Solution Manual for Microeconomics: Principles, Applications and Tools, 10th Edition, Arthur

Solution Manual for Microeconomics: Principles,

Applications and Tools, 10th Edition, Arthur
O’Sullivan, Steven Sheffrin, Stephen Perez

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 8 [23]
Production Technology
and Cost
Chapter Summary
Chapter 8 [23] introduces the costs that firms will incur when producing in the short run and in the long
run. The chapter also illustrates how the different cost curves are drawn and explains why each curve
behaves in a certain way. Finally, the chapter demonstrates how these costs are calculated in order to
determine the firm’s level of profit. Here are the main points of the chapter:
 In the short run, marginal costs are expected to be increasing due to diminishing returns; average
cost curves are expected to be U-shaped.
 In the long run, firms may experience economies of scale due to specialization or spreading of the
cost of indivisible inputs, and thus, long-run average cost curves will be L-shaped as per-unit
costs first decrease and then remain constant.
 The minimum efficient scale is reached when economies of scale are exhausted and per-unit costs
become constant.
 Eventually, the firm may experience diseconomies of scale due to coordination problems or rising
input prices, resulting in increasing per-unit costs.

Learning Objectives:
8.1 Economic Cost and Economic Profit: Define economic cost and economic profit.
8.2 A Firm with a Fixed Production Facility—Short-Run Costs: Draw the short-run marginal-cost and
average-cost curves.
8.3 Production and Cost in the Long Run: Draw the long-run marginal cost and average cost curves.
8.4 Examples of Production Cost: Provide examples of production costs.

Approaching the Material

Most students will not be very familiar with the process of production. Go slowly. Use examples they are
familiar with—fast food, music—rather than widget factories. Make sure they understand that declining
average fixed cost is the key to firm size and market structure.

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92 O'Sullivan/Sheffrin/Perez, Microeconomics, 10e

Chapter Outline
8.1 [23.1] Economic Cost and Economic Profit
1. Economic profit is total revenue minus economic costs.
2. (From an earlier chapter) Total revenue is the money the firm gets from selling its product; it
equals the price per unit of output times the quantity sold.
3. Economic cost is the opportunity cost of the inputs used in the production process; it is equal
to explicit cost plus implicit cost.
4. Explicit cost is the actual monetary payment for inputs.
5. Implicit cost is the opportunity cost of inputs that do not require a monetary payment.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST

The opportunity cost of something is what you sacrifice to get it.

Review this key question and the related application:

Question 1: What is the opportunity cost of an entrepreneur?

APPLICATION 1: OPPORTUNITY COST AND ENTREPRENEURSHIP

When homeowners rent out their homes, there are other costs to consider besides the fees charged by
Airbnb and relevant taxes. They also must consider the opportunity cost of their time in serving as
hosts, such as the time involved in answering e-mails and cleaning up after their guests leave.
Including these costs will decrease their actual profit from hosting.

6. An accountant identifies all the firm’s explicit costs (actual cash payments for inputs) and
calculates profits by subtracting explicit costs from total revenue. Accounting cost is defined
as the explicit costs of production. Accounting profit is defined as total revenue minus
accounting cost.
7. An economist includes the firm’s implicit costs (opportunity costs, including costs of the
entrepreneur’s time and/or funds) and calculates profit by subtracting economic cost (explicit
plus implicit costs) from total revenue.

8.2 [23.2] A Firm with a Fixed Production Facility: Short-Run Costs

1. In the short run, with at least one factor of production fixed, a firm with an existing
production facility must decide how much output to produce.
2. In the long run, a firm must decide what type of production facility to build because, in the
long run, all factors of production can be varied.

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 Chapter 8 [23]: Production Technology and Cost 93

 Teaching Tip
A good way to explain the long run is to ask students how far ahead they plan in order to
answer the question, “What are you going to do for the rest of your life?” In the long run,
everything changes.

A. Production and Marginal Product

1. Marginal product of labor is the change in output from one additional unit of labor.
a. Diminishing returns occur as one input increases, while other inputs are held fixed;
output increases at a diminishing rate.
2. The firm’s total-product curve is a curve showing the relationship between the quantity of
labor and the quantity of output produce, ceteris paribus.
3. The short-run production function will generally increase at an increasing rate initially, due to
gains from specialization. The marginal product of labor is increasing.
4. Eventually, diminishing returns to the variable factor will cause the production function to
increase at a decreasing rate. The marginal product of labor is decreasing.

 Teaching Tip
Use the students themselves for this lesson. Ask the class how many of them have jobs
and what they do. Some of the students will have jobs where the produce something—a
product or a service of some type. Pick one job and take students through what they
produce by the hour, day, and week. The increase in their total production every hour or
every day represents their marginal product.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS

Suppose that output is produced with two or more inputs and we increase one input while holding the
other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a
decreasing rate.

B. Short-Run Total Cost

1. Fixed costs (FC) are costs that do not vary with the quantity produced.
2. Variable costs (VC) are costs that vary with the quantity produced. These costs change as
output increases and represent additional labor and materials required to produce more units.
(Total variable cost is the sum of all variable costs.)
3. Short-run total cost (TC) is the total cost of production when at least one input is fixed; it is
equal to fixed cost plus variable cost.
C. Short-Run Average Costs
1. Average fixed cost (AFC) is fixed cost divided by the quantity produced.
2. Average variable cost (AVC) is variable cost divided by the quantity produced.
3. Average total cost (ATC) is total cost divided by the quantity of output produced.
Equivalently, short-run average total cost (ATC) is the sum of average fixed cost plus
short-run average variable cost.

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94 O'Sullivan/Sheffrin/Perez, Microeconomics, 10e

4. Short-run average total cost will be U-shaped because, initially, fixed cost per unit decreases
as the total fixed cost is spread over a larger number of units.

5. However, as marginal costs per unit are increasing due to diminishing returns, eventually the
higher costs of variable inputs per unit will outweigh the gains from spreading fixed costs. At
that point, short-run average total cost will begin to increase.

 Teaching Tip
If the students understood marginal product, you can explain how the shape of the
average cost curve is the flip side of the marginal product curve.

D. Short-Run Marginal Cost

1. Short-run marginal cost is the change in short-run total cost resulting from a one-unit
increase in output.
2. The principle of diminishing returns tells us that as more variable inputs are added to fixed
inputs, production will increase but at a decreasing rate.
3. Because each additional unit thus requires more variable inputs than the previous unit, in the
short run, marginal costs must eventually be increasing as production increases.
E. The Relationship between Marginal Cost and Average Cost
1. If marginal costs are less than average costs, average costs are decreasing.
2. If marginal costs are greater than average cost, average costs are rising.
3. If the marginal costs and average costs are equal, then the average cost is not rising or falling,
and this occurs only at the minimum point on the average cost curve.

Review this key question and the related application:

Question 2: Why is the marginal-cost curve positively sloped?

APPLICATION 2: THE RISING MARGINAL COST OF CRUDE OIL

The marginal cost of producing crude oil for world markets first increases at a moderate rate and then
increases rapidly as the number of barrels produced per day goes up. The curve shows differences in
the cost of extracting oil from different sources. The cost is relatively low for countries in the Middle
East, higher for oil from the North Sea, Canada, and the United States, and highest for oil from the
Arctic.

8.3 [23.3] Production and Cost in the Long Run

A. Expansion and Replication
1. The long-run total cost (LTC) is defined as the total cost of production when the firm is
perfectly flexible in choosing its inputs, including its production facility.
2. The firm’s long-run average cost (LAC) is defined as the long-run total cost divided by the
quantity produced.
3. Constant returns to scale is a situation in which the long-run total cost increases
proportionately with output, so long-run average cost is constant.
4. The firm’s long-run marginal cost (LMC) is the change in long-run cost resulting from a
one-unit increase in output.

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 Chapter 8 [23]: Production Technology and Cost 95

B. Reducing Output with Indivisible Inputs

1. An indivisible input cannot be scaled down to produce a small quantity of output. For
example, a railroad must lay the same amount of track between two cities whether one train
or many trains use it.
2. If there are indivisible inputs, cutting output in half will not cut costs in half, and thus, the
LAC curve is negatively sloped.

 Teaching Tip
Have the students use the university as an example. Ask them why the school is the size
that it is. Could it be smaller? Bigger? What would happen to tuition?

C. Scaling Down and Labor Specialization

1. Specialization may initially make additional workers more productive, as less time is spent
switching between tasks and specific skills are improved; thus, per-unit costs fall as quantity
increases.
2. If there are gains from specialization of inputs, cutting output in half will not cut costs in half
because less specialization causes workers to be less productive, and thus, the LAC curve is
negatively sloped.

 Teaching Tip
Furniture and automobile manufacturing are good examples of labor specialization. Ask
the students what they would expect to pay for handmade furniture or a car built by a
single individual. Why?

D. Economies of Scale
1. A firm experiences economies of scale, a situation in which the long-run average cost of
production decreases as output increases, if the LAC curve is negatively sloped.

 Teaching Tip
Ask the students what they think their electric bill would be if they were the local electric
company’s only customers. Why? The discussion will flow to scale economies and
diseconomies.

2. The minimum efficient scale for a firm is defined as the output level at which scale
economies are exhausted. In this situation, the long-run average cost curve becomes
horizontal. Beyond this point, a firm will not have lower per-unit costs if it produces more.
E. Diseconomies of Scale
1. Diseconomies of scale is a situation in which the long-run average cost of production
increases as output increases. Diseconomies often occur due to:
a. Coordination problems: Larger firms are more difficult to coordinate and may require
several layers of management, increasing per-unit costs.
b. Increasing input costs: As a firm expands, it increases its demand for inputs. At some point,
this demand may be sufficiently large to drive up input prices and thus raise input costs.

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96 O'Sullivan/Sheffrin/Perez, Microeconomics, 10e

F. Actual Long-Run Average-Cost Curves

1. Actual long-run average-cost curves tend to be L-shaped because:
a. They are negatively sloped for small quantities of output due to economies of scale
resulting from indivisible inputs and specialization.
b. These economies of scale are exhausted as output becomes large and the long-run
average cost curve becomes horizontal over a wide range of output.
G. Short-Run versus Long-Run Average Cost
1. The difference between the short-run and long-run curve is predominantly with large
quantities. The short-run average cost curve is positively sloped for large quantities of outputs
due to diminishing returns and the resulting increases in labor cost per unit of output. In the
long run, the firm can scale up its operation so that it does not suffer from diminishing
returns. If there are no diseconomies of scale, the long-run average-cost curve will be
negatively sloped or horizontal.

Review this key question and the related application:

Question 3: How do indivisible inputs affect production costs?

APPLICATION 3: INDIVISIBLE INPUTS AND THE COST OF FAKE KILLER WHALES

Sea lions eat fish off the coast of Washington, reducing fish harvests. Rick Funk has offered to build fake
killer whales to scare off the sea lions. The mold costs $11,000, and production costs are around $5,000.
One whale would cost $16,000, two 21,000, and three would be $26,000. The mold is an illustration of
indivisible costs.

8.4 [23.4] Examples of Production Cost

A. Scale Economies in Wind Power
1. Large wind turbines are more expensive than small ones, but they have a greater generating
capacity.
B. Average Cost of a Music Video
1. The marginal cost of making an additional video is small.
2. The average cost of a video depends on how many copies are distributed. The average-cost
curve is negatively sloped.
C. Solar versus Nuclear
1. Recent innovations have reduced the cost of solar power.
2. The cost of nuclear power has increased.
3. The cost gap between solar and nuclear power has been eliminated, and today, the cost is
roughly the same for each.

Additional Applications to Use in Class

Question: How do large corporations respond to a bad economy?
ADDITIONAL APPLICATION: MICROSOFT TO CUT UP TO 5,000 JOBS
Anonymous
"Microsoft to Cut up to 5,000 Jobs"
MSNBC.com

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 Chapter 8 [23]: Production Technology and Cost 97

Summary: Key Points in the Article

Technology companies are not immune to the current economic slowdown. Software giant Microsoft
Corporation announced its intent to cut 5,000 jobs over the next 18 months. The company’s initial wave
of 1,400 layoffs begins immediately. This is the first such workforce reduction since the company was
founded in 1975 other than minimal reductions due to acquisitions. Chipmaker Intel also indicated that
slow sales would force it to layoff 6,000 manufacturing employees in the near future.

In addition to the layoffs, Microsoft announced other cost cutting measures such as reducing vendors and
contingent staff, facilities, and cutting some capital expenditures and marketing expenses. The cuts appear
to be forward looking as the company missed profitability estimates by only a small fraction. Instead of
the expected 50 cents per share in profits, the company posted profits of 47 cents a share. However, total
profits are below year ago numbers, and the company indicated cost cutting measures would be needed to
increase profitability. Microsoft refused to provide forecasts for the remainder of the year citing “market
volatility.”

Analyzing the News

Microsoft and other companies that are still making money appear to be retrenching for an extended
downturn. If a company can’t increase profits by generating more revenue, the only other option is to
slash costs. Of course, as all firms engage in this behavior, it can push the economy even lower and
require another round of layoffs and create the self-fulfilling downward spiral the government fears.

Thinking Critically Questions

1. Why are corporate profits important?
2. Why do future profits matter?
3. How might a reduction in marketing expenditures impact the company’s future profits?

Question: How are economies of sale improving the race car industry?
ADDITIONAL APPLICATION: THE MOST VALUABLE TEAMS IN NASCAR
Gage, Jack
“The Most Valuable Teams in NASCAR”
Posted 7/24/2008 on MSNBC.com
Forbes

Summary: Key Points in the Article

NASCAR team values have increased dramatically in the past two years. However, the days of small one
or two car teams may be ending soon because the values of many small teams have fallen. The trend has
driven some industry consolidation as smaller teams have merged in order to achieve some economies of
scale.
The top two teams operate a total of nine cars in NASCAR and stand better odds of cashing in with
virtually the same investment in operations. For example, both a one-car team and a five-car team have to
operate a mechanic shop, and the five-car shop has a much better chance of victory.

Team valuations move with victories, and the top team, Hendrick Motorsports, has a value of
$335 million. This amount is up more than 24 percent over last year, while Petty Enterprises, a two-car
team, lost 9 percent in value over the previous year. The Petty team “hasn’t won a Cup Series in nearly a
decade.”

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98 O'Sullivan/Sheffrin/Perez, Microeconomics, 10e

Analyzing the News

Economies of scale occur when a firm can spread fixed costs over more units of production. In the case of
NASCAR, the cost of administration and mechanic shops is about the same for a five-car team or a one-
car team. And the odds of success are much higher for a five-car team.

Thinking Critically Questions

1. What are economies of scale?
2. What are constant returns to scale?
3. What are diseconomies of scale?

Solutions to End-of-Chapter Exercises

Chapter 8 [23]
SECTION 8.1 [23.1]: ECONOMIC COST AND ECONOMIC PROFIT
1.1 opportunity cost
1.2 opportunity, time, funds
1.3 accounting profit, opportunity costs
1.4 economic, accounting, accounting, economic
1.5 40,000; 8,000
1.6 short
1.7 long
1.8 time required to arrange a stay and clean up after a guest leaves.
1.9 a. The opportunity cost of capital is $2,000 per year, or $2 per lawn.
MC = $24; AC = $24 + $2 = $26.
b. The opportunity cost of capital is $2,000 per year, or $4 per lawn.
MC = $24; AC = $24 + $4 = $28.

SECTION 8.2 [23.2]: A FIRM WITH A FIXED PRODUCTION FACILITY: SHORT-RUN

COSTS
2.1 J, S
2.2 specialization and increasing labor productivity
2.3 Diminishing returns, spreading the fixed cost
2.4 increase
2.5 average
2.6 , 
2.7 False
2.8 positively
2.9 1: 60, 10, 70, — , 60, 10, 70
2: 60, 18, 78, 8, 30, 9, 39
3: 60, 30, 90, 12, 20, 10, 30
4: 60, 45, 105, 15, 15, 11.25, 26.25
5: 60, 65, 125, 20, 12, 13, 25
2.10 a. $40 per paddle = [1/10] × [$150 for entrepreneur + 3 × $50 for other workers + $100 fixed cost]
b. $25 per paddle = [1/10] × [4 × $50 for labor + $50 fixed cost]
c. $20 per paddle = [1/10] × [2 × $50 for labor + $100 fixed cost]

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 Chapter 8 [23]: Production Technology and Cost 99

2.11 a. Fixed cost = $60

b. Quantity MC AVC ATC
1 — 30 90
2 20 25 55
3 40 30 50
4 50 35 50
5 60 40 52
AVC approaches ATC from below as output increases (reflecting decreasing AFC as output
increases). When MC > ATC, ATC increases; when MC < ATC, ATC decreases.

2.12 Average cost will exceed 10 cents per pencil because ATC is U-shaped, and the new plant’s
output exceeds the output of the larger of the two existing operations.

SECTION 8.3 [23.3]: PRODUCTION AND COST IN THE LONG RUN

3.1 fixed costs, constant returns to scale
3.2 1.60, 2.10
3.3 diminishing returns, long
3.4 indivisible
3.5 If output per firm drops from 5 million ton miles to 1 million ton miles, the average cost will
increase from $0.10 to $0.11. The unit cost increases by only 10%.
3.6 a. AC(40) = 15, AC(100) = 9, and AC(400) = 6
b.

3.7 Diminishing returns reflect the eventual decrease in marginal product as employment of one input
is increased, with all other inputs fixed. Diseconomies of scale reflect the decreasing productivity,

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100 O'Sullivan/Sheffrin/Perez, Microeconomics, 10e

due perhaps to increasing coordination problems, as the employment of all inputs is increased
proportionately.
3.8 $123, $13

3.9 a. The cost of the first whale is $23,000, more than the previous $16,000.
b. Production becomes less costly with production of the third whale.

SECTION 8.4 [23.4]: APPLICATIONS OF PRODUCTION COST

4.1 decreases
4.2 high, very low
4.3 Total Cost = $800,000 and Average Cost = $0.0200/kwh.
4.4

4.5

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Solution Manual for Microeconomics: Principles, Applications and Tools, 10th Edition, Arthur

Chapter 8 [23]: Production Technology and Cost 101

Critical Thinking

1. The annual opportunity cost of the capital contribution is $30,000 times the annual interest rate.
The annual labor cost is the income that could be earned in another job.

2. Decrease the number of workers from 20 to 19 and compute the change in the quantity produced,
for example, 100 − 94 = 6. The change in cost is the $120 wage + $30 savings in plastic, so the
marginal cost is $150 / 6 = $25.

3. The average cost decreases from $4200 for 1 kw, to $2700 for 2 kw, to $2200 for 3 kw, and so on
down to $1700 for 6 kw.

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