Chapter 5: Answers to Questions and Problems

1. a. When K = 16 and L = 16, Q = (16 )

(16 ) = 16 . Thus, APL = Q/L = 16/16 = 0.75 0.25 1. When K = 16 and L = 81, Q = (16 ) (81) = ( 8 )( 3) = 24 . Thus, APL =
0.75 0.25

24/81 = 8/27. 3 4 b. The marginal product of labor is MPL = 2 ( L ) . When L = 16,

MPL = 2 (16 ) = 1/ 4 . When L = 81, MPL = 2 (81) = 2 / 27 . Thus, as the number of units of labor hired increases, the marginal product of labor decreases MPL (16 ) = 1/ 4 > 2 / 27 = MPL ( 81) , holding the level of capital fixed. c. We must equate the value marginal product of labor equal to the wage and solve
3 4 3 4

for L. Here, VMPL = ( P )( MPL ) = ( $100 ) 2 ( L ) equal to the wage of $25 gives 200 ( L ) quantity of labor is L = 16. 2. See Table 5-1.
(1) Capital K 0 1 2 3 4 5 6 7 8 9 10 11 (2) Labor L 20 20 20 20 20 20 20 20 20 20 20 20 (3) Output Q 0 50 150 300 400 450 475 475 450 400 300 150 (4) Marginal Product of Capital MP K -50 100 150 100 50 25 0 -25 -50 -100 -150
3/ 4

3/ 4

) = 200 ( L )

3/ 4

. Setting this

= 25 . Solving for L, the optimal

(5) Average Product of Capital AP K -50 75 100 100 90 79.17 67.86 56.25 44.44 30 13.64

(6) Average Product of Labor AP L -2.50 7.50 15 20 22.50 23.75 23.75 22.50 20 15 7.50

(7) Value Marginal Product of Capital VMP K -100 200 300 200 100 50 0 -50 -100 -200 -300

Table 5-1

a. Labor is the fixed input while capital is the variable input. b. Fixed costs are 20($15) = $300. c. To produce 475 units in the least-cost manner requires 6 units of capital, which cost $75 each. Thus, variable costs are ($75)(6) = $450. d. Using the VMPK = r rule, K = 5 maximizes profits. e. The maximum profits are $2(450) $15(20) $75(5) = $225 .
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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 = 50 2 3 b. VC (10 ) = 25 (10 ) + 30 (10 ) + 5 (10 ) = $8, 250 . c. C (10) = 50 + 25(10) + 30(10) + 5(10) = $8,300 . $50 d. AFC (10) = = $5 . 10 VC (10 ) $8, 250 e. AVC (10 ) = = = $825 . 10 10 f. ATC (10 ) = AFC (10 ) + AVC (10 ) = $830 .
2 3

g. MC (10) = 25 + 60(10 ) + 15(10) = $2,125 .

5.

Since MRTS KL

w , the firm is not using the cost minimizing combination of labor r and capital. To minimize costs, the firm should use more labor and less capital since MPL 50 MPK 75 the marginal product per dollar spent is greater for labor: . = > = 6 12 w r

6.

See Table 5-2.

Quantity Q 0 100 200 300 400 500 600

Fixed Cost FC 10,000 10,000 10,000 10,000 10,000 10,000 10,000

Total Cost TC 10,000 20,000 25,000 40,000 60,000 100,000 150,000

Table 5-2

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Michael R. Baye

7. a. For a quadratic multi-product cost function, economies of scope exist if f aQ1Q2 > 0 . In this case, f = 75 and a = 0.25 , so economies of scope exist since f is fixed cost, which is always nonnegative. b. Cost complementarities exist since a = 0.25 < 0 . c. Since a = 0.25 < 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. 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 more steep. 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. Since MRTS KL w , 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 fewer units of capital and more units of labor, since MPL 100 MPK 100 = > = . 8 16 w r

9.

10.

11.

The profit-maximizing level of labor and output is achieved where VMPL = w . Here, VMPL = 2 ( $100 )( 4 )
1/ 2

( L)

1 2

= $400 ( L )

1/ 2

and w = $100 per day. Solving yields L

= 16. The profit-maximizing level of output is Q = 2(4 ) (16) = 16 units. The firms fixed costs are $10,000, its variable costs are $100(16) = $1,600, and its total revenues are $200(16) = $3,200. Profits are $3,200 $11,600 = $8,400. The firm is suffering a loss, but the loss is lower than the $10,000 that would be lost if the firm shut down its operation. 12. 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.

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13.

Table 5-3 provides some useful information for making your decision. According to the VMPL = w rule, you should hire five units of labor and produce 90 units of output to maximize profits. Your fixed costs are ($10)(5) = $50, your variable costs are ($50)(5) =$250, and your revenues are ($5)(90) = $450. Thus, your maximum profits are $450 - $300 = $150.
(1) Labor L 0 1 2 3 4 5 6 7 8 9 10 11 (2) Capital K 5 5 5 5 5 5 5 5 5 5 5 5 (3) Output Q 0 10 30 60 80 90 95 95 90 80 60 30 (4) Marginal Product of Labor MP L -10 20 30 20 10 5 0 -5 -10 -20 -30 (5) Average Product of Labor AP L -10 15 20 20 18 15.8 13.6 11.3 8.9 6 2.7 (6) Average Product of Capital AP K -2 6 12 16 18 19 19 18 16 12 6 (7) Value Marginal Product of Labor VMPL -50 100 150 100 50 25 0 -25 -50 -100 -150

Table 5-3

14. 15.

The $1,200 per month that could be earned by renting out the excess rental space. Had she not spent the $6,000 on advertising but instead collected the $65,000 refund, her total loss would have been limited to her sunk costs of $10,000. Her decision to spend $6,000 on advertising in an attempt to fetch an extra $5,000 was clearly foolish. However, the $6,000 is a sunk cost and therefore irrelevant in deciding whether to accept the $66,000 offer. She should accept the $66,000 offer because doing so makes her $1,000 better off than obtaining the $65,000 refund. 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 about 3 million kilowatts per hour, and diseconomies of scale 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.

16.

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Michael R. Baye

17.

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 $50 per panel, so the value marginal product of the third worker is $50(290) = $14,500. Table 5-4 summarizes the VMPL for each choice of labor. Since the wage is $7,000, the profit maximizing number of workers is 4.
Machines 5 5 5 5 5 5 5 Workers Output MPL VMPL Wage 0 0 1 600 600 $30,000 $7,000 2 1,000 400 $20,000 $7,000 3 1,290 290 $14,500 $7,000 4 1,480 190 $9,500 $7,000 5 1,600 120 $6,000 $7,000 6 1,680 80 $4,000 $7,000 Table 5-4

18.

The rental rate of capital is 475,000, computed as r = MPK P = .5 950,000 = 475,00 . Therefore, the marginal product of labor is MPL 0.5 0.0014 cars per hour, which is found by solving . Costs are = 1,330 475,000 minimized when the marginal rate of technical substitution is 0.0028.
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 divisions 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 aQ1Q2 > 0 , respectively, and compare profitability under the different scenarios.

19.

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