Microeconomics | Assignment 2| Dr.

GK

Source: Managerial Economics by Hirschey

1. Marginal Analysis: Tables. Climate Control Devices, Inc., estimates that sales of
defective thermostats cost the firm $50 each for replacement or repair. Boone Carlyle, an
independent engineering consultant, has recommended hiring quality control inspectors so
that defective thermostats can be identified and corrected before shipping. The following
schedule shows the expected relation between the number of quality control inspectors and
the thermostat failure rate, defined in terms of the percentage of total shipments that prove
to be defective.
Number of Quality Control Thermostat Failure Rate (%)
Inspectors
0 5.0
1 4.0
2 3.2
3 2.6
4 2.2
5 2.0

The firm expects to ship 250,000 thermostats during the coming year, and quality control
inspectors each command a salary of $60,000 per year.
A. Construct a table showing the marginal failure reduction (in units) and the dollar value of
these reductions for each inspector hired.
B. How many inspectors should the firm hire?
C. How many inspectors should be hired if additional indirect costs (lost customer goodwill
and so on) were to average 30 percent of direct replacement or repair costs?

2. Incremental Analysis. Founded in 1985, Starbucks Corporation offers brewed coffees,

espresso beverages, cold blended beverages, various complementary food items, and
related products at over 12,000 retail outlets in the United States Canada, the United
Kingdom, Thailand, Australia, Germany, China, Singapore, Puerto Rico, Chile, and
Ireland. Over 100 outlets are featured in the Greater Chicago Land area alone. For a new
unit in Chicago’s O’Hare Airport, suppose beverage customers spend an average $4 on
beverages with an 80 percent gross margin, and food customers spend an average $5 on
sandwiches and salads with a 50 percent gross margin. In both cases, gross margin is simply
 price minus input cost and does not reflect variable labor and related expenses. Customer
traffic throughout the day is as follows:
A. Assume labor, electricity, and other incremental costs are $175 per hour of operation;
calculate the profit-maximizing hours of operation per day.

B. Assume the store is open 365 days per year, and that incremental rental costs are $2
million per year. Calculate optimal incremental profits. Should Starbucks close this
site?

Hour of Day Beverage Customers Food Customers Profit Contribution ($)

06:00 150 50 605.00

07:00 250 100 1,050.00
08:00 200 75 827.50
09:00 175 50 685.00
10:00 100 25 382.50
11:00 200 75 827.50
12:00 200 175 1,077.50
13:00 125 150 775.00
14:00 75 75 427.50
15:00 50 50 285.00
16:00 100 25 382.50
17:00 75 50 365.00
18:00 50 75 347.50
19:00 50 25 222.50
20:00 25 25 142.50
21:00 25 10 105.00
22:00 25 10 105.00
Total 1,875 1,045 8,612.50

3. Marginal Analysis: Tables. Meredith Grey is a regional sales representative for Dental
Laboratories, Inc., a company that sells alloys created from gold, silver, platinum, and other
precious metals to several dental laboratories in Washington, Oregon, and Idaho. Grey’s
goal is to maximize total monthly commission income, which is figured at 8 percent of
gross sales. In reviewing monthly experience over the past year, Grey found the following
relations between days spent in each state and monthly sales generated:

Days Washington Days Oregon Gross Days Idaho Gross

Gross Sales ($) Sales ($) Sales ($)

0 $10,000
1 25,000
2 37,500
3 47,500
4 55,000
0 $0
1 8,750
2 16,250
3 22,500
4 26,250
0 $6,250
1 12,500
2 17,500
3 21,250
4 23,750
 5 60,000 5 28,750 5 25,000
6 62,500 6 30,000 6 25,000
7 62,500 7 31,250 7 25,000

A. Construct a table showing Grey’s marginal sales per day in each state.

B. If administrative duties limit Grey to only 10 selling days per month, how should they
be spent to maximize commission income?

C. Calculate Grey’s maximum monthly commission income.

4. Not-for-Profit Analysis. The Denver Athlete’s Club (DAC) is a private, not-for-profit

athletic club located in Denver, Colorado. DAC currently has 3,500 members but is
planning on a membership drive to increase this number significantly. An important issue
facing John Blutarsky, DAC’s administrative director, is the determination of an
appropriate membership level. In order to efficiently employ scarce DAC resources, the
board of directors has instructed Blutarsky to maximize DAC’s operating surplus, defined
as revenues minus operating costs. They have also asked Blutarsky to determine the effects
of a proposed agreement between DAC and a neighboring club with outdoor recreation and
swimming pool facilities. Plan A involves paying the neighboring club $100 per DAC
member. Plan B involves payment of a fixed fee of $400,000 per year. Finally, the board
has determined that the basic membership fee for the coming year will remain constant at
$2,500 per member irrespective of the number of new members added and whether plan A
or plan B is adopted. In the calculations for determining an optimal membership level,
Blutarsky regards price as fixed; therefore, P _ MR _ $2,500. Before considering the effects
of any agreement with the neighboring club, Blutarsky projects total and marginal cost
relations during the coming year to be as follows:

𝑇𝐶 = $3,500,000 + $500𝑄 + $0.25𝑄2

𝑀𝐶 = ∂TC/ ∂Q = $500 + $0.5𝑄
where Q is the number of DAC members.

A. Before considering the effects of the proposed agreement with the neighboring club,
calculate DAC’s optimal membership and operating surplus levels.

B. Calculate these levels under plan A.

C. Calculate these levels under plan B.

5. Marginal Analysis. Characterize each of the following statements as true or false, and
explain your answer.
A. If marginal revenue is less than average revenue, the demand curve will be downward
sloping.

B. Profits will be maximized when total revenue equals total cost.

 C. Given a downward-sloping demand curve and positive marginal costs, profit-
maximizing firms will always sell less output at higher prices than will revenue-
maximizing firms.

D. Marginal cost must be falling for average cost to decline as output expands.

E. Marginal profit is the difference between marginal revenue and marginal cost and will
always equal zero at the profit-maximizing activity level.

6. Profit Maximization: Equations. 21st Century Insurance offers mail-order automobile

insurance to preferred-risk drivers in the Los Angeles area. The company is the low-cost
provider of insurance in this market but doesn’t believe its annual premium of $1,500 can
be raised for competitive reasons. Rates are expected to remain stable during coming
periods; hence, P _ MR _ $1,500. Total and marginal cost relations for the company are as
follows:
𝑇𝐶 = $41,000,000 + $500𝑄 + $0.005𝑄2
𝑀𝐶 = ∂TC/ ∂Q = $500 + $0.01𝑄

A. Calculate the profit-maximizing activity level.

B. Calculate the company’s optimal profit, and optimal profit as a percentage of sales
revenue (profit margin).

7. Average Cost Minimization. Giant Screen TV, Inc., is a Miami-based importer and
distributor of 60-inch screen HDTVs for residential and commercial customers. Revenue
and cost relations are as follows:

𝑇𝑅 = $1,800Q − $0.006𝑄2
𝑀𝑅 = ∂TF/ ∂Q = $1,800 − $0.012𝑄
𝑇𝐶 = $12,100,000 + $800𝑄 + $0.004𝑄2
𝑀𝐶 = ∂TC/ ∂Q = $800 + $0.008𝑄
A. Calculate output, marginal cost, average cost, price, and profit at the average cost
minimizing activity level.
B. Calculate these values at the profit-maximizing activity level.

C. Compare and discuss your answers to parts A and B.

8. Price and Total Revenue. The Portland Sea Dogs, the AA affiliate of the Boston Red Sox
major league baseball team, have enjoyed a surge in popularity. During a recent home
stand, suppose the club offered $5 off the $12 regular price of reserved seats, and sales
spurted from 3,200 to 5,200 tickets per game.
 A. Derive the function that describes the price–output relation with price expressed as a
function of quantity (tickets sold). Also express tickets sold as a function of price.

B. Use the information derived in part A to calculate total revenues at prices in $1

increments from $5 to $15 per ticket. What is the revenue-maximizing ticket price? If
variable costs are negligible, is this amount also the profit-maximizing ticket price?

9. A. Fill in the missing data for price (P), total revenue (TR), marginal revenue (MR), total
cost (TC), marginal cost (MC), profit (π), and marginal profit (Mπ) in the following table:

𝑻𝑹 = 𝐏 ∗ 𝐐 𝑴𝑹 = 𝑴𝑪 = 𝑴𝝅 =
Q P ($)
𝛛𝐓𝐑/𝛛𝐐
TC ($)
𝛛𝐓𝐂/𝛛𝐐
π ($) 𝛛𝛑/𝛛𝐐
($)
($) ($) ($)
0 160 0 - 0 0 0 -
1 150 150 150 25 25 125 125
2 140 55 30 100
3 390 35 300 75
4 90 130 350
5 110 550 175
6 600 50 55 370
7 630 290 60 -30
8 80 640 355 285
9 75 -85
10 600 525

B. At what output level is profit maximized?

C. At what output level is revenue maximized?

D. Discuss any differences in your answers to parts B and C.

10. Graphic Analysis

A. Given the output (Q) and price (P) data in the following table, calculate total revenue
(TR) and marginal revenue (MR):

Q P 𝑻𝑹 = 𝐏 ∗ 𝐐 𝑴𝑹 = 𝛛𝐓𝐑/𝛛𝐐

0 $10
1 9
 2 8
3 7
4 6
5 5
6 4
7 3
8 2
9 1
10 0

B. Graph these data using “dollars” on the vertical axis and “quantity” on the horizontal
axis. At what output level is revenue maximized?
C. Why is marginal revenue less than average revenue at each price level?

11. Market Equilibrium. Eye-de-ho Potatoes is a product of the Coeur d’Alene Growers’
Association. Producers in the area are able to switch back and forth between potato and
wheat production, depending on market conditions. Similarly, consumers tend to regard
potatoes and wheat (bread and bakery products) as substitutes. As a result, the demand and
supply of Eye-de-ho Potatoes are highly sensitive to changes in both potato and wheat
prices. Demand and supply functions for Eye-de-ho Potatoes are as follows:

𝑄𝐷 = −1,450 − 25𝑃 + 12.5𝑃𝑊 + 0.1𝑌 Demand

𝑄𝑆 = −100 + 75𝑃 + 25𝑃𝑊 − 12.5𝑃𝐿 + 10𝑅 Supply

where P is the average wholesale price of Eye-de-ho Potatoes ($ per bushel), PW is the
average wholesale price of wheat ($ per bushel), Y is income (GDP in $ billions), PL is the
average price of unskilled labor ($ per hour), and R is the average annual rainfall (in inches).
Both QD and QS are in millions of bushels of potatoes.

A. When quantity is expressed as a function of price, what are the Eye-de-ho Potatoes
demand and supply curves if PW_ $4, Y_ $15,000 billion, PL_ $8, and R_ 20 inches?

B. Calculate the surplus or shortage of Eye-de-ho Potatoes when P_ $1.50, $2, and $2.50.

C. Calculate the market equilibrium price–output combination.

12. Demand and Supply Curves. Demand and supply conditions in the market for unskilled
labor are important concerns to business and government decision makers. Consider the
case of a federally mandated minimum wage set above the equilibrium, or market clearing,
wage level. Some of the following factors have the potential to influence the demand or
quantity demanded of unskilled labor. Influences on the supply or quantity supplied may
also result. Holding all else equal, describe these influences as increasing or decreasing,
and indicate the direction of the resulting movement along or shift in the relevant curve(s).
A. An increase in the quality of secondary education

B. A rise in welfare benefits

 C. An increase in the popularity of self-service gas stations, car washes, and so on

D. A fall in interest rates

E. An increase in the minimum wage

13. Supply Curve Determination. Olympia Natural Resources, Inc., and Yakima Lumber,
Ltd., supply cut logs (raw lumber) to lumber and paper mills located in the Cascades
Mountain region in the state of Washington. Each company has a different marginal cost
of production, depending on its own cost of landowner access, labor and other cutting costs,
the distance cut logs must be shipped, and so on. The marginal cost of producing 1 unit of
output, measured as 1,000 board feet of lumber (where 1 board foot is 1 square foot of
lumber, 1 inch thick), is

𝑀𝐶𝑂 = $350 + $0.00005𝑄𝑂 (Olympia)

𝑀𝐶𝑌 = $150 + $0.0002𝑄𝑌 (Yakima)
The wholesale market for cut logs is vigorously price competitive, and neither firm is able to
charge a premium for its products. Thus, P=MR in this market.
A. Determine the supply curve for each firm. Express price as a function of quantity and
quantity as a function of price. (Hint: Set P=MR=MC to find each firm’s supply curve.)
B. Calculate the quantity supplied by each firm at prices of $325, $350, and $375. What is
the minimum price necessary for each individual firm to supply output?
C. Assuming these two firms make up the entire industry in the local area, determine the
industry supply curve when P< $350.
D. Determine the industry supply curve when P> $350. To check your answer, calculate
quantity at an industry price of $375 and compare your result with part B.

14. Demand Function. The Creative Publishing Company (CPC) is a coupon book publisher
with markets in several south-eastern states. CPC coupon books are sold directly to the
public, sold through religious and other charitable organizations, or given away as
promotional items. Operating experience during the past year suggests the following
demand function for CPC’s coupon books:

𝑄 = 5,000 − 4,000𝑃 + 0.02𝑃𝑜𝑝 + 0.25𝐼 + 1.5𝐴

where Q is quantity, P is price ($), Pop is population, I is disposable income per household
($), and A is advertising expenditures ($).

A. Determine the demand faced by CPC in a typical market in which P=$10, Pop =
1,000,000persons, I = $60,000, and A = $10,000.
 B. Calculate the level of demand if CPC increases annual advertising expenditures from
$10,000 to $15,000.

C. Calculate the demand curves faced by CPC in parts A and B.

15. Supply Curve Determination. Cornell Pharmaceutical, Inc., and Penn Medical, Ltd.,
supply generic drugs to treat a wide variety of illnesses. A major product for each company
is a generic equivalent of an antibiotic used to treat postoperative infections. Proprietary
cost and output information for each company reveal the following relations between
marginal cost and output:

𝑀𝐶𝐶 = $10 + $0.004𝑄𝐶 (Cornell)

𝑀𝐶𝑃 = $8 + $0.004𝑄𝑃 (Penn)
The wholesale market for generic drugs is vigorously price competitive, and neither firm is
able to charge a premium for its products. Thus, P = MR in this market.
A. Determine the supply curve for each firm. Express price as a function of quantity and
quantity as a function of price. (Hint: Set P= MR= MC to find each firm’s supply curve.)
B. Calculate the quantity supplied by each firm at prices of $8, $10, and $12. What is the
minimum price necessary for each individual firm to supply output?
C. Assuming these two firms make up the entire industry, determine the industry supply
curve when P< $10.
D. Determine the industry supply curve when P> $10. To check your answer, calculate
quantity at an industry price of $12 and compare your answer with part B.

16. A review of industry-wide data for the jelly and jam manufacturing industry suggests the
following industry supply function:
𝑄 = −59,000,000 + 500,000𝑃 − 125,000𝑃𝐿
−500,000𝑃𝐾 + 2,000,000𝑊
where Q is cases supplied per year, P is the wholesale price per case ($), PL is the average price
paid for unskilled labor ($), PK is the average price of capital (in percent), and W is weather
measured by the average seasonal rainfall in growing areas (in inches).
A. Determine the industry supply curve for a recent year when PL = $8, PK = 10 percent,
and W=20 inches of rainfall. Show the industry supply curve with quantity expressed as
a function of price and price expressed as a function of quantity.

B. Calculate the quantity supplied by the industry at prices of $50, $60, and $70 per case.

C. Calculate the prices necessary to generate a supply of 4 million, 6 million, and 8 million
cases.
17. Demand Analysis. The demand for housing is often described as being highly cyclical
and very sensitive to housing prices and interest rates. Given these characteristics, describe
the effect of each of the following in terms of whether it would increase or decrease the
quantity demanded or the demand for housing. Moreover, when price is expressed as a
function of quantity, indicate whether the effect of each of the following is an upward or
downward movement along a given demand curve or involves an outward or inward shift
in the relevant demand curve for housing. Explain your answers.

A. An increase in housing prices

B. A fall in interest rates

C. A rise in interest rates

D. A severe economic recession

E. A robust economic expansion

18. Demand and Supply Curves. The following relations describe monthly demand and
supply relations for dry cleaning services in the metropolitan area:

𝑄𝐷 = 500,000 − 50,000 𝑃 (Demand)

𝑄𝑆 = 100,000 + 100,000 𝑃 (Supply)
where Q is quantity measured by the number of items dry cleaned per month and P is
average price in dollars.
A. At what average price level would demand equal zero?

B. At what average price level would supply equal zero?

C. Calculate the equilibrium price–output combination

19. Demand Curves. The Eastern Shuttle, Inc., is a regional airline providing shuttle service
between New York and Washington, DC. An analysis of the monthly demand for service
has revealed the following demand relation:

𝑄 = 26,000 − 500𝑃 − 250𝑃𝑂𝐺 + 200𝐼𝐵 − 5,000𝑆

where Q is quantity measured by the number of passengers per month, P is price ($), POG
is a regional price index for other consumer goods (1967 = 1.00), IB is an index of business
activity, and S, a binary or dummy variable, equals 1 in summer months and 0 otherwise.

A. Determine the demand curve facing the airline during the winter month of January if
POG = 4 and IB = 250.
 B. Determine the demand curve facing the airline, quantity demanded, and total revenues
during the summer month of July if P = $100 and all other price-related and business
activity variables are as specified previously.

20. Demand and Supply Curves. The following relations describe monthly demand and
supply conditions in the metropolitan area for recyclable aluminum:

𝑄𝐷 = 317,500 − 10,000𝑃 (Demand)

𝑄𝑆 = 2500 + 7,500𝑃 (Supply)

Where Q is quanity measured in pounds of scrap aluminum and P is price in cents.

Complete the following.

Price (1) Quantity Quantity Surplus (+) or

Supplied Demanded Shortage (-)
(2) (3) (4)= (2) - (3)
15₵

16

17

18

19

20

21. Elasticity. The demand for personal computers can be characterized by the following point
elasticities: price elasticity = -5, cross-price elasticity with software = -4, and income
elasticity = 2.5. Indicate whether each of the following statements is true or false, and
explain your answer.
A. A price reduction for personal computers will increase both the number of units
demanded and the total revenue of sellers.
B. The cross-price elasticity indicates that a 5 percent reduction in the price of personal
computers will cause a 20 percent increase in software demand.
C. Demand for personal computers is price elastic and computers are cyclical normal
goods.
D. Falling software prices will increase revenues received by sellers of both computers and
software.
E. A 2 percent price reduction would be necessary to overcome the effects of a 1 percent
decline in income.
22. Advertising Elasticity. Enchantment Cosmetics, Inc., offers a line of cosmetic and
perfume products marketed through leading department stores. Product manager Erica
Kane recently raised the suggested retail price on a popular line of mascara products from
$9 to $12 following increases in the costs of labor and materials. Unfortunately, sales
dropped sharply from 16,200 to 9,000 units per month. In an effort to regain lost sales,
Enchantment ran a coupon promotion featuring $5 off the new regular price. Coupon
printing and distribution costs totalled $500 per month and represented a substantial
increase over the typical advertising budget of $3,250 per month. Despite these added costs,
the promotion was judged to be a success, as it proved to be highly popular with consumers.
In the period prior to expiration, coupons were used on 40 percent of all purchases and
monthly sales rose to 15,000 units.

A. Calculate the arc price elasticity implied by the initial response to the Enchantment price
increase.
B. Calculate the effective price reduction resulting from the coupon promotion.
C. In light of the price reduction associated with the coupon promotion and assuming no
change in the price elasticity of demand, calculate Enchantment’s arc advertising
elasticity.
D. Why might the true arc advertising elasticity differ from that calculated in part C?

23. Budget Constraints. Holding all else equal, indicate how each of the following changes
would affect a budget constraint that limits consumption of goods (Y) and services (X).
Explain your answer.
A. Deflation that uniformly drops the price of all goods and services.
B. Inflation that consistently increases the price of all goods and services.
C. Technical change that reduces the price of goods, but leaves the price of services
unchanged.
D. Economic growth that boosts the level of disposable income.
E. Government-mandated health care coverage for workers that boosts the price of goods
by 3 percent and increases the price of services by 5 percent.

24. Cross-Price Elasticity. B. B. Lean is a catalog retailer of a wide variety of sporting goods
and recreational products. Although the market response to the company’s spring catalog
was generally good, sales of B. B. Lean’s $140 deluxe garment bag declined from 10,000
to 4,800 units. During this period, a competitor offered a whopping $52 off their regular
$137 price on deluxe garment bags.

A. Calculate the arc cross-price elasticity of demand for B. B. Lean’s deluxe garment bag.

B. B. Lean’s deluxe garment bag sales recovered from 4,800 units to 6,000 units following
a price reduction to $130 per unit. Calculate B. B. Lean’s arc price elasticity of demand
for this product.
 C. Assuming the same arc price elasticity of demand calculated in part B, determine the
further price reduction necessary for B. B. Lean to fully recover lost sales (i.e., regain
a volume of 10,000 units).

25. Indifference Curves. Suggest briefly whether each of the following statements about
indifference curves that show preferences between goods and services is true or false and
defend your answer.
A. Consumers prefer higher indifference curves that represent greater combinations of
goods and services to lower indifference curves that represent smaller combinations of
goods and services.
B. Indifference curves slope downward because if the quantity of one consumer product
is reduced, the quantity of the other must also decrease to maintain the same degree of
utility.
C. The slope of an indifference curve shows the rate at which consumers are willing to
trade-off goods and services.
D. The fact that indifference curves do not intersect stems from the “more is better”
principle.
E. In difference curves bend inward (are convex to the origin) because if goods are
relatively abundant, the added value of another.

26. Income Elasticity. Ironside Industries, Inc., is a leading manufacturer of tufted carpeting
under the Ironside brand. Demand for Ironside’s products is closely tied to the overall pace
of building and remodeling activity and, therefore, is highly sensitive to changes in national
income. The carpet manufacturing industry is highly competitive, so Ironside’s demand is
also very price-sensitive. During the past year, Ironside sold 30 million square yards (units)
of carpeting at an average wholesale price of $15.50 per unit. This year, household income
is expected to surge from $55,500 to $58,500 per year in a booming economic recovery.

A. Without any price change, Ironside’s marketing director expects current-year sales to
soar to 50 million units because of rising income. Calculate the implied income arc
elasticity of demand.

B. Given the projected rise in income, the marketing director believes that a volume of 30
million units could be maintained despite an increase in price of $1 per unit. On this
basis, calculate the implied arc price elasticity of demand.

C. Holding all else equal, would a further increase in price result in higher or lower total
revenue?

27. Law of Diminishing Marginal Utility. Indicate whether each of the following statements
is true or false. Explain why.
 A. The law of diminishing marginal utility states that as an individual increases
consumption of a given product within a set period of time, the utility gained from
consumption eventually declines.
B. When prices are held constant, a diminishing marginal utility for consumption
decreases the cost of each marginal unit of satisfaction.
C. Marginal utility measures the added satisfaction derived from a 1-unit increase in
consumption, holding consumption of other goods and services constant.
D. When goods are relatively scarce, the law of diminishing marginal utility means that
the added value of another unit of goods will be small in relation to the added value of
another unit of services.
E. The law of diminishing marginal utility gives rise to a downward-sloping demand curve
for all goods and services.

28. Cross-Price Elasticity. The South Beach Cafe recently reduced appetizer prices from $12
to $10 for afternoon “early bird” customers and enjoyed a resulting increase in sales from
90 to 150 orders per day. Beverage sales also increased from 300 to 600 units per day.

A. Calculate the arc price elasticity of demand for appetizers.

B. Calculate the arc cross-price elasticity of demand between beverage sales and
appetizer prices.
C. Holding all else equal, would you expect an additional appetizer price decrease to $8
to cause both appetizer and beverage revenues to rise? Explain.

29. Utility Theory. Determine whether each of the following statements is true or false. Explain
why.

A. According to the theory of consumer behavior, more is always better.

B. Consumers must understand how much one product is preferred over another in order
to rank order consumption alternatives.

C. A market basket is a descriptive statement that relates satisfaction or well-being to the

consumption of goods and services.

D. The nonsatiation principle abstracts from time and place considerations.

E. Marginal utility measures the consumer’s overall level of satisfaction derived from
consumption activities.

30. Optimal Pricing. In an effort to reduce excess end-of-the-model-year inventory, Harrison

Ford offered a 1 percent discount off the average price of 4WD Escape Gas-Electric Hybrid
sold during the month of August. Customer response was wildly enthusiastic, with unit
sales rising by 10 percent over the previous month’s level.

A. Calculate the point price elasticity of demand for Harrison Ford 4WD Escape Gas-
Electric Hybrid SUVs sold during the month of August.
 B. Calculate the profit-maximizing price per unit if Harrison Ford has an average
wholesale (invoice) cost of $23,500 and incurs marginal selling costs of $350 per unit.

31. Marginal Rate of Technical Substitution. The following production table gives estimates
of the maximum amounts of output possible with different combinations of two input
factors, X and Y. (Assume that these are just illustrative points on a spectrum of continuous
input combinations.)

Units of Estimated Output Per Day

Y Used

5 210 305 360 421 470

4 188 272 324 376 421
3 162 234 282 324 360

2 130 188 234 272 305

1 94 130 162 188 210
1 2 3 4 5
Units of X used
A. Do the two inputs exhibit the characteristics of constant, increasing, or decreasing
marginal rates of technical substitution? How do you know?
B. Assuming that output sells for $3 per unit, complete the following tables:

X Fixed at 2 Units
Units of Total Marginal Average Marginal
Y Used Product of Y Product of Y Product of Y Revenue
Product of Y

Y Fixed at 3 Units
Units of Total Marginal Average Marginal
X Used Product of X Product of X Product of X Revenue
Product of X

3
 4

C. Assume that the quantity of X is fixed at 2 units. If output sells for $3 and the cost of Y
is $120 per day, how many units of Y will be employed?
D. Assume that the company is currently producing 162 units of output per day using 1 unit
of X and 3 units of Y. The daily cost per unit of X is $120 and that of Y is also $120.
Would you recommend a change in the present input combination? Why or why not?
E. What is the nature of the returns to scale for this production system if the optimal input
combination requires that X=Y?

32. Production Function Concepts. Indicate whether each of the following statements is true
or false. Explain your answers.

A. Decreasing returns to scale and increasing average costs are indicated when ꟙQ < 1.
B. If the marginal product of capital falls as capital usage grows, the returns to capital are
decreasing.
C. L-shaped isoquants describe production systems in which inputs are perfect
substitutes.
D. Marginal revenue product measures the profit earned through expanding input usage.
E. The marginal rate of technical substitution will be affected by a given percentage
increase in the marginal productivity of all inputs.

33. Compensation Policy. “Pay for performance” means that employee compensation closely
reflects the amount of value derived from each employee’s effort. In economic terms, the
value derived from employee effort is measured by net marginal revenue product. It is the
amount of profit generated by the employee, before accounting for employment costs.
Holding all else equal, indicate whether each of the following factors would be responsible
for increasing or decreasing the amount of money available for employee merit-based pay.

A. Government mandates for employer-provided health insurance

B. Rising productivity due to better worker training
C. Rising employer sales due to falling imports
D. Falling prices for industry output
E. Rising prevalence of uniform employee stock options.

34. Returns to Scale. Determine whether the following production functions exhibit constant,
increasing, or decreasing returns to scale.

A. Q = 0.5X + 2Y + 40Z
B. Q = 3L + 10K + 500
 C. Q = 4A + 6B + 8AB
D. Q = 7L2 + 5LK + 2K2
E. Q = 10L 0.5 K 0.3

35. Optimal Compensation Policy. Café-Nervosa.com, based in Seattle, Washington, is a

rapidly growing family business that offers a line of distinctive coffee products to local and
regional coffee shops. Assume founder and president Frasier Crane is reviewing the
company’s sales force compensation plan. Currently, the company pays its three
experienced sales staff members a salary based on years of service, past contributions to
the company, and so on. Niles Crane, a new sales trainee and brother of Frasier Crane, is
paid a more modest salary. Monthly sales and salary data for each employee are as follows:
Niles Crane has shown great promise during the past year, and Frasier Crane believes that
a substantial raise is clearly justified. At the same time, some adjustment to the
compensation paid to other sales personnel also seems appropriate. Frasier Crane is
considering changing from the current compensation plan to one based on a 5 percent
commission. He sees such a plan as being fairer to the parties involved and believes it
would also provide strong incentives for needed market expansion.

Sales Staff Average Monthly Sales ($) Monthly Salary ($)

Roz Doyle 160,000 6,000

Daphne Moon 100,000 4,500

Martin Crane 90,000 3,600

Niles Crane 75,000 2,500

A. Calculate Café-Nervosa.com’s salary expense for each employee expressed as a

percentage of the monthly sales generated by that individual.
B. Calculate monthly income for each employee under a 5 percent of monthly sales
commission–based system.
C. Will a commission-based plan result in efficient relative salaries, efficient salary levels,
or both?

36. Optimal Input Mix. The First National Bank received 3,000 inquiries following the latest
advertisement describing its 30-month IRA accounts in the Boston World, a local
newspaper. The most recent ad in a similar advertising campaign in Massachusetts
Business, a regional business magazine, generated 1,000 inquiries. Each newspaper ad
costs $500, whereas each magazine ad costs $125.
 A. Assuming that additional ads would generate similar response rates, is the bank
running an optimal mix of newspaper and magazine ads? Why or why not?
B. Holding all else equal, how many inquiries must a newspaper ad attract for the current
advertising mix to be optimal?

37. Marginal Revenue Product of Labor. To better serve customers interested in buying cars
over the Internet, Smart Motors, Inc., hired Nora Jones to respond to customer inquiries,
offer price quotes, and write orders for leads generated by the company’s Web site. During
the last year, Jones averaged 1.5 vehicle sales per week. On average, these vehicles sold
for a retail price of $25,000 and brought the dealership a profit contribution of $1,000 each.

A. Estimate Jones’ annual (50 workweek) marginal revenue product.

B. Jones earns a base salary of $60,000 per year, and Smart Motors pays an additional 28
percent

38. Optimal Input Level. Ticket Services, Inc., offers ticket promotion and handling services
for concerts and sporting events. The Sherman Oaks, California, branch office makes heavy
use of spot radio advertising on WHAM-AM, with each 30-second ad costing $100. During
the past year, the following relation between advertising and ticket sales per event has been
observed:
Sales (units) = 5,000 + 100A - 0.5A2
∂Sales (units)/∂Advertising = 100 – A
Here, A represents a 30-second radio spot ad, and sales are measured in numbers of tickets.
Rachel Green, manager for the Sherman Oaks office, has been asked to recommend an
appropriate level of advertising. In thinking about this problem, Green noted its resemblance
to the optimal resource employment problem studied in a managerial economics course. The
advertising–sales relation could be thought of as a production function, with advertising as an
input and sales as the output. The problem is to determine the profit-maximizing level of
employment for the input, advertising, in this “production” system. Green recognized that a
measure of output value was needed to solve the problem. After reflection, Green determined
that the value of output is $2 per ticket, the net marginal revenue earned by Ticket Services
(price minus all marginal costs except advertising).

A. Continuing with Green’s production analogy, what is the marginal product of advertising?
B. What is the rule for determining the optimal amount of a resource to employ in a production
system? Explain the logic underlying this rule.
C. Using the rule for optimal resource employment, determine the profit-maximizing number
of radio ads.
39. Net Marginal Revenue. Crane, Poole & Schmidt, LLC, is a successful Boston-based law
firm. Worker productivity at the firm is measured in billable hours, which vary between
partners and associates. Partner time is billed to clients at a rate of $250 per hour, whereas
associate time is billed at a rate of $125 per hour. On average, each partner generates 25
billable hours per 40-hour workweek, with 15 hours spent on promotion, administrative,
and supervisory responsibilities. Associates generate an average of 35 billable hours per
40-hour workweek and spend 5 hours per week in administrative and training meetings.
Variable overhead costs average 50 percent of revenues generated by partners and 60
percent of revenues generated by associates.

A. Calculate the annual (50 workweek) net marginal revenue product of partners and
associates.
B. If partners earn $175,000 and associates earn $70,000 per year, does the company have
an optimal combination of partners and associates? If not, why not? Make your answer
explicit and support any recommendations for change.

40. Production Function Estimation. Consider the following Cobb–Douglas production

function for bus service in a typical metropolitan area:

𝑄 = 𝑏0 𝐿𝑏 1 𝑘 𝑏 2 𝐹 𝑏 3
Where

Q = output in millions of passenger miles

L = labor input in worker hours
K = capital input in bus transit hours
F = fuel input in gallons

Each of the parameters of this model was estimated by regression analysis using monthly
data over a recent 3-year period. Results obtained were as follows:

𝑏̂0 = 1.2; 𝑏 1 = 0.28; 𝑏 2 = 0.63; 𝑏 3 = 0.12

The standard error estimates for each coefficient are
𝜎𝑏̂0 = 0.4; 𝜎𝑏̂1 = 0.15; 𝜎𝑏̂2 = 0.12; 𝜎𝑏̂3 = 0.07

A. Estimate the effect on output of a 4 percent decline in worker hours (holding K and F
constant).
B. Estimate the effect on output of a 3 percent reduction in fuel availability accompanied
by a percent decline in bus transit hours (holding L constant).
C. Estimate the returns to scale for this production system.