Topic 3: Production and Costs

1.

Explain the meaning of the following criteria used in determining market structure of
Coca-Cola :
concentration: high
product differentiation: differentiated
barriers to entry: high
Market structure: Oligopoly

2.

Explain the difference between explicit and implicit costs, giving examples.

Answer:
Explicit costs are current expenses for purchasing or hiring resources required by the firm,
such as payments for labour, raw materials, electricity, and also depreciation. They are
determined by the price paid in the market for these resources.
Implicit costs are less obvious. Implicit costs are the opportunity costs of self-owned, selfemployed resources used by a firm and not explicitly paid for as a cost, such as the
opportunity cost of the proprietors labour (salary foregone) or interest foregone by the firms
owner when using his own funds (which could have been invested) rather than borrowing
funds and paying interest (an explicit cost).
3.

Bill own and runs a kebab shop. The following data are about his financial matters in
his first year of business:
$
190,000
Total revenue
65,000
Salary that Bill could have earned if he had worked for another firm
90,000
Loan from a bank
9,000
Interest paid to the bank
70,000
Purchase of durable assets with his own money
4,200
Dividend that he could have earned by investing his $70,000 in shares
14,000
Depreciation of the durable assets
30,000
Salary for an assistant
67,000
Raw materials purchased and used
Using the relevant figures (some figure/s is/are irrelevant), calculate Bills accounting
profit and economic profit for his first year of business. Show your calculations.

Answer:
Total explicit costs
Total implicit costs
Accounting profit
Economic profit

=
=
=
=

$(9,000 + 14,000 + 30,000 + 67,000) = $120,000

$(65,000 + 4,200) = $69,200
$190,000 - $120,000 = $70,000
$190,000 - $120,000 - $69,200 = $800

4.

The table below shows the total production of a firm as the quantity of labour employed
increases, with all other factors of production remaining constant.
L
0
1
2
3
4
5
6
7
8

TP
0
80
200
310
400
450
480
490
480

(a) Calculate the marginal product and the average product of labour.
(b) What is the relationship between the average and marginal physical product?
(c) Define the law of diminishing returns. Is the marginal physical product calculated
in part (a) consistent with the law of diminishing returns?
(d) Draw a sketch graph showing the relationship between the three curves: total
product, marginal physical product, and average physical product.
Answer:
(a)

L
0
1
2
3
4
5
6
7
8

TP
0
80
200
310
400
450
480
490
480

APL
80.0
100.0
103.3
100.0
90.0
80.0
70.0
60.0

MPL
80
120
110
90
50
30
10
-10

(b)

When MP is higher than AP, AP increases. When MP is lower than AP, AP decreases.
For example, as the second unit of labour is added, the MPL is 120 which increases the
APL from 80 to 100. When the sixth unit of labour is added, the MPL is 30, bringing
down the APL from 90 to 80.

(c)

According to the law of diminishing returns, as successive units of a variable input are
added to a set of fixed inputs, given the technology, then the marginal product of the
variable input must eventually diminish. The figures above show that MP increases to a
maximum of 120 as the second worker is employed, and then diminishes with further
increases in employment of labour. Hence the MP is consistent with the law of
diminishing returns.
2

(d)

Output
500

TP

400
300
200
MPP
APP

100
1

5.

The equation below shows the total production of a firm as the quantity of labour
employed increases, with all other factors of production remaining constant.
Q=L+4 L
(a) Calculate the marginal product (MPL) and the average product of labour (APL).
(b)

Define the law of diminishing returns. Sketch the Q. Is the marginal product
calculated in part (a) consistent with the law of diminishing returns? (PLEASE
NOTE that in an exam situation you will not be expected to sketch this
function, but should know what it looks like).

Answer:
Q=L+4 L
(a)
MP L=

Q
4
=1+ 40.5L0.5=1+
L
2 L

If we equalize MPL to zero, we get L=4.

Q L+ 4 L
4
AP L = =
=1+
L
L
L
(b)

According to the law of diminishing returns, as successive units of a variable input are
added to a set of fixed inputs, given the technology, then the marginal product of the
variable input must eventually diminish. The figure below shows that MP is consistent
with the law of diminishing returns.

The MPL shows that as L increases output will begin to fall just plug in L =0, 1, 4, 9,
16 and 25 and note that in each case output increases by less and after L=4, it starts
decreasing. This is consistent with the law of diminishing returns.

0
6.

16

Given the following data for a firm:

Q

TFC ($)

0
1
2
3
4
5
6
7
8
9
10

200
200
200
200
200
200
200
200
200
200
200

TVC ($)
0
50
90
120
160
220
300
400
520
670
900

(a)

For each of the levels of output shown above, calculate the following:
total cost (TC)
average fixed cost (AFC)
average variable cost (AVC)
average total cost (ATC)
marginal cost (MC).

(b)
(c)
(d)

Why is MC the same when computed from either TVC or from TC?
Sketch a graph showing AVC, ATC and MC.
Explain how we can determine the value of AFC from this graph, without
sketching the AFC curve.
Explain why the MC curve cuts AVC and ATC at their minimum points.
If TFC were $300 rather than $200, explain how this would affect the AFC, AVC,
ATC, and MC curves.

(e)
(f)
Answer:

(a)

Q TFC($) TVC($)

0
1
2
3
4
5
6
7
8
9
10
(b)

(c)

200 0
200
20050
250
20090
290
200120 320
200160 360
200220 420
200300 500
200400 600
200520 720
200670 870
200900 1100

TC($) AFC($)

200
100
67
50
40
33
29
25
22
20

50
45
40
40
44
50
57
65
74
90

AVC($) ATC($)

250
145
107
90
84
83
86
90
97
110

MC($)

50
40
30
40
60
80
100
120
150
230

MC measures the change in total cost as output changes by one unit. Since TC is the
sum of TFC and TVC, the change in TC must be equal to the change in TVC as output
changes (TFC being unchanged as output changes, by definition). Hence MC is the
same when computed from TVC or from TC.
$
250

MC

200
150

ATC

100

AVC

50
1

2 3

8 9

10

(d)

Since TC = TVC + TFC, then ATC = AVC + AFC or AFC = ATC AVC.
So at each output the AFC is measured by the vertical distance between the ATC and
AVC curves.

(e)

Whenever the marginal quantity is larger than the average quantity, the average quantity
must increase. Whenever the marginal quantity is smaller than the average quantity, the
average quantity must decrease. If the marginal quantity is equal to the average
quantity, the average quantity is unchanged. This is a general mathematical
relationship. In the diagram for (c), when MC is below ATC, ATC falls. When MC is
above ATC, ATC rises. Since MC increases from below ATC to above ATC, MC must
cut the minimum point in ATC, and so at this minimum point MC and ATC are equal.
The same relationship exists between MC and AVC.

(f)

If TFC increased by $100 to $300, AFC would increase. The size of this increase
would be large for low levels of output and getting smaller as the level of output
increased. Therefore AVC and MC would remain unchanged because they depend on
variable costs, not fixed costs. ATC, being the sum of AFC and AVC, would shift up by
the amount of the increase in AFC ie, by a large amount at low levels of output and
by smaller amounts at lower levels of output.

7.

The following production and cost functions relate to a small firm that incurs fixed
costs of $100 and labour costs of $10 per hour.

Q=100 LL2
TC=100+10 L
(a)

Calculate:
average and marginal product
Marginal cost of hiring an additional worker

(b)

Explain the relationship between

average product and average variable cost
marginal product and marginal cost.

Answer:
(a)

Q=100 LL

TC =100+10 L

Calculate:
average and marginal product
A PL =

Q
=100L
L

MP L=

Q
=1002 L
L

Marginal cost of hiring an additional worker

MC L =

TC
=10
,
L

So the MC of hiring one more worker is the wages they get paid. Or the variable cost.
(b)

When AP ( ), AVC ( )
6

This can also be shown by the following:

APL =

TVC

PL

PL

AVC =

and when MP ( ), MC ( ),
The latter suggests that the we should hire workers until the MP we get from one more
worker is equal to the cost of hiring one more worker.
MPL = MCL
100-2L = 10
And L = 45
This can also be shown by the following:

MPL =

TVC

MC =

PL

PL