Chapter 4 Production and the Costs of Production

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INSTRUCTOR’S MANUAL

CHAPTER 4
PRODUCTION AND THE COSTS OF PRODUCTION

CHAPTER GOALS

This chapter deals with production and the costs of production. After reading this chapter, students should be able to:

•Distinguish between the short run and long run and between a fixed input and a variable input.

•Formulate a simple production function for a business firm.

•Describe how the law of diminishing returns relates to the productivity of a variable input and a firm’s costs of production in the short run.

•Identify the costs of production that a firm realizes in the short run.

•Describe how economies of scale and diseconomies of scale affect the long-run average total cost curve of a firm.

•Assess the tradeoffs that can emerge when a firm decides to become bigger.

•Identify examples of how firms have adjusted their costs in response to changing market conditions.

•Distinguish between accounting profit and economic profit.

LECTURE HINTS AND IDEAS

This chapter gives an overview of production and cost functions, beginning with fixed and variable inputs and a discussion of diminishing returns. These topics lead into the various definitions for short-run cost functions: TC, TFC, TVC, ATC, AVC, AFC, and MC, along with the corresponding curves. This is followed by a discussion of long-run cost curves, as well as economies of scale, diseconomies of scale, and constant returns to scale. Examples include Ford, Wal-Mart, and McDonald’s. The chapter ends with an introduction to profits, bringing together the total revenue concept from Chapter 3 with the cost concepts in this chapter.

By necessity, the chapter contains much “dry” material, but it is important for students to learn because it lays the foundation for the market structure chapters to come. Students must familiarize themselves with a number of different production and cost curves, as well as definitions of essential concepts such as short run versus long run and normal profit versus economic profit. The lecture on diminishing returns can be related to the diminishing marginal utility lecture from Chapter 2. Because there are many news stories about companies engaging in cost cutting, these examples can serve to enliven and illustrate the mechanics of cost and production.

BREAK-THE-ICE DISCUSSION STARTERS

1.“Suppose you run a T-shirt company, and your economist friend has just told you that you made zero economic profit this past year. Would you be able to stay in business in the long run?” Yes. This question gets students thinking about the difference between accounting profit and economic profit, and the implications for the long run.

2.“Would you ever hire a worker in the range of diminishing returns?” This question helps clarify the difference between total product and marginal product. The answer is yes, but not if marginal returns are negative.

3.“What are some examples of fixed costs for a clothing manufacturer? What are some examples of variable costs?” It helps students to think about a specific business when classifying costs this way.

4.“What would happen to a firm’s costs if its workers became more productive due to improved training?” Explain that costs would be lower because the cost curves themselves would shift downward (not a movement along existing curves).

5.“A health care insurance company finds that its division in one state is a money loser and decides to cut off insurance to that state in order to cut costs. Is this the best decision?” The discussion should include other options, such as improving efficiency, and consider the company’s duty, if any, to provide services in the state.

BRIEF ANSWERS TO STUDY QUESTIONS AND PROBLEMS

1.a.The marginal product of labor equals 20, 25, 20, 15, 10.

b.Marginal product at first increases, but because of the law of diminishing returns, marginal product eventually declines. Total product increases at a decreasing rate.

c.As a firm adds workers (variable input) to machinery (fixed input), for example, some workers may be underutilized because they have little work to do while waiting in line to use the machinery. Because the addition of yet ever more workers continues to increase output, but by successfully smaller increments, the firm realizes diminishing marginal returns.

2.a.The marginal product of labor equals 100, 120, 160, 140, 80, 20, –40.

b.As the firm hires additional labor, the total product curve increases first at an increasing rate, then at a decreasing rate, while the marginal product curve first rises, then falls.

c.Six workers

d.After the third worker

3.a.The total fixed cost curve is a horizontal line in the figure. The total cost curve and total variable cost curve are parallel to each other, with the difference between them being equal to total fixed cost. Consistent with the law of diminishing marginal returns, total variable cost and total cost initially rise at decreasing rates, then rise at increasing rates.

b.The average fixed cost curve continues to decline as output expands, while the average variable cost curve and average total cost curve are U-shaped. The marginal cost curve is U-shaped and intersects average variable cost and average total cost at their minimum points.

c.As a firm applies additional workers to machinery, the marginal productivity of workers may initially increase, which means that the firm realizes falling marginal cost. As additional workers are applied to machinery, their marginal productivity declines and the firm realizes rising marginal cost.

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5.Total cost = $700, average total cost = $2.33, average fixed cost = $1.33, price = $2.33

6.The long-run average total cost curve will appear as a horizontal line, suggesting constant returns to scale.

7.Taking advantage of economies of scale may require large production runs. Thus, a firm would have to be a large size to be efficient.

8.The manager should compare the fixed cost of a new oven and the variable cost of hiring additional workers, considering as well the marginal productivity of each and the time frame involved.

9.ABC Construction’s average total cost curve and the marginal cost curve both shift upward.

10.The publishing company’s average total cost curve and marginal cost curve both shift downward.