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MSci 607: Applied economics for management

Managerial Economics and Strategy (2017) by Perloff and Brander


Lecture 02 (Production and cost) Solutions

Chapter 5
1.2. The production function shows the maximum amount of output that can be produced from
given levels of labor and capital because the production function includes only efficient
production processes. A firm engages in efficient production if it cannot produce its current level
of output with fewer inputs, given existing knowledge about technology and the organization of
production. The combination q = 10, L = 3, and K = 6 cannot be a point on the production
function with point q = 10, L = 3, and K = 5 because it would not be efficient.

2.2. After the sixth unit, marginal product of labor falls to zero. Total product remains at six
units, and average product of labor falls after the sixth unit.

0.75 0.25
2.3. The production function is q  L K .
APL  q / L  L0.25 K 0.25   K / L 
0.25
.
a.

b.
MPL  dq /dL  3
4  K / L  0.25 .
c. The marginal product curve intersects the average product at the maximum of the average
product curve. If the marginal product exceeds the average product, the average product curve
must be rising. If marginal product is less than average product, the marginal product curve must
be falling.

2.4.
a. No diminishing marginal returns to labor. With K fixed at any level, marginal product of labor
is constant at 10.

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b. Diminishing marginal returns to labor. With capital fixed at two units, the production function
becomes Q = 1.414L1/2. Marginal product of labor, calculated using the derivative formula, is
MPL = 0.707L1/2, which decreases as L is increased.

3.5. a. The isoquants are right angles as the firm must have one disk and one hour of recording
time (capital) to make a recording. Increasing one input without increasing the other results in no
increase in output.
b. The MRTS is 0 along the horizontal portion of an isoquant and is negative infinity along the
vertical portion. It is undefined at the corner point.
c. If labor is less than capital, then the total product curve is increasing in the labor input up to
point where labor equals capital, after which it is constant. The average product of labor is
positive and constant if labor is less than capital and declining if labor exceeds capital. The
marginal product of labor is one if labor is less than capital and drops to zero if labor exceeds or
equals capital.

3.6. a. See figure.

b. See figure. Assume the number of copy machines K is fixed at 1. Then production function is
Q = 1000 * min(L, 3). For L  = 3, Q = 1000L; for L  3, Q = 3000.

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3.8. The isoquants are straight lines. The marginal product of B is one. If we put B on vertical
axis, the MRTS (the slope of the isoquant) is –½.

4.2. This production function is a Cobb-Douglas. Even though it has three inputs instead of two,
the same logic applies. Thus we can calculate the returns to scale as the sum of the exponents: 
= 0.27 + 0.16 + 0.61 = 1.04. Thus it has (nearly) constant returns to scale. The marginal product
of material is q/M = 0.61L0.27K0.16M–0.39 = 0.61q/M.

4.3. a. This production always displays constant return to scale.


b. This production function has decreasing, constant, or increasing returns to scale as    is
less than, equal to, or greater than 1.

4.8. The first worker increases output by 25 and the second by 10. That is, the marginal
productivity of the first worker is 25, and the marginal productivity of the second worker is 10.
This is an illustration of diminishing marginal returns to labor. This diminishing return to extra
labor may be due to too many workers sharing too few machines or to crowding. It is possible
(but unknown) that adding a second kiln and more materials along with the second worker would
double the output to 50, or constant returns to scale.

6.1. The marginal product of labor will increase if the firm experiences falling output and
reduces its work force. If the work force remained constant and less output were produced,
marginal product would fall.

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Chapter 6
1.4. The opportunity cost of a resource is the value of the next best alternative use of that
resource. Thus, the opportunity cost of the pipe is $10 because that is the amount that it could
otherwise be sold for. A sunk cost is a past expenditure that cannot be recovered. The pipe’s
sunk cost is $1 because this the original cost of the pipe, but this amount cannot be recovered.

2.4. a. AFC = 10/q.MC = 10. AVC = 10.AC = 10/q  10.

b. AFC = 10/q. MC = 2q. AVC = q. AC = 10/q  q.

c. AFC = 10/q. MC = 10  8q  3q2. AVC = 10  4q  q2. AC = 10/q  10  4q  q2.

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2.6. [Cost values in the graph are incorrect, but the shapes are correct.]
C  15q for q  80
C  1,200 + 20(q – 80) = 20q – 400 for q > 80
For q  80, MC  AVC  AC  15. For q > 80, MC  20, AVC  AC  20 400/q.

2.8. See figure below. Suppose L is measured in person-hours (number of workers times the hours
they work), then the production function is Q = 4L. Then
VC = 10L = 10(Q/4) = 2.5Q and AVC = MC = 2.5

.5

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2.9. Since α + β < 1, the production function exhibits decreasing returns to scale. If capital is
fixed at 100, then output in the short run is
0. 32 0 .56 0.32
q=10 L (100 ) =131. 8 L
The amount of labor required to produce output q is
0 .32 3. 125
0. 0075q=L  L=(0.0075 q ) .
Thus, the firm’s cost function is
C = 10L + 20K = 10(0.0075q)3.125 + 20(100) = 10(0.0075q)3.125 + 2000.
VC = 10(0.0075q)3.125,
AVC = 10(0.0075)3.125q2.125,
MC = 3.125(10)(0.0075)(0.0075q)2.125 = 0.234(0.0075q)2.125.
These can be graphed in Microsoft Excel.

3.2. If the firm were minimizing its cost, the extra output it gets from the last dollar spent on
labor, MPL / w  50/200  0.25, should equal the extra output it derives from the last dollar spent
on capital, MPK / r  200/1, 000  0.2. Thus, the firm is not minimizing its costs. It would do
better if it used relatively less capital and more labor, from which it gets more extra output from
the last dollar spent.

3.3. The price of labor (w) is now 25 percent cheaper. Assuming that the price of capital (r) does
not change and remains the same, the isocost faced by producers becomes less steep (–w/r before
the subsidy as compared to –0.75w/r after the subsidy). Assuming a strictly convex technology,
at the optimum, the producer will use less of both workers and capital than before for the same
output. However, since labor is now cheaper relative to capital (relatively cheaper), the firm will
now employ relatively more labor than capital.

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3.6. Firms will maximize profit by producing where the ratio of the marginal product of labor to
MP L w
=
the marginal product of capital is equal to the ratio of the input prices: MP K r . The ratio of
marginal products equals
MP L 0 . 5 L−0. 5 K 0 .5 K
= =
MP K 0 . 5 L 0. 5 K−0 .5 L .
In the United States, the ratio of input prices equals 1, so when producing optimally, K = L.
To produce 100 units of output in the United States,
100 = L0.5L0.5  L = 100 and K = 100.
The cost of producing 100 units of output in the United States is
C = 10(100) + 10(100) = 2,000.
In Mexico, the ratio of input prices equals 0.5, so when producing optimally, 2K = L.
To produce 100 units of output in Mexico,
100 = (2K)0.5(K)0.5  100 = 1.41K  K = 70.71 and L = 141.42.
The cost of producing 100 units of output in Mexico is
C = 5(141.42) + 10(70.71) = $1,414.21.

3.7. The cost function for Google is C = F + cq. The marginal cost in this case is constant and
equal to c. (If you know calculus, this can be found by taking the derivative of the cost function.)
Average cost can be found by dividing the cost function by q, which gives AC = (F/q) + c.
Google enjoys economies of scale as long as the AC curve is falling. Because this AC function is
always declining, Google will enjoy economies of scale anytime it increases output.

3.8. If it takes two units of labor (at a wage of w per unit) and one unit of labor (at a price of r per
unit) in a fixed proportion to produce a unit of the good, then the cost associated with producing
one unit will be 2w + r and the cost of producing q units will be (2w + r)q. In the case of two
inputs that are perfect substitutes with identical marginal productivities (as implied by the q = L
+ K production function), then the firm will simply use whichever input is cheapest, and its cost
will be the price of that input multiplied by the number of units produced. For example, if labor
is cheaper than capital, then the total cost of production will be C = wq.

4.1. Learning by doing is where the productive skills and knowledge that workers and managers
gain from experience lowers the average cost of production. Workers who are given a new task
perform it slowly the first few times they try, but their speed increases with practice. Managers
may learn how to organize production more efficiently, discover which workers to assign to
which tasks, and determine where more inventories are needed and where they can be reduced.
Engineers may optimize product designs by experimenting with various production methods. For
these reasons, the average cost of production tends to fall over time, and the effect is particularly
strong with new products.

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4.2. A firm’s learning curve, which shows the relationship between average cost and cumulative
output (the sum of its output since the firm started producing), is
r
AC =a+ bN ,
where AC is its average cost; N is its cumulative output; and a, b, and r are constants. If r = 0,
then AC = a + b. If r = 0, then average cost does not fall with cumulative output (average cost
remains constant with cumulative output), so there is no learning by doing. If average cost
decreases with output, then r < 0, which is a characteristic of learning by doing. If N = 0, then
AC = a.
Therefore, a represents the average cost of production before any learning by doing.

5.3. Economies of scope is the situation in which it is less expensive to produce goods jointly
than separately. Diseconomies of scope is the situation in which it is less expensive to produce
goods separately than jointly. A measure of the degree to which there are economies of scope is
C (q 1 , 0)+C (0 , q2 )−C (q1 ,q 2 )
SC = C (q1 , q2 ) ,
where C(q1,0) is the cost of producing q1 units of the first good by itself, C(0,q2) is the cost of
producing q2 units of the second good by itself, and C(q1,q2) is the cost of producing both goods
together. If the cost of producing the two goods separately is the same as producing them
together, then SC is zero. If it is cheaper to produce the goods jointly, SC is positive. If SC is
negative, there are diseconomies of scope, and the two goods should be produced separately.
For example, if a firm produces fuel and heating oil in fixed proportions, then it does not produce
heating fuel without producing gasoline (or, alternatively, it does not cost any extra to also
produce gasoline when producing heating fuel). Similarly, the firm does not produce gasoline
without producing heating fuel (or it does not cost any extra to also produce heating fuel when
producing gasoline). Therefore, the firm’s measure of economies of scope is positive and equal
to 1 because C(q1,0) = C(0,q2) = C(q1,q2).

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