Principles of Microeconomics Scarcity and Social Provisioning Chapter 10 Cost and Industry Structure

CHAPTER 10 . COST AND INDUSTRY STRUCTURE INTRODUCTION TO COST AND INDUSTRY STRUCTURE Figure . Amazon is an American international electronic commerce company that sells books , among many other things , shipping them directly to the consumer . There is no Amazon store . Credit modification of work by William Creative Commons ) AMAZON In less than two decades , has transformed the way books are sold , bought , and even read . Prior to Amazon , books were primarily sold through independent bookstores with limited inventories in small retail locations . There were exceptions , of course Borders and Barnes Noble offered larger stores in urban areas . In the last decade , however , pendent bookstores have become few and far between , Borders has gone out of business , and Barnes Noble is . Online delivery and purchase of books has indeed overtaken the more traditional business models . How has Amazon changed the book selling industry ?

How has it managed to crush its competition ?

A major reason for the giant retailer success is its production model and cost structure , which has enabled Amazon to undercut the prices of its competitors even when factoring in the cost of shipping . Read on to see how firms great ( like Amazon ) and small ( like your corner deli ) determine What to sell , at what output and price .

PRINCIPLES or ECONOMICS 279 CHAPTER OBJECTIVES Introduction to Cost and Industry Structure In this chapter , you will learn about Explicit and Implicit Costs , and Accounting and Economic Profit The Structure of Costs in the Short Run The Structure of Costs in the Long Run his chapter is the first of four chapters that explore the theory of the firm . This theory explains that firms behave in much the same way as consumers behave . What does that mean ?

Let define what is meant by the firm . A firm ( or business ) combines inputs of labor , capital , land , and raw or finished component materials to produce outputs . If the firm 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 define the of firms . These decisions include , but are not limited to What product or products should the firm produce ?

How should the products be produced ( what production process should be used ) How much output should the firm produce ?

What price should the firm charge for its products ?

How much labor should the firm employ ?

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

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

How difficult is it for new firms to enter the industry ?

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

Figure illustrates the range of different market structures , which we will explore in Perfect , Monopoly , and Monopolistic Competition and Oligopoly . First lets take a look at how firms determine their costs and desired profit levels . Then we will discuss costs in the short run and long run and the factors that can each .

230 ERIK DEAN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Many Many firms Few firms One 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 firms are all trying to sell identical products . At the other one firm is selling the 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 firms selling similar , but not identical , products . Oligopoly is a situation with few firms that sell identical or similar products .

EXPLICIT AND IMPLICIT COSTS , AND ACCOUNTING AND ECONOMIC PROFIT LEARNING 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 enterprise , the ownership of businesses by private individuals , is a hallmark of the economy . When people think of businesses , often giants like , or General Motors come to mind . But firms come in all sizes , as shown in Table . The vast majority of American firms have fewer than 20 employees . As of 2010 , the Census Bureau counted lion firms with employees in the economy . Slightly less than half of all the workers in private firms are at the large firms , meaning they employ more than 500 workers . Another 35 of workers in the economy are at firms with fewer than 100 workers . These businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses . Indeed , Table does not include a separate category for the millions of small businesses where a single owner or a few partners are not officially paid wages or a salary , but simply receive whatever they can earn . Number of Employees Firms ( of total firms ) Number of Paid Employees ( of total employment ) Total million ( million ( million ( million ( million ( 500 or more ( million ( Table . Range in Size of US . Source Census , 2010 ) Each of these businesses , regardless of size or complexity , tries to earn a profit Profit Total Revenue Total Cost Total revenue is the income brought into the firm from selling its products . It is calculated by plying the price of the product times the quantity of output sold

282 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Total Revenue Price Quantity We will see in the following chapters that revenue is a function of the demand for the firms products . We can distinguish between two types of cost explicit and implicit . Explicit costs are costs , that is , payments that are actually made . Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs . Implicit costs are more subtle , but just as important . They resent the opportunity cost of using resources already owned by the firm . Often for small businesses , they are resources contributed by the owners for example , working in the business while not ting a formal salary , or using the ground of a home as a retail store . Implicit costs also allow for depreciation of goods , materials , and equipment that are necessary for a company to operate . See the Work it Out feature for an extended example . These two definitions of cost are important for distinguishing between two conceptions of profit , accounting profit and economic profit . Accounting profit is a cash concept . It means total revenue minus explicit difference between dollars brought in and dollars paid out . Economic profit 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 profit , whether or not it is economically successful depends on its economic profit . CALCULATING IMPLICIT COSTS Consider the following example . Fred currently Works for a corporate law firm . He is considering opening his own legal practice , where he expects to earn per year once he gets established . To run his own firm , he would need an office and a law clerk . He has found the perfect office , which rents for per year . A law clerk could be hired for per year . If these figures are accurate , would Fred legal practice be profitable ?

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 35 , 000 Total explicit costs 85 , 000 Step . Subtracting the explicit costs from the revenue gives you the accounting profit . Revenues Explicit costs 85 , 000 Accounting profit 115 , 000 But these calculations consider only the explicit costs . To open his own practice , Fred would have to quit his current job , where he is earning an annual salary of . This would be an implicit cost of opening his own firm . Step . You need to subtract both the explicit and implicit costs to determine the true economic profit Economic profit total revenues costs implicit costs 200 , 000 per year

PRINCIPLES or ECONOMICS 283 Fred would be losing per year . That does not mean he would not want to open his own business , but it does mean he would be earning less than if he worked for the corporate firm . Implicit costs can include other things as well . Maybe Fred values his leisure time , and starting his own firm would require him to put in more hours than at the corporate firm . In this case , the lost leisure would also be an implicit cost that would subtract from economic profits . Now that we have an idea about the different types of costs , lets look at cost structures . A firm cost structure in the long run may be different from that in the short run . We turn to that distinction in the next section . KEY CONCEPTS AND SUMMARY Privately owned firms are motivated to earn profits . Profit is the difference between revenues and costs . While accounting profit considers only explicit costs , economic profit considers both explicit and implicit costs . A firm had sales revenue of million last year . It spent on labor , on capital and on materials . What was the firm accounting profit ?

Continuing from Question , the firm factory sits on land owned by the firm that could be rented out for per year . What was the firms economic profit last year ?

REVIEW QUESTIONS . What are explicit and implicit costs ?

Would an interest payment on a loan to a firm be considered an explicit or implicit cost ?

What is the difference between accounting and economic profit ?

CRITICAL THINKING QUESTIONS Small Mom and Pop firms , like inner city grocery stores , sometimes exist even though they do not earn economic profits . How can you explain this ?

PROBLEMS A firm 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 firm make the investment ?

Show your Work .

284 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER REFERENCES 2010 Census . accounting profit total revenues minus explicit costs , including depreciation economic profit total revenues minus total costs ( explicit plus implicit costs ) explicit costs costs for a firm , for example , payments for wages and salaries , rent , or materials firm an organization that combines inputs of labor , capital , land , and raw or finished component materials to produce outputs . implicit costs opportunity cost of resources already owned by the firm and used in business , for example , expanding a factory onto land already owned private enterprise the ownership of businesses by private individuals production the process of combining inputs to produce outputs , ideally of a value greater than the value of the inputs revenue income from selling a firm product defined as price times quantity sold SOLUTIONS Answers to Questions Accounting profit total revenues costs ( 50 , 000 Economic profit accounting profit implicit cost

THE STRUCTURE OF COSTS IN THE SHORT RUN LEARNING OBJECTIVES By the end of this section , you will be able to Analyze costs as by total cost , fixed cost , variable cost , marginal cost , and average cost . Calculate average profit Evaluate patterns of costs to determine potential profit he cost of producing a firm output depends on how much labor and physical capital the firm uses . A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or meals . However , the cost structure of all firms can be broken down into some common underlying patterns . When a firm looks at its total costs of production in the short run , a useful starting point is to divide total costs into two categories fixed costs that can not be changed in the short run and variable costs that can be changed . FIXED AND VARIABLE COSTS Fixed costs are expenditures that do not change regardless of the level of production , at least not in the short term . Whether you produce a lot or a little , the fixed 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 runs out . 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 level of fixed costs varies according to the specific 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 fixed costs at all if it rents trucks by the day when needed . Variable costs , on the other hand , are incurred in the act of more you produce , the greater the variable cost . Labor is treated 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 . As a concrete example of fixed and variable costs , consider the barber shop called The Clip Joint shown in Figure . The data for output and costs are shown in Table . The fixed 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 first two columns of the table

286 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER show the quantity of haircuts the barbershop can produce as it hires additional barbers . The third column shows the fixed costs , which do not change regardless of the level of production . The fourth column shows the variable costs at each level of output . These are calculated by taking the amount of labor hired and multiplying by the wage . For example , two barbers cost 80 160 . Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column . So , for example , with two barbers the total cost is 160 160 320 . 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 ( sisal I ' I 10 20 30 50 60 70 80 90 Total Cost ( Output Figure . How Output Affects Total Costs . At zero production , the fixed costs of 160 are still present . As production increases , variable costs are added to fixed costs , and the total cost is the sum of the two . The relationship between the quantity of output being produced and the cost of producing that output is shown graphically in the figure . The fixed costs are always shown 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 returns , discussed in the chapter on Choice in a World of Scarcity , 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 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 ,

PRINCIPLES or ECONOMICS 287 though , the marginal gain in output diminishes as each additional barber is added . For example , as the number of barbers rises from two to three , the marginal output gain is only 20 and as the number rises from three to four , the marginal gain is only 12 . 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 up , and run the cash register . A second barber reduces the level of disruption from jumping back and forth between these tasks , and allows a greater division of labor and specialization . The result can be greater increasing marginal returns . However , as other barbers are added , the advantage of each additional barber is less , since the specialization of labor can only go so far . The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did . This is the pattern of diminishing marginal returns . As a result , the total costs of production 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 others way . In this case , the addition of still more barbers would actually cause output to decrease , as shown in the last row of Table . This pattern of diminishing marginal returns is common in production . As another example , sider the problem of irrigating a crop on a farmers field . The plot of land is the fixed factor of tion , while the water that can be added to the land is the key variable cost . As the farmer adds water to the land , output increases . But adding more and more water brings smaller and smaller increases in output , until at some point the water the field and actually reduces output . Diminishing returns occur because , at a given level of fixed costs , each additional input contributes less and less to overall production . AVERAGE TOTAL COST , AVERAGE VARIABLE COST , MARGINAL COST The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well . The first five 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 reflected in the curves shown in Figure . Labor Quantity Fixed Cost Variable Cost Total Cost Marginal Cost Average Total Cost Average Variable 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 of producing 40 haircuts is 320 , the average total cost for producing each of 40 haircuts is 40 , 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 fixed cost mathematically , the denominator is so small that average total cost is

283 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 20 . 18 16 14 A A 17 . 10 20 30 40 60 70 80 90 100 Output Figure . Cost Curves at the Clip Joint . The information on total costs , fixed cost , and variable cost can also be presented on a basis . Average total cost ( ATC ) is calculated by dividing total cost by the total quantity produced . The average total cost curve is typically shaped . Average variable cost ( is calculated by dividing variable cost by the quantity produced . The average variable cost curve lies below the average total cost curve and is typically or . Marginal cost ( is calculated by taking the change in total cost between two levels of output and dividing by the change in output . The marginal cost curve is . large . Average total cost then declines , as the fixed costs are spread over an increasing quantity of put . 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 . But 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 kick in . Average variable cost obtained when variable cost is divided by quantity of output . For example , the variable cost of producing 80 haircuts is 400 , so the average variable cost is 80 , or per cut . Note that at any level of output , the average variable cost curve will always lie below the curve for average total cost , as shown in Figure . The reason is that average total cost includes average variable cost and average fixed cost . Thus , for 80 haircuts , the average total cost is per haircut , while the average variable cost is per haircut . However , as output grows , fixed 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 of output . Marginal cost is somewhat different . Marginal cost is the additional cost of producing one more unit of output . So it is not the cost per unit of all units being produced , but only the next one ( or next few )

PRINCIPLES or ECONOMICS 289 Marginal cost can be calculated 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 . A small range of increasing marginal returns can be seen in the figure 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 . 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 nomic meaning of marginal and average costs . If the marginal cost of production is below the average cost 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 tion 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 firm to firm . 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 fixed cost , marginal cost , average total cost , and average variable cost is useful because each statistic offers its own insights for the firm . Whatever the firms quantity of production , total revenue must exceed total costs if it is to earn a profit . As explored in the chapter Choice in a World of Scarcity , fixed costs are often sunk costs that can not be recouped . In thinking about what to do next , sunk costs should typically be ignored , since this spending has already been made and can not be changed . However , variable costs can be changed , so they convey information about the firms ability to cut costs in the present and the extent to which costs will increase if production rises . WHY ARE TOTAL COST AND AVERAGE COST NOT ON THE SAME GRAPH ?

Total cost , fixed cost , and variable cost each reflect different aspects of the cost of production over the entire quantity of output being produced . These costs are measured in dollars . In contrast , marginal cost , average cost , and average variable

290 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER cost are costs per unit . In the previous example , they are measured as cost per haircut . Thus , it would not make sense to put all of these numbers on the same graph , since they are measured 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 against the horizontal axis , compared to the values for total cost , fixed cost , and variable cost . Using the figures from the previous example , the total cost of producing 40 haircuts is 320 . But 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 firm whether it can earn profits given the current price in the market . If we divide profit by the quantity of output produced we get average profit , also known as the firms profit gin . Expanding the equation for profit gives . pro fit average profit quantity produced total revenue total cost quantity produced total revenue total cost quantity produced quantity produced average average But note that price quantity produced ' produced price Thus average profit price average cost This is the firms profit margin . This definition implies that if the market price is above average cost , average profit , and thus total profit , will be positive if price is below average cost , then profits will be negative . The marginal cost of producing an additional unit can be compared 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 profits would be affected by increasing or decreasing production . A VARIETY OF COST PATTERNS The pattern of costs varies among industries and even among firms in the same industry . Some have high fixed costs , but low marginal costs . Consider , for example , an Internet company that provides medical advice to customers . Such a company might be paid by consumers directly , or perhaps hospitals or healthcare practices might subscribe on behalf of their patients . Setting up the

PRINCIPLES or ECONOMICS 291 website , collecting the information , writing the content , and buying or leasing the computer space to handle the web traffic are all fixed costs that must be undertaken before the site can work . However , when the website is up and running , it can provide a high quantity of service with relatively low able 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 fixed costs , but then might appear close to , up to a large quantity of output , reflecting the low variable costs of operation . If the website is popular , however , a large rise in the number of visitors will overwhelm the website , and increasing output further could require a purchase of additional computer space . For other firms , fixed costs may be relatively low . For example , consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter . For fixed costs , such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels . Still other firms may find that diminishing marginal returns set in quite sharply . If a manufacturing plant tried to run 24 hours a day , seven days a week , little time remains for routine maintenance of the equipment , and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment . Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs , and then using these calculations as a basis for average total cost , average variable cost , and marginal cost . However , making a final 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 firm finds itself . Before we turn to the analysis of market structure in other chapters , we will analyze the firms cost structure from a perspective . KEY CONCEPTS AND SUMMARY In a perspective , firms total costs can be divided into fixed costs , which a firm must incur before producing any output , and variable costs , which the firm incurs in the act of producing . Fixed costs are sunk costs that is , because they are in the past and can not be altered , they should play no role in economic decisions about future production or pricing . Variable costs typically show marginal returns , so that the marginal cost of producing higher levels of output rises . Marginal cost is calculated 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 . costs are typically rising . A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit . Average total cost is calculated by taking total cost and dividing by total output at each different level of output . Average costs are typically on a graph . If a firm average cost of production is lower than the market price , a firm will be earning profits . Average variable cost is calculated by taking variable cost and dividing by the total output at each level of output . Average variable costs are typically . If a firm average variable cost of production is lower than the market price , then the firm would be earning profits if fixed costs are left out of the picture .

292 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER SELF ' QUESTIONS . 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 Cost Fixed Cost Total Cost Average Total Cost Average Variable Cost Marginal Cost 30 30 25 30 45 30 70 30 00 30 35 30 Table . Based on your answers to the WipeOut Ski Company in Question , now imagine a situation where the firm produces a quantity of units that it sells for a price of 25 each . What will be the company profits 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 profits ?

REVIEW QUESTIONS What is the difference between fixed costs and variable costs ?

Are there fixed costs in the ?

Explain . Are fixed costs also sunk costs ?

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

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

How is each of the following calculated marginal cost , average total cost , average variable cost ?

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

Use your response to explain what spreading the overhead means . How does fixed cost affect marginal cost ?

Why is this relationship important ?

Average cost curves ( except for average fixed cost ) tend to be , decreasing and then increasing .

PRINCIPLES OF ECONOMICS 293 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 ?

PROBLEMS . Return to Figure . What is the marginal gain in output from increasing the number of barbers 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 of producing 60 and 72 haircuts . Draw the graph of the three curves between 60 and 72 haircuts . average profit profit divided by the quantity of output produced profit margin average total cost total cost divided by the quantity of output average variable cost variable cost divided by the quantity of output fixed cost expenditure that must be made before production starts and that does not change regardless of the level of production marginal cost the additional cost of producing one more unit total cost the sum of fixed and variable costs of production variable cost cost of production that increases with the quantity produced EXERCISES Answers to Questions Quantity Variable Cost Fixed Cost Total Cost Average Total Cost Average Variable Cost Marginal Cost 30 30 10 30 40 10 25 30 55 15 45 30 75 20 70 30 100 25 100 30 130 30 135 30 165 35 Table . a . Total revenues in this example will be a quantity of five units multiplied by the price of , which equals 125 . Total costs When producing five units are 130 . Thus , at this level of quantity and output the firm experiences losses ( or negative profits ) of . If price is less than average cost , the firm is not making a profit . At an output of five units , the average cost is . Thus , at a glance you can see the firm is making losses . At a second glance , you can see that it must be losing for each unit produced ( that is , average cost of

294 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER unit minus the price of unit ) With five units produced , this observation implies total losses of . When producing five units , marginal costs are unit . Price is unit . Thus , the marginal unit is not adding to profits , but is actually subtracting from profits , which suggests that the firm should reduce its quantity produced .

THE STRUCTURE OF COSTS IN THE LONG RUN LEARNING OBJECTIVES By the end of this section , you will be able to Calculate 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 he long run is the period of time when all costs are variable . The long run depends on the specifics of the firm in is not a precise period of time . If you 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 fixed in the long run . A firm can build new factories and chase new machinery , or it can close existing facilities . In planning for the long run , the firm will pare 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 specific new invention like the tablet computer . The firm will search for the duction 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 firm must fear that if it does not seek out the methods of production , then it may lose sales to competitor firms that find a way to produce and sell for less . CHOICE OF PRODUCTION TECHNOLOGY Many tasks can be performed with a range of combinations of labor and physical capital . For example , a firm can have human beings answering phones and taking messages , or it can invest in an automated voicemail system . A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets , or it can invest in a computerized system that will require fewer ees . A firm can hire workers to push supplies around a factory on rolling carts , it can invest in 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 a private firm that is hired by local governments to clean up public parks .

296 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Three different combinations of labor and physical capital for cleaning up a single park appear in Table . The first 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 produce the same firm will choose the production 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 firm will choose to substitute away from labor and use more machinery . Example A Workers cost 40 , machines cost 80 Labor Cost Machine Cost Total Cost Cost techno 10 40 400 80 160 560 Cost techno 40 280 80 320 600 Cost techno 40 120 80 560 680 Example Workers cost 55 , machines cost 80 Labor Cost Machine Cost Total Cost Cost techno 10 55 550 80 160 710 Cost techno 55 385 80 320 705 Cost techno 55 165 80 560 725 Example Workers cost 90 , machines cost 80 Labor Cost Machine Cost Total Cost Cost techno 10 90 900 80 160 Cost techno 90 630 80 320 950 Cost techno 90 270 80 560 830 Table . Total Cost with Rising Labor Costs Example A shows the firms 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 . wages keep rising up to 90 , while the cost of machines remains unchanged , then technology clearly becomes the form of production , as shown in example This example shows that as an input becomes more expensive ( in this case , the labor input ) firms 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 , firms will seek to substitute the use of other inputs . When a multinational employer like or sets up a bottling plant

PRINCIPLES OF ECONOMICS 297 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 of workers 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 firm 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 . 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 . CO Average Cost of Production ( 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 because the larger scale of production leads to lower average costs . The average cost curve in Figure may appear similar to the average cost curves presented earlier in this chapter , although it is rather than . But there is one major ence . The economies of scale curve is a average cost curve , because it allows all factors of production to change . The average cost curves presented earlier in this chapter assumed the existence of fixed costs , and only variable costs were allowed to change . One prominent example of economies of scale occurs in the chemical industry . Chemical plants have

293 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER a lot of pipes . The cost of the materials for producing a pipe is related to the circumference of the pipe and its length . However , the volume of chemicals that can through a pipe is determined by the area of the pipe . The calculations in Table show that a pipe which uses twice as much material to make ( as shown by the circumference of the pipe doubling ) can actually carry four times the volume of chemicals because the area of the pipe rises by a factor of four ( as shown in the Area column ) Circumference ( 27 ) Area ( pipe 125 inches square inches pipe inches square inches pipe 502 inches 201 . square inches Table . Comparing Pipes Economies of Scale in the Chemical Industry A doubling of the cost of producing the pipe allows the chemical firm 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 . But the chemical engineers who design these plants have long used what they call the 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 firms are limited to operating on a single average cost curve ( corresponding to the level of fixed 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 of which represents one specific level of fixed costs . More precisely , the average cost curve will be the least expensive average cost curve for any level of output . Figure shows how the average cost curve is built from a group of average cost curves . Five cost curves appear on the diagram . Each curve represents a different level of fixed 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 five curves , presumably there are an infinite number of other curves between the ones that are shown . This family of average cost curves can be thought of as representing different choices for a firm that is planning its level of investment in fixed cost physical that different choices about capital ment in the present will cause it to end up with different average cost curves in the future . The average cost curve shows the cost of producing each quantity in the long run , when the firm can choose its level of fixed costs and thus choose which average costs it desires . If the firm 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 firm that intends to produce would be foolish to choose the level of fixed costs at or . At the level of fixed 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 fixed costs is too high for producing at lowest possible cost , and again average costs would be very high as a result .

PRINCIPLES OF ECONOMICS 299 Cost ( Output Constant of scale returns of scale to scale Figure . From Average Cost Curves to Average Cost Curves . The five different average cost ( curves each represents a different level of fixed costs , from the low level of fixed costs at to the high level of fixed costs at . Other curves , not shown in the diagram , lie between the ones that are shown here . The average cost ( curve shows the lowest cost for producing each quantity of output when fixed costs can vary , and so it is formed by the bottom edge of the family of curves . If a firm wished to produce quantity , it would choose the fixed costs associated with . The shape of the cost curve , as drawn in Figure , is fairly common for many industries . The portion of the average cost curve , where it is sloping from output els to to , illustrates the case of economies of scale . In this portion of the average cost curve , larger scale leads to lower average costs . This pattern was illustrated 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 , and it is called constant returns to scale . In this range of the curve , the average cost of production does not change much as scale rises or falls . The ing Clear it Up feature explains where diminishing marginal returns fit into this analysis . 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 with the idea of diminishing marginal returns , Where marginal costs rise as production expands . But diminishing marginal returns refers only to the average cost curve , where one variable input ( like labor ) is increasing , but other inputs ( like tal ) are fixed . Economies of scale refers to the average cost curve Where all inputs are being 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 increasing or constant economies of scale when all inputs change together to produce a operation .

300 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 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 . This situation is called of scale . A firm or a factory can grow so large that it becomes very difficult to manage , resulting in unnecessarily high costs as many layers of management try to with workers and with each other , and as failures to communicate lead to disruptions in the flow 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 age 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 inefficient 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 firm , not just a large factory . The leviathan effect can hit firms that become too large to run efficiently , across the entirety of the enterprise . Firms that shrink their operations are often responding to finding itself in the region , thus moving back to a lower average cost at a lower output level . 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 firms will compete in an industry , and whether the firms in an industry have many different sizes , or tend to be the same size . For example , say that one million dishwashers are sold every year at a price of 500 each and the run average cost curve for dishwashers is shown 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 firms built a plant that produced dishwashers per year or dishwashers per year , the average costs of production at such plants would be well above 500 , and the firms would not be able to compete . HOW CAN CITIES BE VIEWED AS EXAMPLES OF ECONOMIES OF SCALE ?

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

The mental 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

PRINCIPLES OF ECONOMICS 301 I ' 500 500 ' Tim . 20000 Output Output ( curve a clear minimum point ( A 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 bottom can compete . In this case , any firm producing a quantity between and can compete effectively , although firms producing less than or more than would face higher average costs and be unable to compete . 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 many shoppers are looking for . 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 economies . These agglomeration factors help to explain why every economy , as it develops , has an increasing proportion of its 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 countries around the world , will be determined by their ability to benefit from the economies of agglomeration and to minimize or counterbalance the corresponding . A more common case is illustrated in Figure ( where the curve has a area of constant returns to scale . In this situation , any firm 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 firms making each ) or as few as 50 producers ( one

302 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER million dishwashers divided by firms making each ) The producers in this market will range in size from firms that make units to firms that make units . But firms that produce below units or more than will be unable to compete , because their average costs will be too high . Thus , if we see an industry where almost all plants are the same size , it is likely that the average cost curve has a unique bottom point as in Figure ( a ) However , if the average cost curve has a wide bottom like Figure ( then firms of a variety of different sizes will be able to compete with each other . The section of the average cost curve in Figure ( can be interpreted 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 with four times as much capacity that produces a quantity of . The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of , while another firm owns four separate manufacturing plants , which each produce a quantity of . This second explanation , based on the insight that a single firm may own a number of different manufacturing plants , is especially useful in explaining why the average cost curve often has a large thus why a seemingly smaller firm may be able to compete quite well with a larger firm . At some point , however , the task of coordinating and aging many different plants raises the cost of production sharply , and the 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 ) pared 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 firms . But 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 firms in the market would be three . A handful of firms in a market is called an oligopoly , and the chapter on Monopolistic 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 run average cost curve is , but total demand for the product is only . For simplicity , ine 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 firm tried to challenge this monopoly while producing a quantity lower than units , the prospective competitor firm 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 firm . Thus , the shape of the average cost curve reveals whether competitors in the market will be different sizes . If the curve has a single point at the bottom , then the firms in the market will be about the same size , but if the curve has a segment of constant returns to scale , then firms 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 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

PRINCIPLES or ECONOMICS 303 , then many firms will compete . If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the , a few firms 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 firms in an industry . For much of the twentieth century , the most common change has been to see alterations in , 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 of output . However , new production technologies do not inevitably lead to a greater average size for firms . 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 or plants to generate electricity as efficiently as large ones . Another example of a ven 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 firms . On one side , the new technology may make it easier for small firms to reach out beyond their local geographic area and find 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 technology will create markets where one large company will tend to command a large share of total sales , as has done in the production of software for personal computers or Amazon has done in online bookselling . Moreover , improved information and technologies might make it easier to manage many different plants and operations across the country or around the world , and thus encourage larger firms . This ongoing battle between the forces of smallness and largeness will be of great interest to economists , businesspeople , and . 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 . Amazon has no retail locations it sells online and delivers by mail . Amazon offers almost any book in print , convenient purchasing , and prompt delivery by mail . Amazon holds its inventories in huge warehouses in locations around the world . The warehouses are highly computerized using robots and relatively workers , making for low average costs per sale . Amazon demonstrates the significant advantages economies of scale can offer to a firm that exploits those economies .

304 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER KEY CONCEPTS AND SUMMARY A production technology refers to a specific combination of labor , physical capital , and technology that makes up a particular method of production . In the long run , firms can choose their production technology , and so all costs become variable costs . In making this choice , firms 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 increase also . The average cost curve shows the lowest possible average cost of production , allowing all the inputs to production to vary so that the firm is choosing its production technology . A sloping shows economies of scale a shows constant returns to scale an sloping shows of scale . If the average cost curve has only one quantity produced that results in the lowest possible average cost , then all of the firms competing in an try should be the same size . However , if the has a segment at the bottom , so that a range of different quantities can be produced at the lowest average cost , the firms competing in the industry will display a range of sizes . The market demand in conjunction with the average cost curve determines how many firms 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 of production is lowest , the market will have many firms 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 . SELF CHECK QUESTIONS . 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 of production ?

Which method should the firm use , and why ?

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 firm choose now ?

Automobile manufacturing is an industry subject to significant 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 ?

PRINCIPLES OF ECONOMICS 305 REVIEW QUESTIONS . What shapes would you generally expect each of the following cost curves to have fixed costs , variable costs , marginal costs , average total costs , and average variable costs ?

What is a production technology ?

In choosing a production technology , how will firms 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 firms in most markets be located at or close to the bottom of the average cost curve ?

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

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

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

How might such an improvement affect other firms in the industry ?

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

Why or why not ?

PROBLEMS PROBLEMS 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 lots of 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 unit and a unit of capital costs 400 , what production method should be sen ?

What method should be chosen if the cost of labor rises to ?

constant returns to scale expanding all inputs proportionately does not change the average cost of production of scale the average cost of producing each individual unit increases as total output increases average cost ( curve shows the lowest possible average cost of production , allowing all the inputs to production to vary so that the firm is choosing its production technology

306 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER production technologies alternative methods of combining inputs to produce output average cost ( curve the average total cost curve in the short term shows the total of the average fixed costs and the average variable costs SOLUTIONS Answers to Questions . The new table should look like this Labor Cost Machine Cost Cost of technology 10 40 400 50 100 Cost of technology 40 280 50 200 Cost of technology 40 120 50 350 Table . The firm should choose production technology since it has the lowest total cost . This makes sense since , with cheaper machine hours , one would expect a shift in the direction of more machines and less labor . Labor Cost Machine Cost Total Cost Cost of technology 10 40 400 55 110 510 Cost of technology 40 280 55 220 500 Cost of technology 40 120 55 385 505 Table 10 . The firm should choose production technology since it has the lowest total cost . Because the cost of machines increased ( relative to the previous question ) you would expect a shift toward less capital and more labor . This is the situation that existed in the United States in the . Since there is only demand enough for firms to reach the bottom of the average cost curve , you would expect one firm will not be around in the long run , and at least one firm will be struggling .