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Chapter 12 Leaning MAp/Microeconomics_10th_Edition_by_David_Col 291.pdf

After reading this chapter, you should be able to:

LO12-1 Distinguish technical efficiency from economic efficiency.

LO12-2 Explain how economies and diseconomies of scale influence the shape of long-run cost curves.

LO12-3 Explain the role of the entrepreneur in translating cost of production to supply.

LO12-4 Discuss some of the problems of using cost analysis in the real world.

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Economic efficiency consists of making things that are worth more than they cost.

—J. M. Clark

Welcome back from your intermission. I hope you’ve rees- tablished your relationship with the real world and are ready to return, with renewed vigor, to the world of economics. When we took our intermission in the last chapter, we had worked our way through the various short-run costs. The short run is a time period in which some inputs are fixed. In the first part of this chapter, we consider firms’ long-run decisions and the determi- nants of the long-run cost curves. Then, in the second part, we’ll talk about applying cost analysis to the real world. Firms have many more options in the long run than they do in the short run. They can change any input they want. Plant size is not given; neither is the technology available given. To make their long-run decisions, firms look at the costs of the various inputs and the technologies available for combining those inputs, and then decide which combination offers the low- est cost. Say you’re opening a hamburger stand. One decision you’ll have to make is what type of stove to buy. You’ll quickly discover that many different types are available. Some use more gas than oth- ers but cost less to buy; some are electric; some are self-cleaning and hence use less labor; some are big; some are little; some use microwaves; some use convec- tion. Some have long-term guarantees; some have no guarantees. Each has a col- orful brochure telling you how wonderful it is. After studying the various detailed specifications and aspects of the production technology, you choose the stove that has the combination of characteristics that you believe best fits your needs. Next you decide on workers. Do you want bilingual workers, college-educated workers, part-time workers, experienced workers . . . ? You get the idea: Even simple production decisions involve complicated questions. These decisions are made on the basis of the expected costs, and expected usefulness, of inputs.

Technical Efficiency and Economic Efficiency When choosing among existing technologies in the long run, firms are inter- ested in the lowest cost, or most economically efficient, methods of production. They consider all technically efficient methods and compare their costs. The terms economically efficient and technically efficient differ in meaning.

Production and Cost Analysis II

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Technical efficiency means that a production process uses as few inputs as possible to produce a given level of output. When there are multiple inputs, many different production processes can be technically efficient. For example, say that to produce 100 bushels of wheat, one production process uses 10 workers and 1 acre and another pro- duction process uses 1 worker and 100 acres; say also that these are the lowest number of inputs you can use with those production processes. Which of these two production techniques is more efficient? Both are technically efficient since neither involves less of both inputs. (A production process that uses 11 workers and 1 acre would be techni- cally inefficient.) But that doesn’t mean that both of these production processes are equally economically efficient. That question can’t be answered unless you know the relative costs of the two inputs. If renting an acre of land costs $100 and each worker costs $10, our answer likely will be different than if land rents for $10 an acre and each worker costs $100. The economically efficient method of production is the method that produces a given level of output at the lowest possible cost. With land at $100 an acre, you will use the pro- duction process that uses lots of workers and less land. With land at $10 an acre you will use the production process that uses fewer workers but more land. Thus, all eco- nomically efficient production processes are technically efficient, but not all techni- cally efficient production processes are economically efficient. In long-run production decisions, firms will look at all available production technolo- gies and choose the technology that, given the available inputs and their prices, is the economically efficient way to produce. These choices will reflect the prices of the various factors of production. Those prices, in turn, will reflect the factors’ relative scarcities. Consider the use of land by firms in the United States and in Japan. The United States has large amounts of land (8 acres) per person, so the price of land is lower than in Japan, which has only 0.73 acre per person. An acre of rural land in the United States might cost about $1,300; in Japan it costs over $10,000. Because of this differ- ence in the price of inputs, production techniques use much more labor per acre of land in Japan than in the United States. Similarly with Bangladesh: Labor is more abundant and capital is scarcer, so production techniques in Bangladesh use much more labor per unit of capital than in the United States. Whereas Bangladesh would use hundreds of workers and very little machinery to build a road, the United States would use three or four people along with three machines. Both countries are being economically effi- cient, but because costs of inputs differ, the economically efficient method of produc- tion differs. Thus, the economically efficient method of production is the technically efficient method of production that has the lowest cost. (For a further, graphical analy- sis of economic efficiency, see the Appendix at the end of this chapter.)

The Shape of the Long-Run Cost Curve In the last chapter, we saw that the law of diminishing marginal productivity accounted for the shape of the short-run average cost curve. The firm was adding more of a variable input to a fixed input. The law of diminishing marginal productivity doesn’t apply to the long run since, in the long run, all inputs are variable. The most important determinants of what is economically efficient in the long run are economies and diseconomies of scale. Let’s consider each of these in turn and see what effect they will have on the shape of the long-run average cost curve.

Economies of Scale We say that production exhibits economies of scale when long-run average total costs decrease as output increases. For example, if producing 40,000 high-definition TVs costs a firm $16 million ($400 each), but producing 200,000 costs the firm

Q-1 True or false? If a process is economically efficient, it is also technically efficient. Explain your answer.

Q-2 Why does Bangladesh use production techniques that require more workers per acre of land than do the techniques used in the United States?

The shape of the long-run cost curve is due to the existence of economies and diseconomies of scale.

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$40 million ($200 each), between 40,000 and 200,000 units, production exhibits significant economies of scale. One can also say that there are increasing returns to scale. In real-world production processes, at low levels of production, economies of scale are extremely important because many production techniques require a certain minimum level of output to be useful. For example, say you want to produce a pound of steel. You can’t just build a mini blast furnace, stick in some coke and iron ore, and come out with a single pound of steel. The smallest technically efficient blast furnaces have a production capacity measured in tons per hour, not pounds per year. The cost of the blast furnace is said to be an indivisible setup cost (the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use). Indivisible setup costs are important because they create many real-world economies of scale: As output increases, the costs per unit of output decrease. As an example, consider this book. Preparing the book for publishing is an indivisible setup cost; it is a cost that must be incurred if any production is to take place, but it is not a cost that increases with the number of books produced. That means that the more copies of the book that are produced, the lower the cost per book. That’s why it costs more per book to produce a textbook for an upper-level, low-enrollment course than it does for a lower-level, high-enrollment course. The same amount of work goes into both (both need to be written, edited, and composited), and the printing costs differ only slightly. The actual production or print-run costs of printing a book (the costs to print and bind the book after it is all prepared) are only about $3 to $8 per book. The other costs are indivisible setup costs. Prices of produced goods, including books, reflect their costs of production. As you move to upper-level academic courses, where print runs are smaller, you’ll likely discover that the books are smaller and less color- ful but are priced the same as, or more than, this introductory text.

In the production of steel, the cost of a blast furnace is an indivisible setup cost that requires a minimum level of production to be economically feasible.

Q-3 Why are larger production runs often cheaper per unit than smaller production runs?

REAL-WORLD APPLICATION

In the late 1980s, the normal production run of a U.S. auto- maker was 200,000 units. Why was it so high? Because of indivisible setup costs of the then-current production tech- nology. In order to reduce those indivisible setup costs to an acceptable level, the production level per year had to equal at least 200,000, or the car was consid- ered an economic failure. Small-sports-car sales did not meet that sales level, and so, in the 1980s, small, low-cost sports cars faded from the scene. For example, the Pontiac Fiero, a small American sports car, was dropped in 1988. But what is an indivisible setup cost depends on the structure of production. In the 1980s, Japanese companies changed the nature of automobile production by organiz- ing assembly lines so that many cars with different sizes and shapes could share the same assembly line, allowing

Changing Technology in Automobile Production economies of scope (discussed later in the chapter). This redesign lowered the indivisible setup costs for each type of car, and made the Japanese companies’ minimum prof- itable production level 30,000, not 200,000. The Mazda Miata was one of the first cars developed using this new

assembly-line approach, and it was a big success. In response to the challenge, other car companies switched their as- sembly lines to this alternative, and, over the past 30 years, there has been an enormous increase in the number of rea- sonably priced sporty two-seaters.

These changes are ongoing. Auto companies are designing their various lines of cars so that the components of

one are easily interchangeable with the components of another, allowing more shared assembly lines and lower indivisible setup costs.

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In the long-run planning decisions about the cost of producing this book, the expected number of copies to be sold was an important element. That figure influenced the number of books produced, which in turn affected the expected cost per unit. This will be the case any time there are economies of scale. With economies of scale, cost per unit of a small production run is higher than cost per unit of a large production run. Figure 12-1(a) demonstrates a long-run production table; Figure 12-1(b) shows the related typical shape of a long-run average cost curve. (Notice that there are no fixed costs. Because we’re in the long run, all costs are variable.) Economies of scale account for the downward-sloping part. Cost per unit of output is decreasing. Because of the importance of economies of scale, businesspeople often talk of a minimum efficient level of production. What they mean by minimum efficient level of production is that, given the price at which they expect to be able to sell a good, the indivisible setup costs are so high that production runs of less than a certain size don’t make economic sense. Thus, the minimum efficient level of production is the amount of production that spreads setup costs out sufficiently for a firm to undertake produc- tion profitably. At this point, the market has expanded to a size large enough for firms to take advantage of all economies of scale. The minimum efficient level of production is where the average total costs are at a minimum.

Diseconomies of Scale Notice that on the right side of Figure 12-1(b) the long-run average cost curve is upward-sloping. Average cost is increasing. We say that production exhibits diseconomies of scale when long-run average total costs increase as output increases. For example, if producing 200,000 high-definition TVs costs the firm $40 million ($200 each) and pro- ducing 400,000 high-definition TVs costs the firm $100 million ($250 each), there are diseconomies of scale associated with choosing to produce 400,000 rather than 200,000. One also can say there are decreasing returns to scale. Diseconomies of scale usually, but not always, start occurring as firms get large. It is important to remember that diminishing marginal productivity is not the cause of diseconomies of scale.

In the long run, all inputs are variable, so only economies of scale can influence the shape of the long-run cost curve.

Diminishing marginal productivity refers to the decline in productivity caused by increasing units of a variable input being added to a fixed input. Diseconomies of scale refer to the decreases in productivity that occur when there are equal percentage increases of all inputs (no input is fixed).

FIGURE 12-1 (A AND B) A Typical Long-Run Average Total Cost Table and Curve

In the long run, average costs initially fall because of economies of scale; then they are constant for a while, and finally they tend to rise due to diseconomies of scale.

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Diseconomies of scale

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(b) Long-Run Average Cost Curve

Minimum e�cient level of production

11 12 13 14 15 16 17 18 19 20

Total Costs Total Costs Total Costs Average Total Quantity of Labor of Machines = TCL + TCM Costs = TC/Q

11 $381 $254 $ 635 $58 12 390 260 650 54 13 402 268 670 52 14 420 280 700 50 15 450 300 750 50 16 480 320 800 50 17 510 340 850 50 18 549 366 915 51 19 600 400 1,000 53 20 666 444 1,110 56

(a) Long-Run Production Table

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Diseconomies of scale could not occur if production relationships were only tech- nical relationships. If that were the case, the same technical process could be used over and over again at the same per-unit cost. In reality, however, production relationships have social dimensions, which introduce the potential for important diseconomies of scale into the production process in two ways:

1. As the size of the firm increases, monitoring costs generally increase. 2. As the size of the firm increases, team spirit or morale generally decreases.

Monitoring costs are the costs incurred by the organizer of production in seeing to it that the employees do what they’re supposed to do. If you’re producing something yourself, the job gets done the way you want it done; monitoring costs are zero. How- ever, as the scale of production increases, you have to hire people to help you produce. This means that if the job is to be done the way you want it done, you have to monitor (supervise) your employees’ performance. The cost of monitoring can increase sig- nificantly as output increases; it’s a major contributor to diseconomies of scale. Most big firms have several layers of bureaucracy devoted simply to monitoring employees. The job of middle managers is, to a large extent, monitoring. The other social dimension that can contribute to diseconomies of scale is the loss of team spirit (the feelings of friendship and being part of a team that bring out peo- ple’s best efforts). Most types of production are highly dependent on team spirit. When the team spirit or morale is lost, production slows considerably. The larger the firm is, the more difficult it is to maintain team spirit. Another important reason why diseconomies of scale can come about is that the bigger things get, the more checks and balances are needed to ensure that all the various components of production are coordinated. The larger the organization, the more checks and balances and the more paperwork. Some large firms manage to solve these problems and avoid diseconomies of scale. But problems of monitoring and loss of team spirit often limit the size of firms. They underlie diseconomies of scale in which less additional output is produced for a given increase in inputs, so that per-unit costs of output increase.

Q-4 If production involved only technical relationships and had no social dimension, what would the long- run average total cost curve look like?

As firms become larger, monitoring costs increase and achieving team spirit is more difficult.

REAL-WORLD APPLICATION

The T-shirt said “Made in China,” but when economist Pietra Rivoli, in her delightful book The Travels of a T-Shirt in the Global Economy, tracked down the process of making the T-shirt that she bought in Florida, she discovered that it’s a lot more complicated than that. True, the company that sewed the shirt was in Shanghai, China. But guess where the cot- ton for the shirt came from? West Texas, USA, at a farm like the Reinsch family farm that is highlighted in Rivoli’s book. Now here’s an exam question for you: Why, if China’s labor cost is 1/20 that of U.S. labor costs, is the cotton for a T-shirt grown in the United States, shipped across the ocean to China to be woven and sewn into a T-shirt, and shipped back again to the United States to be sold?

Travels of a T-Shirt and Economies of Scale Answer: Economies of scale (and some U.S. subsidies, but you aren’t expected to know that yet). In fact, the United States leads the world in the production of cotton, and has done so for over 200 years. Farms in Africa average

8 acres and in China average less than 1 acre. The Reinsch’s farm is 1,000 acres and can produce about 500,000 pounds of cotton, enough for 1.3 million T-shirts. Size makes a difference; cotton farmers outside the United States almost exclu- sively handpick their cotton. Because U.S. farmers have such large farms, they can use large machinery to do all the picking, and thereby take advantage of

economies of scale, countering the much higher labor costs in the United States.

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Constant Returns to Scale Sometimes in a range of output, a firm does not experience either economies of scale or diseconomies of scale. In this range, there are constant returns to scale where long-run average total costs do not change with an increase in output. Constant returns to scale are shown by the flat portion of the average total cost curve in Figure 12-1(b). Constant returns to scale occur when production techniques can be replicated again and again to increase output. This occurs before monitoring costs rise and team spirit is lost. The long-run and the short-run average cost curves have similar U shapes. But it’s important to remember that the reasons why they have this U shape are quite different. The assumption of initially increasing and then eventually diminishing marginal productivity (as a variable input is added to a fixed input) accounts for the shape of the short-run average cost curve. Economies and diseconomies of scale account for the shape of the long-run average total cost curve; initially economies of scale drive aver- age costs down, then diseconomies of scale drive average costs up.

The Importance of Economies and Diseconomies of Scale Economies and diseconomies of scale play important roles in real-world long-run production decisions. Economies of scale are an important reason why firms attempt to expand their markets either at home or abroad. If they can make and sell more at lower per-unit costs, they will make more profit. Diseconomies of scale prevent a firm from expanding and can lead corporate raiders to buy the firm and break it up in the hope that the smaller production units will be more efficient, thus eliminating some of the diseconomies of scale.

Envelope Relationship Since in the long run all inputs are flexible, while in the short run some inputs are not flexible, long-run cost will always be less than or equal to short-run cost at the same level of output. To see this, let’s consider a firm that had planned to pro- duce 100 units but now adjusts its plan to produce more than 100. We know that in

Q-5 Why is the short-run average cost curve a U-shaped curve?

Q-6 Why is the long-run average total cost curve generally considered to be a U-shaped curve?

Economies and diseconomies of scale play important roles in real-world long- run production decisions.

REAL-WORLD APPLICATION

Companies are continually searching for ways to avoid diseconomies of scale, and there are hundreds of management fads that claim to avoid them, which have come (and gone). One recent fad is holacracy (the term is a play on the word bureaucracy), which is an organizational structure in which roles are defined around work, not people, authority is dis- tributed to teams, decisions are made lo- cally, and everyone is bound (the CEO and maintenance person alike) by the same set of highly visible rules. One company to recently adopt this structure is the shoe company Zappos, an online shoe and clothing

Holacracy, Diseconomies of Scale, and Zappos company. Leaders at Zappos argue that the holacracy structure is far more effi- cient than other methods of organiza- tion. Many observers have their doubts about whether the holacracy organiza- tional structure will make Zappos more efficient and, if it does, whether it can be adapted to more traditional companies. Most companies have found that a blend of top-down and bottom-up control inevi-

tably evolves into the system firms actually use. But if hol- acracy at Zappos is successful, we will expect other firms to adopt it, since they are always looking for ways to im- prove efficiency.

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Chapter 12 ■ Production and Cost Analysis II 249

the long run the firm chooses the lowest-cost method of production. In the short run, it faces an additional constraint: All expansion must be done by increasing only the variable input. That constraint must increase average cost (or at least not decrease it) compared to what average cost would have been had the firm planned to produce that level to begin with. If it didn’t, the firm would have chosen that new combination of inputs in the long run. Additional constraints increase cost. The envelope relationship is the relationship between long-run and short-run aver- age total costs. It tells us that, at the planned output level, short-run average total cost equals long-run average total cost, but at all other levels of output, short-run average total cost is higher than long-run average total cost. This relationship is shown in Figure 12-2. Why it is called an envelope relationship should be clear from the figure. Each short-run average total cost curve touches (is tangent to) the long-run average total cost curve at one, and only one, output level; at all other output levels, short-run average cost exceeds long-run average cost. The long-run average total cost curve is an enve- lope of short-run average total cost curves. The intuitive reason why the short-run average total cost curves always lie above or tangent to the long-run average cost curve is simple. In the short run, you have chosen a plant; that plant is fixed, and its costs for that period are part of your average fixed costs. Changes must be made within the confines of that plant. In the long run, you can change everything, choosing the combination of inputs in the most efficient manner. The more options you have to choose from, the lower the costs of production. Put another way: Additional constraints always raise costs (or at least won’t lower them). So in the long run, costs must be the same or lower. Another insight to note about this envelope relationship is the following: When there are economies of scale and you have chosen an efficient plant size for a given output, your short-run average costs will fall as you increase production. Technically, this must be the case because the short-run marginal cost (SRMC) curve goes through the minimum point of the short-run average total cost (SRATC) curve, and the mini- mum point of the SRATC curve is to the right of the efficient level of production in the long run. That means that at output Q2, SRMC2 has to be below SRATC2 and short-run average total cost has to be falling. Intuitively, what’s happening is that at output Q2, your fixed costs are high. Now demand increases and you increase production. Your average fixed costs are high; your marginal costs are low; and initially the fall in

The envelope relationship tells us that at the planned output level, short-run average total cost equals long-run average total cost, but at all other levels of output, short-run average total cost is higher than long-run average total cost.

Additional constraints always raise costs (or at least won’t lower them).

FIGURE 12-2 Envelope of Short-Run Average Total Cost Curves

The long-run average total cost curve is an envelope of the short-run average total cost curves. Each short-run average total cost curve touches the long-run average total cost curve at only one point. (SR stands for short run; LR stands for long run.)

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SRATC2 SRATC3

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average fixed costs more than offsets the increased marginal cost. Once marginal cost exceeds SRATC, that no longer is the case.1 Only when the firm is at the minimum point of the long-run average total cost (LRATC) curve (at output Q3) is the SRATC3 curve tangent to the LRATC curve at a point where the SRMC curve intersects both the curves. For large markets, this point is the least-cost production level of a firm.

Entrepreneurial Activity and the Supply Decision In this chapter and the preceding one, we have discussed the technical nature of costs and production. In the next chapter, we will formally relate costs of production to the

1The above reasoning depends on the curves being smooth (i.e., having no kinks), a standard assumption of the model. If we give up the smoothness assumption, the SRATC curve could be kinked and the SRMC curve could be discontinuous. In that case, the SRATC curve might be tangent to the LRATC curve from the left, but not from the right, and it might not decrease. This would make movement from the long to the short run a discrete jump, whereas the existing model and smoothness assumption make it a smooth continuous movement. So if your intuition doesn’t lead you to understand the model, you are probably thinking of a model with different assumptions. You’ll be in good company, too. When an economist by the name of Jacob Viner first created this model, his intuition led him to a different result because his intuition was basing the analysis on different assumptions than he was using in his formal model.

REAL-WORLD APPLICATION

Understanding costs and their structure will help you understand why intro eco- nomics textbooks are so long—and why their length is to your advantage. The majority of the costs of a book are fixed costs in relation to the length of the book. The initial costs in terms of length are about 20 per- cent of the total price of the book. So increasing the length of the book in- creases costs slightly. But the longer length allows the writer to include more issues that some professors want and many professors require to even consider using the book. That means that greater length can allow publishers to sell more books, al- lowing the fixed costs to be divided over more output. This decrease in fixed cost per unit can lower average total cost more than increasing the length of the book increases average total costs per unit. So if the added length

Why Are Textbooks So Long? increases the number of users, the additional length can lower the aver- age cost of the book.

Length does lower the costs of the book—up to a point. Textbook publish- ers are continually look- ing for that point. They direct authors to shorten their books but also to in- clude almost all issues that various groups want. The latter direction—in fa- vor of inclusion—often takes precedence, which is why textbooks are so long. This doesn’t mean

that textbooks will continue to become longer. Recently, economics textbooks have become smaller because students began to complain that the texts were getting too heavy to carry. There has also been technological change; books are now placing more and more of the less-used chapters on the web, and some are coming out with e-book versions.

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supply of goods. As a bridge between the two chapters, let’s consider the entrepreneur, who establishes the relationship between costs and the supply decision, and discuss some of the problems of using cost analysis in the real world. In thinking about the connection between cost and supply, one fundamental insight is that the revenue received for a good must be greater than the planned cost of produc- ing it. Otherwise why would anyone supply it? The difference between the expected price of a good and the expected average total cost of producing it is the supplier’s expected economic profit per unit. It’s profit that underlies the dynamics of production in a market economy. Cost curves do not become supply curves through some magic process. To move from cost to supply, entrepreneurial initiative is needed. An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average cost of producing it. The entrepreneur is the organizer of production and the one who visualizes the demand and convinces the individuals who own the factors of produc- tion that they want to produce that good. Businesses work hard at maintaining the entrepreneurial spirit in their employees. The greater the difference between price and average total cost, the greater the entrepreneur’s incentive to tackle the organizational problems and supply the good. The role of the entrepreneur is not easily captured in models but should not be underestimated. Entrepreneurs are the visionaries who turn new technologies into usable goods and services. They are the hidden element of supply that is essential to the continued growth of an economy. While financial reward plays a role in entrepre- neurial effort, it is not always the central motivation. People are motivated by many desires, including recognition, fame, and just the pleasure of seeing something done efficiently and well. In recent years we have seen an increase of social entrepreneurship—where entrepreneurs turn their focus on achieving social, rather than just economic, ends. These social entrepreneurs are blending profit motives with other motives into the charters of the corporations, making them for-benefit, not for-profit, corporations. Novo Nordisk is an example. It is a pharmaceutical company whose goal is more than just profit. Instead of a profit bottom line, it has what it calls a triple bottom line. It tries to be profitable, responsible, and valuable for patients, employees, and society. For-benefit institutions provide a way in which people can join together to simultane- ously fulfill their social goals as well as their material welfare goals. Advocates argue that for-benefit corporations will become a new “fourth sector” in the U.S. economy.

Using Cost Analysis in the Real World All too often, students walk away from an introductory economics course thinking that cost analysis is a relatively easy topic. Memorize the names, shapes, and relationships of the curves, and you’re home free. In the textbook model, that’s right. In real life, it’s not, because actual production processes are marked by economies of scope, learning by doing and technological change, many dimensions, unmeasured costs, joint costs, indivisible costs, uncertainty, asymmetries, and multiple planning and adjustment periods with many different short runs. And this is the short list!

Economies of Scope The cost of production of one product often depends on what other products a firm is producing. Economists say that in the production of two goods, there are economies of scope when the costs of producing products are interdependent so that it’s less costly for a firm to produce one good when it’s already producing another. For example,

The expected price must exceed the average total costs of supplying the good for a good to be supplied.

Q-7 Why is the role of the entrepreneur central to the production process in the economy?

In recent years there has been an increase in social entrepreneurship.

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once a firm has set up a large marketing department to sell cereal, the department might be able to use its expertise in mar- keting a different product—say, dog food. A firm that sells gasoline can simultane- ously use its gas station attendants to sell soda, milk, and incidentals. The minimarts so common along our highways and neigh- borhood streets developed because gaso- line companies became aware of economies of scope.

Economies of scope play an important role in firms’ decisions about what combi- nation of goods to produce. They look for both economies of scope and economies of scale. When you read about firms’ mergers, think about whether the combination of their products will generate economies of scope. Many otherwise unexplainable merg- ers between seemingly incompatible firms can be explained by economies of scope.

By allowing firms to segment the pro- duction process, globalization has made economies of scope even more important to firms in their production decisions. Low-cost labor in other countries has led

U.S. firms to locate their manufacturing processes in those countries and to concen- trate domestic activities on other aspects of production. As I have stressed through- out this book, production is more than simply manufacturing; the costs of marketing, advertising, and distribution are often larger components of the cost of a good than are manufacturing costs. Each of these involves special knowledge and expertise, and U.S. companies are specializing in the marketing, advertising, and distribution aspects of the production process. By concentrating on those aspects, and by mak- ing themselves highly competitive by taking advantage of low-cost manufacturing elsewhere, U.S. firms become more competitive and expand, increasing demand for U.S. labor. Often they expand into new areas, taking advantage of economies of scope in distribution and marketing. Consider Nike—it produces shoes and sportswear, right? Wrong. It is primarily a U.S. marketing and distribution company; it outsources its production to affiliate com- panies. Nike expanded its product line from just shoes to a broader line of sports cloth- ing in order to take advantage of economies of scope in its marketing and distribution specialties. Nike is only one of many examples. The large wage differentials in the global economy are causing firms to continually reinvent themselves—to shed aspects of their business where they do not have a comparative advantage, and to add new busi- nesses where their abilities can achieve synergies and economies of scope.

Learning by Doing and Technological Change The production terminology that we’ve been discussing is central to the standard economic models. In the real world, however, other terms and concepts are also important. The production techniques available to real-world firms are constantly changing

Q-8 What is the difference between an economy of scope and an economy of scale?

Thinking Like a Modern Economist Social Norms and Production

The traditional economic model presents the production decision as a cost-based decision. The firm calculates the cost of inputs and chooses the lowest-price input. Modern economists believe that these costs are important, but they also believe that a number of other elements come into play. They are working to devise models that incorporate them. One of the most important of those other elements is social norms, and the choices a firm makes so that they fit the social norms of society. Behavioral economist Dan Ariely argues that social norms play a far greater role in a firm’s decisions than the traditional economic model includes. He argues both that firms should include social norms in their decision making and that economists should develop new models of the firms that incorpo- rate social norms in their decision process. He writes:

If corporations started thinking in terms of social norms, they would realize that these norms build loyalty and—more impor- tant—make people want to extend themselves to the degree that corporations need today: to be flexible, concerned, and willing to pitch in. That’s what a social relationship delivers.

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because of learning by doing and technological change. These changes occur over time and cannot be accurately predicted. Unlike events in the standard economic model, all events in the real world are influenced by the past; people learn by doing. But to keep the model simple, learning by doing isn’t a part of the traditional economic model. Learning by doing simply means that as we do something, we learn what works and what doesn’t, and over time we become more proficient at it. Practice may not make perfect, but it certainly makes better and more efficient. Many firms estimate that output per unit of input will increase by 1 or 2 percent a year, even if inputs or technologies do not change, as employees learn by doing. The concept of learning by doing emphasizes the importance of the past in trying to predict performance. Let’s say a firm is deciding between two applicants for the job of managing its restaurant. One was a highly successful student but has never run a restaurant; the other was an OK student who has run a restaurant that failed. Which one does the firm hire? The answer is unclear. The first applicant may be brighter, but the lack of experience will likely mean that the person won’t be hired. Businesses give enormous weight to experience. So this firm may reason that in failing, the second applicant will have learned lessons that make her the better candidate. U.S. firms faced such a choice when they were invited to expand into the new market economies of Eastern Europe in the early 1990s. Should they hire the former communist managers who had failed to produce efficiently, or should they hire the reformers? (Generally they decided on the former communist managers, hoping they had learned by failing.) Technological change is an increase in the range of production techniques that leads to more efficient ways of producing goods as well as the production of new and better goods. That is, technological change offers an increase in the known range of production. For example, at one point automobile tires were made from rubber, cloth- ing was made from cotton and wool, and buildings were made of wood. As a result of technological change, many tires are now made from petroleum distillates, much cloth- ing is made from synthetic fibers (which in turn are made from petroleum distillates), and many buildings are constructed from steel. The standard long-run model takes technology as a given. From our experience, we know that technological change affects firms’ decisions and production. Technological change can fundamentally alter the nature of production costs.

Q-9 Does learning by doing cause the average cost curve to be downward-sloping?

Many firms estimate worker productivity to grow 1 to 2 percent a year because of learning by doing.

Technological change can fundamentally alter the nature of production costs.

Left: © Bettmann/Corbis; right: © Photodisc/Getty Images RF

The nature of production has changed considerably in the last 70 years. The picture on the left shows a 1933 production line in which people did the work as the goods moved along the line. The picture on the right shows a modern production line. Robots do much of the work.

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In some industries, technological change is occurring so fast that it overwhelms all other cost issues. The digital electronics industry is a good example. The expectation of technological change has been built into the plans of firms in that industry. The industry has followed Moore’s law, which states that the cost of computing will fall by half every 18 months. Indeed, that has happened since the computer was first offered to the mass retail market. With costs falling that fast because of learning by doing and technological change, all other cost components are overwhelmed, and, instead of costs increasing as output rises significantly, as might be predicted because of disec- onomies of scale, costs keep going down. Increased computational power (decreased cost) has affected other industries as well. Technological change has been so dramatic that we no longer talk about changes in a good, but rather the development of entirely new goods and ways of doing things. Con- sider consumer goods. Telephone land lines have been replaced by cell phones, which in turn have been replaced by smartphones that are effectively computers with voice and messaging capabilities. VCRs have been replaced by wireless video streaming. Music isn’t played from CDs as it once was, but is streamed online, chosen by you or for you by programs such as Spotify. You don’t buy paper books but download bits and bytes trans- formed into online multimedia products, which have written components. Computational technology has also revolutionized automobiles, making them more reliable and of much higher quality per dollar spent. In the 1960s, I could work on my own car, changing the points or modifying the carburetor. Modern cars have no such parts; they have been replaced by electronic parts. When a car isn’t running right, its owner must now take it to a garage, which hooks up the car to a diagnostic computer that reports what is wrong. No more lifting the hood. It is not only the engine in the car that is changing. So too is the driving. Driverless cars are on the road, and many expect that in the coming decade, they will be the norm. Automobiles have fundamen- tally changed; they are much more efficient and reliable and their price has fallen because of the introduction of computer technology. As these examples point out, technological change drives costs down and can overwhelm diseconomies of scale, causing prices to fall more and more. Don’t think of technological change as occurring only in high-tech industries. Con- sider chicken production. The price of chickens has fallen enormously over the past 50 years. Why? Because of technological change. At one time, chickens were raised in farmyards. They walked around, ate scraps and feed, and generally led a chicken’s life. Walking around had definite drawbacks—it took space (which cost money); it made standardization (a requirement of taking advantage of economies of scale) difficult, which prevented lowering costs; it used energy, which meant more feed per pound of chicken; and sometimes it led to disease, since chickens walked in their own manure. The technological change was to put the chickens in wire cages so that the manure falls through to a conveyor belt and is transferred outside. Another conveyor belt feeds the chickens food laced with antibiotics to prevent disease. Soft music is played to keep them calm (they burn fewer calories). Once they reach the proper weight, they are slaughtered in a similar automated process. How the chickens feel about this techno- logical change is not clear. (When I asked them, all they had to say was cluck.) This method of raising chickens will likely be replaced in the next couple of decades by another technological change—genetic engineering that will allow chicken parts to be produced directly from single cells. Only the breasts and drumsticks will be produced (and wings if you live in Buffalo) as what is known as “in vitro meat.” All low-efficiency, low-profit-margin parts such as necks, feet, and heads will be elimi- nated from the “efficient chicken.” In many businesses, the effect of learning by doing and technological change on prices is built into the firm’s pricing structure. If they expect their costs to fall with more experience, or if they expect technological advances to lower costs in the future,

Technological change occurs in all industries, not only high-tech industries.

Image Source/Getty Images

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businesses might bid low for a big order to give themselves the chance to lower their costs through learning by doing or technological change. Technological change and learning by doing are intricately related. The efficient chicken production we now have did not come about overnight. It occurred over a 20-year period as firms learned how to do it. Chickens respond to Mozart better than to hip-hop. That had to be learned. Similarly, genetic reproduction of chicken parts will evolve as scientists and firms learn more about cloning and DNA.

Many Dimensions The only dimension of output in the standard model is how much to produce. Many, if not most, decisions that firms make are not the one-dimensional decisions of the tradi- tional model, such as “Should we produce more or less?” They’re multidimensional questions such as “Should we change the quality? Should we change the wrapper? Should we improve our shipping speed? Should we increase our inventory?” Each of these questions relates to a different dimension of the production decision and each has its own marginal costs. Thus, there isn’t just one marginal cost; there are 10 or 20 of them. Good economic decisions take all relevant margins into account. The reason that the traditional model is important is that each of these questions can be analyzed by applying the same reasoning used in the traditional model. But you must remember, in applying the analysis, it’s the reasoning, not the specific model, that’s important.

Unmeasured Costs If asked “In what area of decision making do businesses most often fail to use eco- nomic insights?” most economists would say costs. The relevant costs are generally not the costs you’ll find in a firm’s accounts. Why the difference? Economists operate conceptually; they include in costs exactly what their theory says they should. They include all opportunity costs. Accountants who have to measure firms’ costs in practice and provide the actual dollar figures take a much more pragmatic approach; their concepts of costs must reflect only explicit costs—those costs that are reasonably precisely measurable. To highlight the distinction, let me review the difference between explicit and implicit costs (discussed in the previous chapter) and introduce another difference— how economists and accountants measure depreciation of capital.

Economists includE opportunity cost First, say that a business produces 1,000 widgets2 that sell at $4 each for a total revenue of $4,000. To produce these wid- gets, the business had to buy $1,200 worth of widgetgoo, which the owner has hand- shaped into widgets. An accountant would say that the total cost of producing 1,000 widgets was $1,200 and that the firm’s profit was $2,800. That’s because an accoun- tant uses explicit costs that can be measured. Economic profit is different. An economist, looking at that same example, would point out that the accountant’s calculation doesn’t take into account the time and effort that the owner put into making the widgets. While a person’s time involves no explicit cost in money, it does involve an opportunity cost, the forgone income that the owner could have made by spending that time working in another job. If the business takes 400 hours of the person’s time and the person could have earned $8 an hour working for someone else, then the person is forgoing $3,200 in income. Economists include

Technological change and learning by doing are intricately related.

Good economic decisions take all relevant margins into account.

Q-10 As the owner of the firm, Jim pays himself $1,000. All other expenses of the firm add up to $2,000. What would an economist say are the total costs for Jim’s firm?

2What’s a widget? It’s a wonderful little gadget that’s the opposite of a wadget. (No one knows what they look like or what they are used for.) Why discuss widgets? For the same reason that scientists discuss fruit flies—their production process is simple, unlike most real-world production processes.

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that implicit cost in their concept of cost. When that implicit cost is included, what looks like a $2,800 profit becomes a $400 economic loss.

Economic dEprEciation vErsus accounting dEprEciation Deprecia- tion is a measure of the decline in value of an asset that occurs over time. Say a firm buys a machine for $10,000 that’s meant to last 10 years. After 1 year, machines like that are in short supply, so instead of falling, its value rises to $12,000. An accountant, looking at the firm’s costs that year, would use historical cost (what the machine cost in terms of money actually spent) depreciated at, say, 10 percent per year, so the machine’s depreciation for each of its 10 years of existence would be $1,000. An econ- omist would say that since the value of the machine is rising, the machine has no depreciation; it has appreciation and provides a revenue of $2,000 to the firm. The standard model avoids such messy, real-world issues of measuring depreciation costs and instead assumes that all costs are measurable in a single time period.

The Standard Model as a Framework The standard model can be expanded to include these real-world complications. Mod- ern production is data-intensive, and, as computing and information processing costs fall, cost accounting and production decisions are becoming more and more integrated with the economist’s analysis. Just about every industry has industry- specific software that tailors economic analysis to its particular needs. For example, Robert Kaplan of the Harvard Business School argues that cost accounting systems based on traditional concepts of fixed and variable costs lead firms consistently to make the wrong deci- sions. He argues that in today’s manufacturing, direct labor costs have fallen substan- tially—in many industries to only 2 or 3 percent of the total cost—and overhead costs have risen substantially. This change in costs facing firms requires a much more care- ful division among types of overhead costs, and a recognition that what should and should not be assigned as a cost to a particular product differs with each decision. I don’t discuss these real-world complications because I suspect that even with its simplifications, the standard model has been more than enough to learn in an introduc- tory course. Learning the standard model, however, provides you with only the rudi- ments of cost analysis, in the same way that learning the rules of mechanics provides you with only the basics of mechanical engineering. In addition to a knowledge of the laws of mechanics, building a machine requires years of experience. Similarly for eco- nomics and cost analysis. Introductory economics provides you with a superb frame- work for starting to think about real-world cost measurement, but it can’t make you an expert cost analyst.

Conclusion We’ve come to the end of our discussion of production, cost, and supply. The two chapters we spent on them weren’t easy; there’s tons of material here, and, quite frankly, it will likely require at least two or three reads and careful attention to your professor’s lecture before your mind can absorb it. So if you’re planning to sleep through a lecture, the ones on these chapters aren’t the ones for that. These chapters will provide a framework for considering costs, and as long as you remember that it is only a framework, it will allow you to get into interesting real- world issues. But you’ve got to know the basics to truly understand those issues. So, now that you’ve come to the end of these two chapters, unless you really feel comfort- able with the analysis, it’s probably time to review them from the beginning. (Sorry, but remember, there ain’t no such thing as a free lunch.)

Despite its limitations, the standard model provides a good framework for cost analysis.

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• An economically efficient production process must be technically efficient, but a technically efficient process need not be economically efficient. (LO12-1)

• The long-run average total cost curve is U-shaped. Economies of scale initially cause average total cost to decrease; diseconomies eventually cause average total cost to increase. (LO12-2)

• Production is a social, as well as a technical, phenomenon; that’s why concepts like team spirit are important—and that’s why diseconomies of scale occur. (LO12-2)

• The marginal cost and short-run average cost curves slope upward because of diminishing marginal productivity. The long-run average cost curve slopes upward because of diseconomies of scale. (LO12-2)

Summary • There is an envelope relationship between short-

run average cost curves and long-run average cost curves. The short-run average cost curves are always above the long-run average cost curve. (LO12-2)

• An entrepreneur is an individual who sees an oppor- tunity to sell an item at a price higher than the average cost of producing it. (LO12-3)

• Once we start applying cost analysis to the real world, we must include a variety of other dimensions of costs that the traditional model does not cover. (LO12-4)

• Costs in the real world are affected by economies of scope, learning by doing and technological change, the many dimensions to output, and unmeasured costs such as opportunity costs. (LO12-4)

Key Terms

constant returns to scale

depreciation diseconomies of

scale

economically efficient

economies of scale economies of scope entrepreneur

indivisible setup cost learning by doing minimum efficient level

of production

monitoring cost team spirit technical efficiency technological change

Questions and Exercises

1. What is the difference between technical efficiency and economic efficiency? (LO12-1)

2. One farmer can grow 1,000 bushels of corn on 1 acre of land with 200 hours of labor and 20 pounds of seed. Another farmer can grow 1,000 bushels of corn on 1 acre of land with 100 hours of labor and 20 pounds of seed. (LO12-1) a. Could both methods be technically efficient? b. Is it possible that both of these production processes

are economically efficient? 3. A dressmaker can sew 800 garments with 160 bolts of

fabric and 3,000 hours of labor. Another dressmaker can sew 800 garments with 200 bolts of fabric and 2,000 hours

of identical labor. Fabric costs $100 a bolt and labor costs $10 an hour. (LO12-1) a. Is it possible for both methods to be technically efficient?

Why or why not? b. Is it possible for both methods to be economically

efficient? Why or why not? 4. A student has just written on an exam that, in the long

run, fixed cost will make the average total cost curve slope downward. Why will the professor mark it incorrect? (LO12-2)

5. Why could diseconomies of scale never occur if production relationships were only technical relationships? (LO12-2)

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6. In the early 2000s car makers began to design vehicles’ chassis, engine, and transmissions so that different models could be produced on the same assembly line. Within the first year of implementing the plan, Ford cut production costs by $240 per car. (LO12-2) a. What cost concept was Ford taking advantage of to

produce its savings? b. What effect did the plan likely have on Ford’s

short-run average total cost curve? 7. Draw a long-run average total cost curve. (LO12-2)

a. Why does it slope downward initially? b. Why does it eventually slope upward? c. How would your answers to a and b differ if you had

drawn a short-run cost curve? d. How large is the fixed-cost component of the long-run

cost curve? e. If there were constant returns to scale everywhere,

what would the long-run cost curve look like? 8. Sea lions have been depleting the stock of steelhead trout.

One idea to scare sea lions off the Washington state coast was to launch fake killer whales, predators of sea lions. The cost of making the first whale is $16,000—$5,000 for materials and $11,000 for the mold. The mold can be reused to make additional whales, so additional whales would cost $5,000 apiece. (LO12-2) a. Make a table showing the total cost and average total

cost of producing 1 to 10 fake killer whales. b. Does production of fake whales exhibit diseconomies of

scale, economies of scale, or constant returns to scale?

c. What is the fixed cost of producing fake whales? d. What is the variable cost of producing fake whales?

9. Why are long-run costs always less than or equal to short-run costs? (LO12-2)

10. Draw a short-run marginal cost curve, short-run average cost curve, and long-run average total cost curve for an efficient firm producing where there are diseconomies of scale. (LO12-2)

11. Where along the long-run average total cost curve will an efficient firm try to produce in the long run? (LO12-2)

12. What is the role of the entrepreneur in translating cost of production into supply? (LO12-3)

13. Your average total cost is $40; the price you receive for the good is $12. Should you keep on producing the good? Why? (LO12-3)

14. True or false? Because entrepreneurs are motivated by opportunities to sell an item at a price higher than the average cost of producing it, they do not start for-benefit firms. Explain your answer. (LO12-3)

15. A student has just written on an exam that technological change will mean that the cost curve is downward-sloping. Why did the teacher mark it wrong? (LO12-4)

16. How does learning by doing affect average total costs? (LO12-4)

17. If a firm is experiencing learning by doing, what is likely true about the long-run average total cost curve? Explain your answer. (LO12-4)

Questions from Alternative Perspectives

1. The text presents costs as if a firm could look them up in a book. a. How do you believe a firm’s true costs are revealed? b. Is this an optimal method of finding out costs?

(Austrian) 2. The chapter points out that “businesses give enormous

weight to experience,” or learning by doing. Empirical evidence suggests that, in surveys and applications, women tend to report the nature of their jobs in far less detail than do men. a. How might this contribute to differences in “experience”

between men and women? b. In what other ways might women’s real-world experi-

ences be undervalued when they go to look for jobs? (Feminist)

3. Adam Smith argued that at birth most people were simi- larly talented, and that differences in individual abilities, and hence productivity, are largely the effect of the divi- sion of labor, not its cause. What implications does that insight have for economic policy, and for the way we

should treat others who receive less income than we do? (Religious)

4. Firms have an incentive to “externalize” their costs, that is, to make others face the opportunity costs of their actions while firms reduce their own accounting costs. a. Give some examples of firms doing this. b. What implications for policy does it have?

(Institutionalist) 5. A major survey conducted by economists David Levine

and Laura Tyson found that “in most reported cases the introduction of substantive shop floor participation (job redesign and participatory work groups) leads to some combination of an increase in satisfaction, commitment, quality and productivity, and a reduction in turnover and absenteeism.” Despite that evidence of real cost savings of participatory work groups, only a few U.S. corporate em- ployers (for instance, Xerox and Scott Paper) have taken this high road to labor relations, while many continue to pursue the low road Walmart-like approach to cost saving. Why is that? (Radical)

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Issues to Ponder

1. A pair of shoes that wholesales for $28.79 has approxi- mately the following costs:

Manufacturing labor $ 2.25 Materials 4.95 Factory overhead, operating expenses, and profit 8.50 Sales costs 4.50 Advertising 2.93 Research and development 2.00 Interest .33 Net income to producer 3.33 Total $28.79

a. Which of these costs would likely be a variable cost? b. Which would likely be a fixed cost? c. If output were to rise, what would likely happen to

average total costs? Why? 2. What inputs do you use in studying this book? What

would the long-run average total cost and marginal cost curves for studying look like? Why?

3. If you were describing the marginal cost of an additional car driving on a road, what costs would you look at? What is the likely shape of the marginal cost curve?

4. A major issue of contention at many colleges concerns the cost of meals that is rebated when a student does not sign up for the meal plan. The administration usually says that

it should rebate only the marginal cost of the food alone, which it calculates at, say, $1.25 per meal. Students say that the marginal cost should include more costs, such as the saved space from fewer students using the facilities and the reduced labor expenses on food preparation. This can raise the marginal cost to $6.00. a. Who is correct, the administration or the students? b. How might your answer to a differ if this argument

were being conducted in the planning stage, before the dining hall is built?

c. If you accept the $1.25 figure of a person not eating, how could you justify using a higher figure of about $6.00 for the cost of feeding a guest at the dining hall, as many schools do?

5. When economist Jacob Viner first developed the envelope relationship, he told his draftsman to make sure that all the marginal cost curves went through both (1) the minimum point of the short-run average cost curve and (2) the point where the short-run average total cost curve was tangent to the long-run average total cost curve. The draftsman told him it couldn’t be done. Viner told him to do it anyhow. Why was the draftsman right?

6. The cost of setting up a steel mill is enormous. For exam- ple, a Gary, Indiana, hot-strip mill would cost an esti- mated $1.5 billion to build. Using this information and the cost concepts from the chapter, explain the following quo- tation: “To make operations even marginally profitable, big steelmakers must run full-out. It’s like a car that is more efficient at 55 miles an hour than in stop-and-go traffic at 25.”

Answers to Margin Questions

1. True. Since an economically efficient method of produc- tion is that method that produces a given level of output at the lowest possible cost, it also must use as few inputs as possible. It is also technically efficient. (LO12-1)

2. Bangladesh uses more labor-intensive techniques than does the United States because the price of labor is much lower in Bangladesh relative to the United States. Both countries are producing economically efficiently. (LO12-1)

3. Larger production runs are generally cheaper per unit than smaller production runs because of indivisible setup costs, which do not vary with the size of the run. (LO12-2)

4. Because the same technical process could be used over and over again at the same cost, the long-run average cost curve would never become upward-sloping. (LO12-2)

5. The short-run average cost curve initially slopes down- ward because of increasing marginal productivity and large average fixed costs, and then begins sloping upward because of diminishing marginal productivity, giving it a U shape. (LO12-2)

6. The long-run average total cost curve is generally consid- ered to be U-shaped because initially there are economies of scale and, for large amounts of production, there are diseconomies of scale. (LO12-2)

7. Economic activity does not just happen. Some dynamic, driven individual must instigate production. That dynamic individual is called an entrepreneur. (LO12-3)

8. Economies of scale are economies that occur because of increases in the amount of one good a firm is producing. Economies of scope occur when producing different

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APPENDIX

Isocost/Isoquant Analysis In the long run, a firm can vary more than one factor of production. One of the decisions firms face in this long run is which combination of factors of production to use. Economic efficiency involves choosing those factors to minimize the cost of production. In analyzing this choice of which combination of factors to use, economists have developed a graphical technique called isocost/isoquant analysis. In this technique, the analyst creates a graph placing one factor of production, say labor, on one axis and another factor, say machines, on the other axis, as I have done in Figure A12-1. Any point on that graph represents a combination of machines and labor that can produce a certain amount of output, say 8 pairs of earrings. For example, point A represents 3

machines and 4 units of labor being used to produce 8 pairs of earrings. Any point in the blue shaded area re- presents more of one or both factors and any point in the brown shaded area represents less of one or both factors.

The Isoquant Curve The firm’s problem is to figure out how to produce its output—let’s say it has chosen an output of 60 pairs of earrings—at as low a cost as possible. That means somehow we must show graphically the combinations of machines and labor that can produce 60 pairs of earrings as cheaply as possible. We do so with what is called an isoquant curve. An isoquant curve is a curve that represents com- binations of factors of production that result in equal amounts of output. (Isoquant is a big name for an “equal quantity.”) At all points on an isoquant curve, the firm can produce the same amount of output. So, given a level of output, a firm can find out what combinations of the factors of production will produce that output. Suppose a firm can produce 60 pairs of earrings with the following combination of labor and machines:

Labor Machines Pairs of Earrings

A 3 20 60 B 4 15 60 C 6 10 60 D 10 6 60 E 15 4 60 F 20 3 60

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types of goods lowers the cost of each of those goods. (LO12-4)

9. No. Learning by doing causes a shift in the cost curve because it is a change in the technical characteristics of production. It does not cause the cost curve to be downward-sloping—it causes it to shift downward. (LO12-4)

10. An economist would say that he doesn’t know what total cost is without knowing what Jim could have earned if he had undertaken another activity instead of running his business. Just because he paid himself $1,000 doesn’t mean that $1,000 is his opportunity cost. (LO12-4)

FIGURE A12-1 The Isocost/Isoquant Graph

U n

its o

f m

ac h

in e

Units of labor

1 2 3 4 5 6 7 8 9 10

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This table shows the technical limits of production. It shows that the firm can use, for example, 3 units of labor and 20 machines or 20 units of labor and 3 machines to produce 60 pairs of earrings. The isoquant curve is a graphical representation of the table. I show the isoquant curve for producing 60 pairs in Figure A12-2. Points A to F represent rows A to F in the table. To be sure you understand it, let’s consider some points on the curve. Let’s start at point A. At point A, the firm is producing 60 pairs of earrings using 20 machines and 3 workers. If the firm wants to reduce the number of machines by 5, it must increase the number of units of labor by 1 to keep output constant. Doing so moves the firm to point B. At point B, the firm is also producing 60 pairs of earrings, but is doing it with 15 machines and 4 workers. Alternatively, if the firm were at point D, and it wants to reduce the number of machines from 6 to 4, it must increase the number of units of labor from 10 to 15 to keep output constant at 60. At any point on this iso- quant curve, the firm is being technically efficient—it is using as few resources as possible to produce 60 pairs of earrings. It would never want to produce 60 at a point like G because that point uses more inputs. It is a technically inefficient method of production. The numbers in the production table and the shape of the curve were not chosen randomly. They were chosen to be consistent with the law of diminishing marginal pro- ductivity, which means the curve is bowed inward. That is because as the firm increases the use of one factor more and more, it must use fewer and fewer units of the other factor to keep output constant. This reflects the technical considerations embodied in the law of diminishing mar- ginal productivity. Thus, the chosen numbers tell us that

if a firm wants to keep output constant, as it adds more and more of one factor (and less of the other factor), it has to use relatively more of that factor. For example, ini- tially it might add 1 machine to replace 1 worker, hold- ing output constant. If it continues, it will have to use 1.5 machines, then 2 machines, and so on. The rate at which one factor must be added to com- pensate for the loss of another factor, to keep output constant, is called the marginal rate of substitution. To say that there is diminishing marginal productivity is to say that there is a diminishing marginal rate of substi- tution. It is because the table assumes a diminishing marginal rate of substitution that the isoquant curve is bowed inward. Graphically, the slope of the isoquant curve is the marginal rate of substitution. To be exact, the absolute value of the slope at a point on the isoquant curve equals the ratio of the marginal productivity of labor to the mar- ginal productivity of machines:

∣ Slope ∣ = MPlabor

MPmachines =

Marginal rate of

substitution

With this equation, you can really see why the isoquant is downward-sloping. As the firm moves from point A to point F, it is using more labor and fewer machines. Because of the law of diminishing marginal productiv- ity, as the firm moves from A to F, the marginal pro- ductivity of labor decreases and the marginal productivity of machines increases. The slope of the isoquant falls since the marginal rate of substitution is decreasing. Let’s consider a specific example. Say in Figure A12-2 the firm is producing at point B. If it cuts its input by 5 machines but also wants to keep output constant, it must increase labor by 2 (move from point B to point C). So the marginal rate of substitution of labor for machines between points B and C must be 5/2, or 2.5. The firm can complete this exercise for many differ- ent levels of output. Doing so will result in an isoquant map, a set of isoquant curves that shows technically effi- cient combinations of inputs that can produce different levels of output. Such a map for output levels of 40, 60, and 100 is shown in Figure A12-3. Each curve represents a different level of output. Isoquant I is the lowest level of output, 40, and isoquant III is the highest level of output. When a firm chooses an output level, it is choosing one of those isoquants. The chosen isoquant represents the technically efficient combinations of resources that can produce the desired output.

FIGURE A12-2 Isoquant Curve for 60 Pairs of Earrings

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its o

f m

ac h

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Units of labor 2 4 6 8 10 12 14 16 18 20

E F

Isoquant (60 pairs

of earrings)

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262 Microeconomics ■ Production and Cost Analysis

To see that this is indeed the case, say the firm starts with 20 machines and no labor. If the firm wants to use some combination of labor and machinery, it can give up some machines and use the money it saves by using fewer machines to purchase units of labor. Let’s say it gives up 5 machines, leaving it with 15. That means it has $15 to spend on labor, for which it can buy 3 units of labor. That means 15 machines and 3 units of labor is another combi- nation of labor and machines that cost the firm $60. This means that point C is also a point on the isocost line. You can continue with this exercise to prove to yourself that the line connecting points A and B does represent various combinations of labor and machinery the firm can buy with $60. Thus, the line connecting A and B is the $60 isocost line. To see that you understand the isocost line, it is useful to go through a couple of examples that would make it shift. For example, what would happen to the isocost line if the firm chooses to increase its spending on production to $90? To see the effect, we go through the same exercise as before: If it spent it all on labor, it could buy 18 units of labor. If it spent it all on machines, it could buy 30 units of machinery. Connecting these points will give us a curve to the right of and parallel to the original curve. It has the same slope because the relative prices of the factors of production, which determine the slope, have not changed. Now ask yourself, What happens to the isocost line if the price of labor rises to $10 a unit? If you said the iso- cost curve becomes steeper, shifting along the labor axis to point D while remaining anchored along the machinery axis until the slope is −10/3, you’ve got it. In general, the

The Isocost Line So far I have only talked about technical efficiency. To move to economic efficiency, we have to bring in the costs of production. We do so with the isocost line—a line that represents alternative combinations of factors of production that have the same costs. (Isocost is a fancy name for “equal cost.”) Each point on the isocost line rep- resents a combination of factors of production that, in to- tal, cost the firm an equal amount. To draw the isocost line, you must know the cost per unit of each input as well as the amount the firm has chosen to spend on production. Say labor costs $5 a unit, machinery costs $3 a unit, and the firm has chosen to spend $60. What is the greatest number of earrings it can produce with that $60? To answer that question, we need to create a curve representing the various amounts of inputs a firm can get with that $60. We do so in the fol- lowing manner. Say the firm decides to spend the entire $60 on labor. Since labor costs $5 a unit, it can buy 12 units of labor. This alternative is represented by point A in Figure A12-4. Alternatively, since machines cost $3 a unit, if the firm chooses to spend all of the $60 on machines, it can buy 20 machines (point B in Figure A12-4). This gives us two points on the isocost curve. Of course, the as- sumption of diminishing marginal rates of substitution makes it highly unlikely that the firm would want to produce at either of these points. Instead, it would likely use some combination of inputs. But these extreme points are useful nonetheless because by connecting them (the line that goes from A to B in Figure A12-4), we can see the various combinations of inputs that also cost $60.

FIGURE A12-3 An Isoquant Map

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f m

a ch

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Units of labor

III (100 pairs of earrings)

I (40 pairs of earrings) II (60 pairs of earrings)

FIGURE A12-4 Isocost Curves

U n

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f m

a ch

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Units of labor

2 4 6 8 10 12 14 16 18 20

Slope = – = Plabor

Pmachines

5 3

Increase amount available to spend

–

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262 Microeconomics ■ Production and Cost Analysis

FIGURE A12-3 An Isoquant Map

U n

its o

f m

a ch

in e

Units of labor

III (100 pairs of earrings)

I (40 pairs of earrings) II (60 pairs of earrings)

FIGURE A12-4 Isocost Curves

U n

its o

f m

a ch

in e

Units of labor

2 4 6 8 10 12 14 16 18 20

Slope = – = Plabor

Pmachines

5 3

Increase amount available to spend

–

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Chapter 12 ■ Production and Cost Analysis II 263

But say the firm has an efficient manager—one who has taken introductory economics. As opposed to reducing the number of workers as the other manager did, she increases the number of workers to 6 and re- duces the number of machines to 10. Doing so still pro- duces 60 pairs of earrings, since C is a point on the isoquant curve, but the strategy reduces the cost from $65 at point A to $60 (10 machines at $3 = $30 and 6 workers at $5 = $30). So she is producing 60 pairs of earrings at a cost of $60. She is operating at the eco- nomically efficient point—point C. Let’s talk about the characteristics of point C. Point C is the point where the isoquant curve is tangent to the iso- cost curve—the point at which the slope of the isoquant curve (−MPL/MPM) equals the slope of the isocost curve (−PL/PM). That is, −MPL/MPM = −PL/PM. This can be rewritten as

MPL/PL = MPM /PM What this equation says is that when the additional output per dollar spent on labor equals the additional output per dollar spent on machines, the firm is operating efficiently. It makes sense. If the additional output per dollar spent on labor exceeded the additional output per dollar spent on machines, the firm would do better by increasing its use of labor and decreasing its use of machines. Point C represents the combination of labor and ma- chines that will result in the highest output given the iso- cost curve facing the firm. To put it in technical terms, the firm is operating at an economically efficient point where the marginal rate of substitution equals the ratio of the factor prices. Any point other than C on the isocost curve will cost $60 but produce fewer than 60 pairs of earrings. Any other point than C on the isoquant curve will produce 60 pairs of earrings but cost more than $60. Only C is the economically efficient point given the fac- tor costs. To see that you understand the analysis, say that the price of labor falls to $3 and you still want to produce 60. What will happen to the amount of labor and ma- chines you hire? Alternatively, say that the price of machines rises to $5 and you want to spend only $60. What will happen to the amount of labor and machines you hire? If your answers are (1) you hire more workers and fewer machines and (2) you reduce production using fewer machines and, maybe, less labor, you’ve got the analyses down. If you didn’t give those answers, I sug- gest rereading this appendix, if it is to be on the exam, and working through the questions and exercises.

absolute value of the slope of the isocost curve is the ratio of the price of the factor of production on the x-axis to the price of the factor of production on the y-axis. That means that as the price of a factor rises, the endpoint of the iso- cost curve shifts in on the axis on which that factor is measured.

Choosing the Economically Efficient Point of Production Now let’s move on to a consideration of the economically efficient combination of resources to produce 60 pairs of earrings with $60. To do that, we must put the isoquant cost curve from Figure A12-2 and the isocost curve from Figure A12-4 together. We do so in Figure A12-5. The problem for the firm is to produce as many pairs of earrings as possible with the $60 it has to spend. Or, put another way, given a level of production it has chosen, it wants to produce at the least-cost combination of the factors of production. Let’s now find the least-cost combination of inputs to produce 60 pairs of earrings. Let’s say that, initially, the firm chooses point A on its isoquant curve—that’s at 15 machines and 4 workers. That produces 60 pairs of earrings, but has a cost of $45 + $20 = $65. The firm can’t produce 60 pairs of earrings unless it is willing to spend more than $60. If it fires a worker to bring its cost in line, moving it to point B, it moves down to a lower isoquant—it is producing only 40 pairs. If the firm has a less-than-competent manager, that manager will conclude that you can’t produce 60 for $60.

FIGURE A12-5 Combining Isoquant and Isocost Curves

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Units of labor

2 4 6 8 10 12 14 16 18 20

B A

Slope = MPlabor

MPmachines

Slope = Plabor

Pmachines

(Q = 60)

(Q = 40)

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