Midterm_review_2016_solutions - Solutions to Midterm Review Questions Question 1(i max = P q(L wL L max =(150)8 L 75L L = 600L1\/2 75 = 0 L L = 64(ii q =

Midterm_review_2016_solutions - Solutions to Midterm Review...

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Solutions to Midterm Review Questions Question 1 (i) max L Π = Pq ( L ) - wL max L Π = (150)8 L - 75 L Π ∂L = 600 L - 1 / 2 - 75 = 0 L * = 64 (ii) q * = q ( L * ) = 8 64 = 64 (iii) Π = (150)8 64 - 75(64) = 4800 . Question 2 (a) Both factor prices decrease, but the change in the ratio of factor prices is what matters for the substitution effect. Note that the ratio changes from w/r = 6 / 4 to w/r = 4 / 2. This means that labor becomes relatively more expensive and energy becomes relatively less expensive. Hence, the substitution effects causes the firm to increase consumption of E and decrease consumption of L . (b) Both factor prices decrease, meaning that output should go up. Hence, the output effect (a.k.a. scale effect) causes the firm to increase consumption of both E and L . (c) Both effects go in the same direction for energy, so we can say conclusively that the firm will consume more energy as a result of the factor price changes. However, the two effects go in opposite directions for labor, so we cannot say conclusively whether the firm will consume more or less labor. We would need to know the relative magnitude of these two effects, which would require more information (such
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Unformatted text preview: as the production technology and the output price). Question 3 (a) NPV of owning and operating the old fridge is simply the negative costs of operating the fridge for 4 years. Since the fridge consumes 1400 kWh per year and she pays $0.10 per kWh, she should expect to pay $140 per year. Hence, if we begin in year zero and apply the discount rate r = 0 . 10: NPV old =-3 X t =0 140 1 . 10 t ≈ -$488 . 16 1 (b) NPV of owning and operating he new fridge includes not only the operating costs ($60 per year, using the analogous calculation), but also the cost of purchasing the new fridge today (at t = 0) and the value of selling the used fridge in four years (at t = 3). Hence, NPV new =-3 X t =0 60 1 . 10 t-$1700 + $500 1 . 10 3 ≈ -$1533 . 55 (c) Based on the standard DUM model, we would not expect Zoe to purchase this fridge. NPV new < NPV old , meaning that keeping the old fridge saves her money. 2...
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  • Spring '16
  • Meredith Fowlie
  • Economics, Ratio, Austrian School, factor prices

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