Worksheet - Chapter 5

1. If a good is a Giffen good, which of the following statements is FALSE?

(a) The income effect from a rise in its price causes a rise in demand.
(b) It is an inferior good.
(c) The substitution effect from a rise in its price causes a rise in demand.
(d) The substitution effect from a fall in its price must be smaller than the income effect.

Reading for this question See BVFD Chapter 5 Section 3.

Approaching the question (c) is correct.

The substitution effect comes from the compensated demand. The compensated
demand is either flat or downward-sloping: with an increase in price the quantity
demanded either falls or remains unchanged.

2. Which statement about an indifference curve diagram with good 1 on the horizontal axis
and good 2 on the vertical axis is not correct?

(a) Indifference curves are downward-sloping because consumers have non-satiated

preferences.
(b) The marginal rate of substitution tells you how many units of good 2 you are willing to
give up in order to get one more unit of good 1.
(c) The utility maximising bundle will always be found at a tangency between the
indifference curve and the budget constraint.
(d) Transitivity and preferring more to less imply that indifference curves cannot cross.
Reading for this question

See BVFD Chapter 5.

Approaching the question (c) is the correct answer.
For instance, with perfect substitutes we find solutions at the corners.

3. A firm pays each worker (i.e. each unit of labour L) a wage w = 4 and pays for each
computer (i.e. each unit of capital K) a cost of r = 2. The firm has a production function Y
= min[2K, 2L] and needs to produce Y = 12. Which of the following is correct?

(a) The firm employs 12 workers and buys 12 computers.

(b) The firm buys 12 computers and hires 6 workers.
(c) The firm buys 6 computers and hires 12 workers.
 (d) The firm buys 6 computers and hires 6 workers.

Reading for this question See BVFD Chapter 7.

Approaching the question (d) is the correct answer. Given the firm’s production function
the firm will optimally set 2K = 2L → K = L. The firm needs to produce Y = 12 so it will to
buy computers and hire workers such that 2K = 2L = 12, or K = L = 6.

4. A firm pays each worker (i.e. each unit of labour L) a wage w = 4 and pays for each
computer (i.e. each unit of capital K) a cost of r = 3. The firm has a production function Y
= K + 2L and needs to produce Y = 12. Which of the following is correct?

(a) The firm employs 12 workers and buys no computers.

(b) The firm buys 12 computers and hires no workers.
(c) The firm employs 6 workers and buys no computers.
(d) The firm buys 6 computers and hires no workers.

Reading for this question See BVFD Chapter 7.

Approaching the question (c) is the correct answer.
Here capital and workers are substitutes as inputs of production and the firm is willing to
pay twice as much for workers, as they are twice as productive as computers. Because
the wage is lower than twice the cost of capital, the firm will only hire workers to produce
its output. To produce an output of 12 the firm will need to employ L = Y /2 = 12/2 = 6
workers.

5. Citizens of Taxland can decide how many hours to work. This year, the government of
Taxland introduced a higher income tax. The introduction of the tax lowers the real wage
of Taxland’s citizens, but it is uncertain whether each citizen will work more or fewer
hours following the higher tax. True or False?

Reading for this question See BVFD Chapter 10, Section 4.

Approaching the question: True.
The higher income tax creates a substitution effect and an income effect. The
substitution effect makes leisure relatively less expensive and pushes citizens to work
less and spend more time in leisure, but the income effect makes them want to work
more as they are now relatively poorer. The overall change depends on the strength of
the substitution and income effects. Most candidates correctly identified that the impact
of the tax on labour supply is uncertain, but many explanations did not refer to the
income and substitution effects.
6. Demetra is an agricultural consultant and can choose how many hours to work. Last
year she worked really hard and her boss increased her wage. While the raise increases
Demetra’s real wage, it is uncertain whether she will optimally supply more hours of
work. True or False?

Reading for this question See BVFD Chapter 10, Section 4.

Approaching the question: True.

An increase in the real wage causes a substitution and an income effect. While the
higher wage causes her to substitute away from leisure and work more, the income
effect will make her work less and spend more time in leisure, as she is relatively richer.
The overall effect depends on how strong the substitution and income effects are in this
case. Notice that stating ‘true’ in this question effectively means stating that the impact of
the policy is uncertain. Candidates who answered ‘uncertain’ and gave the correct
explanation were awarded full marks. The crux of this question lies in explaining that the
substitution and income effects work in opposite directions and hence we cannot be sure
about the one that dominates. Candidates who identified the two effects and discussed
them received full marks. Some candidates mentioned that Demitra may increase or
decrease her labour supply without explaining why and were awarded only partial credit

7. Gabriel, a student, has a budget of £60 to spend on cappuccinos (good X) and on cups
of tea (good Y ) during breaks while revising for his economics examination. The prices
of the two goods are PX = 3 and PY = 2, respectively. Gabriel’s preferences over the two
goods are described by the utility function U(X, Y ) = XY , for which MUX = Y and MUY =
X.

(a) Explain how Gabriel’s tastes over cappuccinos and cups of tea can be translated into
indifference curves. Sketch some of these in a diagram. What determines their slope? (6
marks)
(b) Add Gabriel’s budget line to your diagram and find the number of cappuccinos and
cups of coffee Gabriel chooses to consume. Explain why this consumption decision is
optimal. (8 marks)
(c) Margaret faces the same prices and has the same income as Gabriel, but her utility
function is given by U(X, Y ) = X + Y , for which MUX = MUY = 1. Explain how Margaret
will spend her income. (6 marks)
(d) Suppose the price of a cup of tea rises such that PX = PY = 3 and at the same time
the budget Gabriel and Margaret have available to spend increases to £75. How does
this affect their budget line? Do Gabriel and Margaret consume the same bundles as
before? (10 marks)
Reading for this question See BVFD Chapter 5. 10
Approaching the question:

(a) Indifference curves give combinations of the two goods that give Gabriel a particular
level of utility. A sketch with cappuccinos on the horizontal axis and cups of tea on the
vertical axis with convex to the origin indifference curves was expected here, alongside a
brief explanation linking the shape of the indifference curves to the: MRS = MUX / MUY
= Y / X condition. Many candidates included the correct sketch but failed to explain the
shape of the indifference curve.

(b) The budget line is 3X + 2Y = 60, so: Y = 30 − 3 / 2 X. It has a gradient of −3/2 and
intercepts: M/ PX = 20 and M/ PY = 30. At the optimal point: MRS = MUX/ MUY = Y/ X =
PX/ PY = 3 / 2 so 3X = 2Y . Substituting into the budget constraint and solving gives X =
10 and Y = 15.
So Gabriel consumes 10 cappuccinos and 15 cups of tea. At the optimal point: MUX/ PX
= MUY/ PY which implies Gabriel adjusts his spending until the utility gained from the
last pound spent on cappuccinos is the same as the utility gained from the last pound
spent on cups of tea. The majority of candidates were able to find the utility-maximising
bundle but many did not explain why the optimal bundle is at a tangency between the
indifference curve and the budget line.

(c) We have that: MUX /PX = 1/ 3 and MUY/ PY = 1 / 2 are fixed, which reflects the fact
that Margaret views the goods as perfect substitutes. The optimal bundle is not a
tangency, but at a corner of the budget constraint. Candidates were expected to reason
that since: MUY / PY > MUX/ PX the utility gain from spending on cups of tea is always
higher than from spending on cappuccinos, so Margaret will spend all her income on
cups of tea and thus purchases 60/2 = 30 cups of tea and no cappuccinos. The
candidates who recognised this type of preferences typically argued the optimal bundle
correctly, but many candidates mechanically tried to set: MUX/ PX = MUY/ PY leading to
a loss of many marks.

(d) The budget line changes to 3X + 3Y = 75, so Y = 25 − X. It has a gradient of −1 and

the intercepts are 75/3 = 25. Gabriel’s initial optimal bundle continues to be affordable,
but it is no longer optimal as relative price has changed. There will be a substitution
effect away from tea towards coffee until: Y / 3 = X/ 3 which implies X = Y = 12.5 of
each. Margaret can no longer afford her initial bundle so cannot consume there. She is
now indifferent between buying cappuccinos and cups of tea but can afford fewer cups
of tea than before so is worse off. Switching to cappuccinos does not make her better
off.
Candidates who recognised that a key element is whether the previous bundle is
affordable performed well in this question. Some candidates tried to approach this
question only using income and substitution effects, achieving only partial credit.
 Candidates who previously did not recognise the perfect substitutes preferences for
Margaret followed the wrong approach and only received partial credit for their answer.

8. Rita has a budget of £600 to spend on theatre tickets (X) and on restaurant meals (Y ).
Each theatre ticket is priced at £60 (denoted by PX), whereas the price of a restaurant
meal (PY ) is £30. Her utility function is U(X, Y ) = 8√ X + Y , which gives marginal
utilities MUX = 4/ √ X and MUY = 1. Her indifference curves are convex to the origin.

(a) Find the equation of Rita’s budget line. Explain how Rita decides to spend her budget
with the aid of a diagram. (6 marks)
(b) Find the number of theatre tickets and restaurant meals Rita purchases. (6 marks)
(c) Rita receives a pay rise and so increases her budget for theatre tickets and
restaurant meals to £660. Find the number of theatre tickets and restaurant meals Rita
now purchases. (6 marks)
(d) For Rita are theatre tickets and restaurant meals normal goods, inferior goods or not
associated with income? (6 marks)
(e) Suppose the price of restaurant meals falls. How do you expect Rita’s demand for
theatre tickets to change? Explain with reference to substitution and income effects. (6
marks)

Reading for this question See BVFD Chapter 5.

Approaching the question

(a) Indifference curves give combinations of the two goods that give Rita a particular
level of utility. The budget line shows all affordable combinations of the two goods given
Rita’s income. Here the equation for the budget line is: 60X + 30Y = 600 and so Y = 20 −
2X. Rita maximises her utility subject to her budget line. This corresponds to finding a
tangency between the highest attainable indifference curve (convex to the origin) and
the budget line. Candidates who received full marks included in the sketch the correct
intercepts for the budget line (X-intercept is 10 and Y -intercept is 20; note the gradient is
−2) and one or more indifference curves with the optimal bundle indicated as the
tangency – some might mention that: MRS = MUX/ MUY = PX/ PY . Many candidates
lost marks on this question, as they only showed the budget line missing out indifference
curves, and not offering any explanation as to how Rita goes about finding the utility-
maximising bundle.
 (b) The optimal bundle can be found at the tangency between indifference curve and
budget line. At the optimal point: MRS = MUX/ MUY = PX/ PY hence: 4/ √ X = 60/ 30 = 2
=⇒ X = 4. She therefore purchases 4 theatre tickets. Substituting into the budget
constraint: Y = 20 − 2X = 12, so she purchases 12 restaurant meals. At this bundle the
utility gained from the last pound spent on theatre tickets is the same as the utility gained
from the last pound spent on restaurant meals. The majority of candidates found the
correct bundle. Those who lost marks on this question typically failed to explain why they
were setting up the: MRS = MUX/ MUY = PX/ PY condition or to explain intuitively why
this bundle is optimal.

(c) Rita now has a new budget line: 60X + 30Y = 660 and so Y = 22 − 2X. Rita still
maximises utility where: MRS = MUX/ MUY = PX/ PY . Hence as before: MRS = MUX/
MUY = PX/ PY =⇒ 4/ √ X = 60/ 30 = 2 =⇒ X = 4. She buys the same number of theatre
tickets as before! From her new budget constraint: Y = 22 − 2X = 14, so she purchases
14 restaurant meals.
Excellent answers in this part included a diagram showing the new (higher) indifference
curve Rita can attain.

(d) Candidates can see from (b) and (c) that an increase in income gives rise to an
increase in restaurant meals only. Theatre tickets are thus not associated with income
(in the interior equilibrium). Hence the income elasticity for theatre tickets is zero.
Restaurant meals are normal goods – they increase with income. The income elasticity
is positive. The majority of candidates argued this correctly.

(e) A fall in the price of restaurant meals gives rise to a substitution effect away from
theatre tickets towards restaurant meals. A price fall increases purchasing power and
usually gives rise to an income effect, but there is none here because the income
elasticity of demand for theatre tickets is zero. Hence there is an unambiguous fall in
Rita’s demand for theatre tickets. Many candidates could correctly discuss the
substitution and income effects for restaurant meals but failed to link the finding in part
(d) (income effect is zero for theatre tickets) to the discussion here, leading to wrong
statements. Excellent answers showed the effects on a diagram, but many were missing
some components, and some tried to find the substitution effect on the new indifference
curve rather than the old. Candidates who offered a generic discussion of income and
substitution effects straight from the subject guide, without reference to the specifics of
this question lost a lot of marks.

9. Will and Kate share a house. They each have a weekly budget of £12 to spend on green
smoothies (good X) and cups of bubble tea (good Y ), which are priced at PX = £2 and
PY = £3 in their local caf´e. Will’s preferences are described by the utility function U(X,
Y ) = X + Y , for which MU X = MU Y = 1. Kate’s preferences are described by the utility
function U(X, Y ) = X − Y , for which MU X = 1 and MU Y = −1.
(a) Explain how the preferences of Will and Kate over green smoothies and cups of
bubble tea can be translated into indifference curves. Sketch some of these in two
separate diagrams and explain their shape. (10 marks)
(b) How many cups of bubble tea are demanded by Will and Kate? Sketch the optimal
consumption decision of Will and Kate in the diagrams sketched in (a). (10 marks)
(c) The caf´e owner is considering lowering PY to stimulate sales of bubble tea. Do you
expect such a strategy to be effective in increasing the demand for bubble tea of Will
and Kate? You may wish to support your argument with diagrams. (10 marks)

Reading for this question See BVFD Chapter 5.

Approaching the question:

(a) Indifference curves give combinations of the two goods that give Will and Kate a
particular level of utility. Will views smoothies and bubble tea as perfect substitutes, so
indifference curves are linear with a slope of −1. Kate derives utility from smoothies but
dislikes bubble tea – consuming it lowers her utility. So, she would need to consume 1
more smoothie to compensate for the disutility of consuming 1 cup of bubble tea.
Indifference curves are linear with a slope of 1. A sketch with bubble tea and smoothies
on the axes was expected here to show Will and Kate’s preferences. A common mistake
was treating both Will and Kate’s preferences as Cobb–Douglas or perfect substitutes
(ignoring Kate’s preferences do not satisfy non-satiation). Some candidates realised
Kate does not like good Y but discussed how extra units of good X can compensate for
the consumption of Y , without realising that Kate can simply avoid consuming the good.
The mistake compounds throughout the question, as the diagram in this part would be
incorrect and the optimal bundle in part

(b) would also be wrong for Kate. (b) For Will: MU X/ PX = 1/ 2 and MU Y/ PY = 1/ 3 .
They are fixed, reflecting the fact that Will views the goods as perfect substitutes. The
optimal point is not a tangency but is at the corner. Since: MU Y/ PY < MU X/ PX) the
utility gain from spending on green smoothies is always higher than from spending on
cups of bubble tea! So Will spends all income on smoothies. (Another possible
explanation is that since smoothies are less expensive, Will spends all income on
smoothies.) Hence X = 12/2 = 6 smoothies and Y = 0 cups of bubble tea. Add a budget
line with gradient −2/3; optimal bundle at corner on the horizontal axis. Kate dislikes
bubble tea – spending money on bubble tea lowers her utility and so all her income is
spent on green smoothies. Hence X = 12/2 = 6 smoothies and Y = 0 cups of bubble tea.
The budget line has a gradient of −2/3 so the optimal bundle is again at the corner on
the horizontal axis.
 (c) Nothing can convince Kate to buy bubble tea at a positive price as she dislikes it and
her utility falls by consuming it. So lowering PY will be ineffective in stimulating demand
from Kate. The budget line pivots out around the horizontal axis intercept – but she still
will choose that invariant point as her optimal bundle. For Will, lowering PY will pivot out
the budget line and make it steeper as the relative price of green smoothies to cups of
bubble tea rises. If PY falls but stays above £2, then Will still chooses to consume only
green smoothies. Only if PY falls below £2 will Will choose to switch to consuming
bubble tea – the optimal bundle shifts to the other corner (horizontal axis intercept).

10. Sam views a packet of cheese (good X) and a bottle of wine (good Y ) as perfect
complements. Each month Sam sets aside £80 to spend on cheese and wine. The
prices of the two goods are PX = PY = £10.

(a) Sketch some of Sam’s indifference curves in a diagram and explain their shape. (5
marks)
(b) Add Sam’s budget line to your diagram. Find the amount of cheese and wine Sam
chooses to consume and add the optimal bundle to your diagram. (10 marks)
(c) Sam is consuming at his optimal bundle when he receives an unexpected gift of two
bottles of wine. Will Sam benefit from receiving this gift? Explain your answer. (5 marks)
(d) Sam is consuming as in (b) when the price of cheese falls (the price of a bottle of
wine is unchanged). Illustrate in a diagram how the fall in the price of cheese changes
Sam’s optimal bundle and decompose the effect of the price fall into a substitution and
an income effect, explaining your reasoning. (10 marks)

Reading for this question See BVFD Chapter 5.

Approaching the question

(a) An indifference curve shows all the combinations of wine and cheese that allow Sam
to reach the same utility. The sketch should contain L-shaped indifference curves with
the corners along the line Y = X. From any bundle where Y = X, adding more of one
good does not add to utility; only increasing both adds to utility. If Y > X (or X > Y ) then
adding more of good Y (or good X) does not add to utility but adding more of X (or good
Y ) does. Many candidates were able to draw these preferences correctly, but not
everyone detailed the graph and some drew Cobb–Douglas preferences.

(b) The budget line 10X + 10Y = 80, or Y = 8 − X. It has a slope of −1 and intercepts: M/
PX = M/ PX = 8. These should be labelled on the diagram. Perfect complements implies
utility is maximised where Y = X. Solving gives Y = X = 4. So 4 packets of cheese and 4
bottles of wine a month. This bundle should be added to the diagram for full marks.
Again, many candidates were able to correctly add the budget constraint to the diagram
and find the optimal bundle for Sam. However, some argued that the solution is at a
tangency where the MRS is equal to the price ratio, which is not the case here (the kink
 is non-differentiable so the MRS is formally undefined there) and the right way to argue
that the solution will be at the kink is to explain that spending more on either cheese than
wine (or the opposite) would not lead to an increase in utility.

(c) From Sam’s optimal bundle, adding two bottles of wine without adding more cheese
does not add to utility. In the diagram, it would mean a move vertically up the same
indifference curve (we would be on the vertical part of the L-shaped indifference curve).
The fact that the gift is unexpected matters (had it been anticipated Sam would have
reallocated income to cheese to ensure Y = X incorporating the gift). Many candidates
here argued that the gift does not increase Sam’s utility and either showed the new
bundle on their diagram or explained that this does not allow him to consume the right
ratio of cheese and wine. Some explained that Sam could sell some of the wine he
receives as a gift to increase his overall utility. This is not the case here because the gift
is unexpected – it happens after Sam has purchased his optimal bundle. However,
candidates who argued either that utility cannot increase (but failed to explain that this is
because the gift is unexpected) or that Sam could reoptimise received partial credit.

(d) The fall in the price of cheese makes Sam relatively richer. Given his preference,
there is no substitution effect here, only an income effect. There is no substitution
because he will still want to consume cheese and wine at the same ratio. However, the
fact that cheese is now cheaper allows him to buy both more cheese and more wine,
making him better off.
This was undoubtedly the hardest part of the question, and many candidates only
provided a short explanation or drew income and substitution effects as if the
preferences were Cobb–Douglas. It was clear that some candidates understood the
material much better than others, as they were able to correctly explain the effects and
draw the correct pictures. Weaker candidates mentioned that Sam will now consume
more cheese due to the substitution effect (failing to recognise that with perfect
complements there is no substitution effect) and drew the substitution effect on the new
and higher indifference curve, rather than the original one.

11. Bowen is the founder of a fashion company. His company produces dresses according
to the production function Q = 2K + L where K captures the sewing machines used in
production and L the number of hours it takes a worker to sew a garment.

(a) What is an isoquant? Draw a few isoquants that correspond to the production
function for dresses. (5 marks)
(b) Bowen wishes to produce 100 dresses. The cost of a sewing machine is £100, while
a worker is paid £20 per hour. What is the optimal combination of sewing machines and
hours of work that Bowen should hire? Show the optimal bundle on your diagram. What
is the cost associated with producing the dresses? (10 marks)
(c) Continue to assume that sewing machines cost £100 and a worker demands a wage
of £20. Bowen’s firm operates in a competitive market, where many other entrepreneurs
can produce similar dresses with the same cost structure. What is the expected market
price of dresses? (5 marks)
(d) Bowen’s runs a successful marketing campaign that makes consumers perceive his
dresses as unique. Bowen is now free to act as a monopolist. Show graphically how
Bowen will decide the price to set and quantity to produce under his new market
structure. (10 marks)

Reading for this question See BVFD Chapters 7 and 8.

Approaching the question:

(a) An isoquant shows the combinations of sewing machines and workers needed to
produce a dress. Isoquants here are linear and downward sloping, reflecting that
workers and sewing machines are perfect substitutes. The slope reflects the trade-off of
hiring one extra sewing machine against hiring one extra worker. Many candidates
included the correct sketch but failed to explain the shape of the isoquants.

(b) Workers are more than twice as cheap as machines so Bowen will optimally only hire
workers. To produce 100 dresses Bowen will need 100 workers and so will pay 2000.
Most candidates were able to find the optimal bundle and its cost, but many did not show
this graphically nor explained why the optimal bundle is at a corner instead of a
tangency. Some tried to set the marginal rate of technical substitution (MRTS) equal to
the input price ratios and found that this was not the case because the MRTS is constant
here. The optimal bundle is at the corner where only labour is demanded. This showsus
the lowest cost needed to produce 100 dresses.

(c) Bowen operates in a perfectly competitive market, so we should expect dresses to

sell at their marginal cost, which is £20. We know that this is the case because we found
in part (b) that at these input prices Bowen would only hire workers and not buy any
sewing machine. Some candidates attempted to take derivatives of the isoquant to figure
out the marginal cost or mentioned the total cost found in part (b). Candidates who
understood how to approach the previous part typically did really well here and correctly
understood that there was no need to derive anything.

(d) A monopoly will operate at the intersection between the marginal revenue curve and
the (constant) marginal cost curve. Here the marginal cost is equal at all levels of
production, so a horizontal line. The demand and marginal revenue are downward
sloping. Many candidates could produce a sketch here, but some wrongly assumed an
 increasing and convex marginal cost curve, failing to connect this part of the question to
the earlier parts. Figure: An illustration of the monopoly outcome in this market.

12. Twixflix is an online platform that produces food travel documentaries. To produce one
episode, one presenter (a worker L) must stand in front of one camera (capital K). If
there are many people presenting, or if multiple cameras are used to shoot the same
presenter, only one episode will be produced, so the production function is: Q = min{K,L}
(a) What is an isoquant? Draw a few isoquants that correspond to the production
function for episodes of travel food documentaries. (5 marks)

(b) Does the production function display increasing returns to scale? (5 marks)
(c) Twixflix wishes to produce 20 episodes. The rental cost of a camera is £150 and
presenters are paid £300 per episode. How many cameras and presenters will the
company demand? Show the optimal bundle on your diagram. What is the cost
associated with producing 20 episodes? (10 marks)
(d) The pandemic made Twixflix operations harder and raised the cost of producing an
episode. Twixflix had committed to buying 100 cameras (a fixed cost) and their total
short-run cost became C(Y ) = 1500 + 300Q2. Draw the short-run marginal cost,
average variable cost and average total cost curves for Twixflix. What is the minimum
price at which Twixflix would produce an episode? (10 marks)

Reading for this question See BVFD Chapter 7.

Approaching the question:

(a) An isoquant shows the combinations of presenters and cameras needed to produce
a number of episodes. Isoquants here are L-shaped, reflecting that cameras and
presenters must be hired in fixed proportions or the amount of shows produced cannot
increase. Most candidates correctly drew isoquants corresponding to a fixed proportion
production function and could define isoquants. Some candidates lost marks in not
explaining the shape of the isoquants or not including details in their diagram. For full
marks candidates should have labelled the axes, included a few L-shaped isoquants and
identified at least one bundle. Figure 1: Isoquants for a fixed proportion production
function.

(b) To check for returns to scale we need to see what happens to the output if we scale
the inputs in the same proportion. Imagine scaling up the inputs by t > 1 (for example,
doubling them). Then the output would be: min{tK,tL} = t min{K, L} = tY so this
production function has constant returns to scale. Output increases by the same
proportion as the inputs. Performance in this question was somewhat bimodal. Many
candidates correctly defined returns to scale and showed that this function displays
constant returns to scale. Others focused on what happens if we are not at the optimal
bundle and stated that there are decreasing returns to scale unless we have the same
amount of capital and labour. This is not the case: doubling inputs outside of the optimal
bundle will still double the output, and in checking for returns to scale we are not
interested in how much a single input contributes to the production.

(c) Twixflix optimally sets K = L. This is because at K > L we could buy fewer cameras
and still have the same amount of documentaries produced. Similarly, when L > K the
firm could hire fewer presenters and produce the same amount of documentaries. To
minimise the cost of producing documentaries we must hire the same amount of
cameras and presenters. To produce 20 episodes we need K = L = Y = 20, so 20
cameras and 20 presenters are required. This costs the company 150 × 20 + 300 × 20 =
9000. Many candidates correctly identified the optimal bundle needed to produce 20
episodes and found the corresponding cost, but some could not show the optimal bundle
in their diagram. A minority of candidates attempted to set the marginal rate of technical
substitution (MRTS) equal to the price ratio and solve as if the production function was
Cobb–Douglas. This is incorrect and the function is not differentiable at the kink, but
partial credit was awarded to those who did this and offered some explanation for why
we should look for the cost-minimising bundle at the kink. Figure: The optimal bundle to
produce 20 documentaries is at the kink where an equal amount of cameras and
presenters are hired.

(d) The cost function now becomes C(Q) = 1500 + 300Q2 . The average cost is: C(Q) Q
1500 = Q + 300Q. The average variable cost is: V C(Q) Q 300Q2/ Q = 300Q. The
marginal cost of production is: MC(Y ) = ∂C(Y ) ∂Y = 600Q. As we are in the short run
the firm will produce an episode if the price is at least equal to the average variable cost
at its minimum (zero). In the short run the firm should be willing to produce if P > AV C
and given the fact that MC > AV C the firm should always be willing to produce. The
supply curve will be the marginal cost curve from an output of zero.
Some candidates really struggled with this question and failed to link it to the details in
the question. Candidates who offered a generic discussion of cost curves and assumed
a U-shaped average cost curve and average variable cost curve and an increasing and
convex marginal cost curve cutting the average variable cost at its minimum received
only partial credit. Candidates who argued that the minimum price the firm would
demand is the marginal cost also received partial credit, as the focus of the question was
on whether the firm requires a minimum output sold in order to produce. Candidates who
claimed that the firm will produce at the minimum of the average total cost curve also
received only partial credit, as having a fixed cost implies being in the short run and
hence production decisions will be made based on the average variable cost. Figure:
The cost curves associated with the production function in the question. Notice that the
maximum production is bounded by the amount of cameras the firm committed to
purchasing: hiring extra presenters after this number does not make the firm produce
more.