Worksheet for Chapters 6 (Production) and 7 (The Cost of Production)

Recap of 1st year work:

Relationship between TP, MP and AP:

TP increases as long as MP is positive, but falls once MP becomes negative.
AP increases if MP is above it, reaches a maximum where it is equal to MP and then falls
when MP is below it.

Relationship between AP and MP:

• When MP > AP, AP increases.
• When MP < AP, AP decreases.
• AP at its maximum when MP=AP.

The difference between TC, TVC and TFC:

TFC = is a horizontal line indicating that total fixed cost remains constant irrespective of total
product.
TVC = has a reversed S-shape. It starts at the origin and then increases at a decreasing rate
up to a point. Thereafter TVC increases at an increasing rate.
TC = has the same shape as the variable cost function, but does not start at the origin. It
starts above the origin at the point on the vertical axis which represents the total fixed cost.
TC = TFC + TVC.

Relationship between marginal cost and the three measures of average cost:
There is only 1 MC curve, but there are 3 average cost curves: AFC (which fall as output ↑),
AVC (which ↓, reaches a minimum where it is intersected by MC and then ↑), and ATC (or
simply AC) (which also ↓, reaches a minimum where it is intersected by MC & then ↑). Both
AVC and AC reach a minimum where they are intersected by MC.

Shape of the cost curves is related to the shape of the productivity curves:
• The shape of the AVC curve is determined by the shape of the AP curve. Over the
range of output for which the AP curve is rising, the AVC curve is falling and over the
range of output for which the AP curve is falling, the AVC curve is rising.
• The shape of the MC curve is determined by the shape of the MP curve. Over the range
of output for which the MP curve is rising, the MC curve is falling and over the range of
output for which the MP curve is falling, the MC curve is rising.

Reasons for cost curves to shift:

The cost curves shift with changes in technology or changes in prices of factors of production.
• An increase in technology that allows more output to be produced from the same
resources shifts the cost curves downward. If the technology requires more capital, a
fixed input, then the average total cost curve shifts upward at low levels of output and
downward at higher levels of output.
• A fall in the price of the fixed factor shifts the AFC and ATC curves downward but leaves
the AVC and MC curves unchanged. A fall in the price of a variable factor shifts the AVC,
ATC, and MC curves downward but leaves the AFC curve unchanged.

Note:
When given a TC function such as the one below you should be able to identify the TFC, the
TVC, the various average cost measures and the marginal cost.
TC = 200 + 5Q.
Recall, TC = TFC + TVC
TFC doesn’t change as output changes.
Therefore, 200 is the TFC and 5Q is the TVC.
Note:
We can use the theory that we learn about in this chapter to tell our managers how many items
of a particular product to produce in order to maximise profit. We can then also work out our
company’s TR.

Note:
Take note of the following characteristics that define the three distinct phases of the long-run
average total cost curve (LRATC):

Economies of scale
• Downward part of LRATC
• Average costs decrease as output increases
• If have a 1% increase in input usage what happens to output?
o Output increases by MORE than 1%
• Why?
o The Sources of Economies of Scale are mostly technological in nature. Some result
from sheer size (for example, buying in volume may mean lower prices). Others
(such as the assembly line) arise from actual innovation in production technique.
Specialisation is thus a key issue.

Constant returns to scale

• Flat portion of LRATC
• Costs remain the same as increase output
• If have a 1% increase in input usage what happens to output?
o Output increases by EXACTLY 1%
o Furthermore, if input prices are fixed, constant returns imply that average cost of
production does not change with scale.
• First point of constant returns to scale is called MINIMUM EFFICIENT SCALE (MES).
o The larger the size of the MES, the more concentrated the industry.
o The smaller the size of the MES, the more competitive the industry.

Diseconomies of scale
• Upward sloped portion of LRATC
• Costs are rising as we increase output
• If have a 1% increase in input usage what happens to output?
o Output increases by LESS THAN 1%
• Why?
o Firm too large (bad communication or coordination problems)
Comparison between indifference curves and isoquants:

Indifference Curve Isoquant

- slope = MRS
= rate at which consumer is willing to
exchange Y for 1X in order to hold U
constant
= inverse MU ratio
= MUX/MUY
For given indifference curve, dU = 0
Derived from different types of Utility
functions:
1. Cobb Douglas ⇒ U = XαYβ
2. Perfect substitutes ⇒ U=αX+βY
3. Perfect complements ⇒ U = min
[αX,βY]
- slope = MRTS
= rate at which producer is able to exchange
K for 1L in order to hold q constant
= inverse MP ratio
= MPL/MPK
For given isoquant, dq = 0
Derived from different types of production
functions:
1. Cobb Douglas ⇒ q = LαKβ
2. Perfect substitutes ⇒ q=αL+βK
3. Perfect complements ⇒ q = min
[αX,βY]

Comparison between MRTS and MP:

MRTS MP
= marginal rate of technical substitution ∆𝑄𝑄
𝑀𝑀𝑀𝑀𝐾𝐾 = the marginal product of K =
∆𝐾𝐾
= the rate at which a firm must substitute one ∆𝑄𝑄
𝑀𝑀𝑀𝑀𝐿𝐿 = the marginal product of L = ∆𝐿𝐿
input for another in order to keep production
at a given level
= -slope of isoquant ∆𝑄𝑄 = 𝑀𝑀𝑀𝑀𝐾𝐾 ∆𝐾𝐾 + 𝑀𝑀𝑀𝑀𝐿𝐿 ∆𝐿𝐿
∆𝐾𝐾 ∆𝑄𝑄 = 0 along a given isoquant
= ∆𝐿𝐿
= the rate at which capital can be exchanged ∆𝑄𝑄 ⇒ 𝑀𝑀𝑀𝑀𝐾𝐾 ∆𝐾𝐾 + 𝑀𝑀𝑀𝑀𝐿𝐿 ∆𝐿𝐿 = 0
for 1 more (or less) unit of labour
∆𝐾𝐾 𝑀𝑀𝑀𝑀𝐿𝐿
∆𝑄𝑄 ⇒ − ∆𝐿𝐿 = 𝑀𝑀𝑀𝑀𝐾𝐾
= ‘inverse’ MP ratio

Two ways to calculate MRTS (= - slope of isoquant):

1. = inverse MP ratio = MPL/MPK (calculated given production function)
2. = -dK / dL (calculated given isoquant equation)
Two ways to calculate MRS (= - slope of indifference curve)
1. Inverse MU ratio = MUX/MUY (calculated given utility function)
2. = - dy / dx (calculated given indifference curve equation)

Some maths:

Deriving an isoquant’s equation

Plug desired Q of output into production function and solve for K as a function of L.

Example 1:
Cobb Douglas isoquants
– Desired Q = 100
– Production function: Q = 10K1/2L1/2
– 100 = 10K1/2L1/2
– K = 100/L (or K = 100L-1)
– slope = -100 / L2
Example 2:
Linear isoquants
– Desired Q = 100
– Production function: Q = 4K + L
– 100 = 4K + L
– K = 25 - 0.25L
– slope = -0.25

Example 3:
Consider the following production functions, where q is the quantity produced of the good, K
is the quantity of capital used, and L is the quantity of labour used:
Production function 1: 𝑞𝑞(𝐾𝐾, 𝐿𝐿) = 𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽
Production function 2: 𝑞𝑞(𝐾𝐾, 𝐿𝐿) = 𝐾𝐾 𝛼𝛼 + 𝐿𝐿𝛽𝛽

Suppose that 𝛼𝛼 = 1 and 𝛽𝛽 = 1. Does Production function 1 have increasing, decreasing or

constant returns to scale? Justify your answer.
Production function 1 is a Cobb-Douglas production function. Because it is a Cobb-Douglas
production function, we can simply add the exponents. Since 𝛼𝛼 + 𝛽𝛽 = 2, and 2 > 1, Production
function 1 has increasing returns to scale.
Alternatively, we can fix a level of capital and labour, say K = 1 and L = 1, and find q. In
this case q = 1. Now, if we double K and L, so that K = 2 and L = 2, we find that q = 4.
Since q has more than doubled when we doubled inputs, this means that the production
function has increasing returns to scale.

Suppose that 𝛼𝛼 = 1 and 𝛽𝛽 = 1. Does Production function 2 have increasing, decreasing or

constant returns to scale? Justify your answer.
This is NOT a Cobb-Douglas production function, so we CANNOT simply add the
exponents. When 𝛼𝛼 = 1 and 𝛽𝛽 = 1, we have q(K, L) = K + L. If K = 1 and L = 1, then q =
2. If K = 2 and L = 2 (we double inputs), then q = 4. Note that output has exactly doubled,
so that with this production function (which is actually perfect substitutes), doubling inputs
leads to exactly doubling output. This means that the production function is constant
returns to scale.
1 1
Suppose that 𝛼𝛼 = and 𝛽𝛽 = . Does Production function 1 have increasing, decreasing or
2 2
constant returns to scale? Justify your answer.
Again, since Production function 1 is a Cobb-Douglas production function we can simply add
1 1
the exponents together. Since 𝛼𝛼 + 𝛽𝛽 = + = 1, this Cobb-Douglas production function has
2 2
constant returns to scale.
Alternatively, we can always fix a level of K and a level of L. If we let K =1 and L = 1, then
𝑞𝑞 = 11⁄2 11⁄2 = 1. Now, if we double capital and labour, we get 𝑞𝑞 = 21⁄2 21⁄2 = 2. Since
output exactly doubled, we have that this production function has constant returns to scale.
1 1
Suppose that 𝛼𝛼 = and 𝛽𝛽 = . Does Production function 2 have increasing, decreasing or
2 2
constant returns to scale? Justify your answer.
Again, this is NOT a Cobb-Douglas production function. So, we see what happens if we
exactly double inputs. Let K =1 and L = 1, so that 𝑞𝑞 = 11⁄2 + 11⁄2 = 2. If we let K = 2 and L =
2, then 𝑞𝑞 = 21⁄2 + 21⁄2 = √2 + √2 = 2√2. Since 2√2 < 2 ∗ 2 (this is the double of the original
output), we have decreasing returns to scale.
Example 4:
The firm’s production function is 𝑞𝑞(𝐾𝐾, 𝐿𝐿) = 𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽
Write down the MPL and the MPK.
𝑀𝑀𝑀𝑀𝐿𝐿 = 𝛽𝛽𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽−1
𝑀𝑀𝑀𝑀𝐾𝐾 = 𝛼𝛼𝐾𝐾 𝛼𝛼−1 𝐿𝐿𝛽𝛽

Find the marginal rate of technical substitution.

𝑀𝑀𝑀𝑀
We know that 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀 𝐿𝐿
𝐾𝐾
Since we have 𝑀𝑀𝑀𝑀𝐿𝐿 and 𝑀𝑀𝑀𝑀𝐾𝐾 :
𝑀𝑀𝑀𝑀𝐿𝐿 𝛽𝛽𝐾𝐾 𝛼𝛼 𝐿𝐿𝛽𝛽−1 𝛽𝛽𝛽𝛽
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 == 𝛼𝛼−1 𝛽𝛽
=
𝑀𝑀𝑀𝑀𝐾𝐾 𝛼𝛼𝐾𝐾 𝐿𝐿 𝛼𝛼𝛼𝛼
𝐾𝐾𝛼𝛼
Why does 𝐾𝐾𝛼𝛼−1 = 𝐾𝐾? Because we can subtract the exponents so that we get 𝐾𝐾 𝛼𝛼−(𝛼𝛼−1) =
𝐾𝐾 𝛼𝛼−𝛼𝛼+1 = 𝐾𝐾.
𝐿𝐿 𝛽𝛽−1 1
Why does = ? Again, if we subtract the exponents we get 𝐿𝐿𝛽𝛽−1− 𝛽𝛽 = 𝐿𝐿−1. And we know
𝐿𝐿 𝛽𝛽 𝐿𝐿
1
that 𝐿𝐿−1 = .
𝐿𝐿

Example 5:

Note:

If f (x, y) = x3 + x2y3 – 2y2, find fx(2, 1) and fy(2, 1).

Solution:
Holding y constant and differentiating with respect to x, we get
fx(x, y) = 3x2 + 2xy3
and so
fx(2, 1) = 3*22 + 2*2*13 = 16
Holding x constant and differentiating with respect to y, we get
fy(x, y) = 3x2y2 – 4y
and so
fy(2, 1) = 3*22*12 – 4*1 = 8

Example 6:
If the production function is linear and given by Q = f(K, L) = aK + bL,
then MPK = a
and MPL = b

Mathematical Exercises:
1. Consider the production function whose equation is given by the formula 𝑞𝑞 = √𝐾𝐾𝐾𝐾.
a) What is the equation of the isoquant corresponding to q = 20?
b) For the same production function, what is the general equation of an isoquant,
corresponding to any level of output q?

a) The q = 20 isoquant represents all of the combinations of labour and capital that allow
the firm to produce 20 units of output. For this isoquant, the production function satisfies
the following equation: 20 = √𝐾𝐾𝐾𝐾.
 To find the equation of the 20-unit isoquant, we solve this equation for K in terms of L.
The easiest way to do this is to square each side of the equation and then solve for K in
terms of L. Doing this yields K = 400/L. This is the equation of the 20-unit isoquant.

b) In the general case, we begin with the production function itself: 𝑞𝑞 = √𝐾𝐾𝐾𝐾. To find the
general equation of an isoquant, we again square each side and solve for K in terms of
L. Doing this yields K = q2/L. (If you substitute q = 20 into this equation, you get the
equation of the 20-unit isoquant that we solved for in (a).)

2. Imagine that the production function for bowls of soup is given by q = KL where:
q = Output of soup bowls per hour
K = capital input per hour
L = Labour input per hour
a) What type of returns are present? Give a reason for your answer.
b) Assuming capital is fixed as K = 16, what will the short-run production function be?
[Simplify your answer.]
c) Derive the function of the short-run marginal production function.
d) Derive the function of the average production function.

a) Constant returns to scale. When one adds up the powers (aka exponents) the answer
is.
b) Q = 4L1/2
c) MP = 2L-1/2
d) AP = 4L-1/2

3. A manufacturer of toasters faces the production function q = 40L – L2 + 54K – 1.5K2.

Workers are paid a wage of R10 an hour and the rental rate of capital is R15 an hour.

a) Determine the optimal combination of capital and labour.

b) Assume that 636 units of output are to be produced. Determine the input mix that will
produce this level of output.
c) Determine the firm’s total cost of producing the level of output calculated in Question 3
(b).

a) MPL = 40 – 2L
MPK = 54 – 3K
The firm’s least-cost combination of inputs must satisfy:
𝑀𝑀𝑀𝑀𝐿𝐿 𝑀𝑀𝑀𝑀𝐾𝐾 40−2𝐿𝐿 54−3𝐾𝐾
= , which implies that =
𝑃𝑃𝐿𝐿 𝑃𝑃𝐾𝐾 10 15
(15)(40 – 2L) = (10)(54 – 3K)
600 – 30L = 540 – 30K
-30L = 540 – 600 – 30K
L=2+K
b) Solving for L, we find L = K + 2 (see above). This relation prescribes the optimal
combination of capital and labour. For example, the input mix K = 8 and L = 10 satisfies
this relationship.
The resulting output is q = (40)(10) – (10)2 + (54)(8) – 1.5(8)2 = 636.
c) The firm’s total input cost is TC = (10)(10) + (15)(8) = R220.
In other words, the minimum cost of producing 636 units is R220 using 10 units of labour
and 8 units of capital.

4. A firm produces output that can be sold at a price of R10. The production function is
given by q = f(K,L) = K1/2L1/2.
 If capital is fixed at 1 unit in the short run, how much labour should the firm employ to
maximise profits if the wage rate is R2? (Question draws on knowledge from Chapter
14.)

4. We simply set the value marginal product of labour equal to the wage rate and solve for
L. Since the production function is Cobb-Douglas, we know that MPL = 0.5K0.5L-0.5.
Now, since P = 10, we know that the VMPL = P * MPL = 5L-0.5. Setting this equal to the
wage, which is R2, we get 5L-0.5 = 2. If we square both sides of this equation, we get
25/L = 4. Thus the profit-maximising quantity of labour is L = 25/4 = 6.25 units.

5. In the country of Madibaz there is a glass manufacturer whose production function is

q=10*L0.5K0.5. Suppose that the glass manufacturer pays a wage, w, of R1 per hour and
that the rental cost of capital, r, is R4.
a) Draw an accurate figure showing how the glass manufacturer minimises its cost of
production.
b) What is the equation of the (long-run) expansion path for this glass manufacturer?
Illustrate the expansion path on the diagram you drew as part of your answer to Question
2(a).
c) Derive the long-run total cost curve equation as a function of q.
a)

b) MPL/MPK = (1/2q/L)/(1/2q/K) = K/L = w/r = 1/4 = > L = 4K

c) c = wL + rK = L + 4K = 8K;
q = 10(LK)1/2 = 20K = > K = q/20; c = 8K = 2q/5

6. Pumelele and Bianca run a landscaping company. They employ people and rent
equipment to facilitate the digging of holes in which trees can be planted. Pumelele and
Bianca rent power auger machines. It has been established that two people are needed
to run each machine. The production function can be written as 𝑞𝑞 = min{10𝐾𝐾, 5𝐿𝐿}.
Pumelele and Bianca pay their workers R10 per hour. The machines rent for R20 per
hour. Pumelele and Bianca need to dig 500 holes by the end of the week.
a) In order to minimise Pumelele and Bianca’s costs for the aforementioned level of output,
how many labour hours should they hire? How many machine hours should they rent?
b) What is the total cost of digging the 500 holes?

a)
500 = min {10 K ,5 L}
10 K = 500
K = 50
5 L = 500
L = 100
b) Total cost = 100w + 50r = 2000

7. A firm produces engines and has a production function q = 5KL, where q is the number
of engines produced per week, K is the number of assembly machines and L is the
number of workers. The rental rate for the machines is r = 10 000 per week and wage
rate w = 500 per week. The plant has a fixed installation of 5 machines.
a) What is the firm’s total cost function to produce q engines?
b) What is the average cost of producing q engines? How does it vary with output?
c) What is the marginal cost of producing q engines?
d) How many workers are required to produce 250 engines, what is the average cost in
this case?

a) K =5
q = 25L
or
L = q/25
TC(q) = rK + wL
TC = (10 000) (5) + (500)(q/25)
TC = 50 000 + 20q
b) AC (q) = TC(q)/q
AC = (50 000 + 20q)/q
Due to the fixed cost of capital the average costs will decrease as quantity increases
c) MC(q) = δTC/δq = 20
d) q = 250
L= q/25
L = 10
AC = (50 000 + 20(250))/250
AC = 220

8. The market for pencils is easy to enter, but entry takes time. In the short run, the number
of firms (and plants) in the industry is fixed. Production occurs in standard sized plants
with each plant having an annual total cost function of TC = 400 + q2 (this includes a
normal rate of return on the plant’s capital). Total costs are measured in rands and q is
measured in number of pencils per year. This cost function means that each plant’s
marginal cost of production is MC = 2q and its average total cost of production is ATC =
400/q + q. All fixed costs are unavoidable in the short run. Currently no firm owns more
than one plant. Pencils are a completely homogeneous good.

a) You own one plant among more than a hundred in the industry. Currently, the price of
a pencil is P = 100. How many pencils do you produce each year? What are your annual
profits?

a) Since pencils are completely homogeneous and you are a small part of the industry, you
are a price-taking firm (part of a perfectly competitive market). So you take the market
price as given, P=100. Like all firms, you maximise profits by producing up to the point
where MR=MC, but since you are a price-taking firm, MR is just the market price, P.

So, set P = MC
100 = 2q
-2q = -100
q = 50

Profit = TR - TC
TR = P X Q
So,
 P x Q – (400 + q2)
(100 x 50) – (400 + 502)
(5000) – (400 + 50 X 50)
(5000) – (400 + 2500)
5000 - 2900
R2100 profit

Basic Theory Questions

1. If the ATC curve is continually declining, what does this imply about the MC curve?
Explain your answer.

. For ATC to be declining, MC must be less than ATC. So if the ATC curve is continually
declining it must be true that the MC curve continuously lies below the ATC curve (MC
need not be declining).

2.

a. Explain the shape of each of the curves above.

b. Explain the relationship between ATC and MC.
c. Explain the relationship between ATC, AFC, and AVC.
d. What is Bob's efficient scale? How do you find the efficient scale? Explain.

a. AFC declines as the quantity goes up because a fixed cost is spread across a greater
number of units. MC declines for the first four units due to an increasing marginal
product of the variable input. MC rises thereafter due to decreasing marginal product.
AVC is U-shaped for the same reason as MC. ATC declines due to falling AFC and
increasing marginal product. ATC rises at higher levels of production due to
decreasing marginal product.
b. When MC is below ATC, ATC must be declining. When MC is above ATC, ATC must
be rising. Therefore, MC crosses ATC at the minimum of ATC.
c. AFC plus AVC equals ATC.
d. Six pairs of blue jeans. Efficient scale is the output that minimises ATC. It is also the
place where MC crosses the average total cost curve.

3. Draw a production function that exhibits diminishing marginal product of labour. Draw
the associated total cost curve. (In both cases, be sure to label the axes.) Explain the
shapes of the two curves you have drawn.
 Figure 1 shows a production function that exhibits diminishing marginal product of
labour. Figure 2 shows the associated total-cost curve. The production function is
concave because of diminishing marginal product, while the total-cost curve is convex
for the same reason.

4. Define total cost, average total cost and marginal cost. How are they related?

Total cost consists of the costs of all inputs needed to produce a given quantity of output.
It includes fixed costs and variable costs. Average total cost is equal to total cost divided
by the quantity produced. Marginal cost is the cost of producing an additional unit of
output and is equal to the change in total cost divided by the change in quantity. An
additional relation between average total cost and marginal cost is that whenever
marginal cost is less than average total cost, average total cost is declining; whenever
marginal cost is greater than average total cost, average total cost is rising and that
marginal cost intersects average total cost at its minimum point.

5. Draw the marginal cost and average total cost curves for a typical firm. Explain why the
curves have the shapes that they do and why they cross where they do.

Figure 3 shows the marginal-cost curve and the average-total-cost curve for a typical
firm. It has three main features: (1) marginal cost is rising; (2) average total cost is U-
shaped; and (3) whenever marginal cost is less than average total cost, average total
cost is declining; whenever marginal cost is greater than average total cost, average
total cost is rising. Marginal cost is rising for output greater than a certain quantity
because in the short run the firm must hire additional labour to produce more output
without being able to buy additional equipment. The average total cost curve is U-
 shaped because the firm initially is able to spread out fixed costs over additional units,
but as quantity increases, it costs more to increase quantity further because the amount
of some input used in the production process is fixed, and so marginal product is
declining. Marginal cost and average total cost have the relationship they have because
marginal cost pulls average total cost in the same direction. The marginal cost and
average total cost curves intersect at the minimum of average total cost; that quantity is
the efficient scale.

6. How and why does a firm’s average total cost curve differ in the short run and in the long
run?

In the long run, a firm can adjust the factors of production that are fixed in the short run;
for example, it can increase the size of its factory. As a result, the long-run average-
total-cost curve has a much flatter U-shape than the short-run average-total-cost curve.
In addition, the long-run curve lies along the lower envelope of the short-run curves.

7. Define economies of scale and explain why they might arise. Define diseconomies of
scale and explain why the might arise.

Economies of scale exist when long-run average total cost falls as the quantity of output
increases, which occurs because of specialisation among workers. Diseconomies of
scale exist when long-run average total cost rises as the quantity of output increases,
which occurs because of coordination problems inherent in a large organisation.

Questions for Review: Chapter 6

1. A production function represents how inputs are transformed into outputs by a firm. In
particular, a production function describes the maximum output that a firm can produce
for each specified combination of inputs. In the short run, one or more factors of
production cannot be changed, so a short-run production function tells us the maximum
output that can be produced with different amounts of the variable inputs, holding fixed
inputs constant. In the long-run production function, all inputs are variable.
2. The marginal product of labour is likely to increase initially because when there are more
workers, each is able to specialise in an aspect of the production process in which he or
she is particularly skilled. For example, think of the typical fast-food restaurant. If there
is only one worker, he will need to prepare the burgers, chips, and cooldrinks, as well as
take the orders. Only so many customers can be served in an hour. With two or three
workers, each is able to specialise, and the marginal product (number of customers
served per hour) is likely to increase as we move from one to two to three workers.
Eventually, there will be enough workers and there will be no more gains from
specialisation. At this point, the marginal product will begin to diminish.
3. The marginal product of labour will eventually diminish because there will be at least
one fixed factor of production, such as capital. As more and more labour is used along
with a fixed amount of capital, there is less and less capital for each worker to use, and
the productivity of additional workers necessarily declines. Think for example of an office
where there are only three computers. As more and more employees try to share the
computers, the marginal product of each additional employee will diminish.
4. In filling a vacant position, you should be concerned with the marginal product of the last
worker hired, because the marginal product measures the effect on output, or total
product, of hiring another worker. This in turn determines the additional revenue
generated by hiring another worker, which should then be compared to the cost of hiring
the additional worker. The point at which the average product begins to decline is the
point where average product is equal to marginal product. As more workers are used
beyond this point, both average product and marginal product decline. However,
 marginal product is still positive, so total product continues to increase. Thus, it may still
be profitable to hire another worker.
5. A production function describes the maximum output that can be achieved with any given
combination of inputs. An isoquant identifies all of the different combinations of inputs that
can be used to produce one particular level of output.
6. Whether a factor is fixed or variable depends on the time horizon under consideration:
all factors are fixed in the very short run while all factors are variable in the long run. As
stated in the text, “All fixed inputs in the short run represent outcomes of previous long-
run decisions based on estimates of what a firm could profitably produce and sell.”
Some factors are fixed in the short run, whether the firm likes it or not, simply because
it takes time to adjust the levels of those inputs. For example, a lease on a building may
legally bind the firm, some employees may have contracts that must be upheld, or
construction of a new facility may take a year or more. Recall that the short run is not
defined as a specific number of months or years but as that period of time during which
some inputs cannot be changed for reasons such as those given above.
7. Convex isoquants indicate that some units of one input can be substituted for a unit of
the other input while maintaining output at the same level. In this case, the MRTS is
diminishing as we move down along the isoquant. This tells us that it becomes more
and more difficult to substitute one input for the other while keeping output unchanged.
Linear isoquants imply that the slope, or the MRTS, is constant. This means that the same
number of units of one input can always be exchanged for a unit of the other input holding
output constant. The inputs are perfect substitutes in this case. L-shaped isoquants imply
that the inputs are perfect complements, and the firm is producing under a fixed
proportions type of technology. In this case the firm cannot give up one input in
exchange for the other and still maintain the same level of output. For example, the firm
may require exactly 4 units of capital for each unit of labour, in which case one input
cannot be substituted for the other.
8. No. An upward sloping isoquant would mean that if you increased both inputs output
would stay the same. This would occur only if one of the inputs reduced output; sort of
like a bad in consumer theory. As a general rule, if the firm has more of all inputs it can
produce more output.
9. MRTS is the amount by which the quantity of one input can be reduced when the other
input is increased by one unit, while maintaining the same level of output. If the MRTS
is 4 then one input can be reduced by 4 units as the other is increased by one unit, and
output will remain the same.
10. As more and more labour is substituted for capital, it becomes increasingly difficult for
labour to perform the jobs previously done by capital. Therefore, more units of labour
will be required to replace each unit of capital, and the MRTS will diminish. For example,
think of employing more and more farm labour while reducing the number of tractor
hours used. At first you would stop using tractors for simpler tasks such as driving
around the farm to examine and repair fences or to remove rocks and fallen tree limbs
from fields. But eventually, as the number or labour hours increased and the number of
tractor hours declined, you would have to plant and harvest your crops primarily by hand.
This would take huge numbers of additional workers.
11. Diminishing returns and returns to scale are completely different concepts, so it is quite
possible to have both diminishing returns to, say, labour and constant returns to scale.
Diminishing returns to a single factor occurs because all other inputs are fixed. Thus,
as more and more of the variable factor is used, the additions to output eventually
become smaller and smaller because there are no increases in the other factors. The
concept of returns to scale, on the other hand, deals with the increase in output when all
factors are increased by the same proportion. While each factor by itself exhibits
diminishing returns, output may more than double, less than double, or exactly double
when all the factors are doubled. The distinction again is that with returns to scale, all
inputs are increased in the same proportion and no inputs are fixed. The production
 function in Exercise 10 is an example of a function with diminishing returns to each factor
and constant returns to scale.
12. Many firms have production functions that exhibit first increasing, then constant, and
ultimately decreasing returns to scale. At low levels of output, a proportional increase
in all inputs may lead to a larger-than-proportional increase in output, because there are
many ways to take advantage of greater specialisation as the scale of operation
increases. As the firm grows, the opportunity for further specialisation may diminish, and
the firm operates at peak efficiency. If the firm wants to double its output, it must
duplicate what it is already doing. So it must double all inputs in order to double its
output, and thus there are constant returns to scale. At some level of production, the firm
will be so large that when inputs are doubled, output will less than double, a situation that
can arise from management diseconomies.

Questions for Review: Chapter 7

1. This is an explicit cost of purchasing the services of the accountant, so it is both an

economic and an accounting cost. When the firm pays an annual retainer of R10 000,
there is a monetary transaction. The accountant trades his or her time in return for
money. An annual retainer is an explicit cost (as well as a fixed cost) and therefore an
economic cost.
2. The economic, or opportunity, cost of doing accounting work is measured by computing
the monetary amount that the owner’s time would be worth in its next best use. For
example, if she could do accounting work for some other company instead of her own,
her opportunity cost is the amount she could have earned in that alternative
employment. Or if she is a great stand-up comic, her opportunity cost is what she could
have earned in that occupation instead of doing her own accounting work.
3.
a. If the owner of a business pays himself no salary, then the accounting cost is zero, but
the economic cost is positive.
True. Since there is no monetary transaction, there is no accounting, or explicit, cost.
However, since the owner of the business could be employed elsewhere, there is an
economic cost. The economic cost is positive, reflecting the opportunity cost of the
owner’s time. The economic cost is the value of the owner’s time in his next best
alternative, or the amount that the owner would earn if he took the next best job.
b. A firm that has positive accounting profit does not necessarily have positive economic
profit.
True. Accounting profit considers only the explicit, monetary costs. Since there may be
some opportunity costs that were not fully realised as explicit monetary costs, it is
possible that when the opportunity costs are added in, economic profit will become
negative. This indicates that the firm’s resources are not being put to their best use.
c. If a firm hires a currently unemployed worker, the opportunity cost of utilising the worker’s
services is zero.
False. From the firm’s point of view, the wage paid to the worker is an explicit cost
whether she was previously unemployed or not. The firm’s opportunity cost is equal to
the wage, because if it did not hire this worker, it would have had to hire someone else
at the same wage. The opportunity cost from the worker’s point of view is the value of
her time, which is unlikely to be zero. By taking this job, she cannot work at another job
or take care of a child or elderly person at home. If her best alternative is working at
another job, she gives up the wage she would have earned. If her best alternative is
unpaid, such as taking care of a loved one, she will now have to pay someone else to
do that job, and the amount she has to pay is her opportunity cost.
4. The marginal product of labour must be increasing. The marginal cost of production
measures the extra cost of producing one more unit of output. If this cost is diminishing,
then it must be taking fewer units of labour to produce the extra unit of output. If fewer
units of labour are required to produce a unit of output, then the marginal product (extra
 output produced by an extra unit of labour) must be increasing. Note also, that MC =
w/MPL, so that if MC is diminishing then MPL must be increasing for any given w.
6. The isocost line represents all possible combinations of two inputs that may be
purchased for a given total cost. The slope of the isocost line is the negative of the ratio
of the input prices. If the input prices are fixed, their ratio is constant and the isocost line
is therefore straight. Only if the ratio of the input prices changes as the quantities of the
inputs change is the isocost line not straight.
7. No. When marginal cost is increasing, average variable cost can be either increasing
or decreasing as shown in the diagram below. Marginal cost begins increasing at output
level q1, but AVC is decreasing. This happens because MC is below AVC and is
therefore pulling AVC down. AVC is decreasing for all output levels between q1 and q2.
At q2, MC cuts through the minimum point of AVC, and AVC begins to rise because MC
is above it. Thus for output levels greater than q2, AVC is increasing.

8. Yes, the average variable cost is increasing. If marginal cost is above average variable
cost, each additional unit costs more to produce than the average of the previous units,
so the average variable cost is pulled upward. This is shown in the diagram above for
output levels greater than q2.
9. Average total cost is equal to average fixed cost plus average variable cost: ATC = AVC
+ AFC. When graphed, the difference between the U-shaped average total cost and U-
shaped average variable cost curves is the average fixed cost, and AFC is downward
sloping at all output levels. When AVC is falling, ATC will also fall because both AVC
and AFC are declining as output increases. When AVC reaches its minimum (the bottom
of its U), ATC will continue to fall because AFC is falling. Even as AVC gradually begins
to rise, ATC will still fall because of AFC’s decline. Eventually, however, as AVC rises
more rapidly, the increases in AVC will outstrip the declines in AFC, and ATC will reach
its minimum and then begin to rise.
10. When the firm experiences economies of scale, its long-run average cost curve is
downward sloping. When costs increase proportionately with output, the firm’s long-run
average cost curve is horizontal. So this firm’s long-run average cost curve has a
rounded L-shape; first it falls and then it becomes horizontal as output increases.
11. The expansion path describes the cost-minimising combination of inputs that the firm
chooses for every output level. This combination depends on the ratio of input prices,
so if the price of one input changes, the price ratio also changes. For example, if the
price of an input increases, the intercept of the isocost line on that input’s axis moves
closer to the origin, and the slope of the isocost line (the price ratio) changes. As the
price ratio changes, the firm substitutes away from the now more expensive input toward
the cheaper input. Thus the expansion path bends toward the axis of the now cheaper
input.
12. Economies of scale refer to the production of one good and occur when total cost
increases by a smaller proportion than output. Economies of scope refer to the
production of two or more goods and occur when joint production is less costly than the
sum of the costs of producing each good separately. There is no direct relationship
between economies of scale and economies of scope, so production can exhibit one
without the other. For example, there are economies of scale producing computers and
 economies of scale producing carpeting, but if one company produced both, there would
likely be no synergies associated with joint production and hence no economies of
scope.
13. No. If the firm always uses capital and labour in the same proportion, the long-run
expansion path is a straight line. But if the optimal capital-labour ratio changes as output
is increased, the expansion path is not a straight line.
14. Economies of scale depend on the relationship between cost and output—that is, how
does cost change when output is doubled? Returns to scale depend on what happens
to output when all inputs are doubled. The difference is that economies of scale reflect
input proportions that change optimally as output is increased, while returns to scale are
based on fixed input proportions (such as two units of labour for every unit of capital) as
output increases.