Chapter 12 .

Production and Cost

41

12
Chapter

Production
and Cost
CHAPTER OUTLINE

I. Explain how economists measure a firms cost of production

and profit.
A. The Firms Goal
B. Accounting Cost and Profit
C. Opportunity Cost
1. Explicit Costs and Implicit Costs
D. Economic Profit
2. Explain the relationship between a firms output and labor
employed in the short run.
A. The Short Run: Fixed Plant
B. The Long Run: Variable Plant
C. Total Product
D. Marginal Product
1. Increasing Marginal Returns
2. Decreasing Marginal Returns
E. Average Product
3. Explain the relationship between a firms output and costs in
the short run.
A. Total Cost
B. Marginal Cost
C. Average Cost
D. Why the Average Total Cost Curve is U-Shaped
E. Cost Curves and Product Curves
F. Shifts in the Cost Curves
1. Technology
2. Prices of Factors of Production
4. Derive and explain a firms long-run average cost curve.
A. Plant Size and Cost
1. Economies of Scale
2. Diseconomies of Scale
3. Constant Returns to Scale

42

Part 4 . A CLOSER LOOK AT DECISION MAKERS

B. The Long-Run Average Cost Curve

1. Economies and Diseconomies of Scale

Whats New in this Edition?

Chapter 12 is slightly rewritten to improve clarity.

Where We Are
In this chapter, we define economic costs and profits. We
examine the relationship between inputs, costs, and
production. This chapter lays the groundwork for the profitmaximizing decisions that are made by firms, which we
study in the next several chapters.

Where Weve Been

We defined what economics means in terms of scarcity,
opportunity cost, choice, and efficient use of resources.
Weve explored the interactions of supply and demand that
bring about the efficient use of resources by equating
marginal benefit to marginal cost. Weve discussed the
rationale behind the downward-sloping demand curve using
marginal utility analysis.

Where Were Going

After this chapter, we look at the demand and marginal
revenue curves for firms in different industry structures. By
combining the cost, demand, and revenue curves, we will see
the profit-maximizing operating decisions made by these
firms.

IN THE CLASSROOM
Class Time Needed
You can complete this chapter in two to three class sessions. However, this is a
very important chapter, so do not short change it. If you judge from your classs
reaction that you need more time, take it!
An estimate of the time per checkpoint is:

12.1 Economic Cost and Profit15 to 25 minutes

Chapter 12 . Production and Cost

12.2 Short-Run Production45 to 65 minutes

12.3 Short-Run Cost45 to 65 minutes

12.4 Long-Run Cost30 to 40 minutes

43

Part 4 . A CLOSER LOOK AT DECISION MAKERS

44

CHAPTER LECTURE
12.1 Economic Cost and Profit
The Firms Goal

The firms goal is to maximize profit.

Accounting Cost and Profit versus Opportunity Cost

Accountants measure revenue and cost using accounting conventions in order to ensure
that the firm pays the proper amount of tax and to give creditors information. But the
costs as measured by accountants are the firms opportunity costs.
The decisions the firm makes to maximize its profit respond to opportunity cost and
economic profit. The opportunity cost of a firms use of resources is the highest-valued
alternative forgone. Opportunity costs include both explicit costs and implicit costs.
An explicit cost is a cost paid in money. Explicit costs are opportunity costs.
An implicit cost is an opportunity cost incurred by a firm when it uses a factor of
production for which it does not make a direct money payment.

Normal Profit and Economic Profit

A firms owner supplies entrepreneurship by organizing the business and bearing the
risk of running it.
Normal profit is the return to entrepreneurship.
Normal is part of a firms opportunity cost because it is the cost of persuading the
entrepreneur of not running another business.
Economic profit is a firms total revenue minus its total opportunity cost. An
economic profit is a profit over and above the normal profit.

12.2 Short-Run Production

A firm owners decisions can be categorized as short run decisions and long run decisions.
The short run is a time frame in which the quantities of some resources are fixed. The
fixed resources include the firms management organization structure, level of
technology, buildings and large equipment. These factors are called the firms plant.
The long run is a time frame in which the quantities of all resources can be varied.
Long-run decisions are not easily reversed so usually a firm must live with the plant size
that it has created for some time.
Help the students to understand that the difference between the long run and short run is not
related to calendar time. Compare the street vendor, who is a firm owner operating out of a food
truck, to the giant automaker firm, General Motors. Ask them how long it would take for the food
vendor to double the size of his or her plant (truck, oven, etc.) versus GM to double its plant size
(factory buildings covering multiple blocks, sophisticated computerized assembly lines and
robotics, etc.). They will realize that the length of time covered by the long run differs among
firms.

Chapter 12 . Production and Cost

45

To increase its output in the short run, a firm must increase the quantity of labor employed. There
are three relationships between the quantity of labor and the firms output.

Product Schedules

The total product is the total quantity of a good produced in a given period.
The marginal product (MP) of labor is
Total
Marginal
the increase in total product that results
Labor
product
product
from a one-unit increase in the quantity of
0
0
labor employed with all other inputs
10
remaining the same.
1
10
The average product of labor is equal to
20
the total product of labor divided by the
2
30
quantity of labor.
6
The table to the right has examples of these
3
36
product schedules.

Average
product

The marginal product curve shows the

additional output generated by each
additional unit of labor. The figure shows a
typical marginal product of labor curve (MP),
with an upside-down U shape. The shape
reflects the point that marginal product has
increasing marginal returns initially and
decreasing marginal returns eventually.
Increasing marginal returns
occurs when the marginal product of an
additional worker exceeds the marginal
product of the previous worker. The
marginal product curve has a positive
slope. At low levels of employment,
increasing marginal returns is likely
because hiring an additional worker
allows large gains from specialization.
Eventually these gains become small or nonexistent and decreasing marginal returns
set in.
Decreasing marginal returns occur when the marginal product of an
additional worker is less than the marginal product of the previous worker. The
marginal product curve has a negative slope. The law of decreasing returns states
that as a firm uses more of a variable input, with a given quantity of fixed inputs, the
marginal product of the variable input eventually diminishes.
The average product curve shows the average product that is generated by labor at each
level of labor. The average product of labor curve (AP) has an upside-down U shape.

10
15
12

Part 4 . A CLOSER LOOK AT DECISION MAKERS

46

As the figure shows, the marginal product curve and the average product curve are
related: when the marginal product of labor exceeds the average product of labor, the
average product of labor increases; when the marginal product of labor is less than the
average product of labor, the average product of labor decreases; and the marginal
product of labor equals the average product of labor when the average product of labor is at
its maximum.

12.3 Short-Run Cost

Labor
0

Output
0

Fixed
cost
(dollars)
50

Variable
cost
Total cost
(dollars) (dollars)
0
50

Average
fixed cost
(dollars)

Average
Average Marginal
variable cost total cost
cost
(dollars)
(dollars) (dollars)

10

50

100

150

5.00

10.00

15.00

30

50

200

250

1.66

6.67

8.33

10.00
5.00
16.67
3

36

50

300

350

1.39

8.33

9.72

The table above continues the previous product schedule table and shows different costs.

Total Cost

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed
cost (TFC) is the cost of the firms fixed factors of productionthe cost of land, capital,
and entrepreneurship. Total variable cost (TVC) is the cost of the firms variable
inputsthe cost of labor. Total cost is the sum of total fixed cost plus total variable cost:

TC = TFC + TVC.
Marginal Cost and Average Costs

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in
output.

Average fixed cost (AFC) is total

fixed cost per unit of output. The value
of AFC falls as output increases.

Average variable cost (AVC) is

total variable costs per unit of output. At
low levels of output, AVC falls as output
increases but at higher levels of output,
AVC rises as output increases.

Average total cost (ATC) is the total

cost per unit of output. ATC = AFC +
AVC. At low levels of output, ATC falls

Chapter 12 . Production and Cost

47

as output increases but at higher levels of output, ATC rises as output increases.

The figure illustrates typical MC, AFC, AVC, and ATC curves. As the figure shows, the
MC curve, the AVC curve, and the ATC curve are all U-shaped. There are other additional
important points about this figure:
The vertical distance between the AVC curve and the ATC curve is the AFC. Because
the AFC decreases as output increases, these curves become closer to each other as
output increases.
The MC curve intersects the AVC curve and ATC curve at their minimums.

Cost Curves and Product Curves

The shape of the cost curves is related to the shape of the productivity curves.
The shape of the AVC curve is determined by the shape of the AP curve. Over the
range of output for which the AP curve is rising, the AVC curve is falling and over the
range of output for which the AP curve is falling, the AVC curve is rising.
The shape of the MC curve is determined by the shape of the MP curve. Over the
range of output for which the MP curve is rising, the MC curve is falling and over the
range of output for which the MP curve is falling, the MC curve is rising.

Shifts in the Cost Curves

The cost curves shift with changes in technology or changes in resource prices.
An increase in technology that allows more output to be produced from the same
resources shifts the cost curves downward. If the technology requires more capital, a
fixed input, then the average total cost curve shifts upward at low levels of output
and downward at higher levels of output.
A fall in the price of the fixed factor of production shifts the AFC and ATC curves
downward but leaves the AVC and MC curves unchanged. A fall in the price of a
variable factor of production shifts the AVC, ATC, and MC curves downward but
leaves the AFC curve unchanged.

12.4 Long-Run Cost

In the long run, a firm can vary the quantity of both labor and capital, so in the long run all costs
are variable costs.

Plant Size and Cost

In the long run, when a firm changes its plant size, its average total cost might rise, fall, or
not change

Economies of scale occur when a firm increases its plant size and labor
employed by the same percentage, its output increases by a larger percentage, so its
average total cost decreases. The main source of economies of scale is greater
specialization of both labor and capital.

Part 4 . A CLOSER LOOK AT DECISION MAKERS

48

Diseconomies of scale occur when a firm increases its plant size and labor
employed by the same percentage, its output increases by a smaller percentage, so its
average total cost increases. Diseconomies of scale arise from the difficulty of
coordinating and controlling a large business.

Constant returns to scale occur when a firm increases its plant size and labor
employed by the same percentage, its output increases by the percentage, so its average
total cost does not change.

Long-Run Costs

In the long run, a firm can use different

plant sizes. Each plant size has a
different short-run ATC curve. Each
short-run ATC curve is U-shaped and
the larger the plant size, the greater is
the output at which the average total
cost is a minimum.

The figure illustrates three average total

cost curves for three plant sizes. ATC1
pertains to the smallest plant size and
ATC3 to the largest.

The long-run average cost

curve, LRAC, is the curve that shows
the lowest average total cost at which it
is possible to produce each output when
the firm has sufficient time to change
both its plant size and labor employed. This curve is derived from the short-run average
total cost curves. It shows the lowest average total cost to produce a given level of output.
In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.

The LRAC slopes downward when the firm has economies of scale, is horizontal when
the firm has constant returns to scale, and slopes upward when the firm has
diseconomies of scale.

Point out to the students that the long-run average cost curve yields the lowest average cost of
production possible when plant size is free to change. Once a firm commits to a specific plant
size, it is locked into a specific short run cost curve configuration. Any significant departure from
the range of output per period that best suits that configuration means the firm will incur higher
short-run average total costs than it would have had it chosen a more appropriate plant size. If the
firms competitors chose their plant size more wisely, the firm might have a tough time surviving!
This observation explains why successful firms often spend much money on long run market
analysis.

Chapter 12 . Production and Cost

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

Lecture Launchers
1.

This chapter is incredibly important because it serves as the basis for the
next three chapters. You know this fact, I know this fact, but your students
dont know this fact. You must tell them this fact because without it you will
definitely lose some of the class. How so? They wont realize that this
chapter is critical until they are unable to grasp the next three chapters. At
that point, several possibilities exist, all unpleasant: These students flunk
the course, these students drop the course, or these students camp out in
your office. Most likely no one would be happy with any of these outcomes,
so launch your lecture by motivating your students with the important
information that Chapter 12 is truly a key to Chapters 13, 14, and 15!

2.

This chapter has a plethora of definitions. Students must learn the

definitions, but they are secondary to the concepts they define and the
insights they bring. Focus on why productivity measures and cost measures
are useful for decision making. Managers must frequently make quick
decisions with little information. If managers have knowledge of a useful
relationship between input measures and production cost measures they
can use their understanding of this link to make inferences about how
production costs might behave when the firms output must change to
accommodate market changes.

3.

This chapter is one more place where an in-class experiment has a huge
payoff and is definitely recommended. The experiment teaches students
about the product curves, and a related assignment that we describe later
teaches them about the short-run cost curves. Allow 30 to 40 minutes for
this production experiment. This experiment motivates the students to go
beyond memorizing the cost and productivity definitions by getting them
directly involved with generating their own data and productivity and cost
measures. This is a fun exercise that will illustrate the concept of
diminishing returns to labor, as well as how short run productivity
measures and cost measures are related. Students genuinely enjoy and learn
from this exercise, even though it might seem childish. You have two inputs:
Capital: A table (of which the class must have an unobstructed view),
some tear-off scratch pads with about 500 sheets of paper, a fully loaded
stapler, and a back-up stapler (also fully loaded).
Labor: Provided by your students.
The capital and labor are used to produce widgets. A widget is a piece
of paper, torn from a pad, folded twice very carefully so that the corners of
the paper align, and stapled. The first fold bisects the paper along its long
side and the second fold is at right angles to the first. Once folded, a staple

Chapter 12 . Production and Cost

is used to hold the folds in place. A widget is fragile and breaks if it falls off
the table.
Start the experiment by hiring a manager from your class and appointing
an auditor. Get the manager to hire a quality controller, an accountant, and
some workers. Tell the manager that he or she must produce widgets as
efficiently as possible and that he or she can discuss the process with his
workers and with the class.
Start the experiment by defining that a day lasts for 1 minute. Get the
class to keep time. On day 1, have 1 worker produce widgets. On day 2,
have 2 workers, and so on. Youll probably run for 10 to 12 days before you
get to almost zero marginal product. Record the inputs and outputs in a
table on the board. Have some fun with quality control, shirking, and
cheating. The auditor must ensure that old widgets and partly made
widgets dont get used in a subsequent day. Each day must start clean.
Now comes the assignment (Stage 1): Get the students to calculate marginal
product and average product from the total product numbers that youre
recorded on the board. Get them to make graphs of the total product,
marginal product, and average product curves. Get them to describe the
curves and to explain their similarities with and differences to the curves
for smoothies in the textbook.
The first assignment covers only production. If you want, you can extend
the experiment with another assignment (Stage 2): Use the data from your
widget production experiment. Tell the students the cost of the capital and
the wage rate of a worker. (Make up the numbers. Any will do.) Tell the
students to calculate total cost, marginal cost, and average cost. Get them to
make graphs of the total cost, marginal cost, and average cost curves. Get
them to describe the curves and to explain their similarities with and
differences to the curves for smoothies in the textbook. This assignment and
the previous one make an outstanding assignment for credit or extra credit.
4.

Though perhaps this suggestion is more of a lecture closer than launcher, be

sure that your students see the big picture. There are two big ideas:
First, a firms long-run production costs depend on the freedom to choose
all inputs. Long-run flexibility enables firms to produce at a lower cost than
is possible in the short run when some inputs are fixed.
Second, in the short run, with one or more fixed inputs, production costs
vary with output in a predictable way because they are directly linked to input
productivity.

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

Land Mines
1.

If you do not create your own data using the experiment described above,
be sure that when you draw the curves in this chapter you use numeric
examples. Either make up your own numbers or use the table the text
provides, but make sure to provide your students with two things: a
preprinted table with the columns labeled (but not filled in) and preprinted
handouts with graphs on which the axes are labeled. If you can, draw the
points (not the actual curves) on the graphs that will correspond to the data
in the tables.
The table should provide a complete spreadsheet, with labor
employment, capital employment, output, AP, MP, TC, TFC, TVC, ATC,
AFC, AVC, and MC. Work through the first part of the table (capital and
labor inputs, output, fixed, variable and total costs). Label and draw these
graphs. Then turn back to the table, completing the data for the average and
marginal cost columns. Finally draw and explain the graphs that relate to
these data. This exercise allows students to listen to the intuition and follow
the example without being distracted trying to get the layout of the table
and graphs correct. Youll also be able to cover more material this way
because you wont be waiting for students to catch up.

2.

Watch out for persistent confusion between economic profit and accounting
profit. You can avoid some of this by thoroughly drilling them in
opportunity cost, so that they understand that non-money cost is still cost.

3.

Students are introduced to more graphs in this chapter. When summing up

the days lecture, the clearest way to show the differences (especially with
respect to the variables on the axes) is to graph each of the curves on the
board at the same time. Suggest that students practice graphing each of the
curves many times noting the maximum points, minimum points, and
intersections. Tell your students that it is important to draw the ATC curve
and MC curve correctly, that is, so that the MC curve intersects the ATC
curve when the ATC is at its minimum.

4.

Distinguish between decreasing marginal product in the short run versus

diseconomies of scale in the long run. Decreasing returns occur when
additional units of labor are combined with a fixed amount of capital.
Diseconomies of scale do not occur for the same reason, because in the long
run both labor and capital can change. Diseconomies of scale occur because
of chaos, organizational overloads, etc.

5.

The grade point average versus marginal grade example in the text is
outstanding to use in class to describe how the marginal product and
marginal cost curves relate to the average product and average cost curves.
Once students can tell a story using the same intuition, they find drawing

Chapter 12 . Production and Cost

those curves much easier. While you have the curves drawn on the board or
overhead, physically pull the average cost curves down (while marginal cost
is below) or pull them up (when the marginal cost curve rises above). Use
theatrics: raise your hands over your head and pull down the curves. If
you have a more sports-oriented class, you can try using a batting average
percentage and at-bat outcome example (if you had a .300 batting average
and you struck out at your next at-bat [the marginal factor], your batting
average is pulled down).

53

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

ANSWERS TO CHECKPOINT EXERCISES

CHECKPOINT 12.1 Economic Cost and Profit
1a. Explicit costs are the $1,500 for the lease of a Web server and $1,750 for
high-speed Internet service. The total explicit costs are $3,250.
The implicit costs are the $20,000 in wages forgone, the $4,000 in rent
forgone, the $100 in forgone interest payments on the savings, the $55,000 in
normal profit, and the $1,500 in economic depreciation for the computer.
The total implicit costs are $80,600.
1b. The economic profit equals total revenue minus total opportunity costs,
which is $45,000 ($3,250 + $80,600) = $38,850. Toni incurred an economic
loss of $38,850 for the year.

CHECKPOINT 12.2 Short-Run Production

1a. The marginal product of the fourth student is the change in total product
that results from hiring the fourth student. The total product with 3
students is 9 houses painted a week and the total product with 4 students is
12 houses painted a week. So the marginal product of the fourth student is
12 houses painted a week minus 9 houses painted a week, which equals 3
houses painted a week.
1b. The average product equals total product divided by the number of
students. When 4 students are hired, average product is 12 houses painted a
week divided by 4 students, which equals 3 houses painted a week.
1c. The marginal product decreases between 4 and 6 students.
1d. When the marginal product, though decreasing, exceeds the average
product the average product increases as more workers are hired.
Eventually as the marginal product decreases it becomes less than the
average product. When the marginal product is less than the average
product, the average product decreases as more workers are hired.

CHECKPOINT 12.3 Short-Run Cost

1a. Assuming
a
5-day
workweek, the total
cost schedules are in
the table to the right.

Output
Total
Total
(houses fixed cost variable Total cost
Labor
painted (dollars
cost
(dollars
(studen
per
per
(dollars
per
ts)
week)
week)
per week)
week)
0
0
500
0
500
1
2
500
250
750
2
5
500
500
1,000
3
9
500
750
1,250
4
12
500
1,000
1,500
5
14
500
1,250
1,750
6
15
500
1,500
2,000

Chapter 12 . Production and Cost

b.

55

The
average
cost
schedules are in the
table to the right.

Output Average
Average
(houses
fixed
variable
Labor
painted
cost
cost
(student
per
(dollars
(dollars
s)
week)
per
per house)
house)
0
0
xx
xx
1
2
250.00
125.00
2
5
100.00
100.00
3
9
55.56
83.33
4
12
41.67
83.33
5
14
35.71
89.29
6
15
33.33
100.00
c. The marginal cost schedule is in the table to the
Output
(houses
right.
Labor
painted
d. The difference between the total cost and total
(students
per
variable cost is the same at all levels of output
)
week)
and is equal to total fixed cost. This difference is
0
0
always equal to the total fixed cost because total
1
2
cost equals total variable cost plus total fixed cost.
2

12

14

15

CHECKPOINT 12.4 Long-Run Cost

a.

b.

If Lizzie doubles her inputs, and her output less than doubles, Lisa
experiences diseconomies of scale. Average total cost rises so that her longrun average cost curve slopes upward.
The source of her diseconomies of scale could be management problems
when she hires more students and leases more equipment. Trying to
organize more equipment and more students across different houses in
different areas of the town requires more communication and coordination.
If she is unable to manage the larger firm as efficiently as she was able to
manage the smaller firm, her average total cost increases.

Average
total cost
(dollars
per
house)
xx
375.00
200.00
138.89
125.00
125.00
133.33
Marginal
cost
(dollars
per
house)
125.00
83.33
62.50
83.33
125.00
250.00

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

ANSWERS TO CHAPTER CHECKPOINT EXERCISES

1a. Joes explicit costs are $2,000 rent he pays the airport and $200 in interest he
pays on his credit card. So Joes total explicit costs are $2,200.
1b. Joes implicit costs are $10,000 of normal profit for running a shoeshine
stand and $500 depreciation for his capital equipment, the chair, polishes,
and brushes. So Joes total implicit costs are $10,500.
1c. Joes economic profit equals his total revenue minus his total opportunity
costs. Joes total revenue is $15,000. His total opportunity costs are the sum
of his explicit costs, $2,200, and his implicit costs, $10,500. Joes total
opportunity costs are $12,700 so his economic profit is $15,000 minus
$12,700, which is $2,300.
2a. Sonyas explicit costs are $10,000 for cards, $5,000 for rent, and $1,000 for
utilities. So Sonyas explicit costs are $16,000.
2b. Sonyas implicit costs are $25,000 in forgone income as a real estate agent,
$14,000 normal profit, $60 in forgone interest, and $400 in economic
depreciation on the cash register, for a total of $39,460.
2c. Sonyas economic profit equals her total revenue, $58,000, minus her total
opportunity costs or $55,640, which is the sum of her explicit and implicit
costs. Sonyas economic profit is
Total
Average Marginal
$58,000 $55,640, which equals
Labor product product
product
$2,360.
0
0
xx
20
3a. The marginal product and average
1
20
20.0
24
product schedules are in the table to
2
44
22.0
the right.
16
3
60
20.0
12
4
72
18.0
8
5
80
16.0
4
6
84
14.0
2
7
86
12.3

3b. Marginal returns increase for the first 2 workers.

3c. Marginal returns decrease after the second worker is hired.

Chapter 12 . Production and Cost

4a. The table to the right has Yolandas

total product, marginal product, and
average product schedules.
4b. Marginal returns increase for the 2nd
and 3rd workers.
4c. After the third worker is hired,
marginal returns decrease.

5a. The variable costs are the

costs of labor; the fixed costs
are the costs of the shaping
board equipment. Assuming
a 5-day work week, the total
cost schedules per day are in
the table to right.

Labo
r
0
1
2
3
4
5
6
7

Labor
0

Total
Average
product product
0
xx

1,000

1,000

2,000

1,000

4,000

1,333

5,000

1,250

Total
product
(body
boards)
0
20
44
60
72
80
84
86

Total
fixed
cost
(dollars)
60
60
60
60
60
60
60
60

57

Marginal
product

Total
variable
cost
(dollars)
0
200
400
600
800
1,000
1,200
1,4000

1,000
1,000
2,000
1,000

Total
cost
(dollar
s)
60
260
460
660
860
1,060
1,260
1,460

5b. Total cost minus total variable cost always equals $60. The difference
between total cost and total variable cost equals total fixed cost, which does
not change with the
Total
Average Average
Average
level of output.
product
fixed
variable total cost
5c. The average cost
Labor
(body
cost
cost
(dollars)
schedules are in the
boards)
(dollars (dollars)
)
table to the right.
0
0
xx
xx
xx
1
20
3.00
10.00
13.00
2
44
1.36
9.09
10.45
3
60
1.00
10.00
11.00
4
72
.83
11.11
11.94
5
80
.75
12.50
13.25
6
84
.71
14.29
15.00
7
86
.70
16.28
16.98

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

Total Marginal
5d. The marginal cost schedule is in the table to the right.
Labor product
cost
5e. Lens average total cost is at a minimum between 44
0
0
10.00
and 60 body boards a day.
1
20
5f. Lens average variable cost is at a minimum between
8.33
44 and 60 body boards a day.
2
44
12.50
5g. Though the range of output over which the minimum
3
60
average total cost and average variable cost occur is
16.67
the same, we know that the average variable cost
4
72
25.00
equals its minimum at a lower level of output than
5
80
the average total cost. The average total cost equals
50.00
the average variable cost plus the average fixed cost.
6
84
100.00
The average fixed cost constantly falls as output
7
86
increases. So as output increases after the average
variable cost reaches a minimum and starts to rise, the
average total cost continues to fall for a while because
the average fixed cost falls and this fall dominates the rise in the average
variable cost. Eventually the rise in the average variable cost is greater than
the fall in the average fixed cost and at that level of output, the average total
cost begins to rise as output increases.
6a. The variable costs are the
Total
Total
Total
costs of labor; the fixed costs Labor Output
fixed
variable
cost
are the costs of the
cost
cost
0
0
1,000
0
1,000
equipment. The total cost
1
1,000
1,000
500
1,500
schedules are in the table to
2
2,000
1,000
1,000
2,000
right.
3
4,000
1,000
1,500
2,500
6b. Total cost minus total
4
5,000
1,000
2,000
3,000
variable cost always equals $1,000. The difference between total cost and
total variable cost equals total fixed cost, which does not change with the
level of output.
Average
Average
Average
6c. The
average
cost
Labor
Output
fixed
variable
total
cost
schedules are in the table
cost
cost
to the right.
0
0
xx
xx
xx
1
1,000
1.00
.50
1.50
2
2,000
.50
.50
1.00
3
4,000
.25
.38
.63
4
5,000
.20
.40
.60

Chapter 12 . Production and Cost

59

6d. The marginal cost schedule is in the table to the right.

Marginal
Labor Output
cost
6e. From the numbers in the average cost table, Yolandas
0
0
average total cost is at a minimum when she produces
.50
5,000 bullfrogs a week.
1
1,000
.50
6f. Yolandas average variable cost is at a minimum when
2
2,000
she produces 4,000 bullfrogs a week.
.25
6g. Average total cost equals average variable cost plus
3
4,000
.50
average fixed cost. Average fixed cost constantly falls
5
5,000
as output increases. So as output increases after
average variable cost reaches a minimum and starts to
rise, average total cost continues to fall for a while
because average fixed cost falls and this fall dominates the rise in average
variable cost. Eventually, the rise in average variable cost is greater than the
fall in average fixed cost and at that level of output, average total cost begins
to rise as output increases.
7.
The completed table
L
TP
TVC
TC
AFC
AVC
ATC
MC
is to the right.
0
0
0
100
xx
xx
xx
13.50
1
10
35
135 10.00 3.50
13.50
2.50
2
24
70
170
4.17 2.91
7.08
2.50
3
38
105
205
2.63 2.76
5.39
5.83
4
44
140
240
2.27 3.18
5.45
11.67
5
47
175
275
2.13 3.72
5.85
8.

9.

A = $1,050. Calculate A using TVC = TC TFC. Total cost is given in the

row. For total fixed cost, TFC, note that TFC = TC TVC. Use the
information in the top row to get TFC = $500. So A = $1,550 $500, which
equals $1,050.
B = $1,200. Calculate B by adding TVC + TFC, with TFC from part (a) as
$500. Then B = $700 + $500, which equals $1,200.
C = $5. Calculate C by calculating TFC TP, which is $500 100 = $5.
D = $8.50. Calculate D by calculating TC TP, which is $850 100= $8.50.
E = $2.50. Calculate E as the change in TC divided by the change in TP,
which is ($1,550 $1,200) (380 240) = $2.50.
The long-run average cost curve, LRAC, shows the lowest average total
cost of producing any level of output when the firm has had sufficient
time to change both its plant size and labor employed. To construct the

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

LRAC curve, calculate the ATC curve for each plant size. The ATC that is
the lowest for each level of output is the LRAC for that level of output.
10.

A firm that is producing at the lowest

average cost might be able to lower its
average cost further by increasing its
production. Figure 12.1 shows an example. If
the firm is producing at point A, the firm can
increase its production by hiring more labor
and increasing the size of its plant and move
to point B. At point B the average cost is
lower than at point A. Between point A and
point B, the firm enjoys economies of scale.

11.

The sources of economies to scale are

specialization of labor and capital. The
sources of diseconomies of scale are
difficulties of management coordination and
communication. In Figure 12.2, economies of
scale occur up to point A, 45,000 units of
output a day, because the long-run average
cost (generally) falls as output increases.
Diseconomies of scale occur at output levels
greater than 45,000 units a day because the
long-run average cost (generally) rises as
output increases.

12.

Your students answers will differ, but economies of scale occur in

industries that are high tech and in agriculture. High tech industries, such

Chapter 12 . Production and Cost

as server farms, can service thousands of customers in one location. The

ATM example in the book provides a good example.
In agriculture, large, commercial farms can hire many workers to specialize
in the many specific tasks that are required. For instance, on a dairy farm
many tasks are required: breeding cows, growing feed, milking, selling, and
delivering milk. A large corporate farm can hire specialists for all these
tasks, versus a single farmer trying to do all of the jobs on a farm.
13.

Your students answers will differ from these answers. Diseconomies of

scale probably occur in large conglomerate companies such as General
Electric, Tyco, or TimeWarner. Managing these types of companies is very
complex because the different business often can have little in common. For
example, General Electric produces light bulbs, locomotives, and CNBC.
Management is already struggling to run these disparate divisions, so if the
company increases still more in size, it is probable that the added
complexity results in average cost rising.
Diseconomies of scale also occur in the electricity industry. We see electrical
utilities buying electricity from other suppliers during extreme weather that
occurs infrequently. If the utility had built a plant to meet demand on these
very cold or very hot days, it would experience diseconomies of scale. As a
result, the utility uses a smaller plant size that minimizes average total cost
on normal days (the vast majority of days), but it must buy additional
power during extreme weather.

61

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Part 4 . A CLOSER LOOK AT DECISION MAKERS

Critical Thinking
14.

The cost of the fiber-optic system is a long-run cost. It also is a sunk cost.
It is a sunk cost because it has already been paid.

15a.

The cost of the human teller is primarily the cost of labor, a variable cost,
with only a slight amount of capital cost. The cost of the ATM is primarily
the cost of the capital, a fixed cost, with only a small amount of labor cost.
So the cost of an ATM shows substantial economies of scale whereas the
cost of a human teller reaches its minimum at a lower scale of transactions
and then starts to rise.
As long as the bank forecasts a reasonably large number of transactions at
a location, with the low cost of an ATM, it makes sense for the bank to
locate an ATM at that location.
Branches of banks that are located in very small towns and that have
relatively few customers will not have ATMs.
For two reasons, ATMs are not as common in China as in the United
States. First, the cost of capital is higher in China and the cost of labor is
lower. So, ATMs do not enjoy as large a cost advantage in China as they
do in the United States. Second, the demand for bank services is lower in
China than in the United States. So, ATMs are less likely to achieve the
large scale of transactions necessary for them to be less expensive than
human tellers.

15b.

15c.
15d.

16a.
16b.

The cost of using human tellers does not change. The cost of using ATMs
increases, so the average total cost curve for ATMs shifts upward.
The tax increases the scale at which it is less expensive to use an ATM
instead of a human teller. As a result, banks hire more human tellers and
create fewer ATMs.

Chapter 12 . Production and Cost

Web Exercises
17a. The marginal cost of growing larger frogs probably increases because the
price of larger frogs exceeds the price of smaller frogs. The marginal cost of
growing additional numbers of similar sized frogs does not appear to
increase because any number of similar sized frogs can be purchased for the
same price.
17b. A firms cost and production curves are such that when the marginal cost is
increasing, then the marginal product is decreasing. Because the marginal
cost of growing larger frogs seems to be increasing, then bull frog farming
displays decreasing marginal returns.
17c. For some people, the value from a larger frog is worth the additional cost
over a smaller frog. Depending on what the consumer does with the bull
frog, larger frogs might have significantly better survival rates (though, of
course, all frogs croak in the end), might be able to jump farther, or might
have noticeably more meat on their legs.
18a. The survivor technique measures economies of scale over the long run by
observing the evolution of the surviving firms. If surviving firms grow over
time while small firms decline, then economies of scale must be present.
18b. The survivor technique works because firms whose costs are higher than
others do not survivethey go bankrupt or are purchased by survivors.
18c. These survivor technique indicates that significant economies of scale exist
in the banking industry and that economies of scale are available at low
asset levels. Banks with assets of $300 million or more appear to have a cost
advantage over smaller banks.
18d. Figure 12.3 illustrates a long-run average cost
that is consistent with what is found using the
survivor technique.

63

64

Part 4 . A CLOSER LOOK AT DECISION MAKERS

19a. The costs fall into 5 categories: 1) land preparation; 2) planting;

3) fertilization; 4) fungicide-insecticide applications; and, 5) harvest costs.
Details of what these costs include are in answer (b) below.
19b. The issue of what is a fixed cost and what is a variable cost depends on
when the costs are being considered, so your students answers might vary.
Assume we are studying a farmer who, in the spring, is determining what
to grow on an acre of soil. So the farmer has already prepared the ground
but has not yet purchased any seed. In this case, the land preparation cost,
$72.36 an acre, is a fixed cost; the planting cost, $313.38 an acre and which
includes the seed and actual planting, is a variable cost; the fertilization
cost, $166 an acre, is a variable cost; the pest control cost, $744.85 per acre, is
a variable cost; and, the harvesting cost, $291 an acre, is a variable cost. Any
cost to rent the land is a fixed cost and was not specifically given on the web
page.
19c. Your students answers will vary, depending
on the assumptions they make. The web page
mentions 5 ton, 8 ton, and 10 ton crops. The
assumption I make is that if the farmer does
not fertilize or spray, the harvest is 5 tons; if the
farmer fertilizes 1/3 the recommended amount
and does 1/3 the recommended spraying, the
harvest is 8 tons; and if the farmer fertilizes the
recommended amount and does all the
recommended spraying, the harvest is 10 tons.
With these assumptions, for 5 tons, TFC is $72,
TVC is $604, TC is $676, AFC is $14, AVC is
$121, and ATC is $135. For 8 tons, TFC is $72,
TVC is $907, TC is $979, AFC is $9, AVC is $113,
and ATC is $122. For 10 tons, TFC is $72, TVC is
$1,513, TC is $1,585, AFC is $7, AVC is $151,
and ATC is $158. The MC between 5 and 8 tons
is $101 a ton and between 8 and 10 tons is $303. These data are illustrated in
Figure 12.4.
19d. The minimum point on the AVC curve is at about 7 tons of pumpkins and
the minimum point on the ATC curve is at about 8 tons of pumpkins.

Chapter 12 . Production and Cost

65

ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions
CHECKPOINT 12.1 Economic Cost and Profit
1. In 2005, Roma was a schoolteacher and earned $40,000. But she enjoys
creating cartoons, so at the beginning of 2006, Roma quit teaching and set to
work as a cartoonist. She stopped renting out her basement for $5,000 a year
and began to use it as her office. She used $5,000 from her savings account
to buy a new computer, and she leased a printer for $150 a year. During
2006, Roma paid $1,250 for paper, utilities, and postage; the bank paid 5
percent a year on savings account balances; and Roma sold $50,000 of
cartoons. Normal profit is $3,000 a year. At the end of 2006, Roma was
offered $4,000 for her computer. For 2006, calculate Roma's:
1a. Explicit costs.
1b. Implicit costs.
1c. Economic profit.
CHECKPOINT 12.2 Short-Run Production
Labor
Total product
2. Lisa has a lawn-mowing business. Lisa hires
(students
per
lawns
cut per
students to mow the lawns. The table sets out
day)
day)
Lisa's total product schedule.
0
0
2a. Calculate the marginal product of the fourth
1
20
student.
2
44
3
70
2b. Calculate the average product of four
4
94
students.
5
114
2c. Over what numbers of students does
6
120
marginal product decrease?
2d. When marginal product decreases, compare average product and marginal
product.
3.

Create some hypothetical short-run production data for a firms labor

employment and output. Calculate the firms average product and marginal
product schedule. Carefully graph the data. What happens at the minimum
of the average product curve?
Labor
Total product
CHECKPOINT 12.3 Short-Run Cost
(students per
(lawns cut per
4. Lisa has a lawn-mowing business. Lisa hires
day)
day)
students at $40 a day to mow lawns. Lisa
0
0
1
. 20
leases 5 lawn mowers for $200 a day. The
2
44
table gives the daily output.
3
70
4a. Construct the total variable cost and total cost
4
94
schedules.
5
114
6
120

66

Part 4 . A CLOSER LOOK AT DECISION MAKERS

4b. Construct the average fixed cost, average variable cost, and average total
cost schedules.
4c. Construct the marginal cost schedule.
4d. Check that the gap between total cost and total variable cost is the same at
all outputs. Explain why.
5.

Create hypothetical short-run production data for a firms labor

employment, amount of capital, and output. Select wages and the cost of
the capital and then calculate the total cost, marginal cost, average fixed
cost, average variable cost, and average total cost schedules and curves.

Answers
CHECKPOINT 12.1 Economic Cost and Profit
1a. Explicit costs are the $150 printer lease and $1,250 for paper, utilities, and
postage. So explicit costs are $1,400.
1b. Implicit costs are $40,000 in wages forgone, $5,000 in rent forgone, $3,000 in
normal profit, $250 in forgone interest payments on the savings, and $1,000
in economic depreciation on the computer. So implicit costs are $49,250.
1c. Economic profit equals total revenue minus total opportunity cost, which is
the sum of the explicit costs and implicit costs. So Roma economic profit is
$50,000 ($1,400 + $49,250), which equals $650. Roma incurs an economic
loss of $650 for the year.
CHECKPOINT 12.2 Short-Run Production
2a. The total product with 3 workers is 70 lawns mowed and the total product
with 4 workers is 94 lawns mowed. So, the marginal product of the fourth
student is 24 lawns.
2b. The average product of four students is (94 lawns) (4 students), which is
23.5 lawns.
2c. The marginal product decreases between 4 and 6 students.
2d. When marginal product decreases, eventually it become less than average
product. Before it is less than average product (that is, when marginal
product, though decreasing, exceeds average product) average product
increases as more workers are hired. When marginal product is less than
average product, average product decreases as more workers are hired.
3.

Students will have individual answers. Make sure their average product
curve is U-shaped and that the marginal product curve intersects the
average product curve at the minimum of the average product curve. Also
make sure that the axes are labeled correctly.

Chapter 12 . Production and Cost

CHECKPOINT 12.3 Short-Run Cost

4a. The total costs are in the table
to the right.
Labor Output
0
1
2
3
4
5
6

0
20
44
70
94
114
120

Total
fixed
cost
200
200
200
200
200
200
200

Total
variable
cost
0
40
80
120
160
200
240

67

Total
cost
200
240
280
320
360
400
440

Average
Average
Average
fixed
variable total cost
cost
cost
0
0
xx
xx
xx
1
20
10.00
2.00
12.00
2
44
4.55
1.82
6.37
3
70
2.86
1.71
4.57
4
94
2.13
1.70
3.83
5
114
1.75
1.75
3.50
4c. The marginal cost is in
Marginal
6
120
1.67
2.00
3.67
Labor Output
cost
the table to the right.
0
0
4d. The gap between total cost and total variable cost is
2.00
the same at all levels of output because total cost
1
20
1.67
minus total variable cost equals total fixed cost. Note
2
44
in the answer to part (a), that the difference between
1.54
total variable cost and total cost is always $200, the
3
70
1.67
amount of total fixed cost.
4
94
2.00
5
114
6.67
6
120

4b. The average costs are

in the table to the right.

5.

Labor

Output

Students will have individual answers. Make sure graphs and axes are
labeled correctly. By generating their own data, students learn the
interaction of output and different costs.

68

Part 4 . A CLOSER LOOK AT DECISION MAKERS

USING EYE ON THE U.S. ECONOMY

The ATM and the Cost of Getting Cash
The article provides interesting data and ATC curves for ATMs. The story and
curves clearly show why large banks do a lot of their business via ATMs as a
result of a large customer base. Smaller banks, on the other hand, face a small
client base and so it is not efficient (cost-effective) for them to provide ATMs to
this small number. It is cheaper for the small banks to use tellers.
Ask your students if they think that smaller banks and credit unions would
be less likely to charge their own customers for using other banks ATM
machines. You can conduct a quick poll of the class to determine if any of the
students have actual experience with this question. The point is that by not
charging its customers for using other banks ATMs, the smaller bank can
increase its scale without having to actually change its plant size. The answer to
the question depends, in part, on the charges the smaller bank has to pay to allow
its customers to be part of the larger network.