEARNING OBJECTIVES By the end of this section , you will be able to Understand the concept of a production function Differentiate between the different types of inputs or factors in a production function Differentiate between and variable inputs Differentiate between production in the short run and in the long run Differentiate between total and marginal product Understand the concept of diminishing marginal productivity In this chapter , we want to explore the relationship between the quantity of output a produces , and the cost of producing that output . We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost . We can answer the former question by looking at the production function . FIGURE The production process for pizza includes inputs such as ingredients , the efforts of the pizza maker , and tools and materials for cooking and serving . Credit Grilled chicken pizza by Keith , BY ) Production is the process ( or processes ) a uses to transform inputs ( labor , capital , raw materials ) into outputs , the goods or services the wishes to sell . Consider pizza making . The ( pizza maker ) takes , water , and yeast to make dough . Similarly , the may take tomatoes , spices , and water to make pizza sauce . The cook rolls out the dough , brushes on the pizza sauce , and adds cheese and other toppings . The uses a wooden put the pizza into the oven to cook . Once baked , the pizza goes into a box ( if it for takeout ) and the customer pays for the good . What are the inputs ( or factors ) in the production process for this pizza ?

Economists divide factors of production into several categories 162 ' Production , Costs , and Industry Structure Natural Resources ( Land and Raw Materials ) The ingredients for the pizza are raw materials . These include the , yeast , and water for the dough , the tomatoes , herbs , and water for the sauce , the cheese , and the toppings . If the pizza place uses a oven , we would include the wood as a raw material . If the establishment heats the oven with natural gas , we would count this as a raw material . forget electricity for lights . If , instead of pizza , we were looking at an agricultural product , like wheat , we would include the land the farmer used for crops here . Labor When we talk about production , labor means human effort , both physical and mental . The was the primary example of labor here . They need to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven , but they also must know how to make the pizza , how long it cooks in the oven and a myriad of other aspects of . The business may also have one or more people to work the counter , take orders , and receive payment . Capital When economists uses the term capital , they do not mean capital ( money ) rather , they mean physical capital , the machines , equipment , and buildings that one uses to produce the product . In the case of pizza , the capital includes the peel , the oven , the building , and any other necessary equipment ( for example , tables and chairs ) Technology Technology refers to the process or processes for producing the product . How does the combine ingredients to make pizza ?

How hot should the oven be ?

How long should the pizza cook ?

What is the best oven to use ?

Gas or wood burning ?

Should the restaurant make its own dough , sauce , cheese , toppings , or should it buy them ?

Entrepreneurship Production involves many decisions and much knowledge , even for something as simple as pizza . Who makes those decisions ?

Ultimately , it is the entrepreneur , the person who creates the business , whose idea it is to combine the inputs to produce the outputs . The cost of producing pizza ( or any output ) depends on the amount of labor capital , raw materials , and other inputs required and the price of each input to the entrepreneur . Let explore these ideas in more detail . We can summarize the ideas so far in terms ofa production function , a mathematical expression or equation that explains the engineering relationship between inputs and outputs , The production function gives the answer to the question , how much output can the produce given different amounts of inputs ?

Production functions are to the product . Different products have different production functions . The amount of labor a farmer uses to produce a bushel is likely different than that required to produce an automobile . Firms in the same industry may have somewhat different production functions , since each may produce a little differently . One pizza restaurant may make its own dough and sauce , while another may buy those . A pizza restaurant probably uses more labor ( to handle table service ) than a purely restaurant . We can describe inputs as either or variable . Fixed inputs are those that ca easily be increased or decreased in a short period of time . In the pizza example , the building is a input . The restaurant owner signs a lease and is stuck in the building until the lease expires . Fixed inputs the maximum output capacity . This is analogous to the potential real shown by society production possibilities curve , the maximum quantities of outputs a society can produce at a given time with its available resources . Variable inputs are those that can easily be increased or decreased in a short period of time . The can order more ingredients with a phone call , so ingredients would be variable inputs . The owner could hire a new person to work the counter pretty quickly as well . Economists often use a form for the production function , Access for free at

Production in the Short Run 163 where represents all the variable inputs , and represents all the inputs . Economists differentiate between short and long run production . The short run is the period of time during which at least some factors of production are . During the period of the pizza restaurant lease , the pizza restaurant is operating in the short run , because it is limited to using the current owner can choose a larger or smaller building . The long run is the period of time during which all factors are variable . Once the lease expires for the pizza restaurant , the shop owner can move to a larger or smaller place . Let explore production in the short run using a example tree cutting ( for lumber ) with a crosscut saw . FIGURE Production in the short run may be explored through the example of lumberjacks using a saw . Credit DO Apple Day Civilian Conservation Corps Demonstration Crosscut Saw ( Gladden ) by Virginia State , BY ) Since by capital is in the short run , our production function becomes , or This equation simply indicates that since capital is , the amount of output ( trees cut down per day ) depends only on the amount of labor employed ( number of lumberjacks working ) We can express this production function numerically as Table below shows . Lumberjacks Trees ( 10 12 13 13 46 TABLE Short Run Production Function for Trees

164 ' Production , Costs , and Industry Structure Note that we have introduced some new language . We also call Output ( Total Product ( which means the amount of output produced with a given amount of labor and a amount of capital . In this example , one lumberjack using a saw can cut down four trees in an hour . Two lumberjacks using a saw can cut down ten trees in an hour . We should also introduce a critical concept marginal product . Marginal product is the additional output of one more worker . Mathematically , Marginal Product is the change in total product divided by the change in labor . In the table above , since workers produce trees , the marginal product of the worker is four trees per day , but the marginal product of the second worker is six trees per day . Why might that be the case ?

It because of the nature of the capital the workers are using . A saw works much better with two persons than with one . Suppose we add a third lumberjack to the story . What will that persons marginal product be ?

What will that person contribute to the team ?

Perhaps they can oil the saw teeth to keep it sawing smoothly or they could bring water to the two people sawing . What you see in the table is a critically important conclusion about production in the short run It may be that as we add workers , the marginal product increases at , but sooner or later additional workers will have decreasing marginal product . In fact , there may eventually be no effect or a negative effect on output . This is called the Law of Diminishing Marginal Product and it a characteristic of production in the short run . Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice . Both concepts are examples of the more general concept of diminishing marginal returns . Why does diminishing marginal productivity occur ?

It because of capital . We will see this more clearly when we discuss production in the long run . We can show these concepts graphically as Figure and Figure illustrate . Figure graphically shows the data from Table . Figure shows the more general cases of total product and marginal product curves . Short Run Total Product for Trees Marginal Product for Trees 14 12 10 III St ( LO of Lumberjacks of Lumberjacks FIGURE Access for free at

Costs in the Short Run 165 FIGURE Costs in the Short Run LEARNING OBJECTIVES By the end of this section , you will be able to Understand the relationship between production and costs Understand that every factor of production has a corresponding factor price Analyze costs in terms of total cost , cost , variable cost , marginal cost , and average cost Calculate average Evaluate patterns of costs to determine potential We explained that a total costs depend on the quantities of inputs the uses to produce its output and the cost of those inputs to the . The production function tells us how much output the will produce with given amounts of inputs . However , ifwe think about that backwards , it tells us how many inputs the needs to produce a given quantity of output , which is the thing we need to determine total cost . Let move to the second factor we need to determine . For every factor of production ( or input ) there is an associated factor payment . Factor payments are what the pays for the use of the factors of production . From the perspective , factor payments are costs . From the owner of each factor perspective , factor payments are income . Factor payments include Raw materials prices for raw materials Rent for land or buildings Wages and salaries for labor Interest and dividends for the use of capital ( loans and equity investments ) for entrepreneurship . is the residual , what left over from revenues after the pays all the other costs . While it may seem odd to treat as a cost , it is what entrepreneurs earn for taking the risk of starting a business . You can see this correspondence between factors and factor payments in the inside loop of the circular diagram in Figure . We now have all the information necessary to determine a costs . A cost function is a mathematical expression or equation that shows the cost of producing different levels of output . Cost 44 52 90 TABLE Cost Function for Producing

166 ' Production , Costs , and Industry Structure What we observe is that the cost increases as the firm produces higher quantities of output . This is pretty intuitive , since producing more output requires greater quantities of inputs , which cost more dollars to acquire . What is the origin of these cost ?

They come rom the production function and discussion of costs in the short run above , Costs in the Short Run , was based on the fol function , which is similar to Table except for instead of trees . factor payments . The owing production Workers ( TABLE We can use the information from the production function to determine production costs . What we need to know is how many workers are required to produce any quantity of output . If we the order of the rows , we invert the production function so it shows ( Workers ( TABLE Now focus on the whole number quantities of output . We eliminate the fractions from the table ( Workers ( TABLE Suppose widget workers receive 10 per hour . Mu the Workers row blanks ) gives us the cost of producing different levels of output . Workers ( Wage Rate per hour 10 10 10 10 Cost TABLE This is same cost function with which we began ! shown in Table 10 ( and eliminating the Now that we have the basic idea of the cost origins and how they are related to production , let drill down into the details . Average and Marginal Costs The cost of producing a output depends on how much labor and physical capital the uses . A list of Access for free at

Costs in the Short Run the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or meals . We can measure costs in a variety of ways . Each way provides its own insight into costs . Sometimes need to look at their cost per unit of output , notjust their total cost . There are two ways to measure per unit costs . The most intuitive way is average cost . Average cost is the cost on average of producing a given quantity . We average cost as total cost divided by the quantity of output produced . AC two costs a total of 44 , the average cost per widget is 22 per widget . The other way of measuring cost per unit is marginal cost . If average cost is the cost of the average unit of output produced , marginal cost is the cost of each individual unit produced . More formally , marginal cost is the cost one more unit of output . Mathematically , marginal cost is tie change in total cost divided by the change in output . Ifthe cost of the widget is and the cost of two is 44 , the marginal cost of the second widget is 44 150 . We can see the Widget Cost table below with average and marginal cost added . TABLE Extended Cost Function for Producing Note that the marginal cost of the unit of output is always the same as total cost . Fixed and Variable Costs We can decompose costs into and variable costs . Fixed costs are the costs of the inputs ( capital ) Because inputs do not change in the short run , costs are expenditures that do not change regardless of the level of production . Whether you produce a great deal or a little , the costs are the same . One example is the rent on a factory or a retail space . Once you sign the lease , the rent is the same regardless of how much you produce , at least until the lease expires . Fixed costs can take many other forms for example , the cost of machinery or equipment to produce the product , research and development costs to develop new products , even an expense like advertising to popularize a brand name . The amount of costs varies according to the line of business for instance , manufacturing computer chips requires an expensive factory , but a local moving and hauling business can get by with almost no costs at all if it rents trucks by the day when needed . Variable costs are the costs of the variable inputs ( labor ) The only way to increase or decrease output is by increasing or decreasing the variable inputs . Therefore , variable costs increase or decrease with output . We treat labor as a variable cost , since producing a greater quantity of a good or service typically requires more workers or more work hours . Variable costs would also include raw materials . Total costs are the sum of plus variable costs . Let look at another example . Consider the barber shop called The Clip Joint in Figure . The data for output and costs are in Table . The costs of operating the barber shop , including the space and equipment , are 160 per day . The variable costs are the costs of hiring barbers , which in our example is 80 per barber each day . The two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers . The third column shows the costs , which do not change regardless of the level . The fourth column shows the variable costs at each level of output . We calculate these by taking the amount of labor hired and multiplying by the

168 ' Production , Costs , and Industry Structure wage . For example , two barbers cost 80 160 . Adding together the costs in the third column and the variable costs in the fourth co produces the total costs in the column . For example , with two barbers the total cost is 160 60 320 . Labor Quantity Fixed Cost Variable Cost Total Cost 16 160 80 240 40 160 160 320 60 160 240 400 72 160 320 480 80 160 400 560 84 160 480 640 82 160 560 720 TABLE Output and Total Costs 700 600 500 400 300 ' 200 Fixed 100 Cost ( 160 ) 10 20 30 40 50 60 70 80 90 Output FIGURE How Output Affects Total Costs At zero production , the costs of 160 are still present . As production increases , variable costs are added to costs , and the total cost is the sum of the two . At zero production , the costs of 160 are still present . As production increases , we add variable costs to costs , and the total cost is the sum of the two . Figure graphically shows the relationship between the quantity of output produced and the cost of producing that output . We always show the costs as the vertical intercept of the total cost curve that is , they are the costs incurred when output is zero so there are no variable costs . You can see from the graph that once production starts , total costs and variable costs rise . While variable costs may initially increase at a decreasing rate , at some point they begin increasing at an increasing rate . This is caused by diminishing marginal productivity which we discussed earlier in the Production in the Short Run section of this chapter , which is easiest to see with an example . As the number of barbers increases from zero to one in the table , output increases from to 16 for a marginal gain ( or marginal product ) of 16 . As the number rises from one to two barbers , output increases from 16 to 40 , a marginal gain of 24 . From that point on , though , the marginal product diminishes as we add each additional barber . For example , as the number of barbers rises from two to three , the marginal product is only 20 and as the number rises from three to four , the marginal product is only 12 . Access for free at

Costs in the Short Run 169 To understand the reason behind this pattern , consider that a barber shop is a very busy operation . The single barber needs to do everything say hello to people entering , answer the phone , cut hair , sweep , and run the cash register . A second barber reduces the level of disruption back and forth between these tasks , and allows a greater division of labor and specialization . The result can be increasing marginal productivity . However , as the shop adds other barbers , the advantage of each additional barber is less , since the specialization of labor can only go so far . The addition ofa sixth or seventh or eighth to greet people at the door will have less impact than the second one did . This is the pattern of diminishing marginal productivity . As a result , the total costs will begin to rise more rapidly as output increases . At some point , you may even see negative returns as the additional barbers begin bumping elbows and getting in each other way . In this case , the addition of still more barbers would actually cause output to decrease , as the last row of Table 79 shows . This pattern of diminishing marginal productivity is common in production . As another example , consider the problem of irrigating a crop on a farmers . The plot of land is the factor of production , while the water that the farmer can add to the land is the key variable cost . As the farmer adds water to the land , output increases . However , adding increasingly more water brings smaller increases in output , until at some point the water the and actually reduces output . Diminishing marginal productivity occurs because , with inputs ( land in this example ) each additional unit of input ( water ) contributes less to overall production . Average Total Cost , Average Variable Cost , Marginal Cost The breakdown of total costs into and variable costs can provide a basis for other insights as well . The columns of Table duplicate the previous table , but the last three columns show average total costs , average variable costs , and marginal costs . These new measures analyze costs on a ( rather than a total ) basis and are in the curves in Figure . 20 14 12 10 Cost ( 10 20 30 40 50 60 70 80 90100 Output FIGURE Cost Curves at the Clip Joint We can also present the information on total costs , cost , and variable cost on a basis . We calculate average total cost ( ATC ) by dividing total cost by the total quantity produced . The average total cost curve is typically . We calculate average variable cost ( by dividing variable cost by the quantity produced . The average variable cost curve lies below the average total cost curve and is also typically . We calculate marginal cost ( by change in total cost between two levels of output and dividing by the change in output . The marginal cost curve is .

170 ' Production , Costs , and Industry Structure Labor Quantity Fixed Variable Total Marginal Average Total Average Variable Cost Cost Cost Cost Cost Cost 16 160 80 240 40 160 160 320 60 160 240 400 72 160 320 480 80 160 400 560 84 160 480 640 TABLE Different Types of Costs Average total cost ( sometimes referred to simply as average cost ) is total cost divided by the quantity of output . Since the total cost 40 haircuts is 320 , the average total cost for producing each of 40 haircuts is , or per haircut . Average cost curves are typically , as Figure shows . Average total cost starts off relatively high , because at low levels of output total costs are dominated by the cost . Mathematically , the denominator is so small that average total cost is large . Average total cost then declines , as the costs are spread over an increasing quantity . In the average cost calculation , the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced . However , as output expands still further , the average cost begins to rise . At the right side of the average cost curve , total costs begin rising more rapidly as diminishing returns come into effect . We obtain average variable cost when we divide variable cost by quantity of output . For example , the variable cost of producing 80 haircuts is 400 , so the average variable cost is , or per haircut . Note that at any level , the average variable cost curve will always lie below the curve for average total cost , as Figure shows . The reason is that average total cost includes average variable cost and average cost . Thus , for 80 haircuts , the average total cost is per haircut , while the average variable cost is per haircut . However , as output grows , costs become relatively less important ( since they do not rise with output ) so average variable cost sneaks closer to average cost . Average total and variable costs measure the average costs of producing some quantity . Marginal cost is somewhat different . Marginal cost is the additional cost of producing one more unit of output . It is not the cost per unit of all units produced , but only the next one ( or next few ) We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity . For example , as quantity produced increases from 40 to 60 haircuts , total costs rise by 400 320 , or 80 . Thus , the marginal cost for each of those marginal 20 units will be , or per haircut . The marginal cost curve is generally , because diminishing marginal returns implies that additional units are more costly to produce . We can see small range of increasing marginal returns in the as a dip in the marginal cost curve before it starts rising . There is a point at which marginal and average costs meet , as the following Clear it Up feature discusses . CLEAR IT UP Where do marginal and average costs meet ?

The marginal cost line intersects the average cost line exactly at the bottom of the average cost occurs at a quantity of 72 and cost of in Figure . The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs . If the marginal cost of production is below the average cost Access for free at

Costs in the Short Run for producing previous units , as it is for the points to the left of where crosses ATC , then producing one more additional unit will reduce average costs the ATC curve will be in this zone . Conversely , if the marginal cost of production for producing an additional unit is above the average cost for producing the earlier units , as it is for points to the right of where crosses ATC , then producing a marginal unit will increase average costs the ATC curve must be in this zone . The point of transition , between where is pulling ATC down and where it is pulling it up , must occur at the minimum point of the ATC curve . This idea of the marginal cost pulling down the average cost or pulling up the average cost may sound abstract , but think about it in terms of your own grades . If the score on the most recent quiz you take is lower than your average score on previous quizzes , then the marginal quiz pulls down your average . If your score on the most recent quiz is higher than the average on previous quizzes , the marginal quiz pulls up your average . In this same way , low marginal costs of production first pull down average costs and then higher marginal costs pull them up . The numerical calculations behind average cost , average variable cost , and marginal cost will change from to . However , the general patterns of these curves , and the relationships and economic intuition behind them , will not change . Lessons from Alternative Measures of Costs Breaking down total costs into cost , marginal cost , average total cost , and average variable cost is useful because each statistic offers its own insights for the . Whatever the quantity of production , total revenue must exceed total costs if it is to earn a . As explored in the chapter Choice in a World of Scarcity , costs are often sunk costs that a can not recoup . In thinking about what to do next , typically you should ignore sunk costs , since you have already spent this money and can not make any changes . However , you can change variable costs , so they convey information about the ability to cut costs in the present and the extent to which costs will increase rises . CLEAR IT UP Why are total cost and average cost not on the same graph ?

Total cost , cost , and variable cost each reflect different aspects of the cost of production over the entire quantity of output produced . We measure these costs in dollars . In contrast , marginal cost , average cost , and average variable cost are costs per unit . In the previous example , we measured them as dollars per haircut . Thus , it would not make sense to put all of these numbers on the same graph , since we measure them in different units ( versus per unit of output ) It would be as if the vertical axis measured two different things . In addition , as a practical matter , if they were on the same graph , the lines for marginal cost , average cost , and average variable cost would appear almost flat against the horizontal axis , compared to the values for total cost , fixed cost , and variable cost . Using the from the previous example , the total cost of producing 40 haircuts is 320 . However , the average cost is , or . If you both total and average cost on the same axes , the average cost would hardly show . Average cost tells a whether it can earn given the current price in the market . Ifwe divide by the quantity of output produced we get average , also known as the margin . Expanding the equation for gives

172 ' Production , Costs , and Industry Structure profit quantity produced total revenue total cost quantity produced average profit total revenue total cost quantity produced quantity produced average COSI However , note that price quantity produced average revenue quantity produced price Thus average average cost This is the margin . This implies that if the market price is above average cost , average , and thus total , will be positive . is below average cost , then will be negative . We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total not . Thus , marginal cost helps producers understand how increasing or decreasing production affects . A Variety of Cost Patterns The pattern of costs varies among industries and even among in the same industry . Some businesses have high costs , but low marginal costs . Consider , for example , an internet company that provides medical advice to customers . Consumers might pay such a company directly , or perhaps hospitals or healthcare practices might subscribe on behalf of their patients . Setting up the website , collecting the information , writing the content , and buying or leasing the computer space to handle the web are all costs that the company must undertake before the site can work . However , when the website is up and running , it can provide a high quantity of service with relatively low variable costs , like the cost of monitoring the system and updating the information . In this case , the total cost curve might start at a high level , because of the high costs , but then might appear close to , up to a large quantity of output , the low variable costs of operation . If the website is popular , however , a large rise in the number will overwhelm the website , and increasing output further could require a purchase of additional computer space . For other , costs may be relatively low . For example , consider that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter . For costs , such may need little more than a car to transport workers to homes of customers and some rakes and shovels . Still other may that diminishing marginal returns set in quite sharply . Ifa manufacturing plant tried to run 24 hours a day , seven days a week , little time remains for routine equipment maintenance , and marginal costs can increase dramatically as the struggles to repair and replace overworked equipment . Every can gain insight into its task of earning by dividing its total costs into and variable costs , and then using these calculations as a basis for average total cost , average variable cost , and marginal cost . However , making a decision about the quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue , which in turn requires looking at the market structure in which the itself . Before we turn to the analysis of market structure in other chapters , we will analyze the cost structure from a perspective . Production in the Long Run LEARNING OBJECTIVES By the end of this section , you will be able to Understand how long run production differs from short run production . Access for free at

Production in the Long Run In the long run , all factors ( including capital ) are variable , so our production function is , Consider a secretarial that does typing for hire using typists for labor and personal computers for capital . To start , the has just enough business for one typist and one to keep busy for a day . Say that documents . Now suppose the receives a rush order from a good customer for 10 documents tomorrow . Ideally , the would like to use two typists and two to produce twice their normal output of documents . However , in the short turn , the has capital , only one . The table below shows the situation ( 521000 TABLE Short Run Production Function for Typing In the short run , the only variable factor is labor so the only way the can produce more output is by hiring additional workers . What could the second worker do ?

What can they contribute to the ?

Perhaps they can answer the phone , which is a major impediment to completing the typing assignment . What about a third worker ?

Perhaps the third worker could bring coffee to the two workers . You can see both total product and marginal product for the above . Now here something to think about At what point ( after how many workers ) does diminishing marginal productivity kick in , and more importantly , why ?

In this example , marginal productivity starts to decline after the second worker . This is because capital is . The production process for typing works best with one worker and one . Ifyou add more than one typist , you get seriously diminishing marginal productivity . Consider the long run . Suppose the demand increases to 15 documents per day . What might the do to operate more ?

If demand has tripled , tie could acquire two more , which would give us a new short run production function as below shows . Typists ( 52 ( 10 15 17 18 18 55 TABLE Long Run Production Function for Typing With more capital , the can hire three workers before diminishing comes into effect . More generally , because all factors are variable , the long run production function shows the most way of producing any level of output .

174 ' Production , Costs , and Industry Structure Costs in the Long Run LEARNING OBJECTIVES By the end of this section , you will be able to Calculate long run total cost Identify economies of scale , of scale , and constant returns to scale Interpret graphs of average cost curves and average cost curves Analyze cost and production in the long run and short run The long run is the period of time when all costs are variable . The long run depends on the of the in is not a precise period of time . Ifyou have a lease on your factory , then the long run is any period longer than a year , since after a year you are no longer bound by the lease . No costs are in the long run . A can build new factories and purchase new machinery , or it can close existing facilities . In planning for the long run , the will compare alternative production technologies ( or processes ) In this context , technology refers to all alternative methods of combining inputs to produce outputs . It does not refer to a new invention like the tablet computer . The will search for the production technology that allows it to produce the desired level of output at the lowest cost . After all , lower costs lead to higher least if total revenues remain unchanged . Moreover , each must fear that if it does not seek out the methods of production , then it may lose sales to competitor that a way to produce and sell for less . Choice of Production Technology A can perform many tasks with a range of combinations of labor and physical capital . For example , a can have human beings answering phones and taking messages , or it can invest in an automated voicemail system . A can hire clerks and secretaries to manage a system folders and cabinets , or it can invest in a computerized system that will require fewer employees . A can hire workers to push supplies around a factory on rolling carts , it can invest in motorized vehicles , or it can invest in robots that carry materials without a driver . Firms often face a choice between buying a many small machines , which need a worker to run each one , or buying one larger and more expensive machine , which requires only one or two workers to operate it . In short , physical capital and labor can often substitute for each other . Consider the example of local governments hiring a private to clean up public parks . Three different combinations of labor and physical capital for cleaning up a single park appear in Table . The production technology is heavy on workers and light on machines , while the next two technologies substitute machines for workers . Since all three of these production methods produce the same will choose the technology that is least expensive , given the prices of labor and machines . Production technology 10 workers machines Production technology workers machines Production technology workers machines TABLE Three Ways to Clean a Park Production technology uses the most labor and least machinery , while production technology uses the least labor and the most machinery . Table outlines three examples of how the total cost will change with each production technology as the cost of labor changes . As the cost of labor rises from example A to to , the will choose to substitute away from labor and use more machinery . Access for free at

Costs in the Long Run Example A Workers cost 40 , machines cost 80 Labor Cost Machine Cost Total Cost Cost of technology 10 40 400 80 160 560 Cost of technology 40 280 80 320 600 Cost of technology 40 120 80 560 680 Example Workers cost 55 , machines cost 80 Labor Cost Machine Cost Total Cost Cost of technology 10 55 550 80 160 710 Cost of technology 55 385 80 320 705 Cost of technology 55 165 80 560 725 Example Workers cost 90 , machines cost 80 Labor Cost Machine Cost Total Cost Cost of technology 10 90 900 80 160 Cost of technology 90 630 80 320 950 Cost of technology 90 270 80 560 830 TABLE Total Cost with Rising Labor Costs Example A shows the cost calculation when wages are 40 and machines costs are 80 . In this case , technology is the production technology . In example , wages rise to 55 , while the cost of machines does not change , in which case technology is the production technology . If wages keep rising up to 90 , while the cost of machines remains unchanged , then technology clearly becomes the form of production , as example shows . This example shows that as an input becomes more expensive ( in this case , the labor input ) will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive . This pattern helps to explain why the demand curve for labor ( or any input ) slopes down that is , as labor becomes relatively more expensive , will seek to substitute the use of other inputs . When a multinational employer like or sets up a bottling plant or a restaurant in a economy like the United States , Canada , Japan , or Western Europe , it is likely to use production technologies that conserve on the number and focuses more on machines . However , that same employer is likely to use production technologies with more workers and less machinery when producing in a country like Mexico , China , or South Africa . Economies of Scale Once a has determined the least costly production technology , it can consider the optimal scale of production , or quantity of output to produce . Many industries experience economies of scale . Economies of scale refers to the situation where , as the quantity of output goes up , the cost per unit goes down . This is the idea behind warehouse stores like Costco or . In everyday language a larger factory can produce at a lower average cost than a smaller factory .

176 ' Production , Costs , and Industry Structure Figure illustrates the idea of economies of scale , showing the average cost of producing an alarm clock falling as the quantity of output rises . For a factory like , with an output level of , the average cost of production is 12 per alarm clock . For a factory like , with an output level of , the average cost of production falls to per alarm clock . For a large factory like , with an output of , the average cost of production declines still further to per alarm clock . 14 12 10 ' 000 000 Quantity of Production FIGURE Economies of Scale A small factory like produces alarm clocks at an average cost of 12 per clock . A medium factory like produces alarm clocks at a cost of per clock . A large factory like produces alarm clocks at a cost of per clock . Economies of scale exist when the larger scale of production leads to lower average costs . The average cost curve in Figure may appear similar to the average cost curves we presented earlier in this chapter , although it is rather than . However , there is one major difference . The economies of scale curve is a average cost curve , because it allows all factors of production to change . The average cost curves we presented earlier in this chapter assumed the existence of costs , and only variable costs were allowed to change . One prominent example of scale occurs in the chemical industry . Chemical plants have many pipes . The cost of the materials for producing a pipe is related to the circumference of the pipe and its length . However , the area of the pipe determines the volume of chemicals that can through it . The calculations in Table show that a pipe which uses twice as much material to make ( as shown by the circumference ) can actually carry four times the volume of chemicals because the pipes area rises by a factor of four ( as the Area column below shows ) Circumference ( Area ( pipe inches square inches pipe inches square inches pipe inches square inches TABLE Comparing Pipes Economies of Scale in the Chemical Industry A doubling of the cost of producing the pipe allows the chemical to process four times as much material . This pattern is a major reason for economies of scale in chemical production , which uses a large quantity of pipes . Of course , economies of scale in a chemical plant are more complex than this simple calculation suggests . However , the chemical engineers who design these plants have long used what they call the Access for free at

Costs in the Long Run tenths rule , a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only as much . Shapes of Average Cost Curves While in the short run are limited to operating on a single average cost curve ( corresponding to the level of costs they have chosen ) in the long run when all costs are variable , they can choose to operate on any average cost curve . Thus , the average cost ( curve is actually based on a group of average cost ( curves , each ofwhich represents one level of costs . More precisely , the average cost curve will be the least expensive average cost curve for any level of output . Figure 710 shows how we build the average cost curve from a group of average cost curves . Five short cost curves appear on the diagram . Each curve represents a different level of costs . For example , you can imagine as a small factory , as a medium factory , as a large factory , and and as very large and . Although this diagram shows only curves , presumably there are an number of other curves between the ones that we show . Think of this family of average cost curves as representing different choices for a that is planning its level of investment in cost physical that different choices about capital investment in the present will cause it to end up with different average cost curves in the future . Cost ( Output Economies Constant of scale returns of scale to scale FIGURE From Average Cost Curves to Average Cost Curves The different average cost ( curves each represents a different level of costs , from the low level of costs at to the high level of costs at . Other curves , not in the diagram , lie between the ones that are here . The average cost ( curve shows the lowest cost for producing each quantity of output when costs can vary , and so it is formed by the bottom edge of the family of curves . If a wished to produce quantity 03 , it would choose the costs associated with . The average cost curve shows the cost each quantity in the long run , when the can choose its level of costs and thus choose which average costs it desires . If the plans to produce in the long run at an output of , it should make the set of investments that will lead it to locate on , which allows producing at the lowest cost . A that intends to produce would be foolish to choose the level of costs at or . At the level of costs is too low for producing at lowest possible cost , and producing would require adding a very high level of variable costs and make the average cost very high . At , the level of costs is too high for producing at lowest possible cost , and again average costs would be very high as a result . The shape of the cost curve , in Figure , is fairly common for many industries . The portion of the average cost curve , where it is sloping from output levels to to , illustrates the case of economies of scale . In this portion of the average cost curve , larger scale leads

178 ' Production , Costs , and Industry Structure to lower average costs . We illustrated this pattern earlier in Figure . In the middle portion of the average cost curve , the portion of the curve around , economies of scale have been exhausted . In this situation , allowing all inputs to expand does not much change the average cost of production . We call this constant returns to scale . In this curve range , the average cost of production does not change much as scale rises or falls . The following Clear It Up feature explains where diminishing marginal returns into this analysis . CLEAR IT UP How do economies of scale compare to diminishing marginal returns ?

The concept of economies of scale , where average costs decline as production expands , might seem to conflict with the idea of diminishing marginal returns , where marginal costs rise as production expands . However , diminishing marginal returns refers only to the average cost curve , where one variable input ( like labor ) is increasing , but other inputs ( like capital ) are . Economies of scale refers to the average cost curve where all inputs are allowed to increase together . Thus , it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change , and at the same time has economies of scale when all inputs change together to produce a operation . Finally , the portion of the average cost curve , running from output level to , shows a situation where , as the level of output and the scale rises , average costs rise as well . We call this situation of scale . A or a factory can grow so large that it becomes very to manage , resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other , and as failures to communicate lead to disruptions in the of work and materials . Not many overly large factories exist in the real world , because with their very high production costs , they are unable to compete for long against plants with lower average costs of production . However , in some planned economies , like the economy of the old Soviet Union , plants that were so large as to be grossly were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses . of scale can also be present across an entire , notjust a large factory . The leviathan effect can hit that become too large to run efficiently , across the entirety of the enterprise . Firms that shrink their operations are often responding to itself in the region , thus moving back to a lower average cost at a lower output level . LINK IT UP Visit this website to read an article about the complexity of the belief that banks can be The Size and Number of Firms in an Industry The shape of the average cost curve has implications for how many will compete in an industry , and whether the in an industry have many different sizes , or tend to be the same size . For example , say that the appliance industry sells one million dishwashers every year at a price of 500 each and the average cost curve for dishwashers is in Figure ( a ) In Figure ( a ) the lowest point of the curve occurs at a quantity of produced . Thus , the market for dishwashers will consist of 100 different manufacturing plants of this same size . If some built a plant that produced dishwashers per year or dishwashers per year , the average costs at such plants would be well above 500 , and the would not be able to compete . Access for free at

Costs in the Long Run 500 . i . 5000 000 Output Output ( a ) curve with a clear minimum point ( curve FIGURE The Curve and the Size and Number of Firms ( a ) firms will produce at output level When the curve has a clear minimum point , then any firm producing a different quantity will have higher costs . In this case , a firm producing at a quantity of will produce at a lower average cost than a firm producing , say , or units . firms will produce between output levels and When the curve has a flat bottom , then firms producing at any quantity along this flat bottom can compete . In this case , any firm producing a quantity between and can compete effectively , although producing less than or more than would face higher average costs and be unable to compete . CLEAR IT UP How can we view cities as examples of economies of scale ?

Why are people and economic activity concentrated in cities , rather than distributed evenly across a country ?

The fundamental reason must be related to the idea of economies of grouping economic activity is more productive in many cases than spreading it out . For example , cities provide a large group of nearby customers , so that businesses can produce at an efficient economy of scale . They also provide a large group of workers and suppliers , so that business can hire easily and purchase whatever specialized inputs they need . Many of the attractions of cities , like sports stadiums and museums , can operate only if they can draw on a large nearby population base . Cities are big enough to offer a wide variety of products , which is what appeals to many shoppers . These factors are not exactly economies of scale in the narrow sense of the production function of a single firm , but they are related to growth in the overall size of population and market in an area . Cities are sometimes called agglomeration These agglomeration factors help to explain why every economy , as it develops , has an increasing proportion of its population living in urban areas . In the United States , about 80 of the population now lives in metropolitan areas ( which include the suburbs around cities ) compared to just 40 in 1900 . However , in poorer nations of the world , including much of Africa , the proportion of the population in urban areas is only about 30 . One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise . If cities offer economic advantages that are a form of economies of scale , then why do all or most people live in one giant city ?

At some point , agglomeration economies must turn into . For example , traffic congestion may reach a point where the gains from being geographically nearby are by how long it takes to travel . High densities of people , cars , and factories can mean more garbage and air and water pollution . Facilities like parks or museums may become overcrowded . There may be economies of scale for negative activities like crime , because high densities of people and businesses , combined with the greater impersonality of cities , make it easier for illegal activities as well as legal ones . The future of cities , both in the United States and in other

180 ' Production , Costs , and Industry Structure countries around the world , will be determined by their ability to from the economies of agglomeration and to minimize or counterbalance the corresponding . We illustrate a more common case in Figure ( where the curve has a area of constant returns to scale . In this situation , any with a level of output between and will be able to produce at about the same level of average cost . Given that the market will demand one million dishwashers per year at a price of 500 , this market might have as many as 200 producers ( that is , one million dishwashers divided by ma ing each ) or as few as 50 producers ( one million dishwashers divided by making each ) The producers in this market will range in size from that make units to that make units . However , that produce below units or more than will be unable to compete , because their average costs will be too high . Thus , ifwe see an industry where almost all plants are the same size , it is like that the average cost curve has a unique bottom point as in ( a ) However , if the average cost curve has a wide bottom like Figure ( then of a variety of different sizes will be to compete with each other . We can interpret the section of the average cost curve in Figure ( in two different ways . One interpretation is that a single manufacturing plant producing a quantity of has the same average costs as a single manufacturing plant four times as much capacity that produces a quantity of . The other interpretation is that one owns a single manufacturing plant that produces a quantity of , while another owns four separate manufacturing plants , which each produce a quantity of . This second explanation , based on the insight that a single may own a number of different manufacturing plants , is especially useful in explaining the average cost curve often has a large thus why a seemingly smaller may be able to compete quite well with a larger . At some point , however , the task of coordinating and managing many different plants raises the cost of production sharply , and the run average cost curve slopes up as a result . In the examples to this point , the quantity demanded in the market is quite large ( one million ) compared with the quantity produced at the bottom of the average cost curve ( or ) In such a situation , the market is set for competition between many . However , what if the bottom of the average cost curve is at a quantity of and the total market demand at that price is only slightly higher than that even somewhat lower ?

Return to Figure ( a ) where the bottom of the average cost curve is at , but now imagine that the total quantity of dishwashers demanded in the market at that price of 500 is only . In this situation , the total number of in the market would be three . We call a handful of in a market an oligopoly , and the chapter on Mono Competition and Oligopoly will discuss the range of competitive strategies that can occur when compete . Alternatively , consider a situation , again in the setting of Figure ( a ) where the bottom of the average cost curve is , but total demand for the product is only . For simplicity , imagine that this demand is highly inelastic , so that it does not vary according to price . In this situation , the market may well end up with a single all units . If any tried to challenge this monopoly while producing a quantity lower than units , the prospective competitor would have a higher average cost , and so it would not be able to compete in the longer term without losing money . The chapter on Monopoly discusses the situation of a monopoly . Thus , the shape of the average cost curve reveals whether competitors in the market will be different sizes . Ifthe curve has a single point at the bottom , then the in the market will be about the same size , but if the curve has a segment of constant returns to scale , then in the market may be a variety of different sizes . The relationship between the quantity at the minimum of the average cost curve and the quantity Access for free at

Costs in the Long Run 181 demanded in the market at that price will predict how much competition is likely to exist in the market . If the quantity demanded in the market far exceeds the quantity at the minimum of the , then many will compete . If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the , a few will compete . If the quantity demanded in the market is less than the quantity at the minimum of the , a monopoly is a likely outcome . Shifting Patterns of Average Cost New developments in production technology can shift the average cost curve in ways that can alter the size distribution of in an industry . For much of the twentieth century , the most common change had been to see alterations in technology , like the assembly line or the large department store , where producers seemed to gain an advantage over smaller ones . In the average cost curve , the economies of scale portion of the curve stretched over a larger quantity . However , new production technologies do not inevitably lead to a greater average size for . For example , in recent years some new technologies for generating electricity on a smaller scale have appeared . The traditional electricity plants needed to produce 300 to 600 megawatts of power to exploit economies of scale fully . However , turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less . These new technologies create the possibility for smaller companies or plants to generate electricity as as large ones . Another example ofa shift to smaller plants may be taking place in the tire industry . A traditional tire plant produces about six million tires per year . However , in 2000 , the Italian company introduced a new tire factory that uses many robots . The tire plant produced only about one million tires per year , but did so at a lower average cost than a traditional tire plant . Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for . On one side , the new technology may make it easier for small to reach out beyond their local geographic area and customers across a state , or the nation , or even across international boundaries . This factor might seem to predict a future with a larger number of small competitors . On the other side , perhaps the new information and communications technology will create markets where one large company will tend to command a large share of total sales , as has done producing of software for personal computers or Amazon has done in online bookselling . Moreover , improved information and communication technologies might make it easier to manage many different plants and operations across the country or around the world , and thus encourage larger . This ongoing battle between the forces of smallness and largeness will be of great interest to economists , businesspeople , and . BRING IT HOME Amazon Traditionally , bookstores have operated in retail locations with inventories held either on the shelves or in the back of the store . These retail locations were very pricey in terms of rent . Until recently , Amazon had no retail locations . It only sold online and delivered by mail . Amazon now has retail stores in California , Oregon and Washington State and retail stores are coming to Illinois , Massachusetts , New Jersey , and New York . Amazon offers almost any book in print , convenient purchasing , and prompt delivery by mail . Amazon holds its inventories in huge warehouses in rent locations around the world . The warehouses are highly computerized using robots and relatively workers , making for low average costs per sale . Amazon demonstrates the advantages economies of scale can offer to a firm that exploits those economies .

182 ' Key Terms Key Terms accounting total revenues minus explicit costs , including depreciation average divided by the quantity of output produced also known as margin average total cost total cost divided by the quantity of output average variable cost variable cost divided by the quantity of output constant returns to scale expanding all inputs proportionately does not change the average cost of production diminishing marginal productivity general rule that as a employs more labor , eventually the amount of additional output produced declines of scale the average cost of producing output increases as total output increases economic total revenues minus total costs ( explicit plus implicit costs ) economies of scale the average cost of producing output decreases as total output increases economies of scale the average cost of producing output decreases as total output increases explicit costs costs for a , for example , payments for wages and salaries , rent , or materials factors ( or inputs ) resources that use to produce their products , for example , labor and capital firm an organization that combines inputs of labor , capital , land , and raw or component materials to produce outputs . cost cost of the inputs expenditure that a must make before production starts and that does not change regardless of the production level inputs factors of production that ca be easily increased or decreased in a short period of time implicit costs opportunity cost of resources already owned by the and used in business , for example , expanding a factory onto land already owned long run period of time during which all of a inputs are variable average cost ( curve shows the lowest possible average cost of production , allowing all the inputs to production to vary so that the is choosing its production technology marginal cost the additional cost of producing one more unit mathematically , marginal product change in a output when it employees more labor mathematically , private enterprise the ownership of businesses by private individuals production the process of combining inputs to produce outputs , ideally ofa value greater than the value of the inputs production function mathematical equation that tells how much output a can produce with given amounts of the inputs production technologies alternative methods of combining inputs to produce output revenue income from selling a product as price times quantity sold short run period of time during which at least one or more of the inputs is average cost ( curve the average total cost curve in the short term shows the total of the average costs and the average variable costs total cost the sum of and variable costs of production total product synonym for a output variable cost cost of production that increases with the quantity produced the cost of the variable inputs variable inputs factors of production that a can easily increase or decrease in a short period of time Key Concepts and Summary Explicit and Implicit Costs , and Accounting and Economic Profit Privately owned are motivated to earn . is the difference between revenues and costs . While accounting considers only explicit costs , economic considers both explicit and implicit costs . Access for free at

Key Concepts and Summary 183 Production in the Short Run Production is the process a uses to transform inputs ( labor , capital , raw materials , etc . into outputs . It is not possible to vary inputs ( capital ) in a short period of time . Thus , in the short run the only way to change output is to change the variable inputs ( labor ) Marginal product is the additional output a obtains by employing more labor in production . At some point , employing additional labor leads to diminishing marginal productivity , meaning the additional output obtained is less than for the previous increment to labor . Mathematically , marginal product is the slope of the total product curve . Costs in the Short Run For every input ( labor ) there is an associated factor payment ( wages and salaries ) The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment . In a perspective , we can divide a total costs into costs , which a must incur before producing any output , and variable costs , which the incurs in the act . Fixed costs are sunk costs that is , because they are in the past and the can not alter them , they should play no role in economic decisions about future production or pricing . Variable costs typically show diminishing marginal returns , so that the marginal cost of producing higher levels rises . We calculate marginal cost by taking the change in total cost ( or the change in variable cost , which will be the same thing ) and dividing it by the change in output , for each possible change in output . Marginal costs are typically rising . A can compare marginal cost to the additional revenue it gains from selling another unit to out whether its marginal unit is adding to . We calculate average total cost by taking total cost and dividing by total output at each different level of output . Average costs are typically on a graph . If a average cost of production is lower than the market price , a will be earning . We calculate average variable cost by taking variable cost and dividing by the total output at each level of output . Average variable costs are typically . If a average variable cost of production is lower than the market price , then the would be earning if costs are left out of the picture . Production in the Long Run In the long run , all inputs are variable . Since diminishing marginal productivity is caused by capital , there are no diminishing returns in the long run . Firms can choose the optimal capital stock to produce their desired level of output . Costs in the Long Run A production technology refers to a combination of labor , physical capital , and technology that makes up a particular method of production . In the long run , can choose their production technology , and so all costs become variable costs . In making this choice , will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible , so as to produce at the lowest possible average cost . Economies of scale refers to a situation where as the level of output increases , the average cost decreases . Constant returns to scale refers to a situation where average cost does not change as output increases . of scale refers to a situation where as output increases , average costs also increase . The average cost curve shows the lowest possible average cost of production , allowing all the inputs to production to vary so that the is choosing its production technology . A shows economies of scale a shows constant returns to scale an shows of scale . If the average cost curve has only one quantity produced that results in the lowest possible

184 ' Questions average cost , then all of the competing in an industry should be the same size . However , if the has a segment at the bottom , so that a can produce a range of different quantities at the lowest average cost , the competing in the industry will display a range of sizes . The market demand in conjunction with the average cost curve determines how many will exist in a given industry . If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the average cost curve , where the cost is lowest , the market will have many competing . If the quantity demanded in the market is less than the quantity at the bottom of the , there will likely be only one firm . Questions . A had sales revenue of million last year . It spent on labor , on capital and on materials . What was the accounting ?

Continuing from Exercise , the factory sits on land owned by the firm that it could rent for per year . What was the economic last year ?

The WipeOut Ski Company manufactures skis for beginners . Fixed costs are 30 . Fill in Table for total cost , average variable cost , average total cost , and marginal cost . Quantity Variable Fixed Total Average Variable Average Total Marginal Cost Cost Cast Cast Cast Cast 30 10 30 25 30 45 30 A 70 30 100 30 135 30 TABLE . Based on your answers to the WipeOut Ski Company in Exercise , now imagine a situation where the produces a quantity of units that it sells for a price of 25 each . a . What will be the company or losses ?

How can you tell at a glance whether the company is making or losing money at this price by looking at average cost ?

At the given quantity and price , is the marginal unit produced adding to ?

If two painters can paint 200 square feet of wall in an hour , and three painters can paint 275 square feet , what is the marginal product of the third painter ?

Return to the problem explained in Table and Table . If the cost of labor remains at 40 , but the cost of a machine decreases to 50 , what would be the total cost of each method ?

Which method should the firm use , and why ?

Access for free at . Review Questions 185 Suppose the cost of machines increases to 55 , while the cost of labor stays at 40 . How would that affect the total cost of the three methods ?

Which method should the choose now ?

Automobile manufacturing is an industry subject to economies of scale . Suppose there are four domestic auto manufacturers , but the demand for domestic autos is no more than times the quantity produced at the bottom of the average cost curve . What do you expect will happen to the domestic auto industry in the long run ?

Review Questions . 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . 21 . 22 . 23 . 24 . 25 . 26 . 27 . 28 . 29 . What are explicit and implicit costs ?

Would you consider an interest payment on a loan to a an explicit or implicit cost ?

What is the difference between accounting and economic ?

What is a production function ?

What is the difference between a input and a variable input ?

How do we calculate marginal product ?

What shapes would you generally expect a total product curve and a marginal product curve to have ?

What are the factor payments for land , labor , and capital ?

What is the difference between costs and variable costs ?

How do we calculate each of the following marginal cost , average total cost , and average variable cost ?

What shapes would you generally expect each of the following cost curves to have costs , variable costs , marginal costs , average total costs , and average variable costs ?

Are there costs in the ?

Explain . Are costs also sunk costs ?

Explain . What are diminishing marginal returns as they relate to costs ?

Which costs are measured on basis costs , average cost , average variable cost , variable costs , and marginal cost ?

What is a production technology ?

In choosing a production technology , how will react if one input becomes relatively more expensive ?

What is a average cost curve ?

What is the difference between economies of scale , constant returns to scale , and of scale ?

What shape of a average cost curve illustrates economies of scale , constant returns to scale , and of scale ?

Why will in most markets be located at or close to the bottom of the average cost curve ?

Critical Thinking Questions 30 . 31 . Small Mom and Pop , like inner city grocery stores , sometimes exist even though they do not earn economic . How can you explain this ?

A common name for cost is overhead . If you divide cost by the quantity of output produced , you get average cost . Suppose cost is . What does the average cost curve look like ?

Use your response to explain what spreading the overhead means .

186 ' Problems 32 . 33 . 34 . 35 . 36 . 37 . 38 . How does cost affect marginal cost ?

Why is this relationship important ?

Average cost curves ( except for average cost ) tend to be , decreasing and then increasing . Marginal cost curves have the same shape , though this may be harder to see since most of the marginal cost curve is increasing . Why do you think that average and marginal cost curves have the same general shape ?

What is the relationship between marginal product and marginal cost ?

Hint Look at the curves . Why do you suppose that is ?

Is this relationship the same in the long run as in the short run ?

It is clear that businesses operate in the short run , but do they ever operate in the long run ?

Discuss . Return to Table . In the top half of the table , at what point does diminishing marginal productivity kick in ?

What about in the bottom half of the table ?

How do you explain this ?

How would an improvement in technology , like the gas turbines or tire plant , affect the average cost curve of a ?

Can you draw the old curve and the new one on the same axes ?

How might such an improvement affect other in the industry ?

Do you think that the taxicab industry in large cities would be subject to economies of scale ?

Why or why not ?

Problems 39 . 40 . 41 . 42 . A is considering an investment that will earn a rate of return . If it were to borrow the money , it would have to pay interest on the loan , but it currently has the cash , so it will not need to borrow . Should the make the investment ?

Show your work . Return to Figure . What is the marginal gain in output from increasing the number from to and from to ?

Does it continue the pattern of diminishing marginal returns ?

Compute the average total cost , average variable cost , and marginal cost 60 and 72 haircuts . Draw the graph of the three curves between 60 and 72 haircuts . A small company that shovels sidewalks and driveways has 100 homes signed up for its services this winter . It can use various combinations of capital and labor intensive labor with hand shovels , less labor with snow blowers , and still less labor with a pickup truck that has a snowplow on front . To summarize , the method choices are Method 50 units of labor , 10 units of capital Method 20 units of labor , 40 units of capital Method 10 units of labor , 70 units of capital If hiring labor for the winter costs and a unit of capital costs 400 , what is the best production method ?

What method should the company use if the cost of labor rises to ?

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