Managerial Economics

Problem Set: Cost

1. A storybook publishing company house in Chandni Chowk, Delhi, has estimated its
total output (book) and total cost. Assuming the general equation of the firm’s total
cost (TC) function as

TC=120+50 Q−10 Q 2 +Q 3
Find out (a) the equations of the TVC, AVC, and MC functions, and
(b) The level of output at which AVC and MC are minimum. Plot the AVC and MC
curves and comment on their shapes.
(c) Find the AVC and MC for the level of output at which the AVC curve is
minimum.

Answer: a) TVC=50 Q−10 Q 2 +Q 3

AVC=50−10Q+Q2
MC=50−20Q+3 Q 2

b) AVC minimum at Q=5 and MC minimum at Q=3.33

AVC and MC are U shaped curves. MC cuts AVC curve from below at its minimum.
Minimum of MC lies to the left of minimum of AVC.
When AVC>MC, AVC is falling, when AVC=MC, AVC is minimum, when AVC<MC,
AVC is rising.

c) AVC minimum at Q=5 so

at Q=5, AVC =MC=25.

2. Keshav Nath, a lawyer working for a large law firm and earning $60,000 per year, is
contemplating setting up his own law practice. He estimates that renting an office
would cost $10,000 per year; hiring a legal secretary would cost $20,000 per year;
renting the required office equipment would cost $15,000 per year; and purchasing
the required supplies, and paying for electricity, telephone, and so forth would cost
another $5,000. The lawyer estimated that his total revenues for the year would be
$100,000, and he is indifferent between keeping his present occupation with the
large law firm and opening his own law office.
(a) How much would be the explicit costs of the lawyer for running his own law
office for the year?
(b) How much would the accounting costs be? The implicit costs? The economic
costs?
(c) Should the lawyer go ahead and start his own practice?

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 Answer: a) Explicit costs= 10,000+20,000+15,000+5,000=$50,000
b) Accounting costs= explicit costs= $50,000
Implicit costs= amount foregone= $60,000
Economic costs= explicit costs +implicit costs = 50,000+60,000=$1,10,000
c) Should not. Because estimated TR= $100,000 < total estimated economic
costs=$110,000

3. For a new product, a manufacturer sets up an infrastructure, which costs him Rs.
550. The variable cost is estimated at Rs. 2.05 per unit of product. The sale price per
unit is fixed at Rs. 3.
a) Write down the cost function, Revenue function and profit function for x units of
the product.
b) Determine the minimum number that must be produced and sold daily to ensure
no loss.
c) If the selling price is increased by 30 paise per piece, what would be the break-
even point?
d) If it is known that at least 500 units of the product can be sold daily, what price
should the manufacturer charge per unit to ensure no loss?
e) Find the price for which it will shut down; the price for which it exits at q=500.

Answer. a. TC=550+2.05x
TR=3x
Profit=0.95x-550

b. 579
c.440
d. 3.15
e. P<2.05 and P<3.15 (exit means, in the long run if he makes losses he will exit. That
happens below the breakeven price!)

4. The cost function of a company is given by TC= 200+55q, where TC is total cost and
q is the quantity of output, both measured in thousands.
a. Identify whether it’s a long-run or short-run cost function. Explain why?
b. If the company produced 100,000 units of goods, what would be its average
variable cost?
c. What would be its marginal cost of production?
d. What would be its average fixed cost?
e. Suppose the company borrows money and expands its factory. Its fixed cost rises
by Rs. 50,000, but its variable cost falls to Rs. 45,000 per 1000 units. The cost of
interest (i) also enters the equation. Each 1-point increase in the interest rate
raises costs by Rs. 3000. Write the new cost equation.
Answer. a. Short run.

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b. VC=55q, AVC=55 ( both in thousands)
c. MC= 55(in thousands)
d. AFC= 2
e. TC=250+45q+3i
5. Suppose that a firm’s production function is q=10 l 1/ 2 k 1/ 2 . The cost of a unit of labor
is Rs. 20 and the cost of a unit of capital is Rs. 80.
a. The firm is currently producing 100 units of output and has determined that the
cost-minimizing quantities of labor and capital are 20 and 5 respectively.
The firm now wants to increase output to 140 units. If capital is fixed in the short
run how much labor will the firm require? Find the firm’s new total cost.
b. Find the cost minimizing level of capital and labor in the long run if the firm
wants to produce 140 units.
c. If the marginal rate of technical substitution is K/L find the optimal level of
capital and labor required to produce the 140 units of output.
Answer. a. TC=800
l= 39
Firm’s new total cost=1180.
b. k=7, l=28
c. same as b.