Managerial Economics, 7e, Global Edition (Keat)

Chapter: 4 Demand Elasticity

Multiple-Choice Questions

1) The price elasticity of demand is a measure of

A) the responsiveness of the quantity demanded to price changes.
B) the quantity demanded at a given price.
C) the shift in the demand curve when price changes.
D) the demand for a product holding price constant.
Answer: A

2) The elasticity of demand for a product is likely to be greater

A) the smaller the number of substitute products available.
B) the smaller the proportion of one's income spent on the product.
C) the larger the number of substitute products available.
D) if the product is an imported good rather than a domestically produced good.
Answer: C

3) If OPEC increases its price of oil, and still the demand for oil decreases by a very small
amount, we can conclude that the demand for oil is
A) relatively elastic.
B) relatively inelastic.
C) perfectly elastic.
D) perfectly inelastic.
Answer: B

4) If the consumption of sugar does not change at all following a price increase from 50 cents per
pound to 65 cents per pound, the demand for sugar is considered to be
A) relatively inelastic.
B) perfectly elastic.
C) perfectly inelastic.
D) unitary elastic.
Answer: C

5) If the demand for a product is said to be relatively inelastic, the "absolute" value of the
elasticity coefficient will be
A) less than one.
B) greater than one.
C) equal to one.
D) zero.
Answer: A
Diff: 1

6) If an item has several good substitutes, the demand curve for that item is likely to be
A) relatively inelastic.
B) relatively elastic.
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C) perfectly inelastic.
D) unit elastic.
Answer: B

7) Remembering that demand elasticity is defined as the percentage change in quantity divided
by the percentage change in price, if price decreases and, in percentage terms, quantity rises
more than price has dropped, total revenue will
A) increase.
B) decrease.
C) remain the same.
D) either increase or decrease.
Answer: A

8) Suppose the price of beans rises from $1.00 a pound to $2.00 a pound, quantity demanded
falls from 10 units to 6 units, the coefficient of elasticity of demand for beans using the arc
elasticity approach is
A) -1.33.
B) -0.75.
C) -0.4.
D) -0.25.
Answer: B

9) Suppose the price of beans rises from $1.00 a pound to $2.00 a pound, quantity demanded
falls from 10 units to 6 units. In this example, the demand for beans is said to be
A) relatively elastic.
B) relatively inelastic.
C) perfectly elastic.
D) perfectly inelastic.
Answer: B

10) A perfectly elastic demand curve

A) can be represented by a line parallel to the vertical axis.
B) is a 45-degree line.
C) can be represented by a line parallel to the horizontal axis.
D) cannot be represented on a two-dimensional graph.
Answer: C

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11) The sensitivity of the change in quantity consumed of one good to a change in the price of a
related good is called
A) cross-elasticity.
B) substitute elasticity.
C) complementary elasticity.
D) price elasticity of demand.
Answer: A

12) The cross-price elasticity of demand for coffee and tea is likely to be
A) greater than zero.
B) less than zero.
C) zero.
D) infinity.
Answer: A

13) The cross-price elasticity of demand for coffee and coffee-cream is likely to be
A) greater than zero.
B) less than zero.
C) zero.
D) infinity.
Answer: B

14) The cross-price elasticity of demand for coffee and caskets is likely to be
A) less than zero.
B) greater than zero.
C) zero.
D) infinity.
Answer: C

15) When purchases of tennis socks decline following an increase in the price of tennis sneakers
(other things remaining equal), the relationship between these two items can be described as
A) substitutable.
B) complementary.
C) unique.
D) ordinary.
Answer: B

16) The owner of a produce store found that when the price of a head of lettuce was raised from
50 cents to $1, the quantity sold per hour fell from 18 to 8. The arc elasticity of demand for
lettuce is
A) -0.56.
B) -1.15.
C) -0.8.
D) -1.57.
Answer: B

17) Suppose the price of crude oil drops from $150 a barrel to $120 a barrel. The quantity bought
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remains unchanged at 100 barrels. The coefficient of price elasticity of demand in this example
would be
A) -0.5.
B) infinity.
C) -1.0.
D) 0.
Answer: D

18) If a firm decreases the price of a good and total revenue decreases, then
A) the demand for this good is price elastic.
B) the demand for this good is price inelastic.
C) the cross elasticity is negative.
D) the income elasticity is less than 1.
Answer: B

19) When total revenue reaches its peak (elasticity equals 1), marginal revenue reaches
A) 1.
B) zero.
C) -1.
D) Cannot be determined from the information provided
Answer: B

20) If the income elasticity of a particular good is negative 0.2, it would be considered
A) a superior good.
B) a normal good.
C) an inferior good.
D) an elastic good.
Answer: C
Diff: 1

Table 1
The following information is provided for Tony Romo's income and expenditures.

Quantity Purchased per Month

Monthly Income Steaks Pizzas
$2,000 2 8
$3,000 4 6

21) In Table 1, Tony's income elasticity of demand for steaks is

A) 1.0.
B) greater than 1.0.
C) less than 1.0.
D) zero.
Answer: B

22) In Table 1, pizzas are classified as a(n)

A) normal good.
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B) positive good.
C) inferior goods.
D) marginal good.
Answer: C

23) In Table 1, steaks are classified as a(n)

A) normal good.
B) positive good.
C) inferior good.
D) marginal good.
Answer: A

24) In Table 1, Tony's income elasticity of demand for pizzas is

A) 0.
B) less than zero.
C) greater than 1.0.
D) 1.0.
Answer: C

25) The government unit that wants to achieve "revenue enhancement" will find it considerably
more favorable to enact an excise tax on goods whose demand is
A) highly elastic.
B) relatively elastic.
C) highly inelastic.
D) unitary elastic.
Answer: C

26) Which of the following instances will total revenue or receipts decline?
A) Price rises and demand is inelastic.
B) Price falls and demand is elastic.
C) Price rises and demand is elastic.
D) Price falls and demand is unit elastic.
Answer: C

27) If the price of a good is increased and total revenue received from the sale of this good
increases, then the price elasticity of demand for the good is
A) elastic.
B) inelastic.
C) unitary.
D) None of the above
Answer: B
28) If the price of a good is decreased and total revenue received from the sale of this good does
not change, then the price elasticity of demand for the good is
A) elastic.
B) inelastic.
C) unitary.
D) None of the above
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Answer: C

29) If the demand for a good is price inelastic and the good price is increased, then the marginal
revenue (MR) received by the seller will
A) not change.
B) decrease.
C) increase.
D) Cannot be determined from this information
Answer: C

30) If the price elasticity of supply of a good is elastic and the good price increases, then the
increase in the good's supply should be
A) greater than the increase in price.
B) less than the increase in price.
C) the same as the increase in price.
D) Cannot be determined from this information
Answer: A

31) Which of the following examples best illustrates the concept of derived demand?
A) An increase in the price of beef results in an increase in the demand for fish.
B) The higher the demand for automobiles, the greater the demand for steel.
C) The demand for Pepsi varies directly with the price of Coke.
D) The demand for a good varies inversely with its price.
Answer: B

32) The derived demand curve for a good component will be more inelastic
A) the larger is the fraction of total cost going to this component.
B) the more inelastic is the demand curve for the final good.
C) the more elastic are the supply curves of cooperating factors.
D) the less essential is the component in question.
Answer: B

33) The minimum wage is an example of a government imposed

A) price control.
B) price ceiling.
C) price floor.
D) Both A and B
E) Both A and C
Answer: E

34) If government imposes a price ceiling on a good that is below the market equilibrium price
A) a surplus will develop.
B) a shortage will develop.
C) producers will reduce their sales price.
D) consumers will reduce their demand for the good.
Answer: B

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35) When a government imposes a price floor on a good that is above the market equilibrium
price
A) a surplus will develop.
B) a shortage will develop.
C) producers will increase their sales price.
D) consumers will increase their demand for the good.
Answer: A

36) A tax that is imposed as a specific amount per unit of a good is a(n)
A) excise or specific tax.
B) sales or ad valorem tax.
C) compound duty.
D) income tax.
Answer: A

37) If government imposes an excise tax on a good and the tax burden is borne equally by buyers
and sellers, then
A) price elasticity of demand is unitary.
B) price elasticity of supply is unitary.
C) the absolute values of price elasticities of demand and supply are equal.
D) None of the above
Answer: C

38) Assuming mustard and burgers are complements, a decline in the price of burgers will
A) decrease the demand for burgers.
B) decrease in the quantity demanded of burgers.
C) increase the demand for mustard.
D) decrease the demand for mustard.
Answer: C

39) Other things remaining the same, an increase in the price of butter can be expected to
A) increase margarine sales.
B) decrease margarine sales.
C) increase butter sales.
D) None of the above
Answer: A

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Analytical Questions Chapter: 4 Demand Elasticity

1) The initial price of a cup of coffee is $1, and at that price, 400 cups are demanded. If the price
falls to $0.90, the quantity demanded will increase to 500.

a. Calculate the (arc) price elasticity of demand for coffee.

b. Based on your answer, is the demand for coffee elastic or inelastic?
c. Based on your answer to a., if the price of coffee is increased by 10%, what will happen to
the revenues from coffee? Carefully explain how you know.

Answer:
a. Arc elasticity = -2.11
b. Elastic
c. Revenues will fall. Demand is elastic, and thus a 1% increase in price will lead to a greater
percentage decrease in quantity demanded. Revenues fall because the price increase does not
make up for the reduction in sales.

2) The demand curve is: QD = 500 - 1/2 P.

a. Calculate the (point) price elasticity of demand when price is $100. Is demand elastic or
inelastic?
b. Calculate the (point) price elasticity of demand when price is $700. Is demand elastic or
inelastic?
c. Find the point at which point elasticity is equal to -1.

Answer:
a. Elasticity = -1/2 (100/450) = -0.11, and is inelastic.
b. Elasticity = -1/2(700/150) = -2.5, and is elastic.
c. Elasticity is -1 at the midpoint of the demand curve, which is at a price of $500 and a
quantity of 250.

3) Suppose that the price elasticity of demand for wheat is known to be -0.75. Will a good wheat
crop (which increases the supply of wheat) be likely to increase or decrease the revenues of
farmers? Carefully explain.

Answer:
A good wheat crop that increases the supply of wheat will cause the equilibrium price of wheat
to decrease (and quantity to increase). Since demand is inelastic, total revenues will fall, as the
percentage change in quantity will be less than the percentage change in price.

4) The demand for salt is relatively price inelastic, while the demand for pretzels is relatively
price elastic. How can you best explain why?

Answer:
Salt has few substitutes, and takes up a small percentage of the consumer's budget, and thus
demand is likely to be inelastic. While pretzels are also a small part of the budget, there are many
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substitutes available.

5) Unions have generally been far more successful in organizing and raising wages in skilled
trades such as carpentry than in unskilled trades. Use the laws of derived demand to explain why.

Answer:

There are at least two reasons. One is that the elasticity of substitution between skilled workers
and other factors of production is low; thus firms cannot substitute some other factor of
production if wages rise. Secondly, skilled labor is likely to be a relatively small percentage of
total costs, and thus raising wages does not cause a large increase in total costs (which would
lead to a reduction in supply, an increase in price, and a decrease in output). Unskilled labor has
more substitutes and is likely to be a larger share of costs for firms that employ it, and thus if
unions raise wages, firms employ other factors of production, and many workers will be laid off.

6) Governments impose excise taxes on goods that have inelastic demand, such as cigarettes,
more often than in other cases. Why?

Answer:
Imposing an excise tax reduces the supply of the good, reducing equilibrium quantity and
raising the price. If demand is elastic, taxes will tend to reduce quantity by a significant amount,
and thus government tax revenues will be relatively small. However, if demand is inelastic, the
reduction in quantity will be small, and government tax revenues will be higher. (Governments
may also impose taxes to deter consumption, but this is likely to be ineffective if elasticity is
low.)

7) Demand and supply in the wheat market are given by:

QD = 2000 - 1000 P and QS = -500 + 1000 P

where Q is millions of bushels and P is price per bushel.

a. Find the equilibrium price and quantity.

b. Suppose that the government wishes to support farm income and thus sets a price floor of
$1.50/bushel. Find the size of the farm surplus.
c. What is the cost of this program to the government?

Answer:
a. P = $1.25, Q = 750
b. If P = $1.50, QD = 500 and QS = 1000. The surplus is 500 (million) bushels.
c. $1.50 × 500 = $750 million.

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8) Demand is given by QD = 6000 - 50P. Domestic supply is QS = 25P. Foreign producers can
supply any quantity at a price of $40.

a. If foreign producers can sell in the domestic market, what is the equilibrium price? What is
the equilibrium quantity? How much is sold by domestic and foreign producers, respectively?
b. Under domestic government pressure, foreign producers voluntarily agree to restrict their
goods. What will happen to the price and quantity? What will happen to the amount that
domestic producers supply? What will happen to revenues of domestic and foreign producers?

Answer:
a. P = $40. Q = 4,000. Of that, domestic producers supply 1,000 units, and foreign producers
supply 3,000 units.
b. The quantity restriction will cause equilibrium price to rise and quantity to decrease.
Domestic producers will sell more, and foreign producers will sell less. Revenues of domestic
producers will rise. The effect on the revenues of foreign producers is unclear; if demand is
inelastic, they may rise.

9) You are told that the price elasticity of demand for widgets is -0.75, the income elasticity of
widgets is 2, and the cross-price elasticity of widgets and gadgets is 4. Carefully explain what
information you can gather from each of these figures.

Answer:

Demand for this good is inelastic with respect to price. This is a normal good as income
elasticity is greater than zero, and it is a luxury/superior good as income elasticity is greater than
one. Widgets and gadgets are substitutes, and they are good substitutes because cross-price
elasticity is elastic (large).

10) If a good's demand function is Q = 30 - 3P, then calculate the price elasticity of demand
when

a. good price is $3 using the point elasticity formula

b. good price is $4 using the point elasticity formula
c. good price decreases from $4 to $3, using the arc elasticity formula
d. good price is $5, using the point elasticity formula
e. good price increases from $4 to $5, using the arc elasticity formula

Answer:
(a) -0.429; (b) -0.667; (c) -0.538; (d) -1.000; (e) -0.818

11) If a price of corn is $3.00 a bushel, 5,000 bushels would be demanded. If the price rises to
$4.00 a bushel, 4,000 bushels would be demanded.

a. What is the (arc) price elasticity of demand?

b. Based on this answer, if the price of corn rose to $5.00 a bushel, what would be the demand
for corn?
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c. If the price of corn decreased from $4.00 to $3.00 a bushel, what would be the change in total
revenue for sellers of corn?
d. If the price of corn increased from $4.00 to $5.00 a bushel, what would be the change in total
revenue for sellers of corn?

Answer:
(a) -0.778; (b) 3,309; (c) -$1,000; (d) +$545

12) Domestic demand for a good is QD = 3000 - 25P. The domestic supply of the good is QS =
20P. Foreign producers can supply any quantity at a price (P) of $30.

a. What is the domestic equilibrium price and quantity?

b. At this domestic equilibrium price, how much of the good will be supplied by domestic
producers and how much by foreign producers?

Answer:
a. P = $30 and Q = 2250
b. Domestic producers supply 600 units and foreign producers supply 1650 units.

13) The income elasticity for most staple foods, such as wheat, is known to be between zero and
one.

a. As incomes rise over time, what will happen to the demand for wheat?
b. What will happen to the quantity of wheat purchased by consumers?
c. What will happen to the percentage of their budgets that consumers spend on wheat?
d. All other things equal, are farmers likely to be relatively better off or relatively worse off in
periods of rising incomes?

Answer:
a. Demand will increase, since wheat has a positive income elasticity.
b. The quantity of wheat purchased will increase.
c. The percentage of consumer budgets spent on wheat and other staple goods will fall, since
the percentage change in the demand for wheat will be less than the percentage change in
income.
d. Farmers are likely to be relatively worse off, since the demand for what they are selling will
be rising less rapidly than the demand for other goods that they are likely to purchase.

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Chapter 6: The Theory and Estimation of Production

Multiple-Choice Questions

1) The term Production Function refers to the

A) use of machinery and equipment in production.
B) relationship between costs and output.
C) relationship between inputs and output.
D) role of labor unions.
Answer: C

2) The production period in which at least one input is fixed in quantity is the
A) production run.
B) long run.
C) short run.
D) planning horizon.
Answer: C

3) The difference between the short-run and the long-run is

A) three months, or one business quarter.
B) the time it takes for firms to change all inputs in the production process.
C) the time it takes for firms to change only their variable inputs.
D) More information is required to answer this question.
Answer: B

4) In a call center, which of the following situations can be considered as a variable input in the
short run?
A) the level of computer software being utilized
B) the number of call center representatives on duty at the center
C) the number of call center managers or supervisors
D) the size (e.g., square footage) of the call center
Answer: B

5) Which of the following holds true?

A) When the Marginal Product (MP) is rising, Marginal cost (MC) is rising; and when MP is
falling, MC is falling.
B) When MP is rising, MC is falling, and when MP is falling, MC is rising.
C) When MP is rising, MC is constant, and when MP is falling, MC is negative.
D) There is no relationship between MP and MC.
Answer: B

6) The marginal product of the variable input

A) is always positive.

12
B) typically falls then rises.
C) is equal to the total product divided by the total amount of the variable input employed.
D) None of the above
Answer: D

7) Which of the following statements about the short-run production function is true?
A) MP always equals AP at the maximum point of MP.
B) MP always equals zero when TP is at its maximum point.
C) TP starts to decline at the point of diminishing returns.
D) When MP diminishes; AP is at its minimum point.
E) None of the above is true.
Answer: B

Answer the questions based on the following information.

Number of Workers Units of Output

0 0
1 40
2 90
3 126
4 150

8) The marginal product of the fourth worker is

A) 150 units of output.
B) 24 units of output.
C) negative.
D) 36 units of output.
Answer: B

9) Average product is at a maximum when the number of workers that are hired is
A) 1.
B) 2.
C) 3.
D) 4.
Answer: B

10) Output (Total Product) is maximized when

A) average productivity is at its maximum.
B) the "law of diminishing returns" sets in.
C) marginal productivity is zero.
D) marginal productivity is at its maximum.
Answer: C

11) If a firm finds itself operating in Stage I, it implies that

A) variable inputs are extremely expensive.
B) it overinvested in fixed capacity.
13
C) it underinvested in fixed capacity.
D) fixed inputs are extremely expensive.
Answer: B
12) A firm that operates in Stage III of the short-run production function
A) has too much fixed capacity relative to its variable inputs.
B) has too little fixed capacity relative to its variable inputs.
C) has greatly overestimated the demand for its output.
D) should try to increase the amount of variable input used.
Answer: B

13) Which of the following indicates when Stage I ends and Stage II begins in the short-run
production?
A) when AP = 0
B) when MP = 0
C) when MP = AP
D) when MP starts to diminish
Answer: C

14) Which of the following indicates when Stage II ends and Stage III begins in the short-run
production function?
A) when AP = 0
B) when MP = 0
C) when MP = AP
D) when MP starts to diminish
Answer: B

15) Stage III of the short-run Production Function is

A) the most efficient mix of inputs.
B) the least costly level of output.
C) where additional units of variable inputs will lead to less output.
D) where additional units of variable inputs will lead to more output.
Answer: C

16) A firm using two inputs, X and Y, is using them in the most efficient manner when
A) MPx = MPy.
B) Px = Py and MPx = MPy.
C) MPx/Py = MPy/Px.
D) MPx/MPy = Px/Py.
Answer: D

17) The "Law of Diminishing Returns" states that

A) additional inputs will reduce output.
B) additional inputs will decrease average productivity.
C) the supply of inputs is becoming scarce.
D) additional inputs will lead to less additional output.
Answer: D

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18) Which of the following is not true about the law of diminishing returns?
A) It is a short-run phenomenon.
B) It refers to diminishing marginal product.
C) It will have an impact on the firm's marginal cost.
D) It divides Stage I and II of the production process.
E) All of the above are true.
Answer: D

19) When the law of diminishing returns takes effect

A) firms must add increasingly more input if they are to maintain the same extra amount of
output.
B) firms must add decreasingly more input if they are to maintain the same extra amount of
output.
C) more input must be added in order to increase its output.
D) a firm must always try to add the same amount of input to the production process.
Answer: A

20) Assume a firm employs 10 workers and pays each $15 per hour. Further assume that the MP
of the 10th worker is 5 units of output and that the price of the output is $4. According to
economic theory, in the short run
A) the firm should hire additional workers.
B) the firm should reduce the number of workers employed.
C) the firm should continue to employ 10 workers.
D) More information is required to answer this question.
Answer: A

21) Decreasing returns to scale

A) indicate that an increase in all inputs by some proportion will result in a decrease in output.
B) must always occur at some point in the production process.
C) are directly related to the law of diminishing returns.
D) All of the above are true.
E) None of the above is true.
Answer: E

22) In the long run, a firm is said to be experiencing decreasing returns to scale if a 10 percent
increase in inputs results in
A) an increase in output from 100 to 110.
B) a decrease in output from 100 to 90.
C) an increase in output from 100 to 105.
D) a decrease in output from 100 to 85.
Answer: C

23) Increasing returns to scale result when

A) in the long-run, an increase in inputs will lead to an increase in the average products of inputs.
B) in the long run, an increase in inputs will lead to an equivalent increase in output.
C) labor becomes more skilled.
D) All of the above
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Answer: A

24) In the short run, finding the optimal amount of variable input involves which relationship?
A) MP = MC
B) AP = MP
C) MP = 0
D) MRP = MFC
Answer: D

25) The perfect substitution of two inputs implies that

A) two inputs can be substituted at a ratio of 1 to 1.
B) one input can be substituted for another up to some point.
C) two inputs can be substituted at some constant ratio.
D) one input can be substituted for another.
Answer: C

26) If MRP > MLC, it means that a firm should

A) use less labor.
B) use more labor.
C) increase its fixed capacity.
D) decrease its fixed capacity.
Answer: B

27) In economic theory, if an additional worker adds less to the total output than previous
workers hired, it is because
A) there may be less that this person can do, given the fixed capacity of the firm.
B) he/she is less skilled than the previously hired workers.
C) everyone is getting in each other's way.
D) the firm is experiencing diminishing returns to scale.
Answer: A

28) When is it not in the best interest of a company to hire additional workers in the short run?
A) when the average product of labor is decreasing
B) when the firm is in Stage II of the production process
C) when the marginal revenue product equals zero
D) when the wage rate is equal to or greater than labor's marginal revenue product
Answer: D

29) An isoquant indicates different combinations of

A) two inputs that can be purchased for the same amount of money.
B) two inputs that can produce the same amount of output.
C) output that can be produced with the same amount of input.
D) output that cost the same amount to produce.
Answer: B

30) Marginal rates of technical substitution (MRTS) represent

A) the optimum combinations of inputs.
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B) cost-minimizing combinations of inputs.
C) the degree to which one input can replace another without output changing.
D) All of the above
Answer: C

31) Which of the following is the best example of two inputs that would exhibit a constant
marginal rate of technical substitution?
A) trucks and truck drivers
B) natural gas and oil
C) personal computers and clerical workers
D) company-employed computer programmers and temporary supplemental computer
programmers
Answer: B

32) Which of the following combination of inputs is most closely reflective of decreasing
marginal rate of technical substitution (MRTS)?
A) oil and natural gas
B) sugar and high fructose corn syrup
C) computers and clerks
D) keyboards and computers
Answer: C

33) Isocost curves represent

A) least cost combinations of inputs.
B) combinations of inputs that can be purchased given their prices for the same total cost.
C) a producers cost function.
D) None of the above
Answer: B

34) If a firm used a combination of inputs that was to the left of its isocost line, it would indicate
that
A) it is exceeding its budget.
B) it is not spending all of its budget.
C) it is operating at its optimal point because it is saving money.
D) None of the above
Answer: B

35) A major advantage of the ________ production function is that it can be easily transformed
into a linear function, and thus can be analyzed with the linear regression method.
A) cubic
B) power
C) quadratic
D) None of the above
Answer: B

36) ________ functions are very useful in analyzing production functions, which exhibit both
increasing and decreasing marginal products.
17
A) Cobb-Douglas
B) Straight-line
C) Quadratic
D) Cubic
Answer: D

37) The following Cobb-Douglas production function, Q = 1.8L0.74K0.36, exhibits

A) increasing returns.
B) constant returns.
C) decreasing returns.
D) Both A and B
Answer: A

38) When the exponents of a Cobb-Douglas production function sum to more than 1, the
function exhibits
A) constant returns.
B) increasing returns.
C) decreasing returns.
D) either increasing or decreasing returns.
Answer: B

39) Which of the following is not one of the strengths of the Cobb-Douglas production function?
A) Both marginal product and returns to scale can be estimated from it.
B) It can be converted into a linear function for ease of calculation.
C) It shows a production function passing through increasing returns to constant returns and then
to decreasing returns.
D) The sum of the exponents indicates whether returns to scale are increasing, constant or
decreasing.
Answer: C

40) An advantage of using the cross-sectional regression method in estimating production is that
A) the problem of technological change over time is overcome.
B) there is no need to adjust data, which are in monetary terms for geographical differences.
C) we can assume that all plants operate at their most efficient input combinations.
D) All of the above
Answer: A

18
Analytical Questions Chapter 6: The Theory and Estimation of Production

Number of
Output
Workers
0 0
1 50
2 110
3 300
4 450
5 590
6 665
7 700
8 725
9 710
10 705

1) The table above shows the weekly relationship between output and number of workers for a
factory with a fixed size of plant.

a. Calculate the marginal product of labor.

b. At what point does diminishing returns set in?
c. Calculate the average product of labor.
d. Find the three stages of production.

Answer:
Number of
Output MPL APL
Workers
0 0 -- --
1 50 50 50
2 110 60 55
3 300 190 100
4 450 150 112.5
5 590 140 118
6 665 75 110.83
7 700 35 100
8 725 25 90.63
9 710 -15 78.89
10 705 -5 70.5

a. See table.
b. Diminishing returns sets in after the third worker is hired.
c. See table.
d. Stage I is between the first and approximately the 5th worker (until APL is maximized);
Stage II is from the 5th worker to the 8th worker (MPL still positive), and Stage III begins with
19
the hiring of the 9th worker (MPL becomes negative).

2) Based on the table above, if the wage rate is $500 and the price of output is $5, how many
workers should the firm hire?

Answer:
Number of
Output MPL MRPL
Workers
0 0 -- --
1 50 50 $250
2 110 60 $300
3 300 190 $950
4 450 150 $750
5 590 140 $700
6 665 75 $375
7 700 35 $175
8 725 25 $125
9 710 -15 $(75)
10 705 -5 $(25)

The firm should hire 5 workers. At the 6th worker, MRPL < MLC.

3) A firm has two plants, one in the United States and one in Mexico, and it cannot change the
size of the plants or the amount of capital equipment. The wage in Mexico is $5. The wage in the
U.S. is $20. Given current employment, the marginal product of the last worker in Mexico is
100, and the marginal product of the last worker in the U.S. is 500.

a. Is the firm maximizing output relative to its labor cost? Show how you know.
b. If it is not, what should the firm do?

Answer:
a. Maximizing output between plants requires that (MPL/w)U.S. = (MPL/w)MEXICO. Since
100/5 (=20) is not equal to 500/20 (=25), the firm is not maximizing output relative to its labor
cost.
b. The firm should hire more U.S. workers and fewer Mexican workers, all other things equal.

4) A firm is making a long-run planning decision. It wants to decide on the optimal size of plant
and labor force. It is considering building a medium-sized plant and hiring 100 workers.
Engineering estimates suggest that at those levels, the marginal product of capital will be 100
and the marginal product of labor will be 75. If the wage rate is $5 and the rental rate on capital
is $10, is the firm making the right decision? Support your answer.
Answer: No, the firm is not making the right decision. Minimizing cost (maximizing output)
requires that (MPL/w) = (MPK/r). 100/10 < 75/5, so the firm should plan to build a smaller plant
and employ more workers, all other things equal.

5) For each of the following functions, describe returns to scale.

20
a. Q = K + L
b. Q = K1/2L3/4
c. Q = K2L

Answer:
a. Constant returns to scale.
b. Decreasing returns to scale.
c. Increasing returns to scale.

6) How would you choose to estimate a production function for a single plant? How would you
choose to estimate a production function for a number of firms in an industry? Explain.
Answer: Estimating a production function for a single plant generally uses time-series analysis,
because it is possible to know if technology and other variables have remained constant over
time. To estimate a production function for a number of firms in an industry, it is customary to
use cross-sectional analysis because it is unlikely that technology and other relevant factors have
remained constant for all firms in the industry over time, and cross-sectional analysis removes
this problem.

7) What are the major issues that must be considered in measuring inputs for regression analysis
of production functions?

Answer: How is labor to be measured? Can it be measured in hours, and if not, how can the
labor actually used in production be expressed? How are materials to be measured? How are
capital assets, which have different rates of depreciation and input intensity, to be measured?

8) What does the expansion path represent?

Answer: The expansion path represents the cost-minimizing choice of inputs, given constant
input prices, for different levels of output.

9) Q = K1/2L1/2
w = $2, r = $2

The firm would like to know the minimum cost of producing 2000 units of output. Find the
combination of inputs that minimizes the cost of producing 2000 units, the total cost, and
identify the expansion path.

Answer:
MPL = 1/2 K1/2L-1/2
MPK = 1/2 K-1/2L1/2
Optimization requires:
MPL/w = MPK/r
This results in K=L, which is the equation of the expansion path.
Q = K1/2L1/2 = 2000
Substitute the expansion path relationship to yield:
K* = L* = 2000
21
Then total cost = TC = 2 ∗ 2000 + 2 ∗2000 = $8,000

10) Q = K1/2L1/2
w = $2, r = $2

The firm would like to know the maximum output that can be produced for $8,000. Find the
combination of inputs that maximizes output for a cost of $8,000, the amount of output that can
be produced, and identify the expansion path.

Answer:
MPL = 1/2 K1/2L-1/2
MPK = 1/2 K-1/2L1/2
Optimization requires:
MPL/w = MPK/r
This results in K=L, which is the equation of the expansion path.
TC = 8,000 = 2L + 2K
Substitute the expansion path relationship to yield:
K* = L* = 2000
Then Q = K1/2L1/2 = 2000.

11) If the price of capital is $24, the price of labor is $15, and the marginal product of capital is
16, the least costly combination of capital and labor requires that the marginal product of labor
be ________.
Answer: MPcapital/ MPlabor = Price of capital/Price of Labor, or marginal product of labor =
10.

12) If a production function is given by the equation Q = 12X + 10X2 - X3, where Q = Output
and X = Input, then calculate the equations for

a. average product
b. marginal product
c. point of diminishing average returns
d. point of diminishing marginal returns

Answer:
a. AP = Q/X, or 12 + 10X - X2
b. MP = dQ/dX, or 12 + 20X - 3X2
c. DAR occurs where AP at a maximum, or dAP/dX = 0, or 10 - 2X = 0, X = 5
d. DMR occurs where MP at a maximum, or dMP/dX = 0, or 20 - 6X = 0, X = 3.33

13) Given the Production Function Q = 72X + 15X2 - X3, where Q = Output and X = Input

a. What is the Marginal Product (MP) when X = 8?

b. What is the Average Product (AP) when X = 6?
c. At what value of X will Q be at its maximum?
d. At what value of X will Diminishing Returns set in?
22
Answer:
a. MP = 72 + 30X - 2X2, MP =120 when X=8;
b. AP = 72 + 15X - X2, AP=126 when X=6;
c. Q at a maximum when MP is 0, or X =12 [-2 has no meaning;]
d. Diminishing returns sets in when MP at a maximum value, or X = 5.

23
Managerial Economics, 7e, Global Edition (Keat)
Chapter 7: The Theory and Estimation of Cost (Appendices 7A, 7B, and 7C)
Multiple-Choice Questions

(1) To an economist, total costs include

(A) explicit, but not implicit costs.
(B) implicit, but not explicit costs.
(C) explicit and implicit costs.
(D) neither explicit nor implicit costs.

(2) Economists consider which of the following costs to be irrelevant to a short-run business
decision?
(A) opportunity cost
(B) out-of-pocket cost
(C) historical cost
(D) replacement cost

(3) Which of the following is a relevant cost?

(A) replacement cost
(B) sunk cost
(C) historical cost
(D) fixed cost
(E) All of the above are relevant.

(4) Which of the following distinctions helps to explain the difference between relevant and
irrelevant cost?
(A) accounting cost vs. direct cost
(B) historical cost vs. replacement cost
(C) sunk cost vs. fixed cost
(D) variable cost vs. incremental cost

(5) Which of the following distinctions does not help to explain the difference between relevant
and irrelevant cost?
(A) historical vs. replacement cost
(B) sunk vs. incremental cost
(C) variable vs. fixed cost
(D) out-of-pocket vs. opportunity cost
(E) All help to explain the difference.

(6) Costs of production that change with the rate of output are
(A) sunk costs.
(B) opportunity costs.
(C) fixed costs.
(D) variable costs.
24
(7) Changes in the short-run total costs result from changes in only
(A) variable costs.
(B) fixed costs.
(C) zero.
(D) total fixed costs.

(8) Economic profit equals accounting profit minus

(A) explicit costs.
(B) implicit costs.
(C) fixed costs.
(D) variable costs.

(9) Which of the following is most likely a fixed cost?

(A) expenditures for raw materials
(B) wages for unskilled labor
(C) fuel cost
(D) property taxes

(10) Average fixed cost

(A) does not change as total output increases or decreases.
(B) varies directly with total output.
(C) falls continuously as total output expands.
(D) rises as the output is expanded.

(11) Average fixed cost is

(A) AC minus AVC.
(B) TC divided by Q.
(C) AVC minus MC.
(D) TC minus TVC.

(12) Which of the following cost relationships is not true?

(A) AFC = AC - MC
(B) TVC = TC - TFC
(C) The change in TVC/the change in Q = MC
(D) The change in TC/ the change in Q = MC
DF ‘/
(13) When a firm increased its output by one unit, its AFC decreased. This is an indication that
(A) the law of diminishing returns has taken effect.
(B) MC < AFC.
(C) AVC < AFC.
(D) the firm is spreading out its total fixed cost.

(14) The distinction between sunk and incremental costs is most helpful in answering which
question?
(A) How many more people should be added to the production process?
25
(B) What is the correct price to charge?
(C) Should we begin to build a new factory?
(D) Should we continue developing a new software application that we began last year?

(15) Which of the following relationships is correct?

(A) When marginal product starts to decrease, marginal cost starts to decrease.
B) When marginal cost starts to increase, average cost starts to increase.
C) When marginal cost starts to increase, average variable cost starts to increase.
D) When marginal product starts to decrease, marginal cost starts to increase.

(16) The relationship between MC and AC can best be described as

(A) when AC increases, MC starts to increase.
(B) when MC increases, AC starts to increase.
(C) when MC decreases, AC decreases.
(D) when MC exceeds AC, AC increases.

(17) The law of diminishing returns begins first to affect a firm's short-run cost structure when
(A) average variable cost begins to increase.
(B) marginal cost begins to increase.
(C) average cost begins to increase.
(D) average fixed cost begins to decrease.

(18) When a firm increased its output by one unit, its AC rose from $45 to $50. This implies that
its MC is
(A) $5.
(B) between $45 and $50.
(C) greater than $50.
(D) Cannot be determined from the above information

(19) When a firm's MC curve shifts to the right, it implies that

(A) new firms are entering the market.
(B) labor productivity is decreasing.
(C) labor productivity is increasing.
(D) the firm's overhead costs are decreasing.

(20) MC increases because

(A) MC naturally increases as the firm nears capacity.
(B) labor is paid overtime wages when volume increases.
(C) in the short run, MC always increases.
(D) the law of diminishing returns takes effect.

(21) The marginal cost will intersect the average variable cost curve
A) when the average variable cost curve is rising.
B) where average variable cost curve equals price.
C) at the minimum point of the average variable cost curve.
D) The two will never intersect.

26
(22) Which of the following cost functions will exhibit both decreasing and increasing marginal
costs?
(A) a cubic cost function
(B) a quadratic cost function
(C) a linear cost function
(D) All of the above

(23) Which of the following statements best represents a difference between short-run and long-
run cost?
(A) Less than one year is considered the short run; more than one year the long run.
(B) There are no fixed costs in the long run.
(C) In the short-run labor must always be considered the variable input and capital the fixed
input.
(D) All of the above are true.

(24) When a firm increased its output by one unit, its AC decreased. This implies that
(A) MC < AC.
(B) MC = AC.
(C) MC < AFC.
(D) the law of diminishing returns has not yet taken effect.

(25) The main factor that explains the difference between accounting cost and economic cost is
(A) opportunity cost.
(B) fixed cost.
(C) variable cost.
(D) All of the above help to explain the difference.

(26) When a firm experiences increasing returns to scale

(A) its AFC will decrease.
(B) its AFC will increase.
(C) its AC will increase.
(D) its AC will decrease.

(27) If a firm's rent increases, it will affect its cost structure in which of the following ways?
(A) AVC will increase.
(B) MC will increase.
(C) TFC will increase.
(D) All of the above will increase.

(28) Which of the following relationships implies that a firm's short-run cost function is linear?
(A) MC = AC
(B) MC = AVC
(C) AC = AFC + AVC
(D) MC > AC

(29) The learning curve

27
(A) is really no different from a marginal cost curve.
(B) calculates average cost at a particular point in time.
(C) shows the decrease in unit cost as more of the same product is produced over time.
(D) None of the above

(30) The learning curve indicates that

(A) economies of scale are taking effect.
(B) repetition of various production tasks cause unit costs to decrease.
(C) workers must learn new skills in order to improve.
(D) it takes time to learn a new skill.

(31) Which level indicates the point of maximum economic efficiency?

(A) lowest point on AC curve
(B) lowest point on AVC curve
(C) lowest point on MC curve
(D) None of the above

(32) Which of the following actions has the best potential for experiencing economies of scope?
(A) producing a product that has appeal to a wider segment of the market
(B) producing computers and software
(C) producing spaghetti and soft drinks
(D) producing cars and trucks

(33) If total cost equals $2,000 and quantity produced is 100 units, then
(A) fixed cost is $200 and average variable cost is $18.
(B) fixed cost is $600 and average variable cost is $14.
(C) fixed cost is $500 and marginal cost is $15.
(D) Either A or B can be correct.

(34) A short-run total cost function, TC = 100 + 32Q - 4Q2 + 0.4Q3, indicates the existence of
(A) a linear total cost curve.
(B) a constant average variable cost curve.
(C) a U-shaped average variable cost curve.
(D) a constant marginal cost curve.

(35) The results of many empirical studies of short-run cost functions have shown that total costs
conform to
(A) a quadratic total cost function.
(B) a power cost function.
(C) a linear cost function.
(D) a cubic cost function.

(36) Among the problems encountered when time series analysis is used to estimate cost
functions is
A) that technological changes may have occurred.
B) that accounting changes may have occurred during the period analyzed.
C) that some costs are recorded on the books of account at a time other than when they are
28
incurred.
D) All of the above

(37) The method of estimating long-run costs in which knowledgeable professionals familiar
with production facilities and processes calculate optimal combination of inputs to produce given
quantities and then estimate costs is known as
(A) engineering cost estimating.
(B) the survivorship method.
(C) regression analysis.
(D) None of the above

(38) When the survivorship method of cost estimating is used, an increase, over time, in the
proportion of industry product produced by medium size firms indicates the existence of
(A) continuing economies of scale.
(B) continuing diseconomies of scale.
(C) a U-shaped long-run average cost curve.
(D) large technological changes.

(39) The major advantage of using cross-sectional analysis for long-run costs studies includes
(A) the inclusion in the sample of different plants of different sizes.
(B) the avoidance of having to adjust for inflationary trends.
(C) the avoidance of having to account for interregional cost differences.
(D) All of the above
(E) A and B above

(40) In the long run

(A) fixed costs tend to be greater than variable costs.
(B) variable costs tend to be greater than fixed costs.
(C) all costs are fixed costs.
(D) all costs are variable costs.

(41) Assuming the existence of economies of scale, if a firm finds that it can reduce its unit cost
by decreasing its scale of production, it means that
(A) it has too much production capacity relative to its demand.
(B) it should try to produce less.
(C) the law of diminishing returns has not taken effect.
(D) it has too much fixed overhead relative to its variable cost.

(42) As a firm attempts to increase its production, its long-run average costs eventually rise
because of
(A) the law of diminishing returns.
(B) diseconomies of scale.
(C) fixed capital.
(D) insufficient demand.

(43) Economies of scale are created by greater efficiency of capital and by

(A) longer chains of command in management.
29
(B) better wages for labor.
(C) smaller plant sizes.
D) increased specialization of labor.

(44) Economies of scale are indicated by

(A) declining long-run AVC.
(B) declining long-run AFC.
(C) declining long-run AC.
(D) declining long-run TC.

(45) Which of the following is a reason for economies of scale?

(A) Fixed costs are spread out as volume increases.
(B) The law of diminishing returns does not take effect.
(C) Input productivity increases as a result of greater specialization.
(D) There is greater savings in transportation costs.

(46) Diseconomies of scale can be caused by

(A) the law of diminishing returns.
(B) bureaucratic inefficiencies.
(C) increasing advertising and promotional costs.
(D) All of the above

(47) Which of the following is the best example of economies of scope?

(A) Coca-Cola expands its global operations to sub-Sahara Africa.
(B) Alcohol for car fuel is produced from corn.
(C) Amazon.com decides to rent out its Web site to independent e-commerce companies.
(D) A company reduces its cost by getting bigger discounts for bulk purchases.

(48) Short-run cost functions are estimated using

(A) time-series regression analysis.
(B) cross-sectional regression analysis.
(C) nominal cost data.
(D) present value cost data.

(49) In estimating short-run cost functions, one must adjust for

(A) price level changes.
(B) accounting procedure changes.
(C) product heterogeneity.
(D) All of the above

(50) Long-run cost functions are estimated using

(A) time-series regression analysis.
(B) cross-sectional regression analysis.
(C) cost accounting data.
(D) None of the above

30
Analytical Questions

One person using one computer can produce 11,000 typed pages per year, and the price per page
for your service is $2.

You are considering three options: (1) expand your business by hiring an assistant; (2) leave your
business the way it is; (3) shut down. Based on the costs and revenues above, which should you
do? Explain and show any relevant calculations.

(2) Fred's Widget Company has purchased $500,000 in equipment, which can be sold for a
salvage value of $300,000 at any time. The best interest rate on alternative investments is 5%.
What is the cost of using this machinery for one year? How would your answer be different if the
machinery had not yet been purchased?

(3) The following table shows the relationship between output and number of workers in the
short run. If the wage is $50/day, find marginal cost of production.

Number of
Workers Output
0 0
1 50
2 110
3 300
4 450
5 590
6 665
7 700
8 725
9 740
10 735

(4) Consider a firm that has just built a plant, which cost $1,000. Each worker costs $5.00 per
hour. Based on this information, fill in the table below.

Number of Average
Marginal Fixed Variable Total Marginal Average
Worker Output Variable
Product Cost Cost Cost Cost Total Cost
Hours Cost
0 0 -- -- --
50 400
100 900
150 1300
200 1600
250 1800
300 1900
31
 350 1950

(5) How would each of the following affect the firm's marginal, average, and average variable
cost curves?

a. An increase in wages
b. A decrease in material costs
c. The government imposes a fixed amount of tax.
d. The rent that the firm pays on the building that it leases decreases.

(6) A firm experiences increasing returns to scale; that is, doubling all its inputs more than
doubles its output. What can be inferred about the firm's short-run costs?

(7) Carefully explain if the following statements are true, false, or uncertain.

a. If average cost is increasing, marginal cost must be increasing.

b. If there are diminishing returns, the marginal cost curve must be positively sloped.
c. Marginal costs decrease as output increases because the firm can spread fixed costs over
more units.

(8) Carefully explain the difference between diseconomies of scale and diminishing returns.

(9) For each of the following cost functions, find MC, AC, and AVC.

a. TC = 20,000 + 10 Q
b. TC = 18,000 + Q + 0.2 Q2
Answer:
a. MC = 10
AC = (20,000/Q) + 10
AVC = 10
b. MC = 1 + 0.4Q
AC = (18,000/Q) + 1 + 0.2Q
AVC = 1 + 0.2Q

32
(10) For each of the following cost functions, if possible, find minimum AC and minimum AVC.

a. TC = 20,000 + 10 Q
b. TC = 18,000 + Q + 0.2 Q2

(11) Given the total cost function TC = 100 + 40Q - 15Q2 + 5Q3, calculate the

a. average fixed cost function (AFC)

b. average variable cost function (AVC)
c. marginal cost function (MC)

(12) Given the production function Q = 21X + 9X2 - X3, where Q = Output, and X = Input

a. At what value of X does Stage II of the production function begin?

b. At what value of X does Stage III of the production function begin?
c. At what value of X does diminishing returns set in?

33