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# Chapter 5

## The Farmers Margin

Farmers in western European countries grow about three times as much wheat per acre as their U.S. counterparts. Due to government policies, European farmers receive a much higher price for their wheat than American farmers - giving them an incentive to use more inputs and to expend more effort at the margin to increase the crop yield per acre. In this chapter we will show how the principle of marginal analysis can be used to understand decisions that lie behind the supply curve.

Chapter Objectives
1. The importance of the firms production function, the relationship between quantity of inputs and quantity of output 2. Why production is often subject to diminishing returns to inputs 3. The various types of costs a firm faces and how they generate the firms marginal and average cost curves 4. Why a firms costs may differ in the short run versus the long run 5. How the firms technology of production can generate increasing returns to scale

## The Production Function

A

production function is the relationship between the quantity of inputs a firm uses and the quantity of output it produces.
fixed input is an input whose quantity is fixed for a period of time and cannot be varied. variable input is an input whose quantity the firm can vary at any time.

## Inputs and Output

The

long run is the time period in which all inputs can be varied. The short run is the time period in which at least one input is fixed. The total product curve shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input.

## Production Function and TP Curve for George and Marthas Farm

Quantity of wheat (bushels) Adding a 7th worker leads to an increase in output of only 7 bushels
100 80 60 40 20

## Quantity Quantity MP of labor of labor L of wheat Q MPL= DQ/ DL

(worker) (bushels) (bushels per worker)
0 19 36 51 64 19 17 15 13

## Adding a 2nd worker leads to an increase in output of only 17 bushels

Total product, TP

0 1 2 3 4

5
6 7 8 1 2 3 4 5 6 7 8

75
84 91 96

11
9 7 5

## Quantity of labor (workers)

Although the total product curve in the figure slopes upward along its entire length, the slope isnt constant: as you move up the curve to the right, it flattens out due to changing marginal product of labor.

## Marginal Product of Labor

The marginal product of an input is the additional quantity of output that is produced by using one more unit of that input. Marginal Product of Labor: change in quantity of output generated by adding one additional worker

## Wheat Yields Around the World

Wheat yields around the world differ substantially because of government policies. In the U.S. farmers receive payments from the government while European farmers benefit from price floors. Consequently, European farmers produce higher yields per acre. In poor countries, foreign aid can lead to depressed yields because it often comes as surplus food.

## Diminishing Returns to an Input

There are diminishing returns to an input when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input.

As we add more and more workers eventually we get less and less output Additional worker cannot add as much output as previous worker

## Marginal Product of Labor Curve

Marginal product of labor (bushels per worker) 19 17 15 13

## There are diminishing returns to labor.

11 9
7 5 Marginal product of labor, MPL 0 1 2 3 4 5 6 7 8 Quantity of labor (workers)

Here, the first worker employed generates an increase in output of 19 bushels, the second worker generates an increase of 17 bushels, and so on

## Total Product, Marginal Product, and the Fixed Input

With more land, each worker can produce more wheat. So an increase in the fixed input shifts the total product curve up from TP10 to TP20.
Quantity of wheat (bushels) 160 140 120 100 80 60 40 20 0 1 2 3 Marginal product of labor (bushels per worker) 30 TP 20 25 TP 10 20 15 10 5 4 5 6 7 8 Quantity of labor (workers) 0 1 2 3 MPL 20 MPL 10 4 5 6 7 8 Quantity of labor (workers)

This shift also implies that the marginal product of each worker is higher when the farm is larger. As a result, an increase in acreage also shifts the marginal product of labor curve up from MPL10 to MPL20.

## (b) Marginal Product Curves

Whats a Unit?

The marginal product of labor (or any other input) is defined as the increase in the quantity of output when you increase the quantity of that input by one unit. What do we mean by a unit of labor? Is it an additional hour of labor, an additional week, or a person-year? The answer is that it doesnt matter, as long as you are consistent. One common source of error in economics is getting units confused say, comparing the output added by an additional hour of labor with the cost of employing a worker for a week. Whatever units you use, always be careful that you use the same units throughout your analysis of any problem.

## Was Malthus Right?

In 1798, Thomas Malthus introduced the principle of diminishing returns to an input. Malthus argued that as a country's population grew but its land area remained fixed, it would become increasingly difficult to grow enough food. World population has increased from about 1 billion when Malthus wrote to more than 6.8 billion in 2010, but in most of the world people eat better now than ever before. So was Malthus completely wrong? Since the eighteenth century, technological progress has been so rapid that it has alleviated much of the limits imposed by diminishing returns.

## From the Production Function to Cost Curves

A

fixed cost is a cost that does not depend on the quantity of output produced. A variable cost is a cost that depends on the quantity of output produced. The total cost is the sum of the fixed cost and the variable cost of producing that quantity of output.

TC = FC + VC

The

## Total Cost Curve for George and Marthas Farm

Cost
\$2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200

Total cost, TC
I H G F E D C

B
A
19 36 51 64 75 84 91 96

## Case: The Mythical Man-Month

Project that could be done by one programmer in twelve months cannot be done by twelve programmers in one month. Adding another programmer on a project actually increases the time to completion

The source of the diminishing returns lies in the nature of the production function for a programming project: Each programmer must coordinate his or her work with that of all the other programmers on the project, leading to each person spending more and more time communicating with others as the number of programmers increases.

## The Mythical Man-Month

Quantity of software code (lines)

TP

## Beyond a certain point, an additional programmer is counterproductive. 0

Marginal product of labor (lines per programmer)

## Quantity of labor (programmers)

0 MPL
Quantity of labor (programmers)

Bernies ice-making company produces ice cubes using a 10-ton machine and electricity. The quantity of output, measured in terms of pounds of ice, is given in this table: The 10-ton machine is a _____ input.

1. 2.

fixed variable

Bernies ice-making company produces ice cubes using a 10-ton machine and electricity. The quantity of output, measured in terms of pounds of ice, is given in this table: Calculate the marginal product of the third unit of the variable input.

1.
2. 3. 4.

## 1000 900 800 600

Bernies ice-making company produces ice cubes using a 10-ton machine and electricity. Suppose a 50% increase in the size of the fixed input increases output by 100% for any given amount of the variable input. What is the fixed input now? the 10 ton machine the 15 ton machine the 20 ton machine 6 kilowatts of electricity

1. 2. 3. 4.

Bernies ice-making company produces ice cubes using a 10-ton machine and electricity. Suppose a 50% increase in the size of the fixed input increases output by 100% for any given amount of the variable input.

Given the original production function, the quantity of ice that can be produced using 2 units of the variable input is _____.
1. 2. 3. 4.

## Two Key Concepts: Marginal Cost and Average Cost

Marginal

cost of producing a good is the additional cost incurred by producing one more unit.
in the case of marginal product, marginal cost is equal to rise (the increase in total cost) divided by run (the increase in the quantity of output).

As

## Costs at Selenas Gourmet Salsas

Total Cost and Marginal Cost Curves for Selenas Gourmet Salsas
(a) Total Cost
Cost Cost of case

## (b) Marginal Cost

\$1,400 1,200

8th case of salsa increases total cost by \$180. case of salsa increases total cost by \$36. 2nd

TC

\$250 200

MC

1,000

800
600 400 200

150
10 0 50

10

10

## Why is the Marginal Cost Curve Upward Sloping?

Because

there are diminishing returns to inputs. As output increases, the marginal product of the variable input declines.
implies that more and more of the variable input must be used to produce each additional unit of output as the amount of output already produced rises. since each unit of the variable input must be paid for, the cost per additional unit of output also rises.

This

And

## Average Total Cost

Average

total cost (ATC), often referred to simply as average cost, is total cost divided by quantity of output produced.
ATC = TC/Q = (Total Cost) / (Quantity of Output)

U-shaped average total cost curve falls at low levels of output, then rises at higher levels.

Average

output.

Average

## Average Total Cost Curve

Increasing

output has two opposing effects on average total costthe spreading effect and the diminishing returns effect:
The

greater the quantity of output over which fixed cost is spread, leading to lower the average fixed cost. The diminishing returns effect: the larger the output, the greater the amount of variable input required to produce additional units leading to higher average variable cost.

## Average Total Cost Curve for Selenas Gourmet Salsas

Cost of case

\$140
120 Minimum average total cost

## Average total cost, ATC

100
80 60 M

40
20 0 1 2 3 4 5 6 7 8 9 10

## Putting the Four Cost Curves Together: Notes

1. Marginal cost is upward sloping due to diminishing returns. 2. Average variable cost also is upward sloping but is flatter than the marginal cost curve. 3. Average fixed cost is downward sloping because of the spreading effect. 4. The marginal cost curve intersects the average total cost curve from below, crossing it at its lowest point.

Marginal Cost and Average Cost Curves for Selenas Gourmet Salsas
Cost of case \$250

MC

200

150

ATC AVC M

The bottom of the U curve is at the level of output at which the marginal cost curve crosses the average total cost curve from below. Is this an accident? No!

100

50 AFC 0 1 2 3 4 5 6 7 8 9 10

## Quantity of salsa (cases) Minimum-cost output

General Principles That Are Always True About a Firms Marginal and Average Total Cost Curves
The

minimum-cost output is the quantity of output at which average total cost is lowestthe bottom of the U-shaped average total cost curve.
the minimum-cost output, average total cost is equal to marginal cost. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling. And at output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost is rising.
At

The Relationship Between the Average Total Cost and the Marginal Cost Curves
Cost of unit MC MC A TC H If marginal cost is above average total cost, average total cost is rising.

B A 1 A 2 M B

MC

If marginal cost is below average total cost, average total cost is falling.

Quantity

When marginal cost equals average total cost, we must be at the bottom of the U, because only at that point is average total cost neither falling nor rising.

## Does the Marginal Cost Curve Always Slope Upward?

practice, marginal cost curves often slope downward as a firm increases its production from zero up to some low level, sloping upward only at higher levels of production. This initial downward slope occurs because a firm that employs only a few workers often cannot reap the benefits of specialization of labor. This specialization can lead to increasing returns at first, and so to a downward-sloping marginal cost curve. Once there are enough workers to permit specialization, however, diminishing returns set in.
In

## More Realistic Cost Curves

Cost of unit MC A TC A VC 2. but diminishing returns set in once the benefits from specialization are exhausted and marginal cost rises.

Quantity

## Dont Put Out the Welcome Mat

Housing developments are profitable for real estate developers but are not necessarily good for residents. Taxes are based on the level of municipal services available. New housing developments make this level of services inadequate. So new services (new schools, new teachers, etc) must be created.
This increases the marginal cost of providing municipal services.

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.
Calculate Alicias marginal cost of the 3rd pie.
1.

2.
3. 4.

## \$1.00 \$1.25 \$2.25 \$3.00

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.

Calculate Alicias variable cost of producing 3 pies (Hint: The variable cost of two pies is just the marginal cost of the first, plus the marginal cost of the second pie, and so on.)
1. 2. 3. 4.

## \$1.58 \$3.25 \$4.10 \$4.75

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.

1. 2. 3. 4.

## \$1.00 \$1.25 \$2.25 \$3.00

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.

1. 2. 3. 4.

## \$1.58 \$3.25 \$4.10 \$4.75

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.

1. 2. 3. 4.

## \$1.58 \$3.25 \$4.10 \$4.58

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.
The spreading effect dominates the range of output from _____ .

1. 2. 3. 4.

0 1 2 5

to to to to

3 4 5 6

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.
The diminishing returns effect dominates the range of output from _____ .

1. 2. 3. 4.

0 1 2 5

to to to to

3 4 5 6

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.
What is Alicias minimum cost output?

1. 2.

3.
4.

1 2 4 5

## pie pies pies pies

Alicias Apple Pies is a roadside business. Alicia must pay \$9 in rent each day. In addition, it costs her \$1.00 to produce the first pie of the day, and each subsequent pie costs 50% more to produce than the one before. For example, the second pie costs \$1.00 1.5 = \$1.50 to produce, and so on.
Making one more pie raises average total cost when output is greater than 4 pies because the marginal cost of the 5th pie is less than the average total cost of the first four pies.

1. 2.

True False

## Short-Run versus Long-Run Costs

Long

Run: All inputs are variable in the long run. In the long run a firms fixed cost becomes a variable it can choose. The firm will choose its fixed cost in the long run based on the level of output it expects to produce. Short Run: In the short run, fixed cost is completely outside the control of a firm.

Choosing the Level of Fixed Cost of Selenas Gourmet Salsas At high output levels,
Cost of case
\$250 200 150 100 50

high fixed cost yields At low output levels, low lower average total fixed cost yields lower cost average total cost

10

## Quantity of salsa (cases)

Low fixed cost (FC = \$108)
Quantity of salsa
(salsa)

## High fixed cost (FC = \$216)

Low variable cost Total cost Average total cost of case ATC2

There is a trade-off between higher fixed cost and lower variable cost for any given output level, and vice versa.
But as output goes up, average total cost is lower with the higher amount of fixed cost.

Total cost

## Average total cost of case A TC1

1 2 3 4 5 6 7 8 9 10

## \$12 48 108 192 300 432 588 768 972 1,200

\$120 156 216 300 408 540 696 876 1,080 1,308

\$120.00 78.00 72.00 75.00 81.60 90.00 99.43 109.50 120.00 130.80

## \$6 24 54 96 150 216 294 384 486 600

\$222 240 270 312 366 432 510 600 702 816

\$222.00 120.00 90.00 78.00 73.20 72.00 72.86 75.00 78.00 81.60

## The Long-run Average Total Cost Curve

The

long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. the minimum points of the Short Run ATC curves to get the Long Run ATC curve.

Connect

## Short-Run and Long-Run Average Total Cost Curves

Cost of case Constant returns to scale ATC 3 B

C 3 4 5 6 7 8 9

## Quantity of salsa (cases)

Returns to Scale
There are increasing returns to scale (economies of scale) when long-run average total cost declines as output increases. There are decreasing returns to scale (decreasing returns to scale) when long-run average total cost increases as output increases. There are constant returns to scale when long-run average total cost is constant as output increases. Network externalities are when the value of a good to people is greater when more people use it.

There

are vast differences in total cost that arise with snow removal.
Washington,

D.C. which does not have a lot of snow has chosen a low fixed cost and does not have much snow removal equipment. As a consequence, a small amount of snow can create havoc for the city.
Chicago

on the other hand has a lot of snow, accepts the higher fixed costs associated with snow removal but which leave it in a position to respond more effectively.

The table below shows three combinations of fixed and average variables cost.

1. 2. 3.

## \$1.80 \$1.67 \$1.00

The table below shows three combinations of fixed and average variables cost.

Which choice leads to the lowest average total cost of producing 12,000 units?

1. 2. 3.

## Choice 1 Choice 2 Choice 3

The table below shows three combinations of fixed and average variables cost.

Which choice leads to the lowest average total cost of producing 22,000 units?

1. 2. 3.

## Choice 1 Choice 2 Choice 3

The table below shows three combinations of fixed and average variables cost.

Which choice leads to the lowest average total cost of producing 30,000 units?
1. 2. 3.

## Choice 1 Choice 2 Choice 3

The table below shows three combinations of fixed and average variables cost.

Suppose that a firm has the choices 1, 2, and 3. Historically they have produced 12,000 units. Suddenly, demand increases sharply leading to a permanent change in production for the firm from 12,000 units to 22,000 units. In the short run we expect that the firm will produce using ______.

1. 2. 3.

## Choice 1 Choice 2 Choice 3

The table below shows three combinations of fixed and average variables cost.

Suppose that a firm has the choices 1, 2, and 3. Historically they have produced 12,000 units. Suddenly, demand increases sharply leading to a permanent change in production for the firm from 12,000 units to 22,000 units. The average cost of production in the short run is

1.

2.
3. 4.

## \$1.67 \$1.75 \$1.36 \$1.30

The table below shows three combinations of fixed and average variables cost.

Suppose that a firm has the choices 1, 2, and 3. Historically they have produced 12,000 units. Suddenly, demand increases sharply leading to a permanent change in production for the firm from 12,000 units to 22,000 units. In the long run we expect that the firm will produce using ______.

1. 2. 3.

## Choice 1 Choice 2 Choice 3

The table below shows three combinations of fixed and average variables cost.

Suppose that a firm has the choices 1, 2, and 3. Historically they have produced 12,000 units. Suddenly, demand increases sharply leading to a permanent change in production for the firm from 12,000 units to 22,000 units. The average cost of production in the long run is _______.

1.

2.
3. 4.

## \$1.67 \$1.75 \$1.36 \$1.30

For the following cases, choose the kind of scale effects you would expect.

A telemarketing firm in which employees make sales calls using computers and telephones.
1. 2. 3.

## diseconomies of scale economies of scale constant returns to scale

For the following cases, choose the kind of scale effects you would expect.

An interior design firm in which design projects are based on the expertise of the firms owner.
1. 2. 3.

## diseconomies of scale economies of scale constant returns to scale

For the following cases, choose the kind of scale effects you would expect.

A diamond-mining company

1. 2. 3.

## Concepts and Measures of Cost

Summary
1.

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The relationship between inputs and output is a producers production function. In the short run, the quantity of a fixed input cannot be varied but the quantity of a variable input can. In the long run, the quantities of all inputs can be varied. For a given amount of the fixed input, the total product curve shows how the quantity of output changes as the quantity of the variable input changes. 2. There are diminishing returns to an input when its marginal product declines as more of the input is used, holding the quantity of all other inputs fixed. 3. Total cost is equal to the sum of fixed cost, which does not depend on output, and variable cost, which does depend on output.

Summary
4.

2 of 3

5.

Average total cost, total cost divided by quantity of output, is the cost of the average unit of output, and marginal cost is the cost of one more unit produced. Ushaped average total cost curves are typical, because average total cost consists of two parts: average fixed cost, which falls when output increases (the spreading effect), and average variable cost, which rises with output (the diminishing returns effect). When average total cost is U-shaped, the bottom of the U is the level of output at which average total cost is minimized, the point of minimum-cost output. This is also the point at which the marginal cost curve crosses the average total cost curve from below.

Summary
6.

3 of 3

7.

In the long run, a producer can change its fixed input and its level of fixed cost. The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost at each level of output. As output increases, there are increasing returns to scale if long-run average total cost declines; decreasing returns to scale if it increases; and constant returns to scale if it remains constant. Scale effects depend on the technology of production.