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
= 108/256 = 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.

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2. See Table 5-1.
(1) (2) (3) (4) (5) (6) (7)
Marginal Average Average Value Marginal
Product of Product of Product Product of
Capital Labor Output
Capital Capital of Labor Capital
MPK APK 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

Table 5-1

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.
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 = $90.
b. VC(10) = 35(10) + 25(10)2 + 10(10)3 = $12,850.
c. C(10) = 90 + 35(10) + 25(10)2 + 10(10)3 = $12,940.
$ 90
d. AFC ( 10 )= =$ 9.
10
VC (10) $ 12,850
e. AVC ( 10 )= = =$ 1,285.
10 10
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 f. ATC(10) = AFC(10) + AVC(10) = $1,294.
g. MC(10) = 35 + 50(10) + 30(10)2 = $3,535.
w
5. Since MRTS KL ≠ r (in this case, 50/60 ≠ 9/10), the firm is not using the cost minimizing
combination of labor 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 60 MP L 50
= > = .
r 10 w 9

6. See Table 5-2.

(1) (2) (3)

(5) (6) (4)(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 37.5 187.5 225 375
500 15,000 147,500 162,500 30 295 325 725
600 15,000 225,000 240,000 25 375 400 775

Table 5-2

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. The second term (-aQ1Q2) must be
positive then since Q1 and Q2 are positive. The first term must also be positive since f
is fixed cost, which is always nonnegative. Therefore, there must be economies of
scope.
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. As an
example, a cattle rancher may have spent $10 million on land, $1 million on ranch
hands, and $250,000 on consultants to start his business. Here, the land cost is fixed
(but generally not sunk since at least some of the cost could be recovered if the land is
resold). The cost for ranch hands is variable, as it can change with the number of
cattle in the short run. The consulting cost is sunk, as it cannot be recovered once it is
spent.
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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 = 2.
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 = < = ,
w 60 20 r
the 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
w 20 20 r
get 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 things
w
equal, this would increase , thereby making the isocost line more steep. This means
r
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 and
r
capital. To achieve the cost minimizing combination of inputs, the previous manager
should have used more units of labor and fewer units of capital, since
MP L 110 MP K 120
= > = .
w 9 r 14

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13. The profit-maximizing level of labor and output is achieved where VMPL = w. Here,
VMP L=
1
2 ()
2 ( $ 500 ) ( 5 )1/ 2 ( L )−1 /2=$ 1118.03( L)−1 /2 and w = $80 per day. Solving
yields L = 195.31. The profit-maximizing level of output is
1 /2 1/ 2
Q=2(5) (195.31) =62.5 units. The firm’s fixed costs are $11,000, its variable
costs are $80(195.31) = $15,625, and its total revenues are $500(62.5) = $31,250.
Profits are $31,250 – $15,625 – $11,000 = $4,625.

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. Table 5-3 provides some useful information for making your decision. According to the
VMPL = w rule, you should hire six units of labor and produce 95 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 Product
Product of
L K Q Labor of Labor of Capital
Labor
MPL APL APK
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

Table 5-3

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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
for $80 per panel, so the value marginal product of the third worker is $80(290) =
$23,200. Table 5-4 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
Table 5-4

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

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 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 −aQ1 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 cost
C(Q) 1.34 Q $ 7,500
is AVC ( Q )= = =$ 1.34 . The average fixed cost is AFC ( Q ) = .
Q Q Q
The entrepreneur will earn a profit when revenues exceed costs, which occurs when
2.25Q > 7,500 + 1.34Q. Solving for Q implies the entrepreneur earns a profit when
she sells Q > 8242 gallons (rounding up). The average fixed cost of selling Q = 8242
$ 7,500
is AFC ( 8242 )= =$ 0.91.
8242

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.

24.
a. Regression results are:
  Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
3.13280364 0.00237724
Intercept 6 1.017847681 3.077870789 1 1.125713647 5.139893646
0.45591040 0.00113808
ln(K) 9 0.138082659 3.301720965 7 0.183625736 0.728195082
0.47282123
ln(L) 9 0.114050074 4.145733747 5.00164E-05 0.24792633 0.697716149

Looking at the t-stats, both ln(K) and ln(L) are statistically significant, since each has
absolute value greater than two.

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 b. The profit-maximizing level of labor is achieved where VMPL = w. Here,
VMP L= ( 0.47 ) e3.13 ( $ 100 )( 400 )0.46 ( L )−0.53=$ 16,919.49( L)−0.53 and w = $95 per unit.
Solving yields L = 17,641.48.
MP L w
c. To achieve the cost minimizing combination of inputs, we need = .
MP K r
0.47 K 75
Therefore, we need = , or K = (75/125)*(0.46/0.47)L. Since we need
0.46 L 125
4000 units, we need 4000 = e3.13K0.46L0.47. Substituting for K, we get 4000 =
e3.13[(75/125)(0.46/0.47)L]0.46L0.47. Solving for L, we have L = 457.21. K = 268.49.

25.
Standard
  Coefficients Error t Stat P-value Lower 95% Upper 95%
23.0417986
Intercept 47272.63036 2051.603308 6 4.1413E-101 43248.38243 51296.87829
12.9976348
Quantity 555.1209628 42.70938281 6 1.02076E-36 471.3459247 638.8960009
15.9803309
Quantity2 4.640748824 0.290403799 9 2.76587E-53 4.071117803 5.210379844
1.17947094
Quantity3 0.00076143 0.000645569 1 0.238393829 -0.000504863 0.002027723
a. Regression results are:
Looking at the t-stats, Quantity and Quantity2 are statistically significant, since each
has absolute value greater than two. Quantity3 is not statistically significant.
b. Fixed costs are the estimate for the intercept, which equals $47,272.63.
c. Taking total costs divided by Q at Q = 140 gives us $1,542.38. Note that we do
not include the Quantity3 term, which was not statistically significant.
d. Marginal costs are 555.12 + 9.28Q. So, at Q = 140, marginal costs are $1,854.32.

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