Handout 4 (Technology, Production, Costs)

We will now begin studying the behavior of firms. Before we understand the behavior of firms (i.e. how do firms decide what level of output to produce at and what price to charge), we must study what affects a firm’s decision. Namely, we need to study the concepts of technology, production, and costs.

For simplicity and for examples throughout this handout, let’s focus on one specific firm: a pizza store on Franklin Street.

Technology->

Technological Change ->

Short Run ->

Long Run ->

Example for short run vs long run:

Types of costs

  1. Variable Cost (VC)
  2. Definition:
  3. Example:
  1. Fixed Cost (FC)
  2. Definition:
  3. Example:

*Costs in the long run?

  1. Total Cost (TC)
  2. Definition:
  3. Implicit Costs
  4. Definition:
  5. Example:
  1. Explicit Costs
  2. Definition:
  3. Example:
  1. Economic Costs

Average Total Cost (ATC) =

Average Fixed Cost (AFC) =

Average variable cost (AVC) =

Marginal Cost (MC) =

What is a production function?

Let’s look at an example for our pizza restaurant on Franklin.

Is this a short-run orlong-run production function? Why?

Quantity of Workers / Quantity of Pizza Ovens / Quantity of pizzas per week / Cost of Pizza Ovens
(______Cost) / Cost of Workers
(______Cost) / Total Cost Per Week / Marginal Cost / Cost Per Pizza
(ATC)
0 / 2 / 0 / 800 / 0
1 / 2 / 200 / 800 / 650
2 / 2 / 450 / 800 / 1300
3 / 2 / 550 / 800 / 1950
4 / 2 / 600 / 800 / 2600
5 / 2 / 625 / 800 / 3250
6 / 2 / 640 / 800 / 3900

Marginal Product of Labor (MPL)

Definition:

Marginal Product of Capital (MPK)

Definition:

Let’s look at an example:

Quantity of Workers / Quantity of Pizza Ovens / Quantity of Pizzas
Produced / Marginal Product of Labor
0 / 2 / 0
1 / 2 / 200
2 / 2 / 450
3 / 2 / 550
4 / 2 / 600
5 / 2 / 625
6 / 2 / 640

Law of Diminishing Returns ->
Cost minimization for the firm

Goal for the firm:

We can derive a very similar cost-minimization rule for firms as we did for consumers (Recall: Consumers optimally consume to maximize their utility by choosing the combination of goods where ______)

Cost minimization principle for the firm->

Let’s look at an example from our pizza restaurant. Suppose you are given the following information about the pizza restaurant (whose owner’s name is Tom):

Marginal Product of Capital – 3000 pizzas per oven

Marginal Product of Labor–1200 pizzas per worker

Wage rate – $300 per week

Price of Ovens – $600 per week

Is Tom minimizing costs? If she is not minimizing costs, explain whether she should buy more ovens and hire fewer workers or buy fewer ovens and hire more workers.

Exercises

  1. Which of the following are examples of a firm experiencing positive technological change?
  2. A firm is able to cut each worker’s wage rate by 10 percent and still produce at the same level of output
  1. A training program makes a firm’s workers more productive
  1. An exercise program makes a firm’s workers more healthy and productive
  1. A firm cuts its workforce and is able to maintain its initial level of output
  1. A firm rearranges the layout of its factory and finds that by using its initial set of inputs, it can produce exactly as much as before
  1. Go back to the example of the pizza restaurant. Explain whether each of the following is a fixed cost or a variable cost.
  2. The payment she makes on her fire insurance policy
  1. The payment she makes to buy pizza dough
  1. The wages she pays her workers
  1. The lease payment she makes to the landlord who owns the building where her store is located
  1. The $300-per-month payment she makes to her local newspaper for running her weekly advertisements
  1. Suppose the total cost of producing 10,000 tennis balls is $30,000 and the fixed cost is $10,000.
  2. What is the variable cost?
  1. When output is 10,000, what are the average variable cost and average fixed cost?
  1. Consider the following information for the Franklin St Pizza Restaurant:

Marginal product of capital -> 4000

Marginal product of labor -> 100

Wage Rate -> $10

Price of ovens ->

Is the restaurant minimizing costs? If it is not, explain how the restaurant could reallocate between ovens and workers.