CH 05

O’Sullivan • Sheffrin • Perez
Production Technology
and Cost
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez
chapter
1 What are the cost components for electronic products?

The Production Cost of an iPod Nano
2 How do indivisible inputs affect production costs?
Indivisible Inputs and the Cost of Fake Killer Whales
3 What are the sources of scale economies in production?
Scale Economies in Wind Power
4 What is the cost structure for information goods?
Information Goods and First-Copy Cost
5 Why does average cost decrease as the quantity produced increases?
The Average Cost of Producing Airplanes
© 2007 Pearson/Prentice Hall, Survey of Economics: Principles, Applications & Tools, 3e, O’Sullivan • Sheffrin • Perez 2 of 33
5.1 ECONOMIC COST AND ECONOMIC PROFIT
chapter
• economic profit
Total revenue minus economic
cost.
economic profit = total revenue – economic cost
• economic cost
The opportunity cost of the inputs
used in the production process;
equal to explicit cost plus implicit
cost.
chapter
• explicit cost
The actual monetary payment for
inputs.
• implicit cost
The opportunity cost of inputs
that do not require a monetary
payment.
chapter
economic cost = explicit cost + implicit cost
accounting cost = explicit cost
• accounting cost
The explicit costs of production.
• accounting profit
Total revenue minus accounting
cost.
accounting profit = total revenue − accounting cost
A FIRM WITH A FIXED PRODUCTION
5.2 FACILITY: SHORT-RUN COSTS
chapter
Production and Marginal Product
• marginal product of labor

The change in output from one
additional unit of labor.
• diminishing returns
As one input increases while the
other inputs are held fixed, output
increases at a decreasing rate.
chapter
Production and Marginal Product
► FIGURE 5.1
Total-Product Curve
• total-product curve
A curve showing the
relationship between the
quantity of labor and the
quantity of output produced,
ceteris paribus.
chapter
Short-Run Total Cost
• fixed cost (FC)

Cost that does not vary with the
quantity produced.
• variable cost (VC)

Cost that varies with the quantity
produced.
• short-run total cost (TC)

The total cost of production when
at least one input is fixed; equal
to fixed cost plus variable cost.
TC = FC + VC
chapter
Short-Run Total Cost
► FIGURE 5.2
Short-Run Costs: Fixed Cost,
Variable Cost, and Total Cost
Extra Application 6
chapter
MICHELIN LOOKS TO CUT PRODUCTION COSTS
Michelin Tire intends to lower production costs by 20 percent in an effort to stay competitive
in the face of stiff competition from Asian tire companies. The company is making the move
in the face of an expected downturn in global truck sales after issuing profit warnings earlier
in the year. Company executives admit the move is driven by increased competition,
primarily from Asia, and that price increases will no longer be able to shore up profits.
• Michelin maintains the inefficiencies stem from the development and manufacturing
processes that are labor intensive and outdated in many plants.
• The company intends to invest about 650 million Euros in its older factories.
• The company does not intend to fire anyone but will reduce the labor force through
attrition since approximately 20,000 employees are slated to retire by 2010.
• The company also intends to get more aggressive in product development in an
effort to rejuvenate the product line.
As companies age, inefficiencies tend to develop unnoticed. It is very often a profit signal
that focuses the attention back on efficiency. Often, such companies are the target of
corporate raiders who attempt to buy inefficient companies and turn them around. After
turnaround, these companies are sold for healthy profits. This market mechanism
ensures long-term efficiency.
chapter
Short-Run Average Costs
• average fixed cost (AFC)

Fixed cost divided by the quantity
produced.
• average variable cost (AVC)

Variable cost divided by the
quantity produced.
chapter
► FIGURE 5.3
chapter
• short-run average total cost (ATC)

Short-run total cost divided by the
quantity of output; equal to AFC plus
AVC.
chapter
Short-Run Marginal Cost
• short-run marginal cost (MC)

The change in short-run total cost
resulting from a one-unit increase in
output.
chapter
Short-Run Marginal Cost
► FIGURE 5.4
Short-Run Marginal and
Average Cost
Extra Application 7
chapter
FEDEX FOUNDER CREDITS SUPPLY-CHAIN FLEXIBILITY
According to Fred Smith, CEO and founder of FedEx, supply chain management and
information technology advances will keep the economy from crash landing. Smith
maintains the changes have made “businesses more responsive to changing economic
conditions.” The result of this ability to respond quickly is that economic contractions are
becoming “shallower and less protracted.”
• Smith maintains the technology and supply chain focus makes it easier for
businesses to recognize a slowing economy.
• Former Fed chairman Alan Greenspan identified “supply chain efficiency as a source
of U.S. economic resilience.”
Firms can spread technology investments over high

volumes of output and lower fixed cost per unit. If the
sales volume is not high enough to achieve economies of
scale, then firms are better off going with a higher variable
cost option. In this case the firm would want a minimum
sales volume of x units to fully take advantage of the
technology investment.
chapter
The Relationship Between Marginal Cost and Average Cost
PRODUCTION AND COST IN
5.3 THE LONG RUN
chapter
Expansion and Replication
► FIGURE 5.5
The Long-Run Average-Cost
Curve and Scale Economies
5.3 THE LONG RUN
chapter
• long-run total cost (LTC)

The total cost of production when a
firm is perfectly flexible in choosing its
inputs.
• long-run average cost (LAC)

The long-run cost divided by the
quantity produced.
5.3 THE LONG RUN
chapter
• constant returns to scale

A situation in which the long-run total
cost increases proportionately with
output, so average cost is constant.
• long-run marginal cost (LMC)

The change in long-run cost resulting
from a one-unit increase in output.
5.3 THE LONG RUN
chapter
Reducing Output with Indivisible Inputs
• indivisible input
An input that cannot be scaled down
to produce a smaller quantity of
output.
5.3 THE LONG RUN
chapter
Scaling Down and Labor Specialization
Labor specialization makes workers more productive because of

continuity and repetition. When we reduce the workforce each
worker will become less specialized, performing a wider variety of
production tasks. The loss of specialization will decrease labor
productivity, leading to higher average cost.
5.3 THE LONG RUN
chapter
Economies of Scale
• economies of scale
A situation in which the long-run
average cost of production decreases
as output increases.
• minimum efficient scale

The output at which scale economies
are exhausted.
5.3 THE LONG RUN
chapter
Diseconomies of Scale
• diseconomies of scale
A situation in which the long-run
average cost of production increases
as output increases.
5.3 THE LONG RUN
chapter
Actual Long-Run Average-Cost Curves
► FIGURE 5.6
Actual Long-Run Average-Cost
Curves for Aluminum, Truck
Freight, and Hospital Services
5.3 THE LONG RUN
chapter
Short-Run Versus Long-Run Average Cost
The difference between the short run and long

run is a firm’s flexibility in choosing inputs.
5.4 APPLICATIONS OF PRODUCTION COST
chapter
THE PRODUCTION COST OF AN iPOD NANO

APPLYING THE CONCEPTS #1: What are the cost components for electronic products?
What’s the cost of producing an iPod Nano, the ultra-thin digital music player with a
storage capacity of 2 GB?
Apple has sold millions of iPods, and its large sales volume gives the company an
advantage in negotiating with its suppliers. For example, the flash memory that
costs Apple $54 would cost smaller companies about $90.
chapter
INDIVISIBLE INPUTS AND THE COST OF FAKE KILLER
WHALES
APPLYING THE CONCEPTS #2: How do indivisible inputs
affect production costs?
Sea lions off the Washington coast eat steelhead and other fish, depleting some
species threatened with extinction and decreasing the harvest of the commercial
fishing industry. A plastics manufacturer has offered to build a life-sized fiberglass
killer whale, mount it on a rail like a roller-coaster, and send the whale diving
through the water to scare off the sea lions, their natural prey.
• The first whale would cost about $16,000 (including $11,000 for the mold and
$5,000 for labor and materials).
• Each additional whale would cost an additional $5,000.
• The cost of producing the first fake killer whale is more than three times the
cost of producing the second.
• In terms of total cost, producing 2 whales would cost a total of $21,000, while
3 whales would cost a total of $26,000, and so on.
This little story illustrates the effects of indivisible inputs on the firm’s cost curves.
The mold is an indivisible input, because it cannot be scaled down and still
produce whales.
chapter
SCALE ECONOMIES IN WIND POWER
APPLYING THE CONCEPTS #3: What are the sources of scale economies in production?
There are scale economies in the production of electricity from wind because
electricity can be generated from turbines of different size. Although large wind
turbines are more costly than small ones, the higher cost is more than offset by
greater generating capacity. The scale economies occur because the cost of
purchasing, installing, and maintaining a wind turbine increases less than
proportionately with the turbine’s generating capacity. Table 23.5 shows the costs
of a small turbine (150-kilowatt capacity) and a large turbine (600-kilowatt
capacity), each with an assumed lifetime of 20 years.
chapter
INFORMATION GOODS AND FIRST-COPY COST
APPLYING THE CONCEPTS #4: What is the cost structure for information goods?
FIGURE 5.7
Average-Cost Curve for an
Information Good
For an information good such as a music
CD, the cost of producing the first copy is
very high, but the marginal cost of
reproduction is low and constant.
chapter
THE AVERAGE COST OF PRODUCING AIRPLANES
APPLYING THE CONCEPTS #5: Why does average cost decrease as the quantity produced
increases?
FIGURE 5.8
Average-Cost Curve of Aircraft
The average cost per airplane decreases
as the number produced increases
because the cost of designing the aircraft
and the cost of capital are spread
over more units and labor specialization
reduces variable cost.
chapter
chapter
accounting cost implicit cost

accounting profit indivisible input
average fixed cost (AFC) long-run average cost (LAC)
average variable cost (AVC) long-run marginal cost (LMC)
constant returns to scale long-run total cost (LTC)
diminishing returns marginal product of labor
diseconomies of scale minimum efficient scale
economic cost short-run average total cost (ATC)
economic profit short-run marginal cost (MC)
economies of scale short-run total cost (TC)
explicit cost total-product curve
fixed cost (FC) variable cost (VC)

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O’Sullivan • Sheffrin • Perez

1 What are the cost components for electronic products?

economic profit = total revenue – economic cost

economic cost = explicit cost + implicit cost

accounting cost = explicit cost

accounting profit = total revenue − accounting cost

Production and Marginal Product

• marginal product of labor

Production and Marginal Product

Short-Run Total Cost

• fixed cost (FC)

• variable cost (VC)

• short-run total cost (TC)

Short-Run Total Cost

MICHELIN LOOKS TO CUT PRODUCTION COSTS

Short-Run Average Costs

• average fixed cost (AFC)

• average variable cost (AVC)

Short-Run Average Costs

Short-Run Average Costs

• short-run average total cost (ATC)

Short-Run Marginal Cost

• short-run marginal cost (MC)

Short-Run Marginal Cost

FEDEX FOUNDER CREDITS SUPPLY-CHAIN FLEXIBILITY

Firms can spread technology investments over high

The Relationship Between Marginal Cost and Average Cost

Expansion and Replication

Expansion and Replication

• long-run total cost (LTC)

• long-run average cost (LAC)

Expansion and Replication

• constant returns to scale

• long-run marginal cost (LMC)

Reducing Output with Indivisible Inputs

Scaling Down and Labor Specialization

Labor specialization makes workers more productive because of

• minimum efficient scale

Actual Long-Run Average-Cost Curves

Short-Run Versus Long-Run Average Cost

The difference between the short run and long

THE PRODUCTION COST OF AN iPOD NANO

accounting cost implicit cost

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