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Practice Questions For Tutorial 3 - 2020 - Section B

The document contains 10 practice questions about production functions, cost minimization, risk preferences, and insurance. Question 1 describes the risk preferences of Larry, Judy, and Carol based on their utility functions. Question 2 involves calculating the expected value and utility of a lottery with a 25% chance of losing $20,000, as well as determining the certainty equivalent and whether insurance would be purchased. Question 3 asks to draw a utility function describing a risk lover when income is low but risk averse when income is high.

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80 views3 pages

Practice Questions For Tutorial 3 - 2020 - Section B

The document contains 10 practice questions about production functions, cost minimization, risk preferences, and insurance. Question 1 describes the risk preferences of Larry, Judy, and Carol based on their utility functions. Question 2 involves calculating the expected value and utility of a lottery with a 25% chance of losing $20,000, as well as determining the certainty equivalent and whether insurance would be purchased. Question 3 asks to draw a utility function describing a risk lover when income is low but risk averse when income is high.

Uploaded by

tan
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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PRACTICE QUESTIONS

1. Describe Larry, Judy and Carol's risk preferences. Their utility as a function of
income is given as follows

Larry: UL(I) = 10 .
Judy: UJ (I) = 3I2.
Carol: UC (I) = 20I.

2. Consider a person with a current wealth of $100,000 who faces a 25% chance
of losing his car worth $20,000. Suppose also that the utility function is U(X) =
ln(X) where X>0
a. Expected value of the lottery?
b. What is the expected utility of the lottery?
c. What is the individual’s certainty equivalent and risk premium?
d. Suppose an insurance company sets the price of the insurance to be
$5600, would this person buy the insurance? Why or why not?
e. Suppose an insurance company sets the price of the insurance be $5300,
would this person buy the insurance? Why or why not?
f. What is the maximum that the person will be willing to pay to buy an
insurance for the loss of car?

3. Draw a utility function over income U(I) that describes a man who is a risk
lover when his income is low but risk averse when his income is high. Can you
explain why such a utility function might reasonably describe a person’s
preferences?

4. A city is considering how much to spend to hire people to monitor its parking
meters. The following information is available to the city manager:
 Hiring each meter monitor costs $10,000 per year.
 With one monitoring person hired, the probability of a driver getting a
ticket each time he or she parks illegally is equal to 0.25.
 With two monitors, the probability of getting a ticket is 0.5; with three
monitors, the probability is 0.75; and with four, it’s equal to 1.
 With two monitors hired, the current fine for overtime parking is $20.

a) Assume first that all drivers are risk neutral. What parking fine would you levy, and
how many meter monitors would you hire (1, 2, 3, or 4) to achieve the current
level of deterrence against illegal parking at the minimum cost?
b) Now assume that drivers are highly risk averse. How would your answer to (a)
change?
5. The marginal product of labor in the production of computer chips is 50 chips
per hour. The marginal rate of technical substitution of hours of labor for
hours of machine capital is 1/4. What is the marginal product of capital?

6. What happens to the marginal product of each individual factor as that factor
is increased and the other factor held constant?
a)

b)
c)

7. The production function for the personal computers of DISK, Inc., is given by
Q = 10K0.5L0.5
Where q is the number of computers produced per day, K is hours of machine time,
and L is hours of labour input. DISK’s competitor, FLOPPY, Inc., is using production
function
Q = 10K0.6L0.4

a) If both companies use the same amounts of capital and labour, which will
generate more output?
b) Assume that capital is limited to 9 machine hours, but labor is unlimited in
supply. In which company is the marginal product of labor greater? Explain.

8. Suppose that a firm’s production function is. The cost of a unit of labor is $20
and the cost of a unit of capital is $80.

a. The firm is currently producing 100 units of output and has determined that the cost-
minimizing quantities of labor and capital are 20 and 5, respectively. Graphically illustrate
this using isoquant and isocost lines.

b. The firm now wants to increase output to 140 units. If capital is fixed in the short run,
how much labor will the firm require? Illustrate this graphically and find the firm’s new
total cost.

c. Graphically identify the cost-minimizing level of capital and labor in the long run if the
firm wants to produce 140 units

d. If the marginal rate of technical substitution is, find the optimal level of capital and
labor required to produce the 140 units of output.
9. A chair manufacturer hires its assembly-line labor for $30 an hour and
calculates that the rental cost of its machinery is $15 per hour. Suppose that a
chair can be produced using 4 hours of labor or machinery in any combination.
If the firm is currently using 3 hours of labor for each hour of machine time, is
it minimizing its costs of production? If so, why? If not, how can it improve the
situation? Graphically illustrate the isoquant and the two isocost lines for the
current combination of labor and capital and for the optimal combination of
labor and capital.

10. Consider Crosby’s corporation, a hypothetical producer of flashlights. Crosby’s


engineers have determined that the firm’s production function is:
Q = 4(KL)0.5
where Q is the output (in thousands of flashlights per month), K is the amount of
capital used per month (in thousand units), and L is the number of hours of labor
employed per month (in thousands). Crosby must pay $8 per hour for labor and $2
per unit for capital.
a. What is the long run cost function?
b. What is the short run cost function when K=10 (ten thousand units of capital)?

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