Gordon Moore, cofounder of Intel, predicted in the early 1970's that the density of transistors in microprocessors would double every 18 months (a revision of his 1965 prediction of doubling every two years.) This prediction has proved amazingly accurate over the past 25 years, and is now known as Moore's law.
A microprocessor starts as a piece of silicon. The silicon is polished and a layer of photoresistive chemicals is applied. A photograph of the required circuits is shined onto the photoresistive layer - this works like a photographic film. The photoresist hardens in the exposed areas. Then hot gases are used to etch away the soft areas where the circuits belong. This process can be repeated through many layers, creating transistors and circuits in the finished chip.
The manufacturing process is highly automated - many steps involve robots. A single 8 inch wafer (a thin disk) can contain several hundred microprocessors. The individual microprocessors are tested by a robot using tiny electrical probes. Defective processors are marked and discarded.
Some chips are rated at various speeds - for example, Pentium CPUs. Commonly a variety of speeds come off the same fabrication line. The final chips are tested and marked with the highest speed which they will support. Then the best chips, which can run at a higher speed, are sold at a higher price. The rest are sold cheaper, and guaranteed for a slower speed.
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By squeezing more transistors into a smaller space, a microprocessor can be produced which does more work in less time (more powerful). It also allows one chip to perform more functions - what used to require several chips can all fit into one chip. For example, the 486 was the first CPU to combine the Arithmetic-Logic-Unit (ALU) and Floating-Point-Unit (FPU) together in a single chip. A Pentium chip now contains an ALU, FPU, and Cache Memory all on one chip. This simplifies the design of the motherboard as there are fewer chips to connect, as well as considerably speeding up processing because there is less data moving around on the motherboard. So the resulting computer is both cheaper and faster.
Squeezing more transistors onto a single chip requires new technologies - smaller circuits require more precise manufacturing techniques. At first, this increases the cost for the new chips. However, once the research and development costs have been recovered by the first few million sales, further manufacturing ususally reduces cost to the same level as earlier models, so in the long run the consumer gets more power for the same price.
A further problem is heat. Transistors use energy and produce heat - more transistors means more heat. Pentium chips produce as much heat as a small light bulb. This heat must be removed by cooling fans - otherwise the chip will expand as it heats up and contract when it cools down. This eventually causes the tiny circuits to crack, which destroys the chip.
Several enabling technologies will make it possible to continue increasing transistor density:
smaller circuits require shorter wavelength light to be used to etch the circuits
lower voltage reduces heat production
different materials may help (e.g. copper instead of aluminum for circuits)
multi-layer chips may give way to true 3-dimensional designs (an exotic possibility)
However, every change in materials and technologies has at least two disadvantages: (1) new technology may be incompatible with older technology; (2) new technology is initially more expensive than the old technology.
It appears that Moore's Law will continue to hold true for at least the next 10-15 years, continuing to fuel rapid change in the computer industry. Noone can hope to make accurate predictions beyond that time. However, the computer industry must attempt to make 5-10 year predictions, as new products takes several years to design and put into production. A company cannot afford to throw away money designing a product which will be obsolete before it goes into production.