In Section 1, we identified how producers

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1 Costs of Production Objectives You may wish to call students attention to the objectives in the Section Preview. The objectives are reflected in the main headings of the section. Bellringer Ask students to think about fast-food restaurants. Ask: How do the owners of these restaurants know how much food to produce each day? What would happen to the owner s profits if the restaurant produced too much or too little food? Then explain that in this section students will learn how producers of goods and services determine ideal levels of output. Vocabulary Builder Have students read the section to discover the meaning of each key term. Then ask them to write definitions of the terms in their own words. Lesson Plan Teaching the Main Concepts L. Focus Explain that marginal s and returns are the key factors in any company s decision about how much of a good or service to produce.. Instruct Begin by discussing the effects of labor on output, stressing the causes of increasing and diminishing marginal returns. Next, introduce the concepts of fixed and variable s, explaining how they combine to determine total and how total is used to determine marginal. Then, discuss how profit is calculated and how it leads to the determination of ideal output. Finally, explain how a firm decides to shut down an unprofitable business.. Close/Reteach Remind students that ideal output is determined by maximizing the use of labor and capital and calculating the production level at which marginal revenue equals marginal. Have students define marginal revenue and marginal s and explain how they are calculated. Preview Objectives After studying this section you will be able to:. Explain how firms decide how much labor to hire to produce a certain level of output.. Analyze the production s of a firm.. Understand how a firm chooses to set output.. Explain how a firm decides to shut down an unprofitable business. marginal product of labor the change in output from hiring one additional unit of labor The supply of beanbag chairs in the market depends on several factors, including the of labor and capital. K E Y U B D L I In Section, we identified how producers respond to a change in price. The law of supply states that producers will offer more goods as the price goes up and fewer as the price falls. In this section, we will explain how a supplier decides how much to produce. Consider a firm that produces beanbags. The firm s factory has one sewing machine and one pair of scissors. The firm s inputs are workers and materials, including cloth, thread, and beans. Assume that each beanbag requires the same amount of materials. As the number of workers increases, what happens to the quantity of beanbags produced? G N I CONCE P T S Incentives To build understanding of the concept of incentives and the s of production, have students complete a tree map graphic organizer like the one shown below. Tell them to put the title of the section in the top box and the main headings of the section in the next row of boxes. In the boxes beneath each heading, they should record main ideas and supporting details. Costs of Production Section Focus Entrepreneurs consider marginal benefits and s when deciding how much output to produce. Ordinarily, firms earn their highest profits when the of making one more unit is the same as the market price of the good. Graphing the Main Idea Labor and Output Key Terms marginal product of labor increasing marginal returns diminishing marginal returns fixed variable total marginal marginal revenue operating One of the basic questions any business owner has to answer is how many workers to hire. To answer this question, owners have to consider how the number of workers they hire will affect their total production. For example, at the beanbag factory, one worker can produce four beanbags per hour. Two workers can make a total of ten bags per hour, and three can make a total of seventeen beanbags an hour. As new workers join the company, total output increases. After the seventh worker is hired, production peaks at beanbags per hour. When the firm hires the eighth worker, however, total output drops to bags per hour. Figure. shows the relationship between labor, measured by the number of workers in the factory, and the number of beanbags produced. Product of Labor The third column of Figure. shows the marginal product of labor, or the change in output from hiring one more worker. This is called the marginal product because it measures the change in output at the margin, where the last worker has been hired or fired. Section Reading Support Transparencies A template and the answers for this graphic organizer can be found in Chapter, Section of the Section Reading Support Transparency System.

2 The first worker to be hired produces four bags an hour, so her marginal product is four bags. The second worker raises total output from four bags an hour to ten, so her marginal product of labor is six. Looking at this column, we see that the marginal product of labor increases for the first three workers, rising from four to seven. Increasing Returns The marginal product of labor increases for the first three workers because there are three tasks involved in making a beanbag. Workers cut and sew cloth into the correct shape, stuff it with beans, and sew the bag closed. In our example, a single worker performing all these tasks would only produce four bags per hour. Adding a second worker would allow each worker to specialize in one or two tasks. If each worker focuses on only one part of the process, she will waste less time switching between tasks and will become more skillful at her assigned tasks. In other words, specialization increases output per worker, so the second worker adds more to output than the first. The firm enjoys increasing marginal returns. In our example, there are benefits from specialization for the first three workers. The firm enjoys a rising marginal product of labor for the first three workers. Diminishing Returns When the fourth through the seventh workers are hired, the marginal product of labor is still positive. Each new worker still adds to total output. However, the marginal product of labor shrinks as each worker joins the company. The fourth worker increases output by six bags, while the seventh increases output by only one bag. Why? After the beanbag firm hires its first three workers, one for each task, the benefits of specialization end. At that point, adding more workers increases total output, but at a decreasing rate. This situation is known as diminishing marginal returns. A firm with diminishing marginal returns of labor will Figure. Product of Labor Labor (number of workers) Output (beanbags per hour) product of labor - produce less and less output from each additional unit of labor added to the mix. The firm suffers from diminishing marginal returns from labor because its workers must work with a limited amount of capital. Remember that capital is any human-made resource that is used to produce other goods. In this example, capital is represented by the factory s single sewing machine and pair of scissors. When there are three workers, but only one needs to use the sewing machine, this worker will never have to wait to get to Figure. Increasing, Diminishing, and Negative Returns product of labor (beanbags per hour) Increasing marginal returns Diminishing marginal returns Negative marginal returns 9 Labor (number of workers) The marginal product of labor is the increase in output added by the last unit of labor. Specialization Why does the marginal product of labor decrease with more than four workers in this example? increasing marginal returns a level of production in which the marginal product of labor increases as the number of workers increases diminishing marginal returns a level of production in which the marginal product of labor decreases as the number of workers increases Labor has increasing and then diminishing marginal returns. Opportunity Cost What is the marginal product of labor when the factory currently employs five workers? Chapter Guided Reading and Review Unit folder, p. asks students to identify the main ideas of the section and to define or identify key terms. L To help students transfer information from one medium to another (statistical to written), ask students to use the graphics on this page to explain how firms decide how much labor to hire. Tell them to write one or more paragraphs and to refer to both of the figures on this page. L Pair each student with a peer tutor who is a native English speaker. Encourage these student pairs to sit together in class so that comprehension difficulties can be addressed quickly. Suggest that each pair meet for a few minutes every day to discuss any key terms or concepts that need clarification. ELL $ Econ : Key Concepts Made Easy Opportunity Cost Some students may have difficulty grasping the concept of something that is marginal. Explain that in economic terms, marginal simply means additional. Display the following list, and encourage students to copy it into their Economics Journals: marginal product of labor = output change from hiring one additional worker marginal = the additional of producing one additional unit marginal revenue = the additional revenue from producing one additional unit Building Key Concepts It decreases because the workers are working with a limited amount of capital. Building Key Concepts Five beanbags per hour. 9

3 Background Corporate Downsizing Workers used to assume that if they were doing a good job for a growing, profitable company, their jobs were secure. During the 99s, however, hundreds of thousands of such workers discovered just how insecure their jobs really were when they unexpectedly found themselves victims of a corporate trend downsizing. When a company downsizes, it lays off a percentage of its workers. Why would growing, profitable companies put loyal employees through such pain? Blame it on diminishing marginal returns. In today s highly competitive marketplace the companies that thrive are lean, tightly focused, and extremely conscious. During the early 99s, such diverse companies as IBM, General Motors, Boeing, and Eastman Kodak looked at their corporate structures and saw inefficient organizations that would lose their competitive edge if they didn t shape up. As a result, employees had to go:, at IBM;, at General Motors;, at Boeing; and, at Eastman Kodak all between 99 and 99. According to some economists, those jobs are lost forever. That s why it is important for companies to pay close attention to hiring levels and what they will gain from their investment. Careful planning today can prevent unnecessary pain tomorrow. Transparency Resource Package Economics Concepts, D: Increasing, Diminishing, and Negative Returns work. When there are more FAST FACT than three workers, the To understand the diminishing factory will assign more than marginal returns of capital, consider one to work at the sewing an Internet service provider that machine. While one is mailed millions of free copies of its software on compact discs. The first working, the other will have discs sent out got customers to wait. She may be able to interested in the product and help cut fabric or stuff bags provided a good return on in the meantime, but every investment. After consumers received several additional discs, bag must be sewn up at some however, the discs no longer caught point, so she cannot greatly their attention and more often than increase the speed of the not ended up in the trash. production process. The problem gets worse as more workers are hired and the amount of capital remains constant. Wasted time waiting for the sewing machine or scissors means that additional Figure. Fixed and Fixed Cost Manager: Some workers are essential to the founding and running of a company and will keep their jobs even if the company closes temporarily. Goods: Companies buy most goods only when they need them. workers will add less and less to total output at the factory. Negative Returns As the table in Figure. shows, adding the eighth worker at the beanbag factory can actually decrease output by one bag. At this stage, workers get in each other s way and disrupt the production process, so overall output decreases. Of course, few companies ever hire so many workers that their marginal product of labor becomes negative. Production Costs Paying workers and purchasing capital are all s of producing goods. Economists Electricity: Lights and other equipment are turned off when the store is closed. Part-time Salesman: In busy times, companies hire workers on shortterm contracts and let them go when they're no longer needed. Fixed Cost Rent: A firm must rent or buy space before it opens for business. Firms must separate fixed s from variable s to determine whether or not to produce at a given market price. Entrepreneurs Why are some employees considered variable s? Block Scheduling Strategies Photo Caption Part-time workers are variable s because they can be asked to work more or fewer hours. Consider these suggestions to take advantage of extended class time: Show the Economics Video Library segment Plummeting Prices, about the lowering of prices for personal computers. After they view the segment, have students create graphs that illustrate the trends over the last two decades. Have students use the Internet to learn more about fixed and variable s. Links with activities can be found within Economics: Principles in Action in the Social Studies area of the Prentice Hall Web site.

4 Figure.9 Production Costs Chapter Beanbags (per hour) 9 Fixed $ Variable $ Total (fixed + variable ) $ 99 9 $ 9 9 revenue (market price) $ Total revenue $ 9 9 Profit (total revenue total ) $ Firms consider a variety of s when deciding how much to produce. Markets and Prices Why is the marginal revenue always equal to $? L (Enrichment) Remind students about the human of downsizing. (You may wish to read them the Background note on p..) Ask them to consider what financial or ethical obligations, if any, employers have to employees who get caught in the corporate numbers game and lose their jobs. Have students write an essay that either (a) makes a convincing argument that companies do not have this obligation, or (b) describes steps that employers could take to help downsized workers get their lives and careers back on track. divide a producer s s into two categories: fixed s and variable s. Fixed Costs A fixed is a that does not change, no matter how much of a good is produced. Most fixed s involve the production facility, the of building and equipping a factory, office, store, or restaurant. Examples of fixed s include rent, machinery repairs, property taxes on a factory, and the salaries of workers who keep the business running even when production temporarily stops. s Variable s are s that rise or fall depending on the quantity produced. They include the s of raw materials and some labor. For example, to produce more beanbags, the firm must purchase more beans and hire more workers to stuff the beanbags. If the company wants to produce less and cut s, it can stop buying beans or have some workers work fewer hours a week. The of labor is a variable because it changes with the number of workers, which changes with the quantity produced. Electricity and heating bills are also variable s, because the company can cut off heat and electricity for the factory and its machines when they are not in use. Total Cost Figure.9 shows some data for the firm that produces beanbags. The firm has a factory that is fully equipped to produce beanbags. How does the of producing beanbags change as the output increases? In our example, the fixed s are the s of the factory building and all the machinery and equipment inside. As shown in the second column in Figure.9, the fixed s are $. per hour. Variable s include the of beans, fabric, and most of the workers hired to produce the beanbags. As shown in the third column, variable s rise with the number of beanbags produced. Fixed s and variable s are added together to find total. Total is shown in the fourth column. Cost If we know the total at several levels of output, we can determine the marginal of production at each level. is the additional of producing one more unit. As shown in Figure.9, even if the firm is not producing a single beanbag, it still fixed a that does not change, no matter how much of a good is produced variable a that rises or falls depending on how much is produced total fixed s plus variable s marginal the of producing one more unit of a good L In order to reinforce understanding of how firms make decisions, have students imagine that they have just started their own businesses to produce greeting cards. How will they decide how many employees to hire? What are their fixed and variable s? Ask students to write a brief proposal that addresses both of these questions. Transparency Resource Package Economics Concepts, E: Fixed Versus s Meeting NCEE Standards Use the following benchmark activity from the Voluntary National Content Standards in Economics to evaluate student understanding of Standard. Analyze the impact (on consumers, producers, workers, savers, and investors) of an increase in the minimum wage, a new tax policy, or a change in interest rates. Preparing for Standardized Tests Have students read the sections titled Fixed Costs and s and then answer the question below. All of the following are examples of variable s except A rent. B electricity. C labor. D heat. Building Key Concepts The marginal revenue equals the market price.

5 L You may wish to have students add the following to their portfolios. To help students create a product on a contemporary economic topic using critical methods of inquiry, ask them to assume that they are business consultants who have been asked to analyze the production s of a firm. The problem is that total s have begun to exceed total revenues. Facts about the company follow. Ask students to write a proposal that suggests ways for the company to cut s and increase revenues. Company: MGQQ Solutions Product: Customized computer programs for small businesses Location: Beverly Hills, California; in newly constructed office complex Employees: owner, receptionist, file clerk, secretary, programmers, accountants Clients: regular, occasional GT Economics Assessment Rubric Economics Assessment Rubrics folder, pp. provides sample evaluation materials for a writing assignment. L Ask students to use the graphics on pp. and to explain how firms make output decisions. You might also display Transparency F and have students use it to demonstrate understanding of these concepts. Transparency Resource Package Economics Concepts, F: Setting Output marginal revenue the additional income from selling one more unit of a good; sometimes equal to price must pay $. an hour for fixed s. If the firm decides to produce just one beanbag an hour, its total rises $. from $. to $. an hour. The marginal of the first beanbag is $.. For the first three beanbags, the marginal falls as output increases. The marginal of the second beanbag is $., and the marginal of the third beanbag is $.. Each additional beanbag is cheaper to make because of increasing marginal returns resulting from specialization. With the fourth beanbag, the marginal starts to rise. The marginal of the fifth per hour is $., the sixth s $9., and the seventh, $.. The rising marginal reflects diminishing returns to labor. The benefits of specialization are exhausted at three beanbags per hour, and diminishing returns set in as more and more workers share a fixed production facility. Setting Output Behind all of the decisions about how many workers to hire is the firm s basic goal: to maximize profits. Profit is defined as total revenue minus total. As you Figure. Cost Curve (in dollars) 9 Output (beanbags per hour) For most firms, the marginal of production falls as output rises from zero, but eventually begins to rise. Markets and Prices How many beanbags an hour should this firm make to produce at the lowest possible marginal? read in Chapter, a firm s total revenue is the money the firm gets by selling its product. Total revenue is equal to the price of each good multiplied by the number of goods sold. Figure.9 shows total revenue when the price of a beanbag is $.. To find the level of output with the highest profit, we look for the biggest gap between total revenue and total. The gap is biggest and profit is highest when the firm makes 9 or beanbags per hour. At this rate, the firm can expect to make a profit of $9. an hour. Revenue and Cost Another way to find the best level of output is to find the output level where marginal revenue is equal to marginal. revenue is the additional income from selling one more unit of a good. If the firm has no control over the market price, marginal revenue equals the market price. Each beanbag sold at $. increases the firm s total revenue by $., so marginal revenue is $.. According to the table, price equals marginal with beanbags, so that s the quantity that maximizes profit at $9 an hour. To understand how an output of beanbags maximizes the firm s profits, suppose that the firm picked a different level of output. If the firm made only beanbags per hour, is it making as much money as it can? From Figure.9, we know that the marginal of the fifth beanbag is $.. The market price for a beanbag is $., so the marginal revenue from that beanbag is $.. The $. difference between the marginal revenue and marginal represents pure profit for the company from making and selling the fifth beanbag. The company should increase its production to five beanbags an hour to capture that profit on the fifth beanbag. If we do the same calculations for a sixth beanbag, we find that the company can capture a profit of $. by producing the sixth beanbag per hour. The price of the seventh beanbag is $. higher than its marginal, so that beanbag earns an Interdisciplinary Connections: Dramatic Arts Building Key Concepts Three beanbags per hour. Production Costs When the Drama Club gets ready to stage a new play, it must deal with many of the same production s as a business. On opening night the actors, director, ume designers, musicians, lighting crew, and set builders will present their product to consumers and hope to make a profit. Making the Connection Ask students to list the fixed and variable s for the production of a musical. Then ask how the Drama Club can decide what to charge for each ticket so that they will make a profit.

6 additional $. in profit for the company. The profit is available any time the company receives more for the last beanbag than it to produce. Any rational entrepreneur would take this opportunity to increase profit. Now suppose that the firm is producing so many beanbags an hour that marginal is higher than price. If the firm produces eleven beanbags an hour, it receives $. for that eleventh beanbag, but the $. of that beanbag wipes out the profit. The firm actually loses $. on the sale of the eleventh beanbag. Because marginal is increasing, and price is constant in this example, the losses would get worse at higher levels of output. The company would be better off producing less and keeping s down. The ideal level of output is where marginal revenue (price) is equal to marginal. Any other quantity of output would generate less profit. Responding to Price Changes What would happen if the price of a beanbag rose from $. to $.? Thinking at the margin, we would predict that the firm would increase production to twelve beanbags per hour. That s the quantity at which the marginal is equal to the new, higher price. At the original price of $., the firm would not produce more than ten beanbags, according to Figure.. When the price rises to $., marginal revenue soars above marginal at that output level. Raising production to twelve beanbags an hour would allow the firm to capture profits on the eleventh and twelfth beanbags. This example shows the law of supply in action. An increase in price from $. to $. causes the firm to increase the quantity supplied from ten to twelve beanbags an hour. The Shutdown Decision Consider the problems faced by a factory that is losing money. The factory is producing at a level of output at which Figure. Output and a Change in Price Preparing for Standardized Tests Have students read the section titled Setting Output and then answer the question below. Which of the following best describes the ideal level of output? A revenue is more than marginal. B revenue is more than total. C revenue is equal to marginal. D revenue is less than total. Cost (per beanbag) $ $ New price Original price Output (beanbags per hour) The most profitable level of output is where price (or marginal revenue) is equal to marginal. Markets and Prices What would happen to output if the market price fell to $? marginal revenue is equal to marginal. As you have read, this is the most profitable level of output. However, the market price is so low that the factory s total revenue is still less than its total, and the firm is losing money. Should this factory continue to produce goods and lose money, or should its owners shut the factory down? This may seem like a silly question. In fact, there are times when keeping a money-losing factory open is the best choice. The firm should keep the factory open if the total revenue from the goods and services the factory produces is greater than the of keeping it open. For example, if the price of beanbags drops to $, and the factory produces at the profit-maximizing level of five beanbags per hour, the total revenue of the business is $ per hour. Weigh this against the factory s operating, or the of operating the facility. The operating includes the variable s the owners must pay to keep the factory running, but not the fixed s, which the owners must pay whether the factory is open or closed. According to Figure.9, if the factory produces five beanbags, the variable is $ per hour. Therefore, the benefit of operating the facility (total revenue of $) operating the of operating a facility, such as a store or factory Chapter Background Profits and More Profits In the world of business, the term profit has a straightforward definition: The excess of total revenue over total. Economists, however, classify profits in varying ways. Let s say that Mr. Denson discovers a new technique for manufacturing snowboards that enables him to produce them for much less than the market price. His excess total revenues are known as entrepreneurial profits. Suppose that there is a sudden huge increase in the number of people who want to take up snowboarding. Mr. Denson s excess total revenues are called windfall profits. Mr. Denson knows that increased interest in snowboarding will mean increased competition, and that could hurt his profits. Therefore, he gets together with his biggest competitor, and the two agree to restrict their output so that demand will outstrip supply; thus, prices and profits will remain high. Now Mr. Denson s excess total revenues have a new name: monopoly profits. L (Reteaching) Ask students to explain what goes into a firm s decision to shut down an unprofitable business. Learning Styles Activity Learning Styles Lesson Plans folder, p. asks students to build a production s table and use it to determine the most profitable level of output for a hypothetical sweatshirt producer. Building Key Concepts Output of beanbags would decrease.

7 GTE Guide to the Essentials Chapter, Section, p. provides support for students who need additional review of the section content. Spanish support is available in the Spanish edition of the guide on p.. Quiz Unit folder, p. includes questions to check students understanding of Section content. Presentation Pro CD-ROM Quiz provides multiple-choice questions to check students understanding of Section content. Answers to... Section Assessment. The marginal product of labor increases up to a point and then decreases as still more workers are hired.. Diminishing marginal returns will probably have a negative effect on labor: As the firm experiences less new output per worker, fewer new workers will be hired, and some may be let go.. Examples of fixed s may include the building rent or mortgage or the property taxes. Variable s include the prices of the wheat, yeast, and milk used to produce baked goods.. is calculated by finding out how much additional results from each additional unit produced. For example, in the duffel bag example, the marginal of the first duffel bag was $. because total rose from $. to $. with the production of one bag.. The smaller factory will experience diminishing returns first because it most likely has half as much capital for workers to use to produce goods.. Student answers should include reasonable explanations for their decisions. (a) variable (b) variable (c) variable (d) fixed (e) variable. (a) $ (b) $ (c) When a factory begins losing money, the owner must consider its operating and revenue when deciding what to do. Section Assessment is greater than the variable ($), so it makes sense to keep the facility running. Consider the effects of the other choice. If the firm were to shut down the factory, it would still have to pay all of its fixed s. The factory s total revenue would be zero because it would be producing nothing for Key Terms and Main Ideas. How does the marginal product of labor change as more workers are hired?. What is the impact of diminishing marginal returns on labor?. Give an example of a fixed and a variable of a bakery.. How does a firm calculate marginal? Applying Economic Concepts. Critical Thinking A firm has two factories, one twice as large as the second. As the number of workers at each factory increases, which factory will experience diminishing returns first?. Decision Making Explain whether each of these expenses of a textile mill is a fixed or a variable, and why. (a) repairs to a leaking roof (b) cotton (c) food for the mill s cafeteria (d) night security guard (e) electricity sale. Therefore, the firm would lose an amount of money equal to its fixed s. For this beanbag factory, the fixed s equal $ per hour, so the factory would lose $ for each hour it is closed. If the factory were to keep producing five beanbags per hour, its total would be $ ($ in fixed s plus $ in variable s) per hour, but it would lose only $ ($ in total minus $ in revenue) for each hour it is open. The factory would lose less money while producing because the total revenue ($) would exceed the variable s ($), leaving $ to cover some of the fixed s. Although the factory would lose money in either situation, it would lose less money by continuing to produce and sell beanbags. How long will a business continue to operate a factory at a loss before it decides to replace the facility? The firm will build a new factory and stay in the market only if the market price of beanbags is high enough to cover all the s of production, including the of building a new factory. Progress Monitoring Online For: Self-quiz with vocabulary practice Web Code: mna-. Math Practice Use the table below to answer the following questions. (a) What is the total when output is? (b) What is the marginal of the third unit? (c) How much should this firm produce if the market price is $? Output Fixed Cost $ $ $ $ $ $ $ $ $9 $ PHSchool.com For: Simulation Activity Visit: PHSchool.com Web Code: mnd- Progress Monitoring Online For additional assessment, have students access Progress Monitoring Online at Web Code: mna- Typing in the Web Code when prompted will bring students directly to detailed instructions for this activity.