Organization and Market Economics Arpit Jain (PGP/24/381)

Homework 5

Chapter 7, Exercise 8
8. You manage a plant that mass produces engines by teams of workers using assembly machines.
The technology is summarized by the production function.

q = 5 KL

Where q is the number of engines per week, K is the number of assembly machines, and L is the
number of labor teams. Each assembly machine rents for r = $10,000 per week and each team
costs w = $5,000 per week. Engine costs are given by the cost of labor teams and machines, plus
$2,000 per engine for raw materials. Your plant has a fixed installation of 5 assembly machines as
part of its design.

a. What is the cost function for your plant — namely, how much would it cost to produce q
engines? What are average and marginal costs for producing q engines? How do average
costs vary with output?

Answer:

We know that Total Cost function is given by

TC (q) = w L + r K

In our case, total cost function for producing q engines will have additional factor of $2000 per
engine in above equation, hence

TC (q) = w L + r K + 2000 q…… (1)

Now, in this situation, r=$10,000, w=$5,000

We need to find out L and K in terms of q

Now, Assembly machines, K = 5 (Given)

Hence q=5KL = 25L therefore, L = q/25

Putting the values in (1)

TC (q) = 5000 x (q/25) + 10000 x 5 + 2000q

TC (q) = 2200q + 50000

The average cost function is then given by

AC (q) = TC (q)/q = 2,200 + 50,000/q

The Marginal cost function is given by

MC (q) = ẟTC (q)/ ẟq = 2,200

Organization and Market Economics Arpit Jain (PGP/24/381)

Hence Average costs will decrease as q increases, more no. of engines are used.

Marginal cost is constant.

b. How many teams are required to produce 250 engines? What is the average cost

per engine?

Answer:

For q = 250,

L will be L= q/25

L = 250/25 = 10

Hence 10 Labor teams will be required to produce 250 engines

Average cost, AC (q) = TC (q)/q = 2,200 + 50,000/q

AC (q= 250) = 2,200 + 50,000/250 = 2200+ 200

AC (q=250) = 2,400

c. You are asked to make recommendations for the design of a new production facility. What
capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize the
total cost of producing any level of output q?

Answer:

For Cost minimization, MPK / r = MPL/ w …. (2)

Now, q= KL (given, K is not 5 now as this is for new production facility)

MPK = ẟ5KL/ ẟK = 5L

MPL = ẟ5KL/ ẟL = 5K

Putting these value in (2)

5L/r = 5K/w

K/L = w/r = 5000/1000

K/L = ½

Hence new plant should accommodate 2 units of labor for every 1 unit of capital.

Capital/labor ratio should be 1:2