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Unformatted text preview: Chapter 7: The Costs of Production
come is horizontal. If the f r experiences increasing returns to scale,
im
cOllgt;lntreturns to scalc. its longrun averagc cost curve falls, then becomes
llilrizontill.
,lo\\. ,jOes change in the price of one input change the firm's longrun erprlnsion ;
, 11. .l'lll. c,rl,;ln~ion
path describes the combination of inputs that the firm chooses to
l l , i n i l l l i ~ ( ~ cost for cvcry output level. This combination depends on the ratio of input
I,r,n.5:i l ' t l ~ vr)~.icc one input changes, the price ratio ;11so changes. For example, if
of
tllc, I)ricc. of' itn input increases, less of the input cam be purchased for the snmc total
;llltl rllc intcrccpt of the isocost linc on that input's axis moves closer to the origin.
:,I,.,,. 1 1 , ~..;~ol)(!of thc isocost line, the price ratio, changes. i the price ratio changes,
~
b
,ill. 1il.n) .sul,..;t.itulcs away from the now more expensive input toward the cheaper
i I l l n l l , Tl~rrs,
the e:.pmsion path bends toward the axis of the now cheaper input. I)istinguish
hctween economies of scale and economies of scope. Why can one be
p,.,,annt r i t t ~ tllc other?
~~l
I?. ~;,.Ollol~li(.s
of' scale rcfcr to the production of' oltc good and occur when proportionat;e
in a11 inputs lead to a moret,hanproportionate increase in output.
~ : c . r ) ~ l c l l l l i of' scope refer to the production of nzorc: than one good and occur when joint
('~
l l l l t l ) ~ ~ is I(bss costly than the sum of the costs of producing each good or service
t
, . i 8 1 ~ ; ~ r ; ~ ~ ( ~ I ~ . is no direct relationship between increasing returns to scale and
TI~cre
~ . ~ . c ) ~ i o ~scope, s production can exhibit one without the other. See Exercise (1.1)
of' i i i ~ ~ SO
l i l y ;I (.;I.<(, n.if.11
constant productspecific returns to scalc and multiproduct economies of
sc.o[)('.
illc.l.cb;15(h.< I:{. Is tho firm's expansion path always a straight line? I I1'01(% run expansion path is a straight line this means that the firm always
long
c ; ~ l ) i t ; ~ l labor in the same proportion. If the capital labor ratio changes a s
ilnd
I ) ~ I I I ) I I I i.; i~lcrc~~~scd
then the expansion path is not a straight linc.
XI). ! II,~.; \ I I. Wh;it is tI~e
difference between economies of scale and returns to scale?
E c o l ~ o l l ~ i (of' scale mensurcs the relationship between cost and output, i.e., when
>s
~ u t l ) t r t is tlo~lblod,
does cost double, less then double, or more than double. Returns s e ; ~ lnlcb;tsrll.cs
~*
what happens to output when all inputs are doubled. L ! EXERCISES I. quits his c o ~ n ~ ~ t ~ r  ~ r o g r a m m iwhere he was earning a salary of $50,000 Per
job, n g
st;lrt his own computer software business in a building that he owns and was
Pr('\'iousl~ ' c ~ ~otu i ~ g $2.4,000 per year. In his first year of business he has the
~
t for
h'llOwinl:s ~ p ( ~ n s c ssalaly paid to himself $40,000, rent, $0, and other expenses $25,000.
:
thtl ; i c ~ o ~ , l ( icost and the
~lg
cost associated with Joe's computer software
to I I h ~ 4 n ~ h S .
, . ;~c~.llit!lti~~g represents the actual expenses, which are $40,000+$0 +
cost
..).O(").$ti:S.OOO.The economic cost includes accounting cost, but also takes into
' l e c O u l l ~0l)i)clrtunity cost. Therefore, economic will include, in addition to accounting
""'1.
(,st).;I$24,000 because Joe gave up $24,000 by not renting the building, and
;ln ( ' N t l ' ; \ S10.000 because he paid himself a salary $10,000 below market ($50,000J
. Economic cost is then $99,000.
lil(' 2.) I Chapter 7: The Costs of Production
2. a. Fill in the blanks in the following table. b
. Draw a graph that shows marginal cost, average variable cost, and average total
cost, with cost on the vertical axis and quantity on the horizontal axis.
Average total cost is ushaped and reaches a minimum a t an output of 7, based on
the above table. Average variable cost is ushaped also and reaches a minimum a t a n
output of 3. Notice from the table that average variable cost is always below average
total cost. The difference between the two costs is the average fixed cost. Marginal
cost is first diminishing, to a quantity of 3 based on the table, and then increases a s q
increases. Marginal cost should intersect average variable cost and average total
cost a t their respective minimum points, though this is not accurately reflected in the
numbers in the table. If the specific functions had been given in the problem instead
of just a series of numbers, then it would be possible to find the exact point of
intersection between marginal and average total cost and marginal and average
variable cost. The curves are likely to intersect a t a quantity that is not a whole
number, and hence are not listed in the above table. 3. A firm has a fixed production cost of $5,000 and a constant marginal cost of production
of $500 per unit produced. a. What is the firm's total cost function? Average cost?
The variable cost of producing an additional unit, marginal cost, is constant a t $500, so VC $5009
VC=$500q, and AVC== $500. Fixed cost is $5,000 and average
4
4
$5,000
fixed cost is  The total cost function is fixed cost plus variable cost or
.
4
TC=$5,000+$500q. Average total cost is the sum of average variable cost and average
fixed cost: ATC = $500 + b. $5,000
4 If the firm wanted to minimize the average total cost, would it choose to be very
large or very small? Explain.
The firm should choose a very large output because average total cost will continue to
decrease as q is increased. As q becomes infinitely large, ATC will equal $500. Chapter 7: The Costs of Production
uppose a firm must pay an annual tax, which is a fixed sum, independent of whether
it produces any output.
a. How does this tax affect the firm's fixed, marginal, and average costs?
Total cost, TC, is equal to fixed cost, FC, plus variable cost, VC. Fixed costs do not
vary with the quantity of output. Because the franchise fee, F F , is a fixed sum, the
firm's fixed costs increase by this fee. Thus, average cost, equal to FC + VC
4 average fixed cost, equal to FC , and FF , increase by the average franchise fee . Note
4
4
that the franchise fee does not affect average variable cost. Also, because marginal
cost is the change in total cost with the production of a n additional unit and because
the fee is constant, marginal cost is unchanged.
b. Now suppose the firm is charged a tax that is proportional to the number of items it
produces. Again, how does this tax affect the firm's fixed, marginah and average
,
costs? Let t equal the per unit tax. When a tax is imposed on each unit produced, variable
costs increase by tq. Average variable costs increase by t, and because fxed costs are
constant, average (total) costs also increase by t. Further, because total cost increases
by t with each additional unit, marginal costs increase by t.
5. A recent issue of Business Week reported the following:
During the recent auto sales slump, GM, Ford, and Chrysler decided
it was cheaper to sell cars to rental companies at a loss than to lay off
workers.
That's because closing and reopening plants is expensive,
partly because the auto makers' current union contracts obligate
them to pay many workers even if they're not working.
When the article discusses selling cars "at a loss," is it referring to accounting profit or
economic profit? How will the two differ in this case? Explain briefly.
When the article refers to the car companies selling a t a loss, it is referring to
accounting profit. The article is stating that the price obtained for the sale of the
cars to the rental companies was less than their accounting cost. Economic profit
would be measured by the difference of the price with the opportunity cost of the
cars. This opportunity cost represents the market value of all the inputs used by the
companies to produce the cars. The article mentions that the car companies must
pay workers even if they are not working (and thus producing cars). This implies
that the wages paid to these workers are sunk and are thus not part of the
opportunity cost of production. On the other hand, the wages would still be included
in the accounting costs. These accounting costs would then be higher than the
opportunity costs and would make the accounting profit lower than the economic
profit.
6. Suppose the economy takes a downturn, and that labor costs fall by 50 percent and are
expected to stay a t that level for a long time. Show graphically how this change in the
relative price of labor and capital affects the firm's expansion path. Figure 7.6 shows a family of isoquants and two isocost curves. Units of capital are on
the vertical axis and units of labor are on the horizontal axis. (Note: In drawing this
figure we have assumed that the production function underlying the isoquants exhibits
constant returns to scale, resulting in linear expansion paths. However, the results do
not depend on this assumption.)
If the price of labor decreases while the price of capital is constant, the isocost curve
pivots outward around its intersection with the capital axis. Because the expansion C h a ~ t e 7: The Costs of Production
r ,/ path is the set of points where the MRTS is equal to the ratio of prices, as the isocost
curves pivot outward, the expansion path pivots toward the labor axis. A s the price of
labor falls relative to capital, the firm uses more labor as output increases.
Capital
Expansion path
before wage fall I 1)fk' 4 Expansion path
after wage fall 1
2 Figure 7.6
7. The cost of flying a passenger plane from point A to point B is $60,000. The airline flies
this route four times per day at 7am, loam, lpm, and 4pm. The first and last flights are
filled to capacity with 240 people. The second and third flights are only half full. Find
the average cost per passenger for each flight. Suppose the airline hires you as a
marketing consultant and wants to know which type of customer it should try to attract,
the offpeak customer (the middle two flights) or the rushhour customer (the first and
last flights). What advice would you offer?
The average cost per passenger is $50,0001240for the full flights and $50,0001120for
the half full flights. The airline should focus on attracting more offpeak customers
in order to reduce the average cost per passenger on those flights. The average cost
per passenger is already minimized for the two peak time flights.
8. You manage a plant that mass produces engines by teams of workers using assembly
machines. The technology is summarized by the production function. q=5KL
where q is the number of engines per week, K is the number of assembly machines, and L
is the number of labor teams. Each assembly machine rents for r = $10,000 per week and
each team costs w = $5,000 per week. Engine costs are given by the cost of labor teams
and machines, plus $2,000 per engine for raw materials. Your plant has a fixed
installation of 5 assembly machines as part of its design.
a. What is the cost function for your plant  namely, how much would it cost to
produce q engines? What are average and marginal costs for producing q engines?
How do average costs vary with output? K is fixed at 5. The shortrun production function then becomes q = 25L. This
implies that for any level of output q, the number of labor teams hired will be
4
L = . The total cost function is thus given by the sum of the costs of capital, labor,
25
and raw materials: Chapter 7: The Costs ofProduction The average cost function is then given by: and the marginal cost function is given by: Marginal costs are constant and average costs will decrease as quantity increases
(due to the fixed cost of capital). b. How many teams are required to produce 250 engines? What is the average cost
per engine?
4
To produce q = 250 engines we need labor teams L = or L=10. Average costs are 25 given by c. You are asked to make recommendations for the design of a new production
ratio should the new plant accommodate if it
facility. What capitalllabor (WL)
wants to minimize the total cost of producing any level of output q?
We no longer assume that K is f u e d a t 5. We need to find the combination of K and
L that minimizes costs a t any level of output q. The costminimization rule is given
by To find the marginal product of capital, observe that increasing K by 1unit increases
q by 5L, so MPK = 5L. Similarly, observe that increasing L by 1 unit increases Q by
5K, so MPL = 5K. Mathematically, Using these formulas in the costminimization rule, we obtain: The new plant should accommodate a capital to labor ratio of 1 to 2. Note that the
current firm is presently operating a t this capitallabor ratio.
9. The shortrun cost function of a company is given by the equation TC=200+55q,where T is the total cost and q is the total quantity of output, both measured in thousands.
C
a. What is the company's fixed cost?
When q = 0, TC = 200, so fixed cost is equal to 200 (or $200,000). Chapter 7: The Costs of Production // b. If the company produced 100,000 units of goods, what is its average variable cost?
With 100,000 units, q = 100. Variable cost is 559 = (55)(100) = 5500 (or $5,500,000).
Average variable cost is c. TVC $5500   $55,or $55,000.
 100
4
What is its marginal costper unit produced? With constant average variable cost, marginal cost is equal to average variable cost,
$55 (or $55,000). d. What is its average fixed cost?
At q = 100, average fmed cost is e. TFC $200
  $2 or ($2,000).
q
100 Suppose the company borrows money and expands its factory. Its fixed cost rises by
$50,000, but its variable cost falls to $45,000 per 1,000 units. The cost of interest (i)
also enters into the equation. Each onepoint increase in the interest rate raises
costs by $3,000. Write the new cost equation.
Fixed cost changes from 200 to 250, measured in thousands. Variable cost decreases
from 55 to 45, also measured in thousands. Fixed cost also includes interest charges:
3i. The cost equation is 10. A chair manufacturer hires its assemblyline 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 the optimal
combination of labor and capital.
If the firm can produce one chair with either four hours of labor or four hours of capital,
machinery, or any combination, then the isoquant is a straight line with a slope of 1
and intercept at K = 4 and L = 4, as depicted in figure 7.10. 30
= 2 when plotted with capital on
15
TC
TC
the vertical axis and has intercepts at K =  and L = . The cost minimizing
15
30
The isocost line, TC = 30L + 15K has a slope of  point is a corner solution, where L = 0 and K = 4. At that point, total cost is $60. Two
isocost lines are illustrated on the graph. The first one is further from the origin and
represents the higher cost ($105) of using 3 labor and 1 capital. The firm will find it
optimal to move to the second isocost line which is closer to the origin, and which
represents a lower cost ($60). In general, the firm wants to be on the lowest isocost line
possible, which is the lowest isocost line that still intersects the given isoquant. Chapter 7: The Costs of Production
Capital
isocost lines
4 isoquant Labor Figure 7.10 1 r 11. Suppose that a firm's production function is q = 10L'K2. 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
costminimizing quantities of labor and capital are 20 and 5 respectively.
Graphically illustrate this situation on a graph using isoquants and isocost lines.
The isoquant is convex. The optimal quantities of labor and capital are given by the
point where the isocost line is tangent to the isoquant. The isocost line has a slope of
114, given labor is on the horizontal axis. The total cost is TC=$20*20+$80*5=$800,
so the isocost line has the equation $800=20L+80K. On the graph, the optimal point
is point A.
capital isoquant labor 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 point on your graph and
find the new cost. 1 r The new level of labor is 39.2. To find this, use the production function q = 10L'K2
and substitute 140 in for output and 5 in for capital.
The new cost is
TC=$20*39.2+$80*5=$1184. The new isoquant for an output of 140 is above and to
the right of the old isoquant for an output of 100. Since capital is fixed in the short
run, the firm will move out horizontally to the new isoquant and new level of labor.
This is point B on the graph below. This is not likely to be the cost minimizing point.
Given the firm wants to produce more output, they are likely to want to hire more
capital in the long run. Notice also that there are points on the new isoquant that
are below the new isocost line. These points all involve hiring more capital. Chapter 7: The Costs ofl'roductton point B  labor
c. Graphically identify the costminimizing level of capital and labor in the long run
if the firm wants to produce 140 units.
This is point C on the graph above. When the firm is at point B they are not
minimizing cost. The firm will find it optimal to hire more capital and less labor and
move to the new lower isocost line. All three isocost lines above are parallel and have
the same slope. d. K If the marginal rate of technical substitution is , find the optimal level of capital L and labor required to produce the 140 units of output.
Set the marginal rate of technical substitution equal to the ratio of the input costs so
that K 20
L
 =  3 K =  . Now substitute this into the production function for K, set q
L 80
4
1 '(L):
equal to 140, and solve for L: 140 = 10L2  \ 4) 3L = 28, K = 7. The new cost is 12. A computer company's cost function, which relates its average cost of production AC
to its cumulative output in thousands of computers Q and its plant size in terms of
thousands of computers produced per year q, within the production range of 10,000 to
50,000 computers is given by
a. Is there a learning curve effect?
The learning curve describes the relationship between the cumulative output and the
inputs required to produce a unit of output. Average cost measures the input
requirements per unit of output. Learning curve effects exist if average cost falls with
increases in cumulative output. Here, average cost decreases as cumulative output, Q,
increases. Therefore, there are learning curve effects. b. Are there economies or diseconomies of scale?
Economies of scale can be measured by calculating the costoutput elasticity, which
measures the percentage change in the cost of production resulting from a one
percentage increase in output. There are economies of scale if the firm can double its
output for less than double the cost. There are economies of scale because the
average cost of production declines as more output is produced, due to the learning
effect. Chapter 7: The Costs of Production 7
' i During its existence, the firm has produced a total of 40,000 computers and is
producing 10,000 computers this year. Next year it plans to increase its production
to 12,000 computers. Will its average cost of production increase or decrease?
Explain.
First, calculate average cost this year:
AC, = 10  0.1Q + 0.3q = 10  (0.1)(40)+ (0.3)(10) = 9.
Second, calculate the average cost next year:
AC2 = 10  (0.1)(50)+ (0.3)(12)= 8.6.
(Note: Cumulative output has increased from 40,000 to 50,000.) The average cost will
decrease because of the learning effect. 13. Suppose the longrun total cost function for an industry is given by the cubic
equation TC = a + bQ + cQ2 + dQ3. Show (using calculus) that this total cost function is
consistent with a Ushaped average cost curve for at least some values of a, b, c, d.
To show that the cubic cost equation implies a Ushaped average cost curve, we use
algebra, calculus, and economic reasoning to place sign restrictions on the parameters
of the equation. These techniques are illustrated by the example below.
First, if output is equal to zero, then TC = a , where a represents fixed costs. In the
short run,fxed costs are positive, a > 0, but in the long run, where all inputs are
variable a = 0. Therefore, we restrict a to be zero.
Next, we know that average cost must be positive. Dividing TC by Q: This equation is simply a quadratic function. When graphed, it has two basic shapes: a
U shape and a hill shape. We want the U shape, i.e., a curve with a minimum
(minimum average cost), rather than a hill shape with a maximum.
At the minimum, the slope should be zero, thus the first derivative of the average cost
curve with respect to Q must be equal to zero. For a Ushaped AC curve, the second
derivative of the average cost curve must be positive.
The first derivative is c + 2dQ; the second derivative is 2d. If the second derivative is
to be positive, then d > 0. If the first derivative is equal to zero, then solving for c as a
function of Q and d yields: c = 2dQ. If d and Q are both positive, then c must be
negative: c c 0.
To restrict b, we know that a t its minimum, average cost must be positive. The
minimum occurs when c + 2dQ = 0. We solve for Q as a function of c and d:
C Q =  > 0 . Next, substituting this value for Q into our expression for average cost,
2d
and simplifying the equation: implying b > c2
. Because c2 >O and d > 0, b must be positive. 4d In summary, for Ushaped longrun average cost curves, a must be zero, b and d must be
positive, c must be negative, and 4db > c2. However, the conditions do not insure that
marginal cost is positive. To insure that marginal cost has a U shape and that its 95 Chapter 7: The Costs of Production
minimum is positive, using the same procedure, i.e., solving for Q at minimum marginal
~ ,
cost c / 3 d , and substituting into the expression for marginal cost b + 2cQ + 3 d ~we find
that c2 must be less than 3bd. Notice that parameter values that satisfy this condition
also satisfy 4db > c2,but not the reverse.
2 3 For example, let a = 0, b = 1 c = 1,d = 1. Total cost is Q  Q + Q ; average cost is
,
1  Q + Q ~and marginal cost is 1  2Q + 3 ~ Minimum average cost is Q = l/2 and
;
~ .
minimum marginal cost is 113 (think of Q as dozens of units, so no fractional units are
produced). See Figure 7.13.
Costs I 0.L 0.b3 o.bO 0.b7 0.k3 i.bo ~~~~~~y
in Dozens Figure 7.13
*14. A computer company produces hardware and software using the same plant and
labor. The total cost of producing computer processing units H and software programs S
is given by where a, b, and c are positive. Is this total cost function consistent with the presence of
economies or diseconomies of scale? With economies or diseconomies of scope?
There are two types of scale economies to consider: multiproduct economies of scale and
productspecific returns to scale. From Section 7.5 we know that multiproduct
economies of scale for the twoproduct case, SK,,are where MCH is the marginal cost of producing hardware and MCs is the marginal cost of
producing software. The productspecific returns to scale are: SH = TC ( H , 5') TC (0, )
S
(H)(McH s, = T C ( H , S )  ) and TC (H,O) (s)(MCS ) Chapter 7: The Costs of Production
where TC(0,S) implies no hardware production and TC(H,O) implies no software
production. We know that the marginal cost of an input is the slope of the total cost
with respect to that input. Since we have MCH = a  cS and MCs = b  cH.
Substituting these expressions into our formulas for SH,,, SH,and S,: SHS aH bS  cHS
=
H a + S b  2cHS
+ S, = 1,because cHS > 0. Also, (aH  C H S ) ( a  cS)
= 1 and similarly
H(a  c S ) (a  cS) There are multiproduct economies of scale, SH,,> 1, but constant productspecific
returns to scale, SH Sc = 1.
=
Economies of scope exist if Sc > 0, where (from equation (7.8) in the text): S,. = TC (H,O)+ TC (0, S )  TC ( H , s ) S,. = TC ( H ,s) , or, U H + ~ S  ( ~ H~CHS)
+b
TC ( H , S )
cHS
S, =
TC ( H ,S ) O' , or ' Because cHS and TC are both positive, there are economies of scope. ...
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This note was uploaded on 10/11/2009 for the course ECON 191 taught by Professor Chen during the Spring '08 term at HKUST.
 Spring '08
 Chen
 Microeconomics

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