Fall 2020

METU, Department of Economics

Instructor: Esma Gaygısız
T.A.: Çiğdem Ekiz
ECON 211 – Problem Set 5 Solutions
Chapter 7

1- Answer and provide an explanation for the following questions

a. Assume that the marginal cost of production is increasing. Can you determine
whether the average variable cost is increasing or decreasing? Explain.
b. Assume that the marginal cost of production is greater than the average variable cost.
Can you determine whether the average variable cost is increasing or decreasing?
Explain.
c. If the firm’s average cost curves are U-shaped, why does its average variable cost
curve achieve its minimum at a lower level of output than the average total cost
curve?
d. A firm has fixed costs of $4,000. Its short-run production function is y = 4x1/2, where
x is the amount of variable factor it uses and y is the amount of output. The price of
the variable factor is $4,000 per unit. Find the short-run total cost function in terms of
output.
Solution:
a. No. When marginal cost is increasing, average variable cost can be either increasing or
decreasing as shown in the diagram below. Marginal cost begins increasing at output level
q1, but AVC is decreasing. This happens because MC is below AVC and is therefore
pulling AVC down. AVC is decreasing for all output levels between q1 and q2. At q2, MC
cuts through the minimum point of AVC, and AVC begins to rise because MC is above it.
Thus for output levels greater than q2, AVC is increasing.
b. Yes, the average variable cost is increasing. If marginal cost is above average variable
cost, each additional unit costs more to produce than the average of the previous units,
so the average variable cost is pulled upward. This is shown in the diagram above for
output levels greater than q2.
c. Average total cost is equal to average fixed cost plus average variable cost: ATC = AVC +
AFC. When graphed, the difference between the U-shaped average total cost and U-
shaped average variable cost curves is the average fixed cost, and AFC is downward
sloping at all output levels. When AVC is falling, ATC will also fall because both AVC
and AFC are declining as output increases. When AVC reaches its minimum (the bottom
of its U), ATC will continue to fall because AFC is falling. Even as AVC gradually
begins to rise, ATC will still fall because of AFC’s decline. Eventually, however, as AVC
rises more rapidly, the increases in AVC will outstrip the declines in AFC, and ATC will
reach its minimum and then begin to rise.
d.
 1 1
2- Suppose the production function of digital cameras is given by 𝑄 = (𝐿2 + 𝐾 2 )2 . What
is the cost minimizing combination of labor and capital for a manufacturer that wants
to produce 121.000 digital camera when prices are 10$ per labor and 1$ per unit of
capital?
Solution:

3- Burcu’s cupcake factory employs workers (L) and cake-machines (K) according to the
following production function: 𝑓(𝐾, 𝐿) = 𝐾 0.5 𝐿0.5. The hourly cost of cake-machine is
$10 and the hourly cost of workers is $40.
a. Write out the Lagrangian for the cost-minimization problem.
b. Derive the optimal cake-machine to labor ratio.
c. Suppose Burcu wishes to produce 1000 units of cupcakes. How much labor and
cake-machine should she employ? How much will it cost to produce?
d. An order arrives doubling the amount of cupcake Burcu needs to produce.
Assuming she is unable to purchase more machines, how much will it cost to meet
the new production level?
e. In the long-run, Burcu will be able to employ more machine as well as labor. If she
continues to produce 2000 units of cupcakes, how much will it cost in the long run?
f. Explain why the cost in the long run is different than in the short run.
Solution:
4- A firm producing hockey sticks has a production function given by 𝑞 = 2𝐾 1/2 𝐿1/2 . In
the short run, the firm’s amount of capital equipment is fixed at K=100. Input prices
are as follows: v=1$, w=4$.
a. Calculate firm’s short run total cost curve. Calculate short run average cost curve.
b. What is firm’s short run marginal cost curve? What are SC, SAC, SMC for the firm
if it produces 25 hockey sticks?
c. Graph the SAC and SMC curves of the firm. Indicate the point you found in part b.
Solution:

5- A firm’s production function is given by q = min{M, L1/2}, where M is the number of

machines and L is the amount of labor that it uses. The price of labor is $1 and the price
of machines is $4 per unit. Find the equation of the firm’s long-run marginal cost and
average cost curve and draw them on a graph.
 Solution:

Multiple Choice:

1- Which of the following statements is true regarding the differences between economic and
accounting costs?
A) Accounting costs include all implicit and explicit costs.
B) Economic costs include implied costs only.
C) Accountants consider only implicit costs when calculating costs.
D) Accounting costs include only explicit costs.

2) Constantine purchased 100 shares of IBM stock several years ago for $150 per share. The
price of these shares has fallen to $55 per share. Constantine's investment strategy is "buy
low, sell high." Therefore, he will not sell his IBM stock until the price rises above $150 per
share. If he sells at a price lower than $150 per share he will have "bought high and sold
low." Constantine's decision:
A) is correct and shows a solid command of the nature of opportunity cost.
B) is incorrect because the original price paid for the shares is a sunk cost and should have no
bearing on whether the shares should be held or sold.
C) is incorrect because when the price of a stock falls, the law of demand states that he
should buy more shares.
D) is incorrect because it treats the price of the shares as an explicit cost.

3) In order for a taxicab to be operated in New York City, it must have a medallion on its
hood. Medallions are expensive, but can be resold, and are therefore an example of
A) a fixed cost.
B) a variable cost.
C) an implicit cost.
D) an opportunity cost.
E) a sunk cost
4) Which of the following statements correctly uses the concept of opportunity cost in
decision making?
I. "Because my secretary's time has already been paid for, my cost of taking on an additional
project is lower than it otherwise would be."
II. "Since NASA is running under budget this year, the cost of another space shuttle launch is
lower than it otherwise would be."
A) I is true, and II is false.
B) I is false, and II is true.
C) I and II are both true.
D) I and II are both false.

5) Carolyn knows average total cost and average variable cost for a given level of output.
Which of the following costs can she not determine given this information?
A) total cost
B) average fixed cost
C) fixed cost
D) variable cost
E) Carolyn can determine all of the above costs given the information provided.

6) In a short-run production process, the marginal cost is rising and the average variable cost
is falling as output is increased. Thus,
A) average fixed cost is constant.
B) marginal cost is above average variable cost.
C) marginal cost is below average fixed cost.
D) marginal cost is below average variable cost.

7) Consider the following statements when answering this question

I. The marginal cost curve intersects the average total cost and average variable cost curves
at their minimum values.
II. When a firm has positive fixed costs, the output level associated with minimum average
variable costs is less than the output associated with minimum average total costs.
A) I is true, and II is false.
B) I is false, and II is true.
C) I and II are both true.
D) I and II are both false.

8) Assume that a firm spends $500 on two inputs, labor (graphed on the horizontal axis) and
capital (graphed on the vertical axis). If the wage rate is $20 per hour and the rental cost of
capital is $25 per hour, the slope of the isocost curve will be
A) 500.
B) 25/500.
C) -4/5.
D) 25/20 or 1.25.

9) A firm's expansion path is

A) the firm's production function.
B) a curve that makes the marginal product of the last unit of each input equal for each
output.
C) a curve that shows the least-cost combination of inputs needed to produce each level of
output for given input prices.
D) none of the above

10) Suppose our firm produces chartered business flights with capital (planes) and labor
(pilots) in fixed proportion (i.e., one pilot for each plane). If the wage rate paid to the pilots
increases relative to the rental rate of capital for the airplanes, then:
A) the optimal capital-labor ratio should increase.
B) the optimal capital-labor ratio should decrease.
C) the optimal capital-labor ratio remains the same.
D) We do not have enough information to answer this question.

11) Use the following two statements to answer this question:

I. Increasing returns to scale cause economies of scale.
II. Economies of scale cause increasing returns to scale.
A) Both I and II are true.
B) I is true, and II is false.
C) I is false, and II is true.
D) Both I and II are false.

12) When there are economies of scale,

A) MC > AC, so cost-output elasticity is greater than AC.
B) MC < AC, so cost-output elasticity is less than AC.
C) MC < AC, so cost-output elasticity is greater than 1.
D) MC < AC, so cost-output elasticity is less than 1.
E) long-run marginal cost is declining.

13) Which of the following situations is NOT possible?

A) SAC and LAC are both increasing for some output levels.
B) SAC is increasing but LAC is decreasing for some output levels.
C) SAC is decreasing but LAC is increasing for some output levels.
D) SAC and LAC are both decreasing for some output levels.
E) All of the above are possible.

14) Bubba Burgers has discovered there are economies of scope available to the restaurant.
Which is most likely to be a response to this discovery?
A) Bubba adds more varied inputs to burger production.
B) Bubba expands burger production, focusing on that one good.
C) Bubba contracts burger production.
D) Bubba adds grilled chicken sandwiches to the menu.
E) Bubba cuts back on the diversity of the menu.

15) Consider the following statements when answering this question.

I. Investment in new technology generates learning by doing.
II. Economies of scale cannot shift the long-run average cost curve down, whereas learning
by doing can.
A) I is true, and II is false.
B) I is false, and II is true.
C) Both I and II are true.
D) Both I and II are false.
16) A learning curve may be expressed as a relationship between the labor per unit (L) and
the total number of units produced (N). Which of the following learning curves exhibits a
faster reduction in cost of production due to learning, (1) L = 10 + N-1 or (2) L = 10 + N-0.5?
A) Learning curve (1)
B) Learning curve (2)
C) Curves (1) and (2) exhibit the same rate.
D) We cannot determine the rate of cost reduction without knowing the value of N.

17) Which of the following is true of cost curves?

A) The ATC curve goes through the minimum of the MC curve.
B) The AVC curve goes through the minimum of the MC curve.
C) The MC curve goes through the minimum of the ATC curve, to the left of the minimum of
the AVC curve.
D) The MC curve goes through the minimum of the AVC curve, to the right of the minimum
of the ATC curve.
E) The MC curve goes through the minimum of both the AVC curve and the ATC curve.

18) A Cobb-Douglas production function:

A) exhibits constant returns to scale.
B) exhibits increasing returns to scale.
C) exhibits decreasing returns to scale.
D) can exhibit constant, increasing, or decreasing returns to scale.