CHAPTER 7 - CHAPTER 7 THE COST OF PRODUCTION REVIEW...

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CHAPTER 7 THE COST OF PRODUCTION REVIEW QUESTIONS 1. A firms pays its accountant an annual retainer of $10,000. Is this an explicit or implicit cost? Explicit costs are actual outlays. They include all costs that involve a monetary transaction. An implicit cost is an economic cost that does not necessarily involve a monetary transaction, but still involves the use of resources. When a firm pays an annual retainer of $10,000, there is a monetary transaction. The accountant trades his or her time in return for money. Therefore, an annual retainer is an explicit cost. 2. The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work? Opportunity costs are measured by comparing the use of a resource with its alternative uses. The opportunity cost of doing accounting work is the time not spent in other ways , i.e., time such as running a small business or participating in leisure activity. The economic cost of doing accounting work is measured by computing the monetary amount that the time would be worth in its next best use . 3. Suppose a chair manufacturer finds that the marginal rate of technical substitution of capital for labor in his production process is substantially greater than the ratio of the rental rate on machinery to the wage rate for assembly- line labor. How should he alter his use of capital and labor to minimize the cost of production? To minimize cost, the manufacturer should use a combination of capital and labor so the rate at which he can trade capital for labor in his production process is the same as the rate at which he can trade capital for labor in external markets. The manufacturer would be better off if he increased his use of capital and decreased his use of labor, decreasing the marginal rate of technical substitution, MRTS . He should continue this substitution until his MRTS equals the ratio of the rental rate to the wage rate. 4. Why are isocost lines straight lines? The isocost line represents all possible combinations of labor and capital that may be purchased for a given total cost. The slope of the isocost line is the ratio of the input prices of labor and capital. If input prices are fixed, then the ratio of these prices is clearly fixed and the isocost line is straight. Only when the ratio or factor prices change as the quantities of inputs change is the isocost line not straight. 5. If the marginal cost of production is increasing, does this tell you whether the average variable cost is increasing or decreasing? Explain. Marginal cost can be increasing while average variable cost is either increasing or decreasing. If marginal cost is less (greater) than average variable cost, then each additional unit is adding less (more) to total cost than previous units added to the total cost, which implies that the AVC declines (increases). Therefore, we need to know whether marginal cost is greater than average variable cost to determine whether the AVC is increasing or decreasing. 6. If the marginal cost of production is greater than the average variable cost, does this tell you whether the average
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CHAPTER 7 - CHAPTER 7 THE COST OF PRODUCTION REVIEW...

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