Introduction to Economics 11175

Week 4

Technology, Production and Costs

 Week 4 Lecture
1. Describe the nature of production
in the short run.

2. Explain the reasons behind the

shape of the total product, marginal
product and average product curves
in the short run.

3. Distinguish between different

types of short run costs.

4. Understand the nature of

production and cost in the long run.
Some economic definitions
• Firm: An organization that comes into being when a person or a group
of people decides to produce a good or service to meet a perceived
demand.
• Technology: the processes a firm uses to turn inputs into outputs of
goods and services
• Technological change: a change in the ability of a firm to produce a
given level of output with a given quantity of inputs.
• Production Function: The relationship between the inputs employed
by the firm and the maximum output it can produce with those
inputs.

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The behaviour of profit maximising firms
• All firms must make several basic decisions to achieve
what we assume to be their primary objective —
maximum profits.

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Short run versus long run
• Economists distinguish between the short-run and
the long-run.

• a period of time where there is at

Short-run least one fixed input
• a sufficient period of time to allow
Long-run all inputs to be varied
Fixed and variable inputs

A fixed • any resource where the

quantity used cannot change
input is: during a specific period of time

A variable • any resource for which the

quantity used can change
input is: during a specific period of time

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 The total product and
marginal product of labor
Quantity of Quantity of Quantity of Marginal
workers copying copies Product of
(L: Labor) machines (K: (Q: Output) Labor (MPL)
Capital)
0 2 0 -
1 2 625 625
2 2 1325 700
3 2 2200 875
4 2 2600 400
5 2 2900 300
6 2 3100 200
Marginal product and the Law of
Diminishing Returns
• Marginal product: The additional output that can be produced
by adding one more unit of a specific input, ceteris paribus.

• Law of diminishing returns: The principle that, at some point,

adding more of a variable input, such as labour, to the same
amount of a fixed input, such as capital, will cause the marginal
product of the variable input to decline.

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 The total product and
marginal product of labor
Shape of the marginal product curve
• Increasing Marginal Returns:
➢ Arises from increased specialization & division of labour as the
first few workers are hired.

• Decreasing Marginal Returns:

➢ More and more workers are using the same equipment and work
area, so while the total number of copies still increases as the 4th
& 5th worker is hired, the rate of increase is slowing.
Law of Diminishing Returns
• Diminishing returns always apply in the short run,
and in the short run every firm will face diminishing
returns. This means that every firm finds it
progressively more difficult to increase its output as
it approaches capacity production.

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Marginal product and average product
• Average product of Labor (APL): The total output
produced by a firm divided by the number of workers,
or, output per worker.

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Marginal product and average product
of labor
Quantity of Quantity of Quantity of Marginal Average
workers (L) copying copies Product of product of
machines (Q) labor labor
(K) (MPL) (APL)
0 2 0 - -
1 2 625 625 625
2 2 1325 700 662.5
3 2 2200 875 733.3
4 2 2600 400 650
5 2 2900 300 580
6 2 3100 200 516.7

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Relationship between marginal and
average product
• If the marginal is above the average, the average
increases.
• If the marginal is below the average, the average falls.
• The marginal is equal to the average, when the latter
is at its maximum.
Shifting short run production curves
• If the technology improves, and/or the fixed
resources increase, it is likely the total output curve
rises.
• For each worker employed, more output can be
produced.
• It is likely this will also result in higher marginal and
average product curves. Productivity rises!
Costs
• Cost theory is the relationship between output and
costs.
• Explicit cost:
➢ A cost that involves spending money. Eg: resources employed by a
firm that takes the form of cash payments.
➢ On the accounting statement
• Implicit cost:
➢ A firm’s opportunity cost of using its own resources or those provided
by its owners
➢ Without a corresponding cash payment
➢ Not on the accounting statement
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 Accounting profit versus
Economic profit
Accounting Profit is:
Total Revenue – Total Explicit Costs
Economic Profit is:
Total Revenue – Total Opportunity Costs
Total Opportunity Cost is:
Explicit Costs + Implicit Costs
Accounting profit versus
Economic profit example
Short run costs
• Fixed cost (TFC): The cost of fixed inputs. Fixed costs do
not vary with output and are sometimes called overhead
costs.
• Variable costs (TVC):The cost of variable input.
Variable cost depends on the number of units of output
produced (eg:- wages, raw materials, etc.)
• Total cost (TC) is the sum of fixed cost and variable
cost: TC = TFC + TVC

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Short run costs
• Average Total Cost (ATC): Total cost divided by the
quantity of output produced

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 Short run costs
Quantity of Quantity of Quantity of Cost of Cost of Total Cost Cost per
workers (L) copying copies Copying Workers of copies copy
machines (Q) Machines (TVC) (TC) (ATC)
(K) (TFC)
0 2 0 $30 $0 $30 -
1 2 625 $30 50 80 $0.13
2 2 1325 $30 100 130 0.10
3 2 2200 $30 150 180 0.08
4 2 2600 $30 200 230 0.09
5 2 2900 $30 250 280 0.10
6 2 3100 $30 300 330 0.11

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Graphing short run costs
 Short run costs

• Marginal Cost: The change in a firm’s total cost from

producing one more unit of a good or service.
 Short run costs
Quantity of Quantity of Marginal Total Cost of Cost per Marginal
workers copies Product of copies (TC) copy Cost of
(L) (Q) Labour (MPL) (ATC) copies
(MC)
0 0 - $30 - -
1 625 625 80 $0.13 $0.08
2 1325 700 130 0.10 0.07
3 2200 875 180 0.08 0.06
4 2600 400 230 0.09 0.13
5 2900 300 280 0.10 0.17
6 3100 200 330 0.11 0.25

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Relationship between average and
marginal cost
 Short run costs
• Average fixed cost: Fixed cost divided by the quantity of
output produced.
Average fixed cost = AFC = TFC/Q
• Average variable cost: Variable cost divided by the
quantity of output produced.
Average variable cost = AVC = TVC/Q
• Average total cost: total cost divided by the quantity of
output produced.
Average total cost = ATC = TC/Q or ATC = AFC + AVC
Relationship between cost curves
• Relationships between MC, ATC, AVC and AFC
➢ The MC, ATC and AVC curves are all U-shaped, and the
marginal cost curve intersects the average variable cost
and average total cost curves at their minimum points.
➢ As output increases, AFC gets smaller and smaller.
➢ As output increases, the difference between average
total cost, and average variable cost decreases.
 Graphing marginal cost (MC) and
average cost curves
P
MC ATC

AVC

The MC curve
intersects the minimum
point of the ATC and
AVC curves

AFC
0 Q 29
Long-run production costs
• In the long run, the quantity of all inputs can be
adjusted:
➢ build a larger factory/downsize
➢ expand onto new land
➢ hire new staff
➢ Leave/enter the industry
• The long-run allows greater planning for the expected
level of production.
The long run
• To examine long run costs, we need to examine the costs
relating to all the possible plant sizes from which firms can
select.
Long run Average
Cost: traces the
lowest cost per
unit at which a firm
can produce any
level of output after
the firm has had the
time to make all
appropriate adjustments
in its plant size.
The long run
Shape of long run average cost curve
• Economies of Scale: when a firm’s long-run average
costs fall as it increases output.
• Constant returns to scale: when a firm’s long-run
average costs remain unchanged as it increases
output.
• Diseconomies of scale: when a firm’s long-run
average costs rise as it increases output.

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Shape of long run average cost curve
Shape of long run average cost curve
Economies of scale
• Reasons:
➢ the division of labour and the use of specialisation
are increased
➢ more efficient use of capital equipment.
➢ bulk buying leading to cheaper inputs.
➢ spreading fixed costs.
➢ Financial economies eg. Negotiating lower interest
rate.
Shape of long run average cost curve

Constant returns to scale

• When LRAC does not change as the firm

increases output.
Shape of long run average cost curve

Diseconomies of scale
• Reasons:
➢ more bureaucracy
➢ increased barrier to communication
➢ management difficulties (lack of coordination).
Lecture revision questions
1. A characteristic of the long run is
A. there are fixed inputs.
B. all inputs can be varied.
C. plant capacity cannot be increased or decreased.
D. there are both fixed and variable inputs.

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Lecture revision questions
2. The law of diminishing marginal returns states
A. that at some point, adding more of a fixed input to a given amount of variable
inputs will cause the marginal product of the variable input to decline.

B. that at some point, adding more of a variable input to a given amount of a

fixed input will cause the marginal product of the variable input to decline.

C. that in the presence of a fixed factor, at some point average product of labour
starts to fall as more and more variable inputs are added.

D. that average total costs of production initially fall and after some point start to
rise at a decreasing rate as output increases.

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Lecture revision questions
3. Refer to the figure below

The marginal product of the 3rd worker is:

A. 57
B. 19
C. 15
D. 11 41
Lecture revision questions
4. What is the relationship between marginal product of labor
and average product of labor?
A. If marginal product of labor is greater than average product of labor,
average product of labor increases.
B. If marginal product of labor is less than average product of labor,
average product of labor increases.
C. At the point where the marginal product of labor curve crosses the
average product of labor curve, the average product of labor curve will
be at its minimum.
D. There is no relationship between average product and marginal
product. 42
Lecture revision questions
5. Implicit costs can be defined as
A. accounting profit minus explicit cost.
B. the non-monetary opportunity cost of using the firm's
own resources.
C. the deferred cost of production.
D. total cost minus fixed costs.

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Lecture revision questions
6. Which of the following is a fixed cost?
A. Payment to hire a security worker to guard the gate
to the factory around the clock
B. Wages to hire assembly line workers
C. Payments to an electric utility company
D. Costs of raw materials

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Lecture revision questions
7. The average total cost of production
A. is the extra cost required to produce one more unit.
B. equals the explicit cost of production
C. equals total cost of production divided by the level of
output.
D. equals total cost of production multiplied by the level
of output.

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Lecture revision questions
8. Maria's Kebab House sells Kebabs. The cost of ingredients (wrap, meat,
tabuli, sauces, etc.) to make a kebabs is $2.00 (per Kebab). Maria's pays
her employees $60 per day. She also incurs a fixed cost of $120 per day.
Calculate Maria's total cost per day when she produces 50 kebabs using
two workers?
A. $100
B. $124.40
C. $220
D. $340

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Lecture revision questions
9. If production displays economies of scale, the long-run
average cost curve is
A. above the short-run average total cost curve.
B. downward sloping.
C. upward sloping.
D. below the long-run marginal cost curve.

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The University of Canberra acknowledges the Ngunnawal people, traditional custodians of the lands where Bruce Campus is situated. We wish to acknowledge and respect their continuing culture and the contribution they make to the life of Canberra and the region.
We also acknowledge all other First Nations Peoples on whose lands we gather.