TUTORIAL EXERCISES

Question 1
Number of Mushrooms per Marginal Product Average Product
Workers Day (pounds) of labor of labor
1 12 12 12
2 30 18 15
3 45 15 15
4 50 5 12.5
5 54 4 10.8
6 56 2 9.33

Table above shows the technology of production at the Matsuko's Mushroom Farm for the month of
May.
a. Complete the table.
b. At which number of labors employed does the law of diminishing returns set in? Why? Explain.

When the firm hired the fourth worker, the law of diminishing marginal returns set in because the
marginal product of labor has declined. This is because the quantity of fixed input is unchangeable but
the quantity of variable input increases in the short run. Therefore when more and more workers get
hired, the marginal product of labor will begin to decline even if it shown an increase in output level.

c. Describe the law of diminishing returns. Does law of diminishing returns apply in the short run
or long run?

Law of diminishing returns is the principle that, at some point, adding more of a variable input, such as
labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the
variable input to decline. Law of diminishing returns is only applicable for short run because short run
indicates the time frame that at least one of the inputs is fixed and all the factors are variable in the long
run.

Question 2
Explain whether each of the following is a fixed cost or a variable cost.
a. payment to hire a security worker to guard the gate to the factory around the clock
fixed cost

b. wages to hire assembly line workers

variable cost

c. payments to an electric utility

fixed cost

d. costs of raw materials

variable cost

e. payment on fire insurance policy

fixed cost
 f. A $300-per-month payment to a local newspaper for advertisement
fixed cost

Question 3
Marginal
Number of Output Office Rent Labor Cost Total Cost
Product of
Workers (boxes) (dollars) (dollars) (dollars)
Labor
0 0 -- 400 0 400
1 220 220 400 200 600
2 470 250 400 400 800
3 680 210 400 600 1000
4 840 160 400 800 1,200
5 940 100 400 1,000 1400
6 980 40 400 1200 1,600

Suzette's Fancy Packaging subcontracts with Sunshine land Pecans to box dried fruit and nuts for
Suzette's mail order business. Suzette rents space for her factory for $400 a week in a nearby strip mall.
She can hire temporary workers for $200 a week. Table above shows her output.

a. Complete the table.

b. In the last week of summer Suzette closes her business to go on a family vacation. What are her
costs during that week?

Office rent – fixed costs

c. In one week, Suzette exactly breaks even. If her revenue for the week is $1,200, how many boxes of
fruit and nuts did she produce?

840 boxes

d. Judging from the marginal product of labor data, would you say that Suzette had to settle for
increasingly unproductive workers? Explain your answer.

No, according to the law of diminishing marginal returns, it only implies that at some point, adding more
of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the
marginal product of the variable input to decline, but it does not indicate the workers are unproductive.
The marginal product of labor decreases is because of the present of fixed inputs which is not
changeable in the short run. Therefore, marginal product of labor decreases after Susan hired the third
worker. The limited office space and the increasing number of workers results in overcrowded in the
office and workers are difficult to get work done in a smaller space, thus delay their working process and
decrease their productivity.

Question 4
 a. Calculate the total fixed cost.

ATC = TC / Q
20 = TC / 100
TC = 2000

AVC = VC / Q
12 = VC / 100
VC = 1200

Fixed cost = Total cost – Variable cost

Fixed cost = 800

b. When output level is 100, what is the total cost and total variable cost of production?

Total cost = 2000

Total variable cost = 1200

TUTORIAL EXERCISES

Question 1
Explain why long run cost curve are typically U-shaped. Relate your explanation with constant,
increasing and decreasing returns to scale concepts.
Due to the presences of the economies of scale, constant return to scale, and diseconomies of scale,
long run cost curve shows a U shape. Economies of scale is a situation where, as the quantity of output
the firm produces go up, the firm’s long run average cost per unit goes down. The reasons of bringing
the firm towards economies of scale are specialization and division of labor, economies of scope, the
container principle, and greater efficiency of large equipment. When the firm experiences the
economies of scale, the long run average cost curve is sloping downwards, which relates to the concept
of increasing return to scale, that a given percentage increase in inputs will lead to the same percentage
increase to output.

Subsequently, the firm is likely to experience constant return to scale if growing larges does not allow
more economies of scale, which presents a straight horizontal line. At this stage, the given percentage
increase in inputs by the firm will lead to a same percentage increase to the output. Likewise, the long
run average cost remains unchanged.

In the third stage, the firm will experience diseconomies of scale, where the firm’s long run average cost
increases due to the increase in output level. The reasons such as management problems of co-
ordination as firms become larger and complex or professionals with years of experience will demand
higher wages, are likely to increase the firm’s long run average cost. Thus, the long run average cost is
upward sloping. However, the given percentage increase in inputs will lead to a smaller percentage
increase in the output, which indicates the concept of decreasing return to scale.

Question 2
How do diminishing returns differ from diseconomies of scale? How does economies of scale differ from
diseconomies of scale? Explain using graphs.

Diminishing marginal returns indicate that at some point, adding more of a variable input to the same
amount of fixed input will cause the marginal product of the variable input to decline. Whereas
diseconomies of scale indicate the situation in which a firm’s long run average costs rise as the firm
increase output. Diminishing marginal returns is applicable to short run and diseconomies of scale is
applicable to long run. Short run implies a time frame in which the quantity of one or more resources
used in production is fixed. Likewise, long run implies a time frame in which the quantities of all
resources or input can be varied and all costs is based on variable inputs.

- Describe economies of scale (provide one or two reasons), where/how it happens and comment
on the firm’s long-run average costs in relation to the level of output.
- Acknowledge that at some point, there would be no more economies of scale (constant returns
to scale) and comment on its long-run average cost in relation to the level of output.
- Describe diseconomies of scale (provide one or two reasons, where/how it happens and
comment on the firm’s long-run average costs in relation to the level of output.

Question 3
Suppose Argyle Sachs has to choose between building a smaller sweater factory and a larger sweater
factory. In the following graph, the relationship between costs and output for the smaller factory is
represented by the curve ATC1, and the relationship between costs and output for the larger factory is
represented by the curve ATC2.
 a. If Argyle expects to produce 3,600 sweaters per month, should he build a smaller factory or a
larger factory? Briefly explain.

Smaller factory. Because ATC 1 indicates a lower total cost and Argyle will have a lower total cost.

b. If Argyle expects to produce 5,000 sweaters per month, should he build a smaller factory or a
larger factory? Briefly explain.

Larger factory. Because ATC 2 indicates a lower total cost and Argyle will have a lower total cost.

c. If the average cost of producing sweaters is lower in the larger factory when Argyle produces
6,500 sweaters per week, why isn't it also lower when Argyle produces 4,000 sweaters per
week?

As economies of scale often take the form of larger factory and larger quantity which allows for lower
average cost, the firm can benefit from the economies of scale with larger quantity produced and lesser
per unit cost. If smaller quantity produced in the larger factory, the average cost would increase
unnecessarily for the business.

Question 4
Differentiate between internal and external economies of scale. Provide examples.

Internal economies of scale measure a company’s efficiency of production. Internal economies of scale
occur due to the factors controlled by the firm’s management team. For instance, technical economies
of scale, marketing economies of scale, managerial economies of scale, financial economies of scale.

External economies of scale happen due to the larger changes within the industry. When the industry
grows, the average cost drops. For example, research and development facilities. transportation
network by a local authority for a local town or city, and relocation of component suppliers and other
support businesses.