Solution Manual for Microeconomics, 16th Canadian

Edition, Christopher T.S. Ragan, Christopher Ragan

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Solution Manual for Microeconomics, 16th Canadian Edition, Christopher T.S. Ragan, Christoph

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Chapter 7: Producers in the Short Run

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Students are often puzzled by the question: “Just how many factors of production can firms vary
when they are producing?” It is important for them to realize that the answer depends on the
context. To understand the principle of substitution, it is necessary to have at least two variable
factors of production, but it may be distracting to deal with more than two. Thus, Classical
economists seeking to illustrate this point used “land” and “labour”. As soon as they wished to
distinguish man-made factors from natural ones, they added “capital”. For other types of
applications, it is necessary to distinguish many kinds of labour skills. We also distinguish between
the basic factors of production (land, labour, and capital) and those intermediate products that are
produced by some firms and used as inputs by others.

We have placed the discussion of economic and technical efficiency in Chapter 8 where it
naturally arises in the discussion of the firm’s long-run choices. Some instructors feel that
efficiency is too important to postpone. However, treating it earlier raises problems since students
should first be exposed to a precise discussion of production functions, firms’ opportunity costs,
and their short-run choices.
***

Chapter 7 begins with a discussion of firms as agents of production. We discuss the various types
of firms, how they are organized, and also how they are financed. Our discussion of the goal of
profit maximization leads to a box on corporate social responsibility and whether it is consistent
with maximizing profits—a topic we hope students will find thought.

The second section examines profits and costs. Central to this discussion is the difference
between the accounting concepts of costs and profits and the corresponding economic concepts.
We also explain why understanding profit maximization requires us to understand both the cost
side and the revenue side of the firm’s problem. This sets us up for the rest of the chapter dealing
with short-run costs. Finally, we briefly mention the great variety of firms’ decisions and their
summary classification as “short run”, “long run”, and “very long run”. It is worth emphasizing to
students that these are types of decisions, not real time periods that are the same for all kinds of
firms.

The chapter’s third section begins the formal analysis of firm behaviour. We introduce and
illustrate the relationship between total product, average product, and marginal product. Students
often seem baffled by the mathematical relationship between marginal and average, so we spend
some time on this. This leads to a box on some everyday examples of the concept of diminishing
returns, including an example of portfolio diversification. Discussion of the box makes for lively
class time and it is sometimes interesting to challenge students to find examples of diminishing
returns in news stories over the next week. When we do this, we usually find that discussion of
why some of the offered illustrations are not cases of diminishing returns provides more insight
than the discussion of correct illustrations.

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 Chapter 7: Producers in the Short Run 79

The fourth and final section examines the whole family of short-run cost curves, which we
develop from a simple production function with fixed capital and fixed factor prices. The short-run
cost curves are developed in the conventional fashion. We plot the short-run cost curves using the
specific example of a production function developed earlier in the chapter. Students can review this
example closely and plot the curves for themselves to make sure they are comfortable with the
various relationships. Our detailed discussion of U-shaped cost curves leads to a box discussing the
digital world in which many products have large fixed development costs but constant and near-
zero marginal costs. Cost curves can still be drawn in these situations, of course, but diminishing
returns no longer apply. This section closes by examining how changes in factor prices and
changes in the firm’s capital stock affect the family of short-run cost curves. This provides a nice
motivation and link to the next chapter on firms’ long-run decisions.

***

A Caveat. This is one of the shorter chapters in the book, but its length is not indicative of
its importance. Students will likely view the production and cost relationships as rather dull stuff.
Since learning this material represents an investment for use later in the course, we suggest to our
students that this is an example of capitalistic production at work—we must invest in some
vocabulary and some analytic tools before discussing the much more interesting matters of pricing
and market structure in later chapters.

Answers to Study Exercises

Fill-in-the-Blank Questions

Question 1
a) production function
b) implicit costs
c) capital; time
d) economic profits
e) short run; long run

Question 2
a) diminishing returns (to the variable factor)
b) marginal product
c) above; below
d) maximum
e) fall; negative

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80 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

Question 3
a) minimum
b) increase
c) increasing
d) increasing
e) capacity
f) marginal cost; average variable cost; average total cost

Review Questions

Question 4

a) Hourly wages are an explicit cost. These are subtracted from revenues for computing both
accounting and economic profits.

b) Depreciation of physical capital is an explicit cost. It is subtracted from revenues for

computing both accounting and economic profits.

c) The risk-free 2% return is part of the alternative return that investors could have earned if they
did not invest in this firm. This is an implicit (opportunity) cost, and is subtracted from revenues
to compute economic profit. It is ignored in the computation of accounting profit.

d) Rental payments for a production facility are an explicit cost. It is subtracted from revenues
for computing both accounting and economic profits.

e) The additional wages the owner could have received in alternative employment is an implicit
(opportunity) cost. It is subtracted from revenues to compute economic profit, but ignored in the
computation of accounting profit.

f) The risk premium of 3% is part of what owners could have earned if they invested elsewhere
rather than in this firm. It is an implicit (opportunity) cost and is subtracted from revenues to get
economic profit, but ignored in the computation of accounting profit.

Question 5
Note that the opportunity cost of remaining in business is not only the $70 000 in explicit expenses
the carpenter incurs, but also the income from the furniture factory that the carpenter cannot
receive because he has made the decision to operate his own shop. If this forgone salary is any
larger than $30 000, then the carpenter should go back to the factory. Another way to say this is
that his (accounting) profits are $30 000 per year when he runs his own business. So if his salary at
his first job is higher than $30 000, he should go back to the factory.

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 Chapter 7: Producers in the Short Run 81

Question 6
There is no reason provided for why the “usual” diminishing returns does not apply in this
situation. We are told that the minimum ATC occurs with at least 8 workers, so ATC is declining
as output rises from zero to the level consistent with 8 workers (given the capital stock). It
follows that the AP curve is rising and reaches a maximum at 8 workers. With diminishing
returns, the AP curve then begins to fall as the number of workers rises from 8 to 16 (and so the
ATC curve rises). The MP curve must be above the AP curve when the latter is rising, and it is
also likely rising. When AP begins to fall, however, MP must be below it. The MP curve will
begin falling (diminishing returns) at a lower number of workers than 8, and it will intersect the
AP curve at its maximum.

Question 7
LeBron James’ average score is 25 points per game (computed over the total number of games
he has played this season). His points from the last game of the season are 12; this is his
marginal score. When his average is re-calculated after the last game, it will be lower than 25
points (although we don’t know how much lower unless we know how many games he played
this season). His average score falls because his marginal score is below his average—the
usually marginal-average relationship.

Question 8

a) At this level of output, note that MC is above ATC, which means that ATC must be rising as
output increases. This further implies that we are at a level of output beyond which ATC and
AVC reach their minimum points. So we are on the upward-sloping portion of the MC curve and
thus are already encountering diminishing marginal returns, and also on the upward-sloping
portion of the AVC curve and so are encountering diminishing average returns.

b) Since the firm is on the upward-sloping portion of the ATC curve, it is operating beyond its
level of capacity.

c) At this level of output, note that MC is below ATC, which means that ATC must be falling as
output increases. This further implies that we are at a level of output below which ATC and AVC
reach their minimum points. So we are on the downward-sloping portion of the marginal and
average curves. The firm has not yet encountered diminishing marginal or average returns.

d) Since ATC is falling, the firm is producing below its capacity.

Question 9

For a firm producing physical products such as steel or lumber or appliances or furniture, the law
of diminishing returns almost certainly applies and so the firm’s cost curves would be like those
discussed in the chapter. In particular, the firm’s MC curve will be U-shaped—although whether
it is “sharply” so or “gradually” so depends crucially on the nature of the firm’s technology.

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82 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

But for a firm making digital products such as apps or movies or online courses or ebooks, the
nature of costs is quite different. In these situations, the firm will typically have large fixed costs
associated with the initial development of the product. But once the product is developed,
additional units of the product can be produced and distributed at very low costs, and this cost
will typically not increase as the level of output increases. In other words, the firm’s MC curve
will be flat (horizontal) at a very low level; diminishing returns is absent. See the box in this
chapter for further discussion.

Problems

Question 10

a) As shown in Table 7-1 in the chapter, accounting profits are equal to revenues minus explicit
costs, and do not include the opportunity cost of the owner’s financial capital. The total revenues
shown are $657 000. The total explicit costs equal $542 000. Thus the accounting profit is the
difference between the two, $115 000.

b) The 16 percent rate of return on capital is an annual rate. If equally risky ventures in other
industries can generate a 16 percent annual return, then the opportunity cost on Mr. Buford’s
capital for one year is 0.16  ($400 000) = $64 000.

c) Economic profits are equal to accounting profits minus the opportunity cost of the owner’s
financial capital. Thus economic profits for Spruce Décor in 2019 are $115 000 – $64 000 = $51 000.
d) If Spruce Décor is a typical firm in the industry then the typical firm is making positive
economic profits. Thus profits in this industry are higher than what is available in equally risky
ventures in other industries. Such positive economic profits will lead other firms to enter this
industry.

Question 11

a) The explicit costs are wages and salaries, bank interest, cost of supplies, and depreciation. The
total is $920,000.

b) The implicit costs are the risk-free return on the owner’s capital, the risk premium on that
same capital, and the additional wages that could have been earned in the next best alternative.
Since alternative wages in this example are zero, the opportunity costs are only the return on the
owner’s capital. The total is $70,000.

c) Accounting profits are revenues minus explicit costs. The accounting profits are $30,000.

d) Economic profits are revenues minus (explicit + implicit) costs. The economic profits are
negative $40,000. So, there are economic losses being earned—meaning that the returns are less
than would be available in the next best alternative venture.

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 Chapter 7: Producers in the Short Run 83

Question 12

a) The table is completed below. Note that for marginal product (MP), the computation is done
for the change in output and labour input between rows. Thus, the first value in the table for MP
reflects the change in output from 0 to 2 and the change in labour from 0 to 1; the marginal
product is therefore equal to ∆TP/∆L = 2/1 = 2.

Units of Labour Number of Snowboards AP MP

(per week) (per week)
0
1 2 2 2
2 5 2.5 3
3 9 3 4
4 14 3.5 5
5 18 3.6 4
6 21 3.5 3
7 23 3.3 2
8 24 3 1

b) The MP and AP curves are shown in the figure below.

Question 13

a) By substituting the values of K and L into the production function provided (Q = KL – .1L2),
the values for Q are found. The answers are:

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84 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

K L Q = KL – .1L2
10 5 50 – .1(25) = 47.5
10 10 100 – .1(100) = 90
10 15 150 – .1(225) = 127.5
10 20 200 – .1(400) = 160
10 25 250 – .1(625) = 187.5
10 30 300 – .1(900) = 210
10 40 400 – .1(1600) = 240
10 50 500 – .1(2500) = 250

b) The following diagram shows the relationship between L and Q, for K fixed and equal to 10.
Note that the curve goes through the origin because when L equals 0, Q also equals 0
(independent of the value of K).

c) If K increases to K = 20, then the values of Q will also increase (for any given value of L). The
re-computed values for Q are in the table below. The new curve is shown in the diagram above,
indicated by K = 20.

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 Chapter 7: Producers in the Short Run 85

K L Q = KL – .1L2
20 5 100 – .1(25) = 97.5
20 10 200 – .1(100) = 190
20 15 300 – .1(225) = 277.5
20 20 400 – .1(400) = 360
20 25 500 – .1(625) = 437.5
20 30 600 – .1(900) = 510
20 40 800 – .1(1600) = 640
20 50 1000 – .1(2500) = 750

d) A larger capital stock means that any given amount of labour now has more capital to work
with, and thus can produce more output. This increase in the average product of labour is reflected
simply by the upward shift in the curve shown above. Note also, however, that in this case (and in
many others), the increase in K also increases the marginal product of labour for any given level of
labour input. This is shown by the increase in the slope of the curve for any level of L. For
example, for L = 25, the slope of the K = 20 curve is greater than the slope of the K = 10 curve.
This shows that the increase in K has made labour more productive at the margin.

Question 14

a) The average product of labour is equal to total output divided by the number of units of labour
input. The values are shown in the table below and the AP curve is plotted in the figure below.

b) The marginal product of labour is equal to the change in total output divided by the change in
labour input that brought it about. In the table above, we compute the marginal product according
to the change in values from one row to the next, so the first row is left empty. The MP curve is
plotted in the figure above. Note that the values are plotted at the midpoints of the units of labour.

Average Product Marginal Product

AP = 200/100 = 2.0
AP = 260/120 = 2.17 MP = 60/20 = 3.0
AP = 350/140 = 2.5 MP = 90/20 = 4.5
AP = 580/160 = 3.63 MP = 230/20 = 11.5
AP = 720/180 = 4.0 MP = 140/20 = 7.0
AP = 780/200 = 3.9 MP = 60/20 = 3.0
AP = 800/220 = 3.64 MP = 20/20 = 1.0
AP = 810/240 = 3.38 MP = 10/20 = 0.5

c) The law of diminishing marginal returns is satisfied for labour because (eventually) the
marginal product of labour falls as more and more labour is used.

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86 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

d) As we explained in the text, the average product of labour can only rise if the marginal
product exceeds the average product. This relationship is seen clearly in the figure for levels of
labour input below 180. Similarly, the average product of labour only falls when the marginal
product is less than the average product, as seen in the figure for values of labour above 180. It
follows that the MP curve must intersect the AP curve at its maximum, as shown in the figure.

Question 15

a) The relationships between output and the units of variable input can be described as follows:
i) Output increases proportionally with the variable input. That is, an x percent
increase in L leads to an x percent increase in total output.
ii) Output is positive even when there is no L. And for each unit change in L there is a
constant unit change in output.
iii) Up to some critical level of L, output increases proportionally with increases in L.
But beyond this critical level of L, further increases in L lead to no change in total
output.
iv) Output increases with every increase in L, but each successive unit increase in L
leads to smaller increases in total output.

b) The average product curves for the four cases are shown in the figure below. In the first case, the
AP is constant. In the second case, due to the positive vertical intercept of the TP curve, the AP
curve falls as L increases. In the third case, up to the critical level of L, L*, the AP is constant. But
beyond that point, since output does not increase but L does, the AP curve falls. In the fourth case,
the AP curve is steadily declining.

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 Chapter 7: Producers in the Short Run 87

c) The marginal product curves are also shown in the diagram above. In the first case, the slope of
the TP curve is constant and so the MP curve is a horizontal line. In the second case, the MP is also
constant, even though AP declines steadily. In the third case, the MP is positive and constant up to
L*, after which point MP is zero. In the fourth case, MP steadily falls and is below AP.

d) Note that in all four cases, AP is only falling if MP is below AP.

Question 16

The graph showing the relationship between agricultural output and fertilizer use is as follows.

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88 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

The average products, calculated as an average over the fifteen-unit intervals, are shown below.
We have calculated the marginal products over the same intervals, but note that the MP applies for
the change from one row to the next.

Fertilizer Average Marginal

Dose Product Product
0 --- ---
15 6.95 0.280
30 3.68 0.413
45 2.62 0.507
60 2.09 0.487
75 1.74 0.327
90 1.46 0.080
105 1.26 0.033
120 1.10 0.027
135 0.98 0.013
150 0.89 0.02

Average product falls throughout, so diminishing average productivity sets in at a very low,
perhaps even zero, dose. Marginal product rises for the first few intervals and then declines
roughly steadily, so diminishing marginal productivity sets in somewhere between thirty and sixty
doses.

Question 17

a) Average fixed cost (AFC) is equal to total fixed cost (TFC) divided by the level of output. The
values for AFC are shown in the table below.

b) Average variable cost (AVC) is equal to total variable cost (TVC) divided by the level of output.
The values for AVC are shown in the table below.

c) Average total cost (ATC) is equal to total cost (TVC + TFC) divided by the level of output.
Alternatively, ATC is equal to the sum of AFC and AVC. The values for ATC are shown in the
table below. The firm’s “capacity” is the level of output at which ATC is minimized, which in this
case is 8 (thousand) bicycles per year.

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 Chapter 7: Producers in the Short Run 89

Output AFC AVC ATC

(000s Average Average Average
per Fixed Cost ($) Variable Cost ($) Total Cost ($)
year)
1 200/1 = 200 40/1 = 40 240
2 200/2 = 100 70/2 = 35 135
3 200/3 = 66.7 105/3 = 35 101.7
4 200/4 = 50 120/4 = 30 80
5 200/5 = 40 135/5 = 27 67
6 200/6 = 33.3 155/6 = 25.8 59.2
7 200/7 = 28.6 185/7 = 26.4 55.0
8 200/8 = 25 230/8 = 28.8 53.8
9 200/9 = 22.2 290/9 = 32.2 54.4
10 200/10 = 20 350/10 = 35 55
11 200/11 = 18.2 425/11= 38.6 56.8

d) The scale diagram is shown below. Note that the upper-most section of the AFC curve is not
shown.

Question 18
a) Average fixed cost is total fixed cost divided by output. Total fixed cost is here given by total
cost ($1,000,000) minus total variable cost ($600,000), which is $400,000. Since output is
20,000 units, average fixed costs must be $400,000/20,000, which equals $20 per unit.
b) Total variable cost is total cost ($100,000) minus total fixed cost ($20,000), which is equal to
$80,000. Since output is 20,000 units, average variable cost must be $80,000/20,000, which
equals $4 per unit.
c) The firm’s average total cost is the sum of average variable cost ($10) and average fixed cost

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Solution Manual for Microeconomics, 16th Canadian Edition, Christopher T.S. Ragan, Christoph

90 Instructor’s Manual for Ragan, Economics, Sixteenth Canadian Edition

($5), which is $15 per unit. The firm’s total cost is then given by the level of output (750 units)
times the average total cost of $15 per unit. So total cost is $11,250.
d) Average variable cost is given by average total cost ($12) minus average fixed cost ($4),
which is equal to $8 per unit. Total variable cost is then equal to the level of output (400 units)
times the average cost of $8 per unit. Total variable cost is therefore $3200.
e) Total fixed costs are given by total costs ($20 million) minus total variable costs ($18 million),
which equals $2 million. Average fixed costs are this $2 million divided by the level of output
(1,250,000 units). Average fixed costs are therefore $1.60 per unit.

Question 19
a) The table is filled out below.

Units of Total Output

TFC TVC TC MC AFC AVC ATC
Labour per day per day
10 100 1000 1000 2000 10.00 10.00 20.00
20 300 1000 2000 3000 5 3.33 6.67 10.00
30 900 1000 3000 4000 1.67 1.11 3.33 4.44
40 1320 1000 4000 5000 2.38 0.76 3.03 3.79
50 1500 1000 5000 6000 5.56 0.67 3.33 4.00
60 1620 1000 6000 7000 8.33 0.62 3.70 4.32
70 1680 1000 7000 8000 16.67 0.60 4.17 4.76

b) The firm’s capacity level of output is that level which minimizes ATC. This occurs when
output is 1320 units per day.

c) One can easily compute the marginal product of labour (in increments of 10 units of labour).
The MP of labour between L=20 and L=30 is equal to 60. The MP of labour between L=30 and
L=40 is 42. So diminishing returns is first encountered somewhere between L = 25 and L = 35.
Note that this is also where MC reaches its minimum and then begins to rise.

Question 20

a) The firm’s average total cost is given by the sum of average variable cost ($100 per unit) and
average fixed cost ($50 per unit), which is $150 per unit. The level of daily output is thus equal
to total costs divided by average total cost, which is $30,000/$150, which is 200 units per day.

b) The firm’s total variable costs are given by the level of output times average variable costs, or
200 units times $100 per unit, which is $20,000 per day.

c) The firm’s total fixed costs are given by the level of output times average fixed costs, or 200
units times $50 per unit, which is $10,000 per day.

*****

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