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Of course, we recognize that you might just might be able to find someone
with a large house in a place like Six Mile who might take the lower offer. We are only
using comparative house sizes as a useful guide for narrowing the search or, in other
ways, lowering the cost of your search. The person with a mansion in Six Mile is, in
short, likely to be a hard sell.
What you really want to find is someone who has a small house in a place like Six
Mile and who is crazy about the beach and the moderate climate near the coast in
Southern California. Indeed, one of the often-overlooked reasons for interview trips is
not only to assess the person’s likely ability on the job, but also to assess how much he or
she likes the new location relative to his or her established location. People who like
your location relatively more can simply be had for less.
We need to return to the question we started with, Should relocating workers be
compensated for housing cost differences? The answer is a qualified no. That is, if
housing makes up the main cost difference, then workers moving to a higher housing cost
location would be too well compensated if the full cost of living difference were paid.
He or she would take less. How much less is a problem that can only be solved by way
of interviews and negotiations.
We caution, however, that our analysis flows from an unstated but important
assumption, that the housing cost difference in the two locations reflects actual cost
differences that are not offset by benefit differences. That is, many times, a questionable
assumption. Property near the coast in Southern California is much more expensive than
in many (but not all) other parts of the country. It is also much more expensive than
similar property fifty or a hundred miles inland, but still in California. We must ask why
property is so expensive and why so much of the cost difference is in the land that any
house sits on. An acre of land in Six Mile may cost no more than a few thousand dollars.
On the other hand, an acre in La Jolla (at this writing) can cost upwards of a cool $1
million (a fact that explains why lots are measured in square feet)!
Why the difference? Obviously the demand for property is much higher in La
Jolla than in Six Mile, which implies that a lot of people must see some added benefits
for being in La Jolla. This implies that for a lot of people, the full difference in housing
cost between the two areas need not be covered by added monetary income. A part of the
difference in living cost is covered by the “non-money income” associated with the
additional amenities in La Jolla that are not compensated for in Six Mile.
The first rule of management (and other disciplines) has sometimes been stated
as, “Different Strokes for Different Folks.” In our foregoing discussion, we do not mean
to suggest that everyone would want to live in La Jolla. If that were the case, the price of
land in La Jolla would be far higher than it already is. We mean only to point out that
“cost of living” differences cited by business people are not always relevant cost
differences because of benefit differences.
To make our point in more concrete terms, it may be true that the measured “cost
of living” in La Jolla is 30 percent higher than the cost of living in Six Mile and, for that
matter, 30 percent higher than the average for the rest of the country. However, no one
should conclude that the cost of doing business in La Jolla (or any other “high cost” area)
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is 30 percent higher than other parts of the country. The so-called cost of living can be
offset in part by amenities and in part by more productive people who are attracted to the
high-cost area. Many people with limited productivity will simply not be able to compete
with their more productive counterparts in their search for property.
19
In making their
employment decisions, firms need to keep these considerations in focus. They need to
look carefully at what is implied by “cost of living.”
Concluding Comments
Demand is not what people would like to have or are willing to buy at a given price.
Rather it is the inverse relationship between price and quantity, a relationship described
by a downward sloping curve.
Although economists do not have complete confidence in all applications of the
law of demand, they consider the relationship between price and quantity to be so firmly
established, both theoretically and empirically, that they call it a law. In difference
curves provide a way of “structuring” consumer preferences and deriving the law of
demand. In the real world, when the price of a good goes down, the quantity purchased
may fall rather than rise. In such cases, economists normally assume (until strong
evidence is presented to the contrary) that some other variable has changed, offsetting the
positive effects of the reduction in price.
Still, it must be remember that not all downward sloping demand curves are alike.
They differ radically in terms of the elasticity of demand, or the responsiveness of
consumers to a price change. Managers of public and private entities must be aware that
the elasticity of demand can affect their business (pricing) strategies.
Review Questions
1. What role does the law of demand play in economic analysis?
2. If the price of jeans rises and the quantity sold goes up, does the demand curve slope
upward? Why or why not?
19
We should, therefore, expect people in high cost areas like La Jolla to have relatively high incomes. One
reason is obvious: People need a high-income to cover the high cost of living. Another reason can go
unnoticed: People who live in high-cost-of-living areas get much of their income in non-money forms, that
is, in the amenities of the area, and these non-money forms of income are not subject to the high marginal
tax rates that high-income people pay. For example, people who live on the coast in Southern California
have to pay high prices for their housing partly because of the climate, which is very temperate (with high
temperatures in the 70s) for much of the year. Accordingly, they have modest heating and cooling bills,
which increase the demand and prices of their houses relative to other parts of California and the Southwest
where the climate is more extreme and the heating and/or cooling bills are much higher. Of course, pretty
scenery can also increase the demand for houses. People in Boulder have been known to say (or lament)
that they have to “eat the mountains,” meaning their food and household budgets are constrained by the
high prices of their houses, inflated by the views of the Rocky Mountains they have.
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3. If the prices of most goods are rising by an average of 15 percent per year, but the
price of gasoline rises just 10 percent per year, what is happening to the real, or
relative, price of gasoline? How do you expect consumers will react?
4. Suppose that a producer raises the price of a good from $4 to $7, and the quantity sold
drops from 250 to 200 units. It is demand for the good elastic or inelastic?
5. If the campus police force is expanded and officers are instructed to increase the
number of parking tickets they give out, what will happen to the number of parking
violations? What may be necessary to eliminate all parking violations? (Why may
that option be rejected?)
6. If the government subsidizes flood insurance, what will happen to the price of that
insurance? What will happen to the value of the property that is lost during floods?
Why?
7. If the price of ballpoint pens falls, will the demand for ballpoint pens change? What
will happen to the demand for pencils? To the demand for paper?
8. If a nation appreciates its currency in relation to other national currencies, what will
be the effect on other nations’ exports and imports? On the willingness of that
nation’s citizens to invest abroad?
9. Will a tax on imports and a subsidy on exports have the same effect on trade as
depreciation of a nation’s currency?
PERSPECTIVE: Experimentally Determined Indifference Curves
An experiment to determine the characteristics of an individual’s indifference curves was performed by
K.R. MacCrimmon and M. Toda with seven students from the University of California at Los Angeles.
The seven students were asked to construct indifference curves for money and ballpoint pens and for
money and pastries. A separate experiment was conducted for each indifference curve. Each experiment
began with an initial reference point, or bundle, containing a given amount of money, measured along the
horizontal axis, but none of the other good. The student was then presented with bundles containing
varying amounts of money and the other good and asked whether each new bundle was preferred or not
preferred to the initial bundle. After repeating this a number of times, a rather concise area remained that
contained bundles the student found just as attractive as the initial bundle. The student then constructed his
or her indifference curve within this area. This experiment was repeated seven times for the money-pen
choices and four times for the money-pastry choices, and each experiment was begun with a different
amount of money. So each student constructed seven indifference curves for money and pens and four
indifference curves for money and pastries.
To motivate students to give thoughtful and honest answers, one of the bundles that had been
considered was randomly chosen after each indifference curve was constructed. If it had been preferred to
the initial bundle, the student received it; otherwise, the student received the initial bundle containing only
money. In the experiments dealing with money and pastries, the student had to eat all the pastries in the
bundle received before the money was awarded.
The resulting indifference curves were checked to see if they exhibited the characteristics that
economists attribute to indifference curves. The indifference curves for each student were overlaid on the
same graph to see if any of them intersected. They did not. The money-pen indifference curves and the
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money-pastry indifference curves were non-intersecting for all students. (The money-pastry indifference
curves for three students did merge together as they moved out over the money axis.)
Also, as expected, the money-pen indifference curves were downward sloping. Students would
give up money only in return for more pens, and vice versa. In other words, both money and pens were
considered goods, not bads. This was not true of the money-pastry indifference curves. When the bundles
being considered contained only a few pastries, male students would give up a little money to obtain
another pastry so that their indifference curves were downward sloping. But after consuming about three
pastries, they would consume another pastry only if they received more money. At this point, pastries
became a bad, and the indifference curves became upward sloping. For the two women in the experiment,
even the first pastry was a bad, and their money-pastry indifference curves were upward sloping from the
beginning.
With only one minor exception, the indifference curves were convex everywhere. This is in
keeping with the assumption of the normal shapes for indifference curves (which exhibit a diminishing
marginal rate of substitution, at least within the vicinity of their tangency with the budget constraint). On
the upward-sloping portions of the money-pastry indifference curves, this convexity meant that the more
pieces of pastry that were consumed, the more money that would be required to encourage a subject to
consume another pastry.
Based on K.R. MacCrimmon and M. Toda, “The Experimental Determination of Indifference
Curves,” The Review of Economic Studies (October 1969), pp. 433-51.
CHAPTER 9
Production Costs and
Business Decisions
The economist’s stock in trade—his tools—lies in his ability to and proclivity to think
about all questions in terms of alternatives. The truth judgment of the moralist, which
says that something is either wholly right or wholly wrong, is foreign to him. The win-
list, yes-no discussion of politics is not within his purview. He does not recognize the
either-or, the all-or-nothing situation as his own. His is not the world of the mutually
exclusive. Instead, his is the world of adjustment, of coordinated conflict, of mutual gain.
James M. Buchanan
ost is pervasive in human action. Managers (as well as everyone else) are
constantly forced to make choices, to do one thing and not another. Cost or
more precisely, opportunity cost is the most highly valued opportunity not
chosen. Although money is a frequently used measure of cost, it is not cost itself.
Although we may not recognize it, cost also pervades our everyday thought and
conversation. When we say “that course is difficult” or “the sermon seemed endless,” we
are indicating the cost of activities. If the preacher’s extended commentary delayed the
church picnic, the sermon was costly. Although complaints about excessive costs
sometimes indicate an absolute limitation, more often they merely mean that the benefits
of the activity are too small to justify the cost. Many people who “can’t afford” a
vacation actually have the money but do not wish to spend it on travel, and most students
who find writing research papers “impossible” are simply not willing to put forth the
necessary effort.
This chapter explores the meaning of cost in human behavior. We will begin by
showing how seemingly irrational behavior can often be explained by the hidden costs of
a choice. We will then develop the concept of marginal cost, which together with
demand and the related concept of supply defines the limits of rational behavior, from
personal activities like painting and fishing to business decisions like how much to
produce.
Inevitably, points made earlier will be reviewed and extended in this chapter.
There is a cost in this repetition, but there is also some benefit in a few varied
reiterations. We will use the cost analysis to make points that seem to defy common
sense in business. For example, we will show that a firm should not necessarily seek to
produce at the level at which the average cost of production is minimized.
C
Chapter 9 Production Costs and
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Explicit and Implicit Costs
Not all costs are obvious. It is not difficult to recognize an out-of-pocket expenditure—
the monthly price you pay for a product or service. This is called an explicit cost.
Explicit cost is the money expenditure required to obtain a resource, product, or service.
For example, the price of your book is an explicit cost of taking a course in economics.
Other costs are less immediately apparent. Hidden costs of the course might include the
time spent going to class and studying, the risk of receiving a failing grade, and the
discomfort of being confronted with material that may challenge some of your beliefs.
These are implicit costs; together they add up to the value of what you could have done
instead. Implicit cost is the forgone opportunity to do or squire something else or to put
one’s resources to another use. Although implicit costs may not be recognized, they are
often much larger than the more obvious explicit costs of an action. (Then, there are
some “costs” that are recognized on accounting statements that should not be considered
in making business decisions. These costs are called “sunk costs.” See the box on the
next page.)
The Cost of an Education
A good illustration of the magnitude of implicit costs is the cost of an education.
Suppose an MBA student—Eileen Payne—takes a course and pays $2,000 for tuition and
$200 for books. The money cost of the course is $2,200, but that figure does not include
the implicit costs to the student. To take a course, Eileen must attend class for about 45
hours and may have to spend twice that much time traveling to and from class,
completing class assignments, and studying for examinations. The total number of hours
spent on any one course, then, might be 135 (30 hours in class plus 105 hours of
traveling, studying, and so forth).
The student could have spent that time doing other things, including working for a
money wage. If Eileen’s time is valued at $25 per hour (the wage she might have
received if working), the time cost of the course is $3,375 (135 hours x $6). Moreover, if
she experiences some anxiety because of taking the course, that psychic or risk cost must
be added to the total as well. If Eileen would be willing to pay $500 to avoid the anxiety,
the total implicit cost of taking the course climbs to $820.
Explicit costs
Tuition $2,000
Books 200
Total explicit cost $2,200
Implicit costs
Time $3,375
Anxiety 500
Total implicit cost $3,875
Total costs of course $6,075
Chapter 9 Production Costs and
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The opportunity cost of the student’s time represents the largest component of the
total cost of the course. The value of one’s time varies from person to person. For
students who are unable to find work, the time costs of taking a course may be quite
small. That is why many young people go to college. Their time cost is generally lower
than that of experienced workers who must give up the opportunity to earn a good wage
in order to attend classes full time.
The Cost of Bargains
Every Wednesday, supermarkets run large newspaper ads listing their weekly specials.
Generally only a few items are offered at especially low prices, for store managers know
that most bargain seekers can be attracted to the store with just a few carefully selected
specials. Once the customer has gone to the store offering a special on steak, he would
have to incur a travel cost in order to buy other items in a different store. Even though
peanut butter may be on sale elsewhere, the sum of the sale price and the travel cost
exceed the regular price in the first store. Through attractive displays and packaging,
customers can be persuaded to buy many other goods not on sale, particularly toiletries,
which tend to bear high markups.
Supermarket chains do not necessarily make huge profits. The grocery industry is
reasonably competitive, and supermarket chains as a group are not highly profitable
compared to other corporations. The stores manage to recoup some of the revenues lost
on sale items by charging higher prices on other goods. In other words, the cost of a
bargain on sirloin steak may be a high price for toothpaste.
PERSPECTIVE: Why “Sunk Costs” Don’t Matter
A
sunk cost is a past cost. Economists define past costs as historical costs that cannot be altered by
current decisions. Such costs are beyond the realm of choice. Will a rational, profit-maximizing
business firm base its current decisions on its historical costs?
An example can help to answer this question. Suppose an oil exploration firm purchases the mineral
rights to a particular piece of property for $1 million. After several month of drilling, the firm
concludes that the land contains no oil (or other valuable mineral resources). Will the firm reason that,
having spent $1 million for the mineral rights, it should continue to look for oil on the land? If the
chances of finding oil are nonexistent, the rational firm will cease drilling on the land and try
somewhere else. The $1 million is a sunk cost that will not influence the decision to continue or cease
exploration. Indeed, the firm may begin drilling on land for which it paid far less for mineral rights, if
management believes that the chances of finding oil are higher there than on the $1 million property.
The underlying reason that sunk costs do not matter to current production decisions is that in the
economist’s use of the term, sunk costs are not really costs. The opportunity cost of an activity is the
value of the best alternative not chosen. In the case of an historical cost, however, there are no longer
any alternatives. Although the oil exploration firm at one time could have chosen an alternative way to
spend the $1 million, once the choice was made the alternative ceased to be available. Nor can the firm
resell the mineral rights for $1 million; those rights are now worth far less because of accumulated
evidence that the land contains little or no valuable minerals. Sunk costs, however painful the memory
of them might be, are gone and best forgotten by the firm. Profits are made by looking forward, not
backward.
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Some shoppers make the rounds of the grocery stores when sales are announced.
For such people, time and transportation are cheap. A person who values his or her time
at $10 an hour is not going to spend an hour trying to save a dollar or two. The cost of
gas alone can make it prohibitively expensive to visit several stores. Because of the costs
of acquiring information, many shoppers do not even bother to look for sales. The
expected benefits are simply not great enough to justify the information cost. These
shoppers enter the market “rationally ignorant.”
Marginal Cost
So far we have been considering cost as the determining factor in the decision to
undertake a particular course of action. The rational person weight the cost of an action
against it benefits and comes to a decision: whether to invest in an education, to shop
around for a bargain, or to operate an airplane. The question is, how much of a given
good or service will an individual choose to produce or consume? How does cost limit a
behavior once a person has decided to engage in it? The answer lies in the concept of
marginal cost.
Rational Behavior and Marginal Cost
Marginal cost is the additional cost incurred by producing one additional unit of a good,
activity, or service. Marginal cost is the cost incurred by reading one additional page,
making one additional friend, giving one additional gift, or going one additional mile.
Depending on the good, activity, or service in question, marginal cost may stay the same
or vary as additional units are produced. For example, imagine that Jan smith wants to
give Halloween candy to ten of her friends. In a sense, Jan is producing gifts by
procuring bags of candy. If she can buy as many bags as she wants at a unit price of fifty
cents, the marginal cost of each additional unit she buys is the same, fifty cents. The
marginal cost is constant over the range of production.
Marginal cost can vary with the level of output, however, for two reasons. The
first has to do with the opportunity cost of time. Suppose Jan wants to give each friend a
miniature watercolor, which she will paint herself over the course of the day. To make
time for painting, Jan can forgo any of the various activities that usually make up her day.
She may choose to give up recreational activities, housekeeping chores, or time spent on
work or study.
If she behaves rationally, she will give up the activities she values least. To do
the first painting, she may forgo straightening up her room—an activity that is low on
most people’s lists of preferences. The marginal cost of her first watercolor is therefore a
messy room. To paint the second watercolor, Jan will give up the more next-to-last item
on her list of favorite activities. As she produces more and more paintings, Jan will forgo
more and more valuable alternatives. In other words, the marginal cost of her paintings
will rise with her output.
If the marginal cost of each new painting is plotted against the quantity of
paintings produced, a curve like the one in Figure 9.1 will result. Because the marginal
Chapter 9 Production Costs and
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5
cost of each additional painting is higher than the marginal cost of the last one, the curve
slopes upward to the right.
Although the marginal cost curve is generally assumed to slope upward, as the
one in Figure 9.1 does, that need not be the case. If Jan placed equal value on all the
forgone activities, her marginal cost would be constant and the marginal cost curve would
be horizontal.
FIGURE 9.1 Rising Marginal Cost
To produce each new watercolor, Jan must
give up an opportunity more valuable than
the last. Thus the marginal cost of her
paintings rises with each new work.
__________________________________
The Law of Diminishing Returns
The second reason marginal cost may vary with output involves a technological
relationship known as the law of diminishing marginal returns. According to the law
of diminishing marginal returns, as more and more units of one resource labor,
fertilizer, or any other resource are applied to a fixed quantity of another resource
land, for instance the increase in total added output gained from each additional unit of
the variable resource will eventually begin to diminish. In other words, beyond some
point less output is received for each added unit of a resource. That is, more of the
resource will be required to produce the same amount of output as before. Beyond some
point, the marginal cost of additional units of output rises.
Although the law of diminishing returns applies to any production process, its
meaning is most easily grasped in the context of agricultural production. Assume you are
producing tomatoes. You have a fixed amount of land (an acre) but can vary the quantity
of labor you apply to it. If you try to do planting all by yourself dig the holes, pour the
water, insert the plants, and core them up you will waste time changing tools. If a
friend helps you, you can divide the tasks and specialize. Less time will be wasted in
changing tools.
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The time you would have spent changing tools can be spent planting more
tomatoes, thus increasing the harvest. At first, output may expand faster than the labor
force. That is, one laborer may be able to plant 100 tomatoes an hour; two working
together may be able to plant 250 an hour. Thus the marginal cost of planting the
additional 150 plants is lower than the cost of the first 100. Up to a point, the more
workers, the greater their efficiency, and the lower the marginal cost—all because of the
economies of specialization. At some point, however, the addition of still more laborers
will not contribute as much to production as in the past, if only because a large number of
workers on a single acre of ground will start bumping into one another. Then the
marginal cost of putting plants into the ground will begin to rise.
Diminishing returns are an inescapable fact of life. If returns did not diminish at
some point, output would expand indefinitely and the world’s food supply could be
grown on just one acre of land (For that matter, it could be grown in a flower box.) The
point at which output begins to diminish varies from one production process to the next,
but eventually all marginal cost curves will slope upward to the right, as in Figure 9.1.
Table 9.1 shows the marginal cost of producing tomatoes with various numbers of
workers, assuming that each worker is paid $5 and that production is limited to one acre.
Working alone, one worker can produce a quarter of a bushel; two can produce a full
bushel (columns 1 and 2). The third column shows the amount each additional worker
adds to total production, called the marginal product. Marginal product is the increase
in total output that results when one additional unit of a resource—for example, labor,
fertilizer, and land is added to the production process, everything else held constant.
The first worker contributed 0.25 (one quarter) of a bushel; the second worker, an
additional 0.75 of a bushel, and so on. These are the marginal products of successive
units of labor.
The important information is shown in the last two columns of the table.
Although two workers are needed to produce the first bushel (column 4), because of the
efficiencies of specialization, only one additional worker is needed to produce the second.
Beyond that point, however, returns diminish. Each additional worker contributes less,
so that two more workers are needed to produce the third bushel and give more to
produce the fourth. If the table were extended, each bushel beyond the fourth would
require a progressively larger number of workers.
Column 5 shows that if all workers are paid the same wage, $5, the marginal cost
of a bushel of tomatoes will decline from $10 for the first bushel to $5 for the second
before rising to $10 again for the third bushel. That is, increasing marginal costs (or
diminishing returns) emerge after the addition of the third worker.
If the marginal cost of each bushel (column 5) is plotted against the number of
bushels harvested, a curve like the one in Figure 9.2 will result. Although the curve
slopes downward at first, for most purposes the relevant segment of the curve is the
upward-sloping portion above point a, will be explained in detail later).
. bushel of tomatoes will decline from $10 for the first bushel to $5 for the second
before rising to $10 again for the third bushel. That is, increasing. ballpoint pens falls, will the demand for ballpoint pens change? What
will happen to the demand for pencils? To the demand for paper?
8. If a nation appreciates