Production, costs and profit maximization Past Year Questions(Solution)

2010 Zone A
1.In a competitive labour market, the supply of labour is given by

LS = 2w

where w is the wage rate. There are 20 identical firms who hire workers, and
they operate in a competitive output market. Each firm uses labour to produce
its output Q and has the production function

Q=4 𝑳

The price in the competitive output market is 5. How many workers are
employed in total? (5 marks)
! !"
Marginal product of labour is !
. Therefore marginal revenue product of labour is !
.
!" !""
Therefore labour demand by each firm is given by = 𝑤 which implies L =
! !!
!"""
Thus market demand for labour is LD =
!!
!"""
Equating LD and LS, ! = 2𝑤
!
Solving, w = 10. Therefore the total employment is 20.

2011 Zone B
2. For each of the following statements, state whether the statement is true or
false, and explain your answer.
(a) If average product is increasing, marginal product must be less than average
product.
(b) If total product is increasing, marginal product must be increasing.
(5 marks)

This tests whether you understand the relation between average and marginal. Suppose you play
a computer game and your average score is 1000. If you score 1500 next time (i.e. the marginal
score is 1500), your average across all games will go up. On the other hand, if the marginal score
is 700, your average score will fall. Use this example to convince yourself that when the marginal
is above the average, the average rises, while if the marginal is below the average, the average
falls. Now, for costs, MC approaches AC from below. Therefore MC meets AC at the lowest
point of AC. But if we consider MP and AP, the picture is different. MP cuts AP from above.

Therefore, at first MP is greater than AP (in which case AP is rising) and subsequently MP is
less than AP (in which case AP is falling). It is also clear that MP cuts AP at the highest point
of AP.

Further, note the relation between total and marginal. Suppose scores in your game can be
positive as well as negative. If your marginal score is positive, your total score over all games will
increase. On the other hand, if your marginal score is strictly negative, your total score will
decrease. Similarly, total product increases so long as MP is strictly positive. It does not matter
whether MP is rising or falling or constant, only the sign matters.
These ideas should be part of your basic knowledge of economics. Once you understand these,
you can answer the question easily.
(a) False. AP increases when MP > AP .
(b) False. Total product increasing implies only that MP > 0. However, MP might be increasing or
decreasing or constant.
You could also draw a picture to illustrate these ideas.

3.Consider the production function

Q = LK

where K is the quantity of capital and L is the quantity of labour. Let w denote
the wage rate and r denote the price of capital, where

r = 4w

Derive the demand functions for labour and capital as functions of output (Q).
(5 marks)

To answer this question, you simply need to equate MRTS with the ratio of factor prices. We
need

Once you write this down, the answer should follow easily.
Here, MPL = K , MPK = L , and r = 4w . Therefore,

which implies L = 4K . Using this in the production function,

which implies

!
which is the demand function for labour. Since K = , the demand function for capital is given
!
by

2012 Zone A
4.There are 50 firms in a competitive industry. Each firm has the production
function q = ln L, where q denotes firm output and L denotes the quantity of
labour employed by the firm. The wage rate is w = 2 and each firm can sell its
output
at price p = 10. What is the total labour employment in the industry? (5 marks)

Each firm optimally sets MRPL = w , which implies p /L = w . So each firm employs L = p /w
units of labour. Therefore the total employment is 50L = 50p /w . For w = 2 and p = 10, total
employment is 250.
5.Suppose firms in a competitive market produce output using a technology
featuring constant returns to scale, and face constant input prices. It follows that
for each firm, the average cost is constant in the short run. Is this true or false?
Explain your answer using a diagram. (5 marks)

This is false. In the short run, capital is typically fixed, giving rise to an average fixed cost that is
decreasing. Further, diminishing returns from labour ensures that the average variable cost is
increasing. So the overall average cost curve has a U-shape in the short run. You should draw a
picture showing the average fixed cost curve, average variable cost curve and the sum of the
two, which is the short run average cost curve.

2012 Zone B
6.A competitive firm produces according to the following production function:
Q = 2𝑳𝟏/𝟐 𝑲𝟏/𝟐
where Q denotes the firm’s output, K denotes capital and L denotes labour. The
price of labour is 4 and the price of capital is 16. Let P be the price at which the
firm can sell its output. In the short-run, capital is fixed at some level K. In the
long run both labour and capital are variable.
(a) Write down the total short run cost of the firm as a function of the output
Q and the fixed level K. [5 marks]

Let K be fixed at 𝐾. From the production function,

Therefore the total cost is

(b) What is the minimum average cost in the short run? [5 marks]
Equate AC and MC .

This implies Q = 4𝐾 . At this quantity, AC= 8.

(c) What is the short-run supply curve of the firm? In answering this question,
be careful to check whether there is a P below which the firm would shut
down in the short run (so that supply would be zero for such prices).
[5 marks]
The supply curve is given by P = MC above the AVC curve. Now

Therefore the firm continues operation at all positive prices, and the supply curve is given
simply by P = MC which is P = 2Q /𝐾 , or
(d) Now consider the long-run scenario in which both labour and capital are
variable inputs. Derive and explain the shapes of the long-run marginal
and average cost curves of the firm. (5 marks)

Now,  

The left hand side is simply K /L . So we have

L = 4K .
It follows that

So K = Q /4 and therefore L = Q . Therefore total cost in the long run is

Therefore long-run AC and MC are both 8. In other words, the long-run AC (and MC) is
constant at 8. This arises from the fact that we have a CRS production function and the factor costs are
constant. The picture below shows the LRAC and LRMC with short-run AC
curves for 𝐾 = .5 and 𝐾 = 1 (and the associated MC curves).

2013 Zone A
7.If the long-run average cost is decreasing in output, the long-run marginal cost
must be decreasing in output as well. Is this true or false? Explain your answer.
(5 marks)

This is false. Decreasing long-run average cost (LRAC) implies that long-run marginal cost
(LRMC) is below long-run average cost, but has no implication on whether the LRMC is
increasing or decreasing. As the picture below shows , LRMC can be increasing while still below
LRAC.
2015 Zone A
8.Short-run average cost exceeds long-run average cost only when there are
economies of scale. Is this true or false? Explain your answer. (5 marks)

This is false. Short-run average costs exceed long-run average costs because the firm is locked
into a certain input mix in the short run that may not be cost minimising when all inputs are
variable. This condition holds regardless of the presence of economies of scale. You should draw a
diagram to illustrate this.