SCHOOL OF BUSINESS AND MANAGEMENT

BACHELOR OF ACCOUTING PROGRAM

BA BU511 – Principles of Economics

Tutorial 3: Week commencing 7th March 2016

Topic: Production and Costs

A. Multiple Choice Questions

1. Production efficiency occurs when production ---------------

A) is at the point beyond the production possibilities frontier
B) is on the production possibilities frontier or inside it
C) is at any attainable point
D) is on the production possibilities frontier.

2. When an extra worker adds less to output than the previous extra worker added, this illustrate
A) the law of constant returns
B) the law of increasing returns
C) the law of diminishing returns
D) labour law

3. The Minimum payment required to keep an entrepreneur engaged in his business or production
activity is called----------------- in economics
A) Supernormal profit
B) Accounting profit
C) Net profit
D) Normal Profit

4. The monetary payments a firm makes to non-owners of the firm who are suppliers of input
resources are called

A) Explicit costs
B) Implicit costs
C) Opportunity costs
D) Fixed costs

5. A producer who cannot control price can maximize profits by

A) Increasing outputs indefinitely
B) Minimize costs at all levels of outputs
C) Expand production capacity, whatever the cost maybe
D) bribe the gov’t to set price in line with their costs

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 B. Short-Answer Question

1. Suppose a firm’s production function is a Cobb-Douglas production function of the form

0 .5 0.5
Q=50L K . Assume that the price of labour is given by w and the price of capital is
given by r.
(a) Suppose that the firm’s capital is fixed at K . What amount of labour will the firm hire
to solve its short-run cost minimization problem?
Because K is fixed in the SR, its marginal product is constant. Hence, you should derive
the marginal product of L only, and then set MPL / MPk = w / r.
Also because K is fixed we can define L in terms of K and Q.

MPL = 25 K1/2 / L1/2 ; MPk = 1 L1/2 = Q / 50 K1/2

= 25 K1/2 / (Q / 50 K1/2) = w / r
= 1,250 K / Q = w / r

→ K = Q w / 1,250 r → L = Q2 / 2,500 K
= Q2 / [2,500(Q w / 1,250 r)]
=Qr/w

(b) Now suppose that that the price of labour w is $5 per unit and the price of capital r is $20
per unit. What is the cost-minimizing input combination if the firm wants to produce
1,000 units per year? Illustrate your result using a suitably labeled diagram
Use the Lagrangian method to solve for L* and K*. Note your objective function is the cost
minimization function (PL x L + PK x K) and your constraint function is the production
function (Q = 50 L0.5 K0.5 ).

Or you can use the formula given in the lecture to compute the least cost combination of L
and K.

MPL / MPK = PL / PK where: PL = 5; PK = 20; and

MPL = ½ x 50 x L1/2-1 x K1/2 = 25 L-1/2 K1/2 = 2√ K / √ L

MPK = ½ x 50 x L1/2 x K1/2-1 = 25 L1/2 K-1/2 = 2√ L / √ K

 MRSL,K = PL / PK
 (2√ K / √ L ) / (2√ L / √ K ) = 5 / 20
 K/L=¼
 K = L / 4 or L = 4K


Use either of these solutions to substitute into your production function and solve for L* and K*
given Q=1000

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 0 .5 0.5 We solve above that L = 4K
Q=50L K .
1000 = 50 (4K)0.5 K0.5 L = 4 x 10
20 = 2 K0.5 K0.5  L* = 40

20 = 2K
 K* = 10

2. A firm has a fixed cost of $60, and variable costs as indicated in the table below

Total Total Total Total Average Average Average Margina

Product Fixed Variable Cost fixed variable total cost l cost
Cost Cost cost cost
0 60 0 60        
1 60 45 105 60 45 105 45
2 60 85 145 30 42.5 72.5 40
3 60 120 180 20 40 60 35
4 60 150 210 15 37.5 52.5 30
5 60 185 245 12 37 49 35
6 60 225 285 10 37.5 47.5 40
7 60 270 330 8.57143 38.5714286 47.1429 45
8 60 325 385 7.5 40.625 48.125 55
9 60 390 450 6.66667 43.3333333 50 65
10 60 465 525 6 46.5 52.5 75

(a) Complete the table

(b) Graph total fixed cost, total variable cost and total cost. Explain how the law of
diminishing returns influences the shape of the variable and total cost curves.
600

500

400

Total Fixed Cost

300
Total Variable Cost
Total Cost
200

100

0
0 1 2 3 4 5 6 7 8 9 10

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 TVC and TC curves are upward trending because as the firm increase its input resources,
the marginal product of the additional inputs contribute less to total output produced.

(c) Graph AFC, AVC, ATC and MC. Explain the derivation and shape of each of these four
curves and the relationships they have to one another. Specifically, explain why MC cuts
both AVC and ATC at their minimum?
120

100

80
Average fixed cost
60 Average variable cost
Average total cost
Marginal cost
40

20

0
0 1 2 3 4 5 6 7 8 9 10
MC cuts ATVC at its minimum because that’s the output level where the input resources
are being utilized optimally to an output level sufficient to cover variable costs and still
ensure revenue is maximized. When MC < ATVC, ATVC is falling, and when
MC>ATVC, ATVC is rising.
MC cuts ATC at its minimum because that’s the output level where input resources are
being utilized optimally to an output level sufficient to cover both variable and fixed
costs and still ensures revenue is maximized. Also, when MC < ATC, ATC is falling, and
when MC > ATC, ATC is rising.

(d) What would happen to the curves you have derived if total fixed costs increased to $100?
TC and TFC will increase by $40, but there will be no change in TVC. Accordingly,
ATFC and ATC will shift upwards while ATVC and MC will remain the same.

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 600 160

140
500 Average
Total 120 fixed cost
Fixed
400 Cost Average
100 variable
Total cost
300 Variable 80
Cost Average
60 total cost
200 Total
Cost Marginal
40
cost
100
20

0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10

(e) What would happen to the curves that you have derived if wages rates, the variable cost,
reduced by 10% at all levels of outputs?

TVC and TC shift downwards, so is ATC, ATVC and MC. There is no change in TFC and
ATFC.

600 120
Tot Average
500 al 100 fixed
Fixe cost
d
400 Cos 80 Average
t variable
Tot cost
300 al 60
Vari Average
abl total
200 e 40 cost
Cos
t Marginal
cost
100 20

0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10

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3. Here is a possibilities table for war goods and civilian goods.

Production Possibilities
Type of product A B C D E
Cars (in millions) 0 2 4 6 8
Missiles (in thousands) 30 27 21 12 0

(a) Graph the data in the table. Are there constant or increasing opportunity costs for the
production of missiles? Increasing opportunity costs
(b) If the economy is currently at point C:
a. What is the cost of one million more cars? A decrease of 4.5 thousand missiles
b. What is the cost of one thousand more guided missiles? A decrease of 0.333
million cars
(c) Label a point G inside the curve. What does it indicate? Inefficient production
(d) Label a point H that lies outside of the PPC:
a. What does it indicate? Unattainable production outputs of cars & missiles
b. What must occur before the economy can attain the level of production indicated
by H. Economic growth either through technological improvement or capital
growth, especially in machines that related to car and missile manufacturing.
(e) Suppose improvements occur in the technology of producing guided missiles but not on
the production of cars?
a. Draw a new PPF illustrating this. This result in the outward shift in the production
of guided missiles only which means that the corner solution for guided missiles
will increase while that for cars stay the same.
b. Now draw a curve that reflects technological improvement in the production of
both products. This results in the increase in the corner solutions of both goods
and outward shift in the PPF for both goods.