Chapter 5: The Production Process and Costs

Answers to Questions and Problems

1. a. When K = 81 and L = 16, Q = (81)0.75(16)0.25 = 54. Thus, APL = Q/L = 54/16 = 3.375.
When K = 81 and L = 256, Q = (81)0.75(256)0.25 = (27)(4) = 108. Thus, APL = 108/81
= 0.422.

b. The marginal product of labor is MPL = (1/4) × (81)0.75(L)-3/4 = (27/4)(L)-3/4. When L =

16, MPL = (27/4)(16)-3/4 = 0.844. When L = 81, MPL = (27/4)(81)-3/4 = 0.25. Thus, as
the number of units of labor hired increases, the marginal product of labor decreases
MPL(16) = 0.844 > 0.25 = MPL(81), holding the level of capital fixed.

c. We must equate the value marginal product of labor to the wage and solve for L.
Here, VMPL = (P)(MPL) = ($200)(27/4)(L)-3/4=1350(L)-3/4. Setting this equal to the
wage of $50 gives 1350(L)-3/4 = 50. Solving for L, the optimal quantity of labor is L =
81.

2. See table below.

(1) (2) (3) (4) (5) (6) (7)

Marginal Average Average Value Marginal
Capital Labor Output Product of Product of Product of Product of Capital
Capital MPK Capital APK Labor APL VMPK
0 20 0 - - - -
1 20 50 50 50 2.50 200
2 20 150 100 75 7.50 400
3 20 300 150 100 15 600
4 20 400 100 100 20 400
5 20 450 50 90 22.50 200
6 20 475 25 79.17 23.75 100
7 20 475 0 67.86 23.75 0
8 20 450 -25 56.25 22.50 -100
9 20 400 -50 44.44 20 -200
10 20 300 -100 30 15 -400
11 20 150 -150 13.64 7.50 -600

a. Labor is the fixed input while capital is the variable input.

b. Fixed costs are 20($30) = $600.

c. To produce 475 units in the least-cost manner requires 6 units of capital, which cost
$25 each. Thus, variable costs are ($25)(6) = $150.

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 d. Using the VMPK = r rule, K = 6 maximizes profits.

e. The maximum profits are $4(475) - $30(20) - $25(6) = $1,150.

f. There are increasing marginal returns when K is between 0 and 3.

g. There are decreasing marginal returns when K is between 3 and 11.

h. There are negative marginal returns when K is greater than 7.

3. The law of diminishing marginal returns is the decline in marginal productivity

experienced when input usage increases, holding all other inputs constant. In contrast,
the law of diminishing marginal rate of technical substitution is a property of a
production function stating that as less of one input is used, increasing amounts of
another input must be employed to produce the same level of output.

4. a. FC = $100.

b. VC(10) = 20(10) + 15(10)2 + 10(10)3 = $11,700.

c. C(10) = 100 + 20(10) + 15(10)2 + 10(10)3 = $11,800.

$ 100
d. AFC (10 )= =$ 10 .
10

VC (10) $ 11,700
e. AVC ( 10 )= = =$ 1,170.
10 10

f. ATC(10) = AFC(10) + AVC(10) = $1,180.

g. MC(10) = 20 + 30(10) + 30(10)2 = $3,320.

w
5. Since MRTS KL ≠ , the firm is not using the cost minimizing combination of labor
r
and capital. To minimize costs, the firm should increase capital (and decrease labor)
since the marginal product per dollar spent is greater for capital:
MP K 45 MP L 60
= > = .
r 8 w 12

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6. See table below.

(1) (2) (3) (4) (5) (6) (7) (8)

Average Average Average
Fixed Variable Total Marginal
Quantity Fixed Variable Total
Cost Cost Cost Cost
Q Cost Cost Cost
FC VC TC MC
AFC AVC ATC
0 15,000 0 15,000 - - - -
100 15,000 15,000 30,000 150 150 300 150
200 15,000 25,000 40,000 75 125 200 100
300 15,000 37,500 52,500 50 125 175 125
400 15,000 75,000 90,000 37.50 187.50 225 375
500 15,000 147,500 162,500 30 295 325 725
600 15,000 225,000 240,000 25 375 400 775

7. a. For a quadratic multi-product cost function, economies of scope exist if f – aQ1Q2 > 0.
In this case, f = 90 and a = -0.5, so economies of scope exist since f is fixed cost,
which is always nonnegative.
b. Cost complementarities exist since a = -0.5 < 0, which holds in this case.
c. Since a = -0.5 < 0, the marginal cost of producing product 1 will increase if the
division that produces product 2 is sold.

8. Fixed costs are associated with fixed inputs, and do not change when output changes.
Variable costs are costs associated with variable inputs, and do change when output
changes. Sunk costs are costs that are forever lost once they have been paid.

9. a. When K = 2 and L = 3, Q = 8 units.

b. The cost-minimizing mix of K and L that produce Q = 8 is K = 2, L = 1.

c. Since K and L are perfect complements in the production process, the cost-
minimizing levels of K and L do not depend on the rental rates of K and L. Therefore,
the cost-minimizing levels of K and L do not change with changes in the relative
rental rates.

10. a. With K = 2 and L = 3, Q = 4(2) + 8(3) = 32.

b. Since the MRTSKL is 8/4 = 2, that means a company can trade two units of capital for
every one unit of labor. This production function does not exhibit diminishing
marginal rate of technical substitution. The perfect substitutability between capital
MP L 8 4 MP K
and labor means that only one input will be utilized. Since = < = , the
w 60 20 r

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 company should hire all capital. To get 32 units of output, this will require 8 units of
capital.

MP L 8 4 MP K
c. Here, we have = > = , so the company should hire only labor. To get
w 20 20 r
32 units of output, this will require 4 units of labor.

11. An investment tax credit would reduce the relative price of capital to labor. Other
w
things equal, this would increase , thereby making the isocost line steeper. This
r
means that the cost-minimizing input mix will now involve more capital and less
labor, as firms substitute toward capital. Labor unions are likely to oppose the
investment tax credit since the higher capital-to-labor ratio will translate into lost
jobs. You might counter this argument by noting that, while some jobs will be lost
due to substituting capital for labor, many workers will retain their jobs. Absent the
plan, automakers have an incentive to substitute cheaper foreign labor for U.S. labor.
The result of this substitution would be a movement of plants abroad, resulting in the
complete loss of U.S. jobs.

w
12. Since MRTS KL ≠ , the firm was not using the cost minimizing combination of labor
r
and capital. To achieve the cost minimizing combination of inputs, the previous
manager should have used more units of capital and fewer units of labor, since
MP L 80 MP K 110
= < = .
w 12 r 15

13. The profit-maximizing level of labor and output is achieved where VMPL = w. Here,
VMP L =
1
2 ()
2 ( $ 400 ) ( 9 )1/ 2 ( L )−1 /2 =$ 1200 (L)−1 /2 and w = $120 per day. Solving yields

L = 100. The profit-maximizing level of output is Q=2(9)1/ 2 (100)1 /2=60 units. The
firm’s fixed costs are $8,000, its variable costs are $120(100) = $12,000, and its total
revenues are $400(60) = $24,000. Profits are $24,000 – $12,000 – $8,000 = $4,000.

14. The higher wage rate in Europe induces Airbus to employ a more capital intensive
input mix than Boeing. Since Airbus optimally uses fewer workers than Boeing, and
profit-maximization entails input usage in the range of diminishing marginal product,
it follows that the lower quantity of labor used by Airbus translates into a higher
marginal product of labor at Airbus than at Boeing.

15. The following table provides some useful information for making your decision.
According to the VMPL = w rule, you should hire six units of labor and produce 95
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 units of output to maximize profits. Your fixed costs are ($20)(8) = $160, your
variable costs are ($60)(6) = $360, and your revenues are ($12)(95) = $1,140. Thus,
your maximum profits are $1,140 – $360 – $160 = $620.

(1) (2) (3) (4) (5) (6) (7)

Value
Marginal Average
Average Marginal
Labor Capital Output Product of Product of
Product of Product of
L K Q Labor Labor
Capital APK Labor
MPL APL
VMPL
0 8 0 - - - -
1 8 10 10 10 1.3 120
2 8 30 20 15 3.8 240
3 8 60 30 20 7.5 360
4 8 80 20 20 10 240
5 8 90 10 18 11.3 120
6 8 95 5 15.8 11.9 60
7 8 95 0 13.6 11.9 0
8 8 90 -5 11.3 11.3 -60
9 8 80 -10 8.9 10 -120
10 8 60 -20 6 7.5 -240
11 8 30 -30 2.7 3.8 -360

16. The $8,000 per month that could be earned by renting out the space used for the
fitness studio.

17. Had she not spent the $8,000 on advertising but instead collected the $75,000 refund,
her total loss would have been limited to her sunk costs of $15,000. Her decision to
spend $8,000 on advertising in an attempt to fetch an extra $5,000 was clearly
foolish. However, the $8,000 is a sunk cost and therefore irrelevant in deciding
whether to accept the $77,000 offer. She should accept the $77,000 offer because
doing so makes her $2,000 better off than obtaining the $75,000 refund.

18. Facility “L” produces 6 million kilowatt hours of electricity at the lowest average
total cost, so this is the optimal facility for South-Florida. Facility “M” produces 2
million kilowatt hours of electricity at the lowest average total cost, so this is the
optimal facility for the Panhandle. There are economies of scale up to just below 3
million kilowatts per hour for facility “M,” and diseconomies of scale thereafter.
There are economies of scale up to just below 4 million kilowatts per hour for facility
“L,” and diseconomies thereafter. Therefore, facility “M” will be operating in the
range of economies of scale while facility “L” will be operating in the range of
diseconomies of scale.

19. To maximize profits the firm should continue adding workers so long as the value
marginal product of labor exceeds the wage. The value marginal product of labor is
defined as the marginal product of labor times the price of output. Here, output sells

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 for $80 per panel, so the value marginal product of the third worker is $80(290) =
$23,200. The table below summarizes the VMPL for each choice of labor. Since the
wage is $9,000, the profit maximizing number of workers is 5.

Machines Workers Outpu MPL VMPL Wage

t
5 0 0 – – –
5 1 600 600 $48,000 $9,000
5 2 1,000 400 $32,000 $9,000
5 3 1,290 290 $23,200 $9,000
5 4 1,480 190 $15,200 $9,000
5 5 1,600 120 $9,600 $9,000
5 6 1,680 80 $6,400 $9,000

20. The rental rate of capital is ¥960,000, computed as r = MPK × P = 0.8 × 1,200,000 =
960,000. Therefore, the marginal product of labor is 0.0015 cars per hour, which is
MP L 0.8
found by solving = . Costs are minimized when the marginal rate of
1,800 960,000
w 1,800
technical substitution is 0.001875 = = .
r 960,000

21. Given the tightly woven marine engine and shipbuilding divisions, economies of
scope and cost complementarities are likely to exist. Eliminating the unprofitable
marine engine division may actually raise the shipbuilding division’s costs and cause
that division to become unprofitable. For this argument to withstand criticism, you
must show the CEO that the quadratic multi-product cost function exhibits cost
complementarities and economies of scope, which occurs when a< 0 and
f −aQ 1 Q 2 >0 , respectively, and compare profitability under the different scenarios.

22. Taking into account both implicit and explicit costs, the total fixed cost from
operating the kiosk is $7,500; the $2,500 in rent plus the $5,000 in forgone earnings.
Total variable costs are $1.34 times the number of gallons. The cost function is
C(Q) = 7,500 + 1.34Q. The marginal cost is the cost of the last unit produced, which
is constant in this case: MC(Q) = $1.34; the wholesale price. The average variable
C(Q) 1.34 Q
cost is AVC ( Q )= = =$ 1.34. The average fixed cost is
Q Q
$ 7,500
AFC (Q )= . The entrepreneur will earn a profit when revenues exceed costs,
Q
which occurs when 2.25Q > 7,500 + 1.34Q. Solving for Q implies the entrepreneur
earns a profit when she sells Q > 8,242 gallons (rounding up). The average fixed cost
$ 7,500
of selling Q = 8,242 is AFC ( 8 ,242 ) = =$ 0.91.
8 , 242

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23. Assuming that the optimal mix of unskilled and semi-skilled labor were being utilized
at the time the legislation passed, in the short run, a higher minimum wage paid to
unskilled labor implies that to minimize costs the retailer should increase its use of
semi-skilled worker and decrease its use or unskilled workers. In the longer run, the
retailer may want to consider substituting capital for labor (invest in some machines
to automate a portion of your boxing needs). Obviously, additional information
would be required to conduct a net present value analysis for these long-run
investments, but it is probably worth getting this information and running some
numbers.

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.