Professor S.

Severinov
Economics 301, UBC
Winter 2012-2013


Answers to Problem Set 4


1. Question for Review 4, Chapter 7 (p.261)
Suppose that labor is the only variable input to the production process. If the marginal cost of
production is diminishing as more units of output are produced, what can you say about the
marginal product of labor.
Answer: The marginal product of labor must be increasing. The marginal cost of production
measures the extra cost of producing one more unit of output. If this cost is diminishing, then it
must be taking fewer units of labor to produce the extra unit of output. If fewer units of labor
are required to produce a unit of output, then the marginal product (extra output produced by
an extra unit of labor) must be increasing.
Mathematically,
the marginal product of labor must be increasing, since MC(q)=wage*dL/dq=wage/MP(L), and since MC
is diminishing then MP
L
must be increasing for any given w.

2. Exercise 8, Chapter 7 (p.262):
You manage a plant that mass-produces engines by teams of workers using assembly machines. The
technology is summarized by the production function
q = 5 KL
where q is the number of engines per week, K is the number of assembly machines, and L is the
number of labor teams. Each assembly machine rents for r = $10,000 per week, and each team costs
w = $5000 per week. Engine costs are given by the cost of labor teams and machines, plus $2000 per
engine for raw materials. Your plant has a fixed installation of 5 assembly machines as part of its
design.
a. What is the cost function for your plant namely, how much would it cost to produce q
engines? What are average and marginal costs for producing q engines? How do average
costs vary with output?
The short-run production function is q = 5(5)L = 25L, because K is fixed at 5. This
implies that for any level of output q, the number of labor teams hired will be

L =
q
25
. The total cost function is thus given by the sum of the costs of capital, labor,
and raw materials:

TC(q) = rK+wL +2000q = (10, 000)(5) + (5, 000)(
q
25
) + 2,000 q
TC(q) = 50,000 +2200q.

The average cost function is then given by:

AC(q) =
TC(q)
q
=
50, 000+ 2200q
q
.
and the marginal cost function is given by:
2200 ) ( = =
dq
dTC
q MC .
Marginal costs are constant at $2200 per engine and average costs will decrease as
quantity increases because the average fixed cost of capital decreases.
b. How many teams are required to produce 250 engines? What is the average cost per engine?
To produce q = 250 engines we need

L =
q
25
or L = 10 labor teams. Average costs are
given by

AC(q= 250) =
50,000+ 2200(250)
250
= 2400.
c. You are asked to make recommendations for the design of a new production facility. What
capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize the total
cost of producing at any level of output q?
We no longer assume that K is fixed at 5. We need to find the combination of K and
L that minimizes costs at any level of output q. The cost-minimization rule is given
by
w
MP
r
MP
L K
= .
To find the marginal product of capital, observe that increasing K by 1 unit increases
q by 5L, so MP
K
= 5L. Similarly, observe that increasing L by 1 unit increases q by
5K, so MP
L
= 5K. Mathematically,
L
K
q
MP
K
5 =
c
c
= and K
L
q
MP
L
5 =
c
c
= .
Using these formulas in the cost-minimization rule, we obtain:

5L
r
=
5K
w

K
L
=
w
r
=
5000
10,000
=
1
2
.
The new plant should accommodate a capital to labor ratio of 1 to 2, and this is the
same regardless of the number of units produced.

3. Exercise 11, Chapter 7 (p. 262):
You manage a plant that mass-produces engines by teams of workers using assembly machines. The
technology is summarized by the production function
q = 5 KL
where q is the number of engines per week, K is the number of assembly machines, and L is the
number of labor teams. Each assembly machine rents for r = $10,000 per week, and each team costs
w = $5000 per week. Engine costs are given by the cost of labor teams and machines, plus $2000 per
engine for raw materials. Your plant has a fixed installation of 5 assembly machines as part of its
design.
a. What is the cost function for your plant namely, how much would it cost to produce q
engines? What are average and marginal costs for producing q engines? How do average
costs vary with output?
The short-run production function is q = 5(5)L = 25L, because K is fixed at 5. This
implies that for any level of output q, the number of labor teams hired will be

L =
q
25
. The total cost function is thus given by the sum of the costs of capital, labor,
and raw materials:

TC(q) = rK+wL +2000q = (10, 000)(5) + (5, 000)(
q
25
) + 2,000 q
TC(q) = 50,000 +2200q.

The average cost function is then given by:

AC(q) =
TC(q)
q
=
50, 000+ 2200q
q
.
and the marginal cost function is given by:
2200 ) ( = =
dq
dTC
q MC .
Marginal costs are constant at $2200 per engine and average costs will decrease as
quantity increases because the average fixed cost of capital decreases.
b. How many teams are required to produce 250 engines? What is the average cost per engine?
To produce q = 250 engines we need

L =
q
25
or L = 10 labor teams. Average costs are
given by

AC(q= 250) =
50,000+ 2200(250)
250
= 2400.
c. You are asked to make recommendations for the design of a new production facility. What
capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize the total
cost of producing at any level of output q?
We no longer assume that K is fixed at 5. We need to find the combination of K and
L that minimizes costs at any level of output q. The cost-minimization rule is given
by
w
MP
r
MP
L K
= .
To find the marginal product of capital, observe that increasing K by 1 unit increases
q by 5L, so MP
K
= 5L. Similarly, observe that increasing L by 1 unit increases q by
5K, so MP
L
= 5K. Mathematically,
L
K
q
MP
K
5 =
c
c
= and K
L
q
MP
L
5 =
c
c
= .
Using these formulas in the cost-minimization rule, we obtain:

5L
r
=
5K
w

K
L
=
w
r
=
5000
10,000
=
1
2
.
The new plant should accommodate a capital to labor ratio of 1 to 2, and this is the
same regardless of the number of units produced.

4. Exercise 4 in Appendix to Chapter 7, p 269.
Suppose the process of producing lightweight parkas by Pollys Parkas is described by the function
q = 10K
.8
(L 40)
.2
where q is the number of parkas produced, K the number of computerized stitching-machine hours,
and L the number of person-hours of labor. In addition to capital and labor, $10 worth of raw
materials is used in the production of each parka.
We are given the production function: q = F(K,L) = 10K
.8
(L 40)
.2
We also know that the cost of production, in addition to the cost of capital and labor,
includes $10 of raw material per unit of output. This yields the following total cost
function:
TC(q) = wL + rK + 10q
By minimizing cost subject to the production function, derive the cost-minimizing
demands for K and L as a function of output (q), wage rates (w), and rental rates on
machines (r). Use these results to derive the total cost function: that is, costs as a
function of q, r, w, and the constant $10 per unit materials cost.
We need to find the combinations of K and L that will minimize this cost function for
any given level of output q and factor prices r and w. To do this, we set up the
Lagrangian:
u = wL + rK + 10q [10K
.8
(L 40)
.2
q]
Differentiating with respect to K, L, and , and setting the derivatives equal to zero:
(1)
cu
cK
= r 10(.8)K
.2
(L 40)
.2
= 0

(2)
cu
cL
= w 10K
. 8
(.2)(L 40)
. 8
= 0

(3)

cu
c
=10 K
.8
(L40 )
.2
q=0.
Note that (3) has been multiplied by 1. The first 2 equations imply:
r = 10 (.8)K
.2
(L 40)
.2
and w= 10K
.8
(.2)(L 40)
.8
.

or
r
w
=
4(L 40)
K
.

This further implies:
K=
4w(L 40)
r
and L-40=
rK
4w
.

Substituting the above equations for K and L40 into equation (3) yields solutions for
K and L:

q=10
4w
r
|
\
|
.
.8
(L40 )
.8
(L40 )
.2
and q =10K
.8
rK
4w
|
\
|
.
.2
.
or
40
3 . 30
8 .
8 .
+ =
w
q r
L
and
2 .
2 .
6 . 7 r
q w
K=
.
We can now obtain the total cost function in terms of only r, w, and q by substituting
these cost-minimizing values for K and L into the total cost function:

TC (q)=wL +rK +10 q
. 10
6 . 7
40
3 . 30
) (
10
6 . 7
40
3 . 30
) (
2 . 8 . 8 . 2 .
2 .
2 .
8 .
8 .
q
q w r
w
q r w
q TC
q
r
q rw
w
w
q wr
q TC
+ + + =
+ + + =


This process requires skilled workers, who earn $32 per hour. The rental rate on the machines used
in the process is $64 per hour. At these factor prices, what are total costs as a function of q? Does
this technology exhibit decreasing, constant, or increasing returns to scale?
Given the values w = 32 and r = 64, the total cost function becomes:
TC(q) = 19.2q + 1280.
The average cost function is then given by
AC(q) = 19.2 + 1280/q.
To find returns to scale, choose an input combination and find the level of output,
and then double all inputs and compare the new and old output levels. Assume K =
50 and L = 60. Then q1 = 10(50)
0.8
(60 40)
0.2
= 416.3. When K = 100 and L = 120, q2
= 10(100)
0.8
(120 40)
0.2
= 956.4. Since q2/q1 > 2, the production function exhibits
increasing returns to scale.
a. Pollys Parkas plans to produce 2000 parkas per week. At the factor prices given above, how
many workers should the firm hire (at 40 hours per week) and how many machines should it
rent (at 40 machine-hours per week)? What are the marginal and average costs at this level
of production?
Given q = 2000 per week, we can calculate the required amount of inputs K and L
using the formulas derived in part a:

40
3 . 30
8 .
8 .
+ =
w
q r
L
and
2 .
2 .
6 . 7 r
q w
K=
.
Thus L = 154.9 worker hours and K = 229.1 machine hours. Assuming a 40 hour
week, L = 154.9/40 = 3.87 workers per week, and K = 229.1/40 = 5.73 machines per
week. Pollys Parkas should hire 4 workers and rent 6 machines per week, assuming
she cannot hire fractional workers and machines.
We know that the total cost and average cost functions are given by:
TC(q) = 19.2q + 1280
AC(q) = 19.2 + 1280/q,
so the marginal cost function is
MC(q) =
dq
q dTC ) (
= 19.2.
Marginal costs are constant at $19.20 per parka and average costs are 19.2 +
1280/2000 or $19.84 per parka.


5. Question for review # 6, Chapter 8, p. 306
At the beginning of the twentieth century, there were many small American automobile manufacturers.
At the end of the century, there were only three large ones. Suppose that this situation is not the result
of lax federal enforcement of antimonopoly laws. How do you explain the decrease in the number of
manufacturers? (Hint: What is the inherent cost structure of the automobile industry?)
Automobile plants are highly capital-intensive, and consequently there are substantial
economies of scale in production. So, over time, the automobile companies that
produced larger quantities of cars were able to produce at lower average cost. They then
sold their cars for less and eventually drove smaller (higher cost) companies out of
business, or bought them to become even larger and more efficient. At very large levels
of production, the economies of scale diminish, and diseconomies of scale may even
occur. This would explain why more than one manufacturer remains.

6. Question for review # 9, Chapter 8, p. 306
True or false: A firm should always produce at an output at which long-run average cost is minimized.
Explain.
False. In the long run, under perfect
competition, firms will produce where long-
run average cost is minimized. In the short
run, however, it may be optimal to produce at
a different level. For example, if price is
above the long-run equilibrium price, the firm
will maximize short-run profit by producing a
greater amount of output than the level at
which LAC is minimized as illustrated in the
diagram. PL is the long-run equilibrium
price, and qL is the output level that
minimizes LAC. If price increases to P' in the short run, the firm maximizes profit by
producing q', which is greater than qL, because that is the output level at which SMC
(short-run marginal cost) equals price.
7. Question for review # 13, Chapter 8, p. 306
The government passes a law that allows a substantial subsidy for every acre of land used to grow
tobacco. How does this program affect the long-run supply curve for tobacco?
A subsidy on land used to grow tobacco decreases every farmers average cost of producing tobacco
and will lead existing tobacco growers to increase output. In addition, tobacco farmers will make
positive economic profits that will encourage other firms to enter tobacco production. The result is
that both the short-run and long-run supply curves for the industry will shift down and to the right

8. Exercise 5, Chapter 8 (p. 307)
Suppose that a competitive firms marginal cost of producing output q is given by MC(q) = 3 + 2q.
Assume that the market price of the firms product is $9.
a. What level of output will the firm produce?
The firm should set the market price equal to marginal cost to maximize its profits:
9 = 3 + 2q, or q = 3.

Price
Output
LAC
SMC
P
L
P'
q
L
q'

SAC
b. What is the firms producer surplus?
Producer surplus is equal to the area below the market price, i.e., $9.00, and above the
marginal cost curve, i.e., 3 + 2q. Because MC is linear, producer surplus is a triangle
with a base equal to 3 (since q = 3) and a height of $6 (since 9 3 = 6). The area of a
triangle is (1/2)(base)(height). Therefore, producer surplus is (0.5)(3)(6) = $9.
Pr ice
Quant it y
1
2
3
4
5
6
7
8
9
10
1 2 3 4
MC(q) = 3 + 2q
Pr oducer s
Sur plus
P = $9.00
Pr oducer
Sur plus


c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the
firms fixed costs are known to be $3. Will the firm be earning a positive, negative, or zero profit
in the short run?
Profit is equal to total revenue minus total cost. Total cost is equal to total variable cost
plus fixed cost. Total variable cost is equal to [AVC(q)]q. Therefore, at q = 3, AVC(q) = 3
+ 3 = 6, and therefore
TVC = (6)(3) = $18.
Fixed cost is equal to $3. Therefore, total cost equals TVC plus TFC, or
C = $18 + 3 = $21.
Total revenue is price times quantity:
R = ($9)(3) = $27.
Profit is total revenue minus total cost:
t = $27 21 = $6.
Therefore, the firm is earning positive economic profits. More easily, you might recall
that profit equals producer surplus minus fixed cost. Since we found that producer
surplus was $9 in part (b), profit equals 9 3 or $6.





9. Exercise 7, Chapter 8 (p.307)
Suppose that a competitive firms marginal cost of producing output q is given by MC(q) = 3 + 2q.
Assume that the market price of the firms product is $9.
a. What level of output will the firm produce?
The firm should set the market price equal to marginal cost to maximize its profits:
9 = 3 + 2q, or q = 3.
b. What is the firms producer surplus?
Producer surplus is equal to the area below the market price, i.e., $9.00, and above the
marginal cost curve, i.e., 3 + 2q. Because MC is linear, producer surplus is a triangle
with a base equal to 3 (since q = 3) and a height of $6 (since 9 3 = 6). The area of a
triangle is (1/2)(base)(height). Therefore, producer surplus is (0.5)(3)(6) = $9.
Pr ice
Quant it y
1
2
3
4
5
6
7
8
9
10
1 2 3 4
MC(q) = 3 + 2q
Pr oducer s
Sur plus
P = $9.00
Pr oducer
Sur plus


c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the
firms fixed costs are known to be $3. Will the firm be earning a positive, negative, or zero profit
in the short run?
Profit is equal to total revenue minus total cost. Total cost is equal to total variable cost
plus fixed cost. Total variable cost is equal to [AVC(q)]q. Therefore, at q = 3, AVC(q) = 3
+ 3 = 6, and therefore
TVC = (6)(3) = $18.
Fixed cost is equal to $3. Therefore, total cost equals TVC plus TFC, or
C = $18 + 3 = $21.
Total revenue is price times quantity:
R = ($9)(3) = $27.
Profit is total revenue minus total cost:
t = $27 21 = $6.
Therefore, the firm is earning positive economic profits. More easily, you might recall
that profit equals producer surplus minus fixed cost. Since we found that producer
surplus was $9 in part (b), profit equals 9 3 or $6.