Microeconomics Chapter 7

Production Function

A function showing the maximum output for each specific combination of inputs, given technology.

Technological Change

A shift in the production function, usually in the direction of a greater quantity of output at each level of input. Technological change may be the result of creation of new products, redesign of old products, or the creation of new methods of manufacturing.

Short Run

A time period in which at least one input cannot be changed.

Long Run

A time period long enough that all inputs can be changed.

Is it possible for marginal cost to be falling and average cost to be rising?

As long as marginal cost is greater than average cost, average cost will be rising. But if you draw a graph with both marginal cost and average cost (such as in Figure 7.12) you will see that for every point that average cost is rising, not only is marginal cost greater than average cost but it is also rising. What would have to happen for marginal cost to decrease after it has already started to increase is that at some level of production, a new opportunity for increases in marginal productivity would have to appear. With a fixed amount of capital, this is highly unlikely (and well beyond any theory we have developed here). Therefore, we would not expect to witness decreasing marginal cost and increasing average cost at any level of output. (Note: it is possible to see increasing marginal cost and decreasing average cost. Look at the levels of output just before minimum average cost.)

Assume that web page developers become more productive. Describe how this will impact marginal and average cost at all levels of production.

As web page developers become more productive, marginal cost will get smaller at each level of output because the change in output will get bigger for each new worker hired. This will decrease the average cost as well.

Explain how an average cost curve is affected by a change in the underlying fixed costs of production and compare the impact to how a marginal cost curve is affected by a change in the underlying fixed cost.

Because average costs include fixed costs (average over the level of output), an increase in the underlying fixed costs will shift the average cost curve up and a decrease in the underlying fixed costs will shift the average cost curve down. The marginal cost curve, however, is unaffected by a change in the underlying fixed costs so it will not change.

Total Variable Costs

For a given level of output, the costs (prices multiplied by the amounts of inputs) of the inputs that can be changed. These costs vary as output changes.

Assume that wages are $20 per hour; at the current number of hours of labor employed, the marginal product of an hour of labor is 10 units of output. Labor is the only variable input. What will happen to marginal cost if you hire one more hour of labor and the marginal product of the next hour of labor employed increases to 15 units of output?

If an hour of labor produces 10 more units of output in an hour and that hour of labor costs $20, the marginal cost is (1 hour x $20) / 10 units of output. That is equal to a marginal cost of $2 per unit. If the next hour of labor's marginal product increases to 15 units per hour, the marginal cost will fall to $1.33 per unit. (1 hour x $20) / 15 units of output = $1.33 per additional unit of output.

If a store owner is doing her best to minimize cost, why is it still true that total variable cost has to increase when output increases?

If at every level of output the store owner is minimizing cost, she will never hire any inputs that are not required for any level of output. Therefore, if she wants to produce more output, she will have to hire more inputs which will add to her total variable costs.

If every worker brought into a production process is identical, why does marginal productivity generally decrease?

If other inputs are not allowed to increase, workers will eventually have fewer units of capital to work with.

If workers become more productive as more are hired, explain what happens to the value of labor to a producer?

If the additional output an employer gets as a result of hiring another worker goes up, the marginal cost of those additional units of output goes down. Consider an increase in marginal productivity from 10 units to 12 units per hour while the wage is $5 per hour. If an employer hires the new worker, the total cost goes up by $5 (the wage). Marginal cost would have been $0.50 under the original marginal product. Now it is $0.42. The labor becomes more valuable to the employer.

How do we consider total cost for a given period of time if some costs are fixed and some costs are variable?

In general, costs of capital are fixed the short run. All costs are variable in the long run. While it is easy to think of variable costs as having a time component (we hire labor per unit of time), fixed costs are harder to consider as having a time component. Economists think in terms of opportunity costs. If you buy a computer, the money you used to buy the computer can no longer earn interest in some other investment per period of time. Therefore, even a fixed input has a time component.

In economics, we introduce simple models that assume inputs are identical. That is, all workers are exactly the same. Is this a realistic assumption? How might it be harder to focus on specific aspects of models if we are worried about different talents that workers bring to the production process?

The assumption is not realistic. But once we master the ability to look at very general differences (such as between labor input versus capital input) we can look at more specific differences (such as between a managerial worker and a production worker).

While marginal productivity pulls the average productivity function toward itself, why does the strength of the influence of marginal product weaken as output rises?

The average cost function follows the marginal cost function. If marginal cost is less than average cost, average cost falls. If marginal cost is greater than average cost, average cost rises.

Marginal Cost

The change in total costs that results from increasing total product by one unit (ΔTC/ΔQ).

Total Fixed Cost

The costs (prices multiplied by the amounts of inputs) of the inputs that are fixed. This is also the amount of cost when total product is zero. Total fixed costs are costs that do not vary as output changes.

Marginal Product

The increase in output from using one more unit of an input while all other inputs are constant (ΔTP/ΔL).

Law of Diminishing Marginal Returns

The marginal product of an input will eventually decrease as more of that input is used. The law of diminishing marginal returns assumes that all other inputs remain constant.

Factors of Production

The resources used to produce goods and services, often divided into three categories: labor, all the physical and mental inputs of people; capital, the machines, tools, buildings, and inventories; and land, the actual land used, including raw materials from land.

Total Cost

The sum of total fixed cost and total variable cost.

Total Product

The total amount of output produced.

Average Product

The total product divided by the number of units of a particular input used.

If a fixed cost does not change as output changes, why do you still have to pay it if you produce zero output?

There are some inputs that you must commit to just to get into the market. For example, you may need factory space. You will have to sign a lease or a loan agreement to get access to the space. The owner of the space or the bank that lends you the money does not care how much you produce. They must get paid every month no matter what. You may have to pay out of your own resources if you produce nothing.

Why is increasing marginal cost a short-run phenomenon?

To understand this, you need to consider why decreasing marginal productivity is a short-run phenomenon as well. We assumed that marginal productivity decreased as the use of labor increased because we ran out of opportunities for labor to use the capital to produce (there were only so many computer work stations for Patricia's web page designers to work with). In the long run, we could increase the amount of capital, which would increase the marginal productivity of the workers. As marginal productivity increases, marginal cost falls. It is important to remember that we are assuming all the workers are identical - the observed increase in marginal cost is not because the additional workers are in any way inferior to the ones already hired. They just have less capital to work with.

Average Cost

Total cost divided by the total product.

In economics, we often focus on the margin of a problem, so the presentation of marginal product comes before the presentation of average product. Why do you think we want you to learn about the average product of labor?

Yes, marginal product is a very important way to look at the decision to hire one more worker or let one worker go. But average productivity gives us a good way to summarize the overall productivity of our workforce. It allows us to take a step back and look at the bigger picture.