ECO101A: Introduction to economics

Tutorial 3: Solution

1. The production function for a product is given by q = 100KL. If the price of capital
is $120 per day and the price of labor $30 per day, what is the minimum cost of
producing 1000 units of output?

The cost-minimizing combination of capital and labor is the one where

𝑀𝑃𝐿 𝑤
= 𝑀𝑅𝑇𝑆 =
𝑀𝑃𝐾 𝑟
𝜕𝑞 𝜕𝑞
The marginal product of labor is 𝜕𝐿 = 100𝐾. The marginal product of capital is 𝜕𝐿 = 100𝐿.
100𝐾 𝐾
Therefore, the marginal rate of technical substitution is = . To determine the optimal
100𝐿 𝐿
capital-labor ratio set the marginal rate of technical substitution equal to the ratio of the wage
rate to the rental rate of capital:
𝐾 30
= 120, or L = 4K.
𝐿

Substitute for L in the production function and solve where K yields an output of 1,000 units:
1,000 = (100)(K)(4K), or K = 1.58.
Because L equals 4K this means L equals 6.32.
With these levels of the two inputs, total cost is:
TC = wL + rK, or
TC = (30)(6.32) + (120)(1.58) = $379.20.
To see if K = 1.58 and L = 6.32 are the cost minimizing levels of inputs, consider small changes
in K and L. around 1.58 and 6.32. At K = 1.6 and L = 6.32, total cost is $381.60, and at K =
1.58 and L = 6.4, total cost is $381.6, both greater than $379.20. We have found the cost-
minimizing levels of K and L.

2. Suppose a production function is given by F(K, L) = KL2, the price of capital is $10,
and the price of labor $15. What combination of labor and capital minimizes the
cost of producing any given output?

The cost-minimizing combination of capital and labor is the one where

𝑀𝑃𝐿 𝑤
= 𝑀𝑅𝑇𝑆 =
𝑀𝑃𝐾 𝑟
𝜕𝑞 𝜕𝑞
The marginal product of labor is 𝜕𝐿 = 2𝐾𝐿. The marginal product of capital is 𝜕𝐿 = 𝐿2 .
Set the marginal rate of technical substitution equal to the input price ratio to determine the
optimal capital-labor ratio:
2𝐾𝐿 15
= , 𝑜𝑟 𝐾 = 0.75𝐿
𝐿2 10
Therefore, the capital-labor ratio should be 0.75 to minimize the cost of producing any given
output.

3. Suppose the process of producing light-weight parkas by Polly’s Parkas is

described by the function:
𝒒 = 𝟏𝟎𝑲𝟎.𝟖 (𝑳 − 𝟒𝟎)𝟎.𝟐
where q is the number of parkas produced, K the number of computerized
stitching machine hours, and L the number of person-hours of labor. In addition
to capital and labor, $10 worth of raw materials are used in the production of each
parka.

We are given the production function:

𝒒 = 𝑭(𝑲, 𝑳) = 𝟏𝟎𝑲𝟎.𝟖 (𝑳 − 𝟒𝟎)𝟎.𝟐
We also know that the cost of production, in addition to the cost of capital and labor,
includes $10 of raw material per unit of output. This yields the following total cost
function:
TC(q) = wL + rK + 10q

a. By minimizing cost subject to the production function, derive the cost-

minimizing demands for K and L as a function of output (q), wage rates (w),
and rental rates on machines (r). Use these results to derive the total cost
function, that is costs as a function of q, r, w, and the constant $10 per unit
materials cost.

We need to find the combinations of K and L that will minimize this cost function for
any given level of output q and factor prices r and w. To do this, we set up the
Lagrangian:

Differentiating with respect to K, L, and λ, and setting the derivatives equal to zero:

The first 2 equations imply:

This further implies:

Substituting the above equations for K and L-40 into equation (3) yields solutions for
K and L:
We can now obtain the total cost function in terms of only r, w, and Q by substituting
these cost-minimizing values for K and L into the total cost function:

b. This process requires skilled workers, who earn $32 per hour. The rental rate
on the machines used in the process is $64 per hour. At these factor prices,
what are total costs as a function of q? Does this technology exhibit decreasing,
constant, or increasing returns to scale?

Given the values w = 32 and r = 64, the total cost function becomes:

TC(q)=19.2q+1280.

The average cost function is then given by

AC(q) = 19.2 + 1280/q.

To find returns to scale, choose an input combination and find the level of output, and
then double all inputs and compare the new and old output levels.
Assume K=50 and L=60. Then q1= 10(50)0.8(60-40)0.2 = 416.3.
When K=100 and L=120, q2= 10(100)0.8(120-40)0.2 = 956.4.
Since q2/q1 > 2, the production function exhibits increasing returns to scale.

c. Polly’s Parkas plans to produce 2000 parkas per week. At the factor prices
given above, how many workers should the firm hire (at 40 hours per week)
and how many machines should it rent (at 40 machines-hours per week)? What
are the marginal and average costs at this level of production?

Given q = 2,000 per week, we can calculate the required amount of inputs K and L
using the formulas derived in part a:

Thus L = 154.9 worker hours and K = 229.1 machine hours. Assuming a 40 hour
week, L = 154.9/40 = 3.87 workers per week, and K = 229.1/40 = 5.73 machines per
week. Polly’s Parkas should hire 4 workers and rent 6 machines per week.

We know that the total cost and average cost functions are given by:

TC(q) = 19.2q + 1280

AC(q) = 19.2 + 1280/q,

so, the marginal cost function is

MC(q) = d TC(q) / d q = 19.2.

 Marginal costs are constant at $19.2 per parka and average costs are 19.2+1280/2000
or $19.84 per parka.
𝟏 𝟏
4. Suppose that a firm’s production function is 𝒒 = 𝟏𝟎𝑳𝟐 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 cost-minimizing 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 1/4, 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.

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.
The new level of labor is 39.2. To find this, use the production function
1 1
𝑞 = 10𝐿2 𝐾 2 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.
 c. Graphically identify the cost-minimizing 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. If the marginal rate of technical substitution is K / L, find the optimal level of
capital 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 /L = 20 / 80, or K = L / 4. Now substitute this into the production function
1
𝐿 1
for K, set q equal to 140, and solve for L: 140 = 10𝐿2 (4)2 , L=28, K= 7. The new
cost is TC=$20*28+$80*7 or $1120.
5. 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
AC = 10 - 0.1Q + 0.3q.
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 cost-output 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.
c. 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:
AC1 = 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.

6. Suppose the long-run 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 U-shaped average cost curve for at least some values
of a, b, c, d.
To show that the cubic cost equation implies a U-shaped 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, fixed 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:
AC = b + cQ + dQ2.
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 U-shaped 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 < 0.
To restrict b, we know that at 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 = − 2𝑑 > 0. Next, substituting this value for Q into our expression for average cost,
and simplifying the equation:
𝑐 𝑐
𝐴𝐶 = 𝑏 + 𝑐𝑄 + 𝑑𝑄 2 = 𝑏 + 𝑐(− 2𝑑) + 𝑑𝑄(− 2𝑑)2, or

𝑐2
𝐴𝐶 = 𝑏 − 4𝑑 > 0.
 𝑐2
implying 𝑏 > 4𝑑. Because c2 > 0 and d > 0, b must be positive.

In summary, for U-shaped long-run 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
minimum is positive, using the same procedure, i.e., solving for Q at minimum
marginal cost - c / 3d, and substituting into the expression for marginal cost b + 2cQ
+ 3dQ2, 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.
For example, let a = 0, b = 1, c = -1, d = 1. Total cost is Q - Q2 + Q3; average cost is
1 - Q + Q2; and marginal cost is 1 - 2Q + 3Q2. Minimum average cost is Q = 1/2 and
minimum marginal cost is 1/3 (think of Q as dozens of units, so no fractional units are
produced).

7. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. Revenues could be greater than
variable costs, but not total costs, in which case the firm is better off producing in the short
run rather than shutting down, even though they are incurring a loss. The firm should
compare the level of loss with no production to the level of loss with positive production,
and pick the option that results in the smallest loss. In the short run, losses will be
minimized as long as the firm covers its variable costs. In the long run, all costs are variable,
and thus, all costs must be covered if the firm is to remain in business.
8. Explain why the industry supply curve is not the long-run industry marginal cost
curve.
In the short run, a change in the market price induces the profit-maximizing firm to change
its optimal level of output. This optimal output occurs when price is equal to marginal cost,
as long as marginal cost exceeds average variable cost. Therefore, the supply curve of the
firm is its marginal cost curve, above average variable cost. (When the price falls below
average variable cost, the firm will shut down.) In the long run, the firm adjusts its inputs
so that its long-run marginal cost is equal to the market price. At this level of output, it is
operating on a short-run marginal cost curve where short-run marginal cost is equal to price.
As the long-run price changes, the firm gradually changes its mix of inputs to minimize
cost. Thus, the long-run supply response is this adjustment from one set of short-run
marginal cost curves to another.
Also note that in the long run there will be entry and the firm will earn zero profit, so that
any level of output where MC>AC is not possible.
9. In long-run equilibrium, all firms in the industry earn zero economic profit. Why
is this true?
The theory of perfect competition explicitly assumes that there are no entry or exit barriers
to new participants in an industry. With free entry, positive economic profits induce new
entrants. As these firms enter, the supply curve shifts to the right, causing a fall in the
equilibrium price of the product. Entry will stop, and equilibrium will be achieved, when
economic profits have fallen to zero.
10. Why do firms enter an industry when they know that in the long run economic
profit will be zero?
Firms enter an industry when they expect to earn economic profit. These short-run profits
are enough to encourage entry. Zero economic profits in the long run imply normal returns
to the factors of production, including the labor and capital of the owners of firms. For
example, the owner of a small business might experience positive accounting profits before
the foregone wages from running the business are subtracted from these profits. If the
revenue minus other costs is just equal to what could be earned elsewhere, then the owner
is indifferent to staying in business or exiting.

11. Suppose a competitive industry faces an increase in demand (i.e., the demand
curve shifts upward). What are the steps by which a competitive market insures
increased output? Will your answer change if the government imposes a price
ceiling?
If demand increases with fixed supply, price and profits increase. The price increase
induces the firms in the industry to increase output. Also, with positive profit, firms enter
the industry, shifting the supply curve to the right. This results in a new equilibrium with a
higher quantity produced and a price that earns all firms zero economic profit. With an
effective price ceiling, profit will be lower than without the ceiling, reducing the incentive
for firms to enter the industry. With zero economic profit, no firms enter and there is no
shift in the supply curve.
12. Suppose you are the manager of a watchmaking firm operating in a competitive
market. Your cost of production is given by C = 200 +2q2, where q is the level of
 output and C is total cost. (The marginal cost of production is 4q. The fixed cost
of production is $200.)
a. If the price of watches is $100, how many watches should you produce to
maximize profit?
Profits are maximized where marginal cost is equal to marginal revenue. Here, marginal
revenue is equal to $100; recall that price equals marginal revenue in a competitive
market: 100 = 4q, or q = 25.
b. What will the profit level be?
Profit is equal to total revenue minus total cost:
π = (100) (25) - (200 + 2*252) = $1050.
c. At what minimum price will the firm produce a positive output?
A firm will produce in the short run if the revenues it receives are greater than its
variable costs. Remember that the firm’s short-run supply curve is its marginal cost
curve above the minimum of average variable cost. Here, average variable cost is
VC/q = 2q2/q = 2q. Also, MC is equal to 4q. So, MC is greater than AVC for any
quantity greater than 0. This means that the firm produces in the short run as long as
price is positive.
13. A firm produces a product in a competitive industry and has a total cost function
TC = 50 + 4q + 2q2 and a marginal cost function MC = 4 + 4q. At the given market
price of $20, the firm is producing 5 units of output. Is the firm maximizing profit?
What quantity of output should the firm produce in the long run?
If the firm is maximizing profit, then price will be equal to marginal cost. P=MC results in
P=20=4+4q=MC, or q=4. The firm is not maximizing profit, since it is producing too much
output. The current level of profit is
profit = 20*5-(50+4*5+2*5*5) = –20,
and the profit maximizing level is
profit = 20*4-(50+4*4+2*4*4) = –18.
Given no change in the price of the product or the cost structure of the firm, the firm should
produce q=0 units of output in the long run since at the quantity where price is equal to
marginal cost, economic profit is negative. The firm should exit the industry.
14. Suppose the cost function is C(q)=4q2+16.
a. Find variable cost, fixed cost, average cost, average variable cost, and average
fixed cost.
Variable cost is that part of total cost that depends on q ( 4q2 ) and fixed cost is that part of
total cost that does not depend on q (16).
VC = 4q2
FC =16
 AC = C(q) /q = 4q + 16/q
AVC = VC/q = 4q
AFC = FC/q = 16/q
b. Show the average cost, marginal cost, and average variable cost curves on a graph.
Average cost is u-shaped. Average cost is relatively large at first because the firm is not
able to spread the fixed cost over very many units of output. As output increases, average
fixed costs will fall relatively rapidly. Average cost will increase at some point because the
average fixed cost will become very small and average variable cost is increasing as q
increases. Average variable cost will increase because of diminishing returns to the variable
factor labor. MC and AVC are linear, and both pass through the origin. Average variable
cost is everywhere below average cost. Marginal cost is everywhere above average variable
cost. If the average is rising, then the marginal must be above the average. Marginal cost
will hit average cost at its minimum point.
c. Find the output that minimizes average cost.
The minimum average cost quantity is where MC is equal to AC:
AC = 4q + 16/q = 8q = MC
16/q = 4q
16 = 4q2
4 = q2
2 = q.
d. At what range of prices will the firm produce a positive output?
The firm will supply positive levels of output as long as P=MC>AVC, or as long as the
firm is covering its variable costs of production. In this case, marginal cost is everywhere
above average variable cost so the firm will supply positive output at any positive price.
e. At what range of prices will the firm earn a negative profit?
The firm will earn negative profit when P=MC<AC, or at any price below minimum
average cost. In part c above we found that the minimum average cost quantity was q=2.
Plug q=2 into the average cost function to find AC=16. The firm will therefore earn
negative profit if price is below 16.
f. At what range of prices will the firm earn a positive profit?
In part e we found that the firm would earn negative profit at any price below 16. The firm
therefore earns positive profit as long as price is above 16.
15. Suppose you are given the following information about a particular industry:
QD = 6500 -100P Market demand
QS =1200P Market supply
 C(q) = 722 + q2 / 200 Firm total cost function
Assume that all firms are identical, and that the market is characterized by pure
competition.
a. Find the equilibrium price, the equilibrium quantity, the output supplied by the
firm, and the profit of the firm.
Equilibrium price and quantity are found by setting market supply equal to market demand,
so that 6500-100P=1200P. Solve to find P=5 and substitute into either equation to find
Q=6000. To find the output for the firm set price equal to marginal cost so that 5=2q/200
and q=500. Profit of the firm is total revenue minus total cost or
Π = pq - C(q) = 5(500) - 722 - 5002/200 = 528.
Notice that since the total output in the market is 6000, and the firm output is 500, there
must be 6000/500=12 firms in the industry.
b. Would you expect to see entry into or exit from the industry in the long-run?
Explain. What effect will entry or exit have on market equilibrium?
Entry because the firms in the industry are making positive profit. As firms enter, the supply
curve for the industry will shift down and to the right and the equilibrium price will fall, all
else the same. This will reduce each firm’s profit down to zero until there is no incentive
for further entry.
c. What is the lowest price at which each firm would sell its output in the long run?
Is profit positive, negative, or zero at this price? Explain.
In the long run the firm will not sell for a price that is below minimum average cost. At any
price below minimum average cost, profit is negative and the firm is better off selling its
fixed resources and producing nzero output. To find the minimum average cost, set
marginal cost equal to average cost and solve for q:
2q/200 = 722/q + q/200
q/200 = 722/q
q2 = 722(200)
q = 380
AC (q = 380) = 3.8.
Therefore, the firm will not sell for any price less than 3.8 in the long run.
d. What is the lowest price at which each firm would sell its output in the short run?
Is profit positive, negative, or zero at this price? Explain.
The firm will sell for any positive price, because at any positive price marginal cost will be
above average variable cost (AVC=q/2000). Profit is negative as long as price is below
minimum average cost, or as long as price is below 3.8.
16. Suppose that a competitive firm has a total cost function C(q) = 450 +15q + 2q2 and a
marginal cost function MC(q) =15 + 4q. If the market price is P=$115 per unit, find
the level of output produced by the firm. Find the level of profit and the level of
producer surplus.
The firm should produce where price is equal to marginal cost so that P=115=15+4q=MC
and q=25. Profit is Π = 115(25) - 450 - 15(25) - 2(252) = 800. Producer surplus is profit
plus fixed cost, which is 1250. Note that producer surplus can also be found graphically by
calculating the area below the price line and above the marginal cost (supply) curve, so that
PS=0.5 * (115-15) * 25=1250.