SYDE 262 Assignment 3 Sample Solution

Question 1
1.1 Production function
A function or graph that describes the relationship between production of products (output)
with the number of workers employed in the process. As demonstrated in the figure below,
the function typically sees a very sharp increase in productivity as the number of workers
increases (scaling the process) until it begins to plateau at a certain number of workers and
will eventually even decrease.

http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=total+product+curve

1.2 Marginal Productivity

Describes the change in productivity with respect to the change in number of workers- in this
context it is usually measured per unit increase in the number of workers. Graphically, this is
the slope (or instantaneous rate of change) of the production function.

The law of diminishing marginal productivity states that for a given set of inputs all of which are
held constant, if one and only one of those inputs keeps increasing, eventually this increase
will lead to a fall in total output as described above.

http://www.raybromley.com/notes/AveMargApp.html
 1.3 Average Productivity
The average productivity that is calculated by dividing productivity by the corresponding number of
workers involved in the process. It is also graphed above in the figure in section 1.2.

Question 2
2.1 Fixed Cost (TFC)
The costs that must be paid by a company regardless of their business activity, also known as
overhead costs. They are one of the two components of total cost. An example of a fixed cost is the
cost of land ownership (land taxes) and maintenance of the location and equipment.

2.2 Variable Cost (TVC)

The costs that change in proportion to the quantity of goods or services produced by a
company. It can be expressed as the sum of marginal costs over all units produced. They are
one of the two components of total cost. An example of a variable cost is the cost a company
pays for raw material, the more they produce the more raw materials they will need.

2.3 Total Cost (TC)

The total economic cost of production defined as the sum of two components: fixed cost
and variable cost.
Question 3
3.1 Average Variable Cost
Average variable cost is the total variable cost per unit of production. It can be found by
dividing the variable costs by the quantity of the output produced, or by subtracting the
average fixed cost from the average total cost. The figure below shows an example of an
average variable cost curve. The average variable cost is generally high at small quantities,
decreases to a minimum value, and then rises.

3.2 Marginal Cost

The marginal cost is the change in the total cost that comes with producing one additional unit
of a good. An example of marginal cost would be if someone is trying to decide whether they
should have another fast food meal after they have already eaten one. In this case the
marginal cost would be the monetary costs and the fact that the meal is unhealthy. The figure
below shows an example of a marginal cost curve. The marginal cost is relatively high at
small quantities of output, then decreases as production increases until it reaches a minimum
value, and then begins increasing again.
 3.3 Average fixed cost
The average fixed cost is the total fixed cost per unit of production. It can be found by dividing
the total fixed costs by the quantity of the produced output or by subtracting the average
variable cost from the average total cost. The figure below shows an example of an average
fixed cost curve. Average fixed cost can be described as an inverse linear function. Since it is
defined as fixed costs divided by quantity, it will approach infinity around the 0 mark and it will
approach 0 as quantity approaches infinity.

3.4 Average total cost

The average total cost is the total cost per unit of production. It is the sum of the average
variable cost and the average fixed cost. It can also be found by dividing the total cost by the
quantity of the output produced. The figure below shows an example of an average total cost
curve. Average total cost is high at small quantities of output and decreases until it hits a
minimum value, then starts to rise.
 3.5 Supply curve
The supply curve is a graphical representation of the relationship between the price of the
product and the quantity of the product that would be available. With the quantity on the
horizontal axis and the price on the vertical axis, the curve tends to slope upwards since
higher prices provide greater incentive for the producer to produce that good. The figure
below shows an example of a supply curve which helps to visually see the relationship
between quantity supplied and price.

Question 4
4.1 Short run costs vs long run costs
Short run costs are always higher than long run costs when considering average total cost
curve. This is demonstrated in the figure below, where all of the grey short run curves are
higher on the graph than the long run curve.
When considering long run costs, costs that were fixed in the short run can be
considered variable, thus there are no fixed costs in the long run.
Graphically, the short run curve can only intersect with the long run cost curve at one point - it
is not always the lowest point of the short run curve.

4.2 Economy of scale

Economy of scale describes the decrease of long term run costs while output increases. As
visualized in the figure below, output increases and cost per unit falls, thus in this zone there
are increased returns to scale meaning that increasing input by one unit results in the output
of more than one unit.
 4.3 Constant returns to scale
Constant returns to scale describes the situation in which an increase in output is proportional
to changes in input of the same amount. Note how in the figure below, this is the portion of
the curve where it evens out and the ratio between output and input approaches 1:1.

4.4 Minimum efficient scale of production

The lowest cost point in the long run average total cost curve, as seen in the figure below. This
is the ideal position for companies as it represents the most revenue for the lowest cost-
optimal profit.

4.5 Diseconomy of scale

When output increases by less than that proportional change in inputs. Note how in the figure below,
one extra unit of input results in less than one extra unit of output, thus resulting a positive sloping curve
in the diseconomy of scale zone. It is less efficient to produce more in this range.

http://welkerswikinomics.com/blog/2010/11/22/from-short-to-long-economies-of-scale-and-the-long-run-average-total-cost-curve/

Question 5
A competitive market is where there is a large number of producers competing with each
other to produce for a large number of consumers. In a competitive market, all producers -
or firms - sell an identical product, do not control the market price of their product and have
a relatively small market share. In a competitive market, there are also no barriers to entry.
With perfect competition, a firm’s marginal revenue curve is elastic, or perfectly
horizontal.This means that if a producer increase the number of products he sells, then the
amount of extra revenue received remains the same. In a monopoly the marginal revenue
curve is negatively sloped since larger output quantities are only possible with lower prices.

http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=marginal+revenue+curve,+monopolistic+competition
Question 6

In a perfectly competitive market, a firm will face economic profit when the marginal cost (MC) curve
intersects the marginal revenue curve (MR) above the average total cost curve (ATC).
In a perfectly competitive market, a firm will face zero economic profit when the marginal
cost (MC) curve intersects the marginal revenue curve (MR) and the average total cost
curve (ATC) at the same point.

In a perfectly competitive market, a firm will face economic loss when the marginal cost (MC) curve
intersects the marginal revenue curve (MR) below the average total cost curve (ATC).

Question 7
In a monopolistic market, a firm will face economic profit when the price dictated by demand
is above the average total cost of the item for the quantity specified by the intersection of
the marginal cost (MC) curve and the marginal revenue (MR) curve.

In a monopolistic market, a firm will face zero economic profit when the price dictated by
demand is equal to the average total cost of the item for the quantity specified by the
intersection of the marginal cost (MC) curve and the marginal revenue (MR) curve.
In a monopolistic market, a firm will face economic loss when the price dictated by demand
is below to the average total cost of the item for the quantity specified by the intersection of
the marginal cost (MC) curve and the marginal revenue (MR) curve.

Question 8
Break-even point is the point at which a firm’s revenue is equal to their expenses. At this point
the firm earns a normal profit but does not have any economic profit or economic loss. It
occurs at the intersections of the total revenue curve and the total cost curve as well as at the
intersections of the average revenue and average cost curves. In a perfectly competitive
market, a firm will face zero economic profit when the marginal cost (MC) curve intersects the
marginal revenue curve (MR) and the average total cost curve (ATC) at the same point. In a
monopolistic market, a firm will face zero economic profit when the price dictated by demand
is equal to the average total cost of the item for the quantity specified by the intersection of the
marginal cost (MC) curve and the marginal revenue (MR) curve. The figures below graphically
shows the break-even point for a perfectly competitive market and a monopoly market.

http://rubanko.myblog.it/2011/12/19/perfectly-competitive/
Shutdown point is the point at which the output price is equal to the average variable cost. At
this point the firm will gain more by shutting down than it will by staying in business. It is the
same for both perfectly competitive and monopoly markets.

http://www.dineshbakshi.com/ib-economics/microeconomics/161-revision-notes/2020-shut-down-price
Question 9
Positive Externality: benefit enjoyed by a third-party that is indirectly affected by the result of
an economic transaction. An example would be people using public transportation (a paid
service) which reduces traffic congestion for those not paying for the use of transit.

Negative Externality: cost imposed onto a third-party that is indirectly affected by the result of
an economic transaction. An example would be the clean-up costs imposed upon the
community when manufacturing activities cause a lot of air pollution.
Question 10
Public goods are commodities or services that are provided without profit to all members of society
either by the government or a private individual or organization. These goods are for the benefit and
well-being of the public. One can consume public goods without reducing its availability to another
individual. No one is ever excluded from receiving public goods. Some examples of public goods
include, national defense, sewer systems, public parks, basic television and radio broadcast. One
problem with public goods is the free-rider problem. This problem states that a rational person will not
contribute to the provision of public goods because they do not need to contribute in order to benefit.
For instance, people can enjoy the city parks regardless of whether they contributed to their upkeep
through local taxes. Since public goods are also non-excludable, which means that once goods are
provided nobody can be excluded from using them, there is a temptation to enjoy the good without
making a contribution. If people stop making contributions then the good would not be provided
anymore. So if people stop paying taxes then the police, army, and judicial system would fail to
operate.

http://en.wikipedia.org/wiki/Public_good
Question 11
The Marginal Social Cost is the total cost to society as a whole for producing one further unit
or taking one further action in an economy. Marginal Social Cost is equal to the marginal
private cost minus the externality. If there are only negative externalities then the marginal
social cost would be greater than the private marginal cost.

http://tutor2u.net/economics/content/topics/externalities/what_are_externalities.htm

Negative externalities lead to an overproduction of those goods that have a high social cost.
For example, the logging of trees for timber may result in society losing a recreation area or
good quality soil to grow crops on but this loss is usually not quantified and included in the
price of the timber that is made from the trees. As a result, the individual entities in the
marketplace have no incentive to factor in these externalities.
 http://en.wikipedia.org/wiki/Social_cost

Question 12
Marginal social benefit is the benefit enjoyed by the entire society, both by the consumer and
by everyone else. For example, high quality health care benefits the person receiving the
healthcare but also people closely related to them, as they no longer have to take time off
work or their other duties due to illness. Marginal social benefit is equal to the marginal private
benefit plus the marginal external benefit.

There are positive externalities if the marginal social benefit exceeds the the marginal private
benefit. Without considering the positive externality, the free market would supply a quantity
Q1 and a price, P1. But if the externality is included, the optimum social output increases to
Q2. But since only Q1 is being consumed when more of the good could be consumed, there is
a resulting deadweight loss.