Exercise #1

1. Jane has compiled the following list of expenses after completing one year of
college. Assume that Jane would be living with her parents and working if she
weren't attending college. Use this information to calculate Jane's economic cost of
attending college for one year.

Tuition $ 8,000
Dormitory room 4,000
Books and supplies 1,000
Food plan 3,000
Foregone income 19,000
Entertainment expenses 1,000
Clothing 2,000
Health insurance 1,000

Solution:
Tuition $ 8,000
Dormitory room 4,000
Books and supplies 1,000
Food plan 3,000
Foregone income 19,000
35,000

2. Before Sarah quit her job as a carpenter, she was earning $35,000 per year. She
rented a building for $12,000 per year and opened a cabinet shop. She spends
$148,000 per year for labor, materials, utilities, and advertising.
(i) How much revenue will the business have to earn in order to break even in
terms of business profit?
(ii) How much revenue will the business have to earn in order to break even in
economic terms?

Solution:
(i) Accounting cost = $12,000 (Rented Building) + $148,000 (Spends per year
for labor, material, utilities and advertising) = $160,000

(ii) Economic cost = $35,000 (Forgone salary as carpenter) + $12,000 (Rented

Building) + $148,000 (Spends per year for labor, material,
utilities and advertising) = $195,000

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3. Climate Control Devices, Inc. estimates that sales of defective thermostats cost the
firm an average of 25 each for replacement or repair. 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 Inspectors Thermostat Failure Rate (percent)

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 30,000 per year.

i. Construct a table showing the marginal failure reduction (in units) and the value
of these reductions (in ) for each inspector hired.
ii. How many inspectors should the firm hire?
iii. How many inspectors would be hired if additional indirect costs (lost customer
goodwill and so on) were to average 30% of direct replacement or repair costs?

Solution:
i. Answer
Number of
Thermostat Marginal Marginal Value of
Quality Number of Failures (= 250,000
Failure rate Failure Failure Reduction (=
Control (col. 2 100)
(percent) Reduction $25 (col. 4)
Inspectors
(col. 1) (col. 2) (col. 3) (col. 4) (col. 5)
0 5.0 12,500 --- ---
1 4.0 10,000 2,500 $62500
2 3.2 8,000 2,000 $50,000
3 2.6 6,500 1,500 37,500
4 2.2 5,500 1,000 25000
5 2.0 5,000 500 1,5000
ii. Inspectors = 2. With $60,000 inspector salary for both , the firm will enjoy
a net marginal return of $2,500 (= $62,500 - $60,000) from hiring a third
inspector. Hiring 3 inspector would result in a marginal loss of $52,500 (=
$37,500 - $90,000).

iii. Inspectors = 2. If additional indirect costs total 30 percent of direct

replacement costs, the marginal value of inspectors (column 5) would rise
by 30 percent. Under these circumstances, the marginal value of a fourth
inspector would rise from $50,000 to $65,000 (= 1.3 50,000), and hiring 2
inspectors could be justified since doing so would increase profits by $5,000
(= $65,000 - $60,000)

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4. 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 the given demand curve or instead involves an outward or inward shift in the relevant
demand curve for housing. Explain your answers.

i. An increase in housing prices

ii. A fall in interest rates
iii. A rise in interest rates
iv. A severe economic recession
v. A robust economic growth (expansion)
vi. A rule that bank should offer loan based on net income rather than gross
income.

Solution:

i. An increase in housing prices will decrease the quantity demanded and

involve an upward movement along the housing demand curve.
ii. A fall in interest rates will increase the demand for housing and cause an
outward shift of the housing demand curve.
iii. A rise in interest rates will decrease the demand for housing and cause an
inward shift of the housing demand curve.
iv. A severe economic recession (fall in income) will decrease the demand for
housing and result in an inward shift of the housing demand curve.
v. A robust economic expansion (rise in income) will increase the demand for
housing and result in an outward shift of the housing demand curve.

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 Exercise #2

MULTIPLE CHOICE

1. What's true about both the short-run and long-run in terms of production and cost analysis?
a. In the short-run, one or more of the resources are fixed
b. In the long-run, all the factors are variable
c. The time horizon determines whether or not an input variable is fixed or not
d. The law of diminishing returns is based in part on some factors of production being fixed,
as they are in the short run.
e. All of the above

2. The marginal product is defined as:

a. The ratio of total output to the amount of the variable input used in producing the output
b. The incremental change in total output that can be produced by the use of one more unit of
the variable input in the production process
c. The percentage change in output resulting from a given percentage change in the amount
d. The amount of fixed cost involved.
e. None of the above

3. Fill in the missing data to solve this problem.

Variable Total Average Marginal

Input Product Product Product
4 ? 70
5 ? ? 40
6 350 ? ?

What is the total product for 5 units of input, and what is the marginal product for 6 units of
input?
a. 320 and 30
b. 350 and 20
c. 360 and 15
d. 400 and 10
e. 430 and 8

4. If the marginal product of labor is 100 and the price of labor is 10, while the marginal product of
capital is 200 and the price of capital is $30, then what should the firm?
a. The firm should use relatively more capital
b. The firm should use relatively more labor
c. The firm should not make any changes they are currently efficient
d. Using the Equimarginal Criterion, we can't determine the firm's efficiency level
e. Both c and d

5. The marginal rate of technical substitution may be defined as all of the following except:
a. the rate at which one input may be substituted for another input in the production process,
while total output remains constant
b. equal to the negative slope of the isoquant at any point on the isoquant
c. the rate at which all combinations of inputs have equal total costs

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 d. equal to the ratio of the marginal products of X and Y
e. b and c

6. The law of diminishing marginal returns:

a. states that each and every increase in the amount of the variable factor employed in the
production process will yield diminishing marginal returns
b. is a mathematical theorem that can be logically proved or disproved
c. is the rate at which one input may be substituted for another input in the production
process
d. none of the above

7. The combinations of inputs costing a constant C dollars is called:

a. an isocost line
b. an isoquant curve
c. the MRTS
d. an isorevenue line
e. none of the above

8. In a relationship among total, average and marginal products, where TP is maximized:

a. AP is maximized
b. AP is equal to zero
c. MP is maximized
d. MP is equal to zero
e. none of the above

9. Holding the total output constant, the rate at which one input X may be substituted for another
input Y in a production process is:
a. the slope of the isoquant curve
b. the marginal rate of technical substitution (MRTS)
c. equal to MPx/MPy
d. all of the above
e. none of the above

10. Concerning the maximization of output subject to a cost constraint, which of the following
statements (if any) are true?
a. At the optimal input combination, the slope of the isoquant must equal the slope of the
isocost line.
b. The optimal solution occurs at the boundary of the feasible region of input combinations.
c. The optimal solution occurs at the point where the isoquant is tangent to the isocost lines.
d. all of the above
e. none of the above

11. In a production process, an excessive amount of the variable input relative to the fixed input is
being used to produce the desired output. This statement is true for:
a. stage II
b. stages I and II
c. when Ep = 1

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 d. stage III
e. none of the above

12. Marginal revenue product is:

a. defined as the amount that an additional unit of the variable input adds to the total revenue
b. equal to the marginal factor cost of the variable factor times the marginal revenue resulting
from the increase in output obtained
c. equal to the marginal product of the variable factor times the marginal product resulting
from the increase in output obtained
d. a and b
e. a and c

13. The isoquants for inputs that are perfect substitutes for one another consist of a series of:
a. right angles
b. parallel lines
c. concentric circles
d. right triangles
e. none of the above

14. In production and cost analysis, the short run is the period of time in which one (or more) of the
resources employed in the production process is fixed or incapable of being varied.
a. true
b. false

15. Marginal revenue product is defined as the amount that an additional unit of the variable input
adds to ____.
a. marginal revenue
b. total output
c. total revenue
d. marginal product
e. none of the above

16. Marginal factor cost is defined as the amount that an additional unit of the variable input adds to
____.
a. marginal cost
b. variable cost
c. marginal rate of technical substitution
d. total cost
e. none of the above

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PROBLEM

1. Emco Company has an assembly line of fixed size A. Total output is a function of the number of
workers (crew size) as shown in the following schedule:

Crew Size Total Output

(No. of Workers) (No. of Units)
0 0
1 10
2 35
3 50
4 56
5 59
6 60
7 60
8 58

Determine the following schedules:

(a) marginal productivity of labor
(b) average productivity of labor
(c) elasticity of production with respect to labor

Solution:

Crew Size Total Output Answer (a) Answer (b) Answer (c)

L Q

0 0 -- -- --
1 10 +10 10 1.00
2 35 +25 17.5 1.43
3 50 +15 16.67 .90
4 56 +6 14 .43
5 59 +3 11.8 .25
6 60 +1 10 .10
7 60 0 8.57 .00
8 58 2 7.25 .28

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 Exercise #3
Problems

1. The table below presents estimates of the maximum levels of output possible with
various combinations of two inputs.

Capital (K)
5 11 25 37 47 51
4 10 23 33 41 44
3 8 18 25 30 34
2 5 11 16 20 22
1 1 4 8 10 11
1 2 3 4 5
Labor (L)

Assume that a unit of output sells for $2 and that the firm currently employs two
units of capital (K = 2).

(i) What is the marginal product of labor when L = 4?

(ii) What is the average product of labor when L = 4?

(iii) What is the marginal revenue product of labor when L = 4? What is the
output elasticity of labor when L = 4?

(iv) If the wage rate of labor is $10, how many units of labor should the firm
hire and how many units of output should it produce?

Solution:
i. The marginal product of labor when L = 4 is (20 16) / (4 3) = 4.
ii. The average product of labor when L = 4 is 20/2 = 10.
iii. The marginal revenue product of labor when L = 4 is (4) ($2) = $8. The
output elasticity of labor when L = 4 is 4/10 = 0.40
iv. The marginal revenue product of labor is ($2) when the firm
employs L = 3 units of labor. The level of output when L = 3 is 16. The
firm still enjoy $2 [(3x$10) (16x$2)]

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2. The table below presents estimates of the maximum levels of output possible with
various combinations of two inputs.

Capital (K)
5 11 25 37 47 51
4 10 23 33 41 44
3 8 18 25 30 34
2 5 11 16 20 22
1 1 4 8 10 11
1 2 3 4 5
Labor (L)

Assume that a unit of output sells for $3 and that the firm currently employs three
units of capital (K = 3).

(i) What is the marginal product of labor when L = 4?

(ii) What is the average product of labor when L = 4?

(iii) What is the marginal revenue product of labor when L = 4? What is the
output elasticity of labor when L = 4?

(iv) If the wage rate of labor is $12, how many units of labor should the firm
hire and how many units of output should it produce?

Solution:

i. The marginal product of labor when L = 4 is (30 25)/(4 3) = 5.

ii. The average product of labor when L = 4 is 30/4 = 7.5.
iii. The marginal revenue product of labor when L = 4 is (5)($3) = $15. The
output elasticity of labor when L = 4 is 5/7.5 = 0.67.
iv. The marginal revenue product of labor is equal to (4)($3) = $12 when
the firm employs L = 5 units of labor. The level of output when L = 5 is
34.

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3. A firm wants to minimize the cost of producing 2,800 units of output per week. It
has hired a production engineer to identify alternative production technologies that
will accomplish this goal. The production technologies use the different
combinations of capital (K) and labor (L) that are listed below.

K 100 90 80 70 60 50 40 30 20 10 8 7
L 8 9 11 14 18 23 30 40 55 80 90 100

Assume that the rental price of capital is $5 and the wage rate of labor is $4.
Determine the minimum cost of producing 2,800 units of output and then show
how the combination of inputs that yield the minimum cost can be determined using
the marginal approach.

Solution:
The total cost of production for each of the combinations listed is given below.

K 100 90 80 70 60 50 40 30 20 10 8 7
L 8 9 11 14 18 23 30 40 55 80 90 100
TC 532 486 444 406 372 342 320 310 320 370 400 435

The minimum cost combination is K = 30 and L = 40. The slope of the isocost
line is 4/5 = 0.80.

The marginal rate of technical substitution between the point defined by K =

50 and L = 23 and the point defined by K = 40 and L = 30 is (50 40)/(30 23)
= 1.4.

Since this is greater than 0.80, the next point should be considered. The
marginal rate of substitution between the point defined by K = 40 and L = 30
and the point defined by K = 30 and L = 40 is (40 30)/(40 30) = 1.

Again, this is greater than 0.80, so the next point should be considered.

The marginal rate of substitution between the point defined by K = 30 and L =

40 and the point defined by K = 20 and L = 55 is (30 20)/(55 40) = 0.67.

This is less than 0.80, so the point of tangency is closest to K = 30 and L = 40.

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4. During the last few days the Superior Company has been running into problems
with its computer system. The last run of the production cost schedule resulted in
the incomplete listing shown below. From your knowledge of cost theory, fill in
the blanks.

Q TC TFC TVC ATC AFC AVC MC

0 40 _____ _____ x x x x
1 _____ _____ _____ 52 _____ _____ _____
2 _____ _____ 20 _____ _____ _____ _____
3 _____ _____ _____ 21.33 _____ _____ _____
4 _____ _____ _____ _____ _____ _____ 4
5 _____ _____ 40 _____ _____ _____ _____
6 _____ _____ _____ 15.67 _____ _____ _____
7 _____ _____ _____ _____ _____ 10 _____
8 _____ _____ 96 _____ _____ _____ _____
9 _____ _____ _____ _____ _____ 15 _____
10 _____ _____ _____ _____ _____ _____ 45

Solution:

TC TFC TVC ATC AFC AVC MC

Q TC/Q
TFC - TVC TC - TFC TC/Q TFC/Q TVC/Q
TVC/Q

0 40 40 0 x x x x
1 52 40 12 52 40 12 12
2 60 40 20 30 20 10 8
3 64 40 24 21.33 13 8 4
4 68 40 28 17 10 7 4
5 80 40 40 16 8 8 12
6 94 40 54 15.67 7 9 14
7 110 40 70 15.71 6 10 16
8 136 40 96 17 5 12 26
9 175 40 135 19.4 4 15 39
10 220 40 180 22 4 18 45

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 Exercise #4

MARKET STRUCTURE

(1) Suppose two competitors, Airbus and Boeing, each face an important strategic decision
concerning whether or not they should boost research and development (R&D) spending on new
aircraft designs. Airbus can choose either row in the payoff matrix defined below, whereas Boeing
can choose either column. For Airbus, the choice is either "boost R&D" or "hold R&D constant;"
for Boeing the choices are the same. Notice that neither firm can unilaterally choose a given cell in
the profit payoff matrix. The ultimate result of this one-shot, simultaneous-move game depends
upon the choices made by both competitors. In this payoff matrix, the first number in each cell is
the profit payoff to Airbus (in billions); the second number is the profit payoff to Boeing (in
billions).

Boeing
Competitive Strategy Boost R&D Hold R&D Constant
Airbus Boost R&D $8 billion; $5 billion $5 billion; $3 billion
Hold R&D Constant $4 billion; $2 billion $9 billion; $4 billion

A. Is there a dominant strategy for Airbus? If so, what is it?

Solution:
No, there is no dominant R&D strategy for Airbus. Notice that if Boeing chooses
to boost R&D, the highest payoff of $8 billion can be achieved if Airbus also
chooses to boost R&D. On the other hand, if Boeing chooses to hold R&D
constant, the highest payoff of $9 billion can be achieved if Airbus also chooses to
hold R&D constant. Therefore, there is no dominant strategy for Airbus. The
profit-maximizing choice by Airbus depends upon the choice made by Boeing.

B. Is there a dominant strategy for Boeing? If so, what is it?

Solution:
No, there is no dominant R&D strategy for Boeing. If Airbus chooses to boost
R&D, the highest payoff of $5 billion can be achieved if Boeing chooses to also
boost R&D. However, if Airbus chooses to hold R&D constant, the highest payoff
of $4 billion can be achieved if Boeing also chooses to hold R&D constant.
Therefore, there is no dominant strategy for Boeing. The profit-maximizing R&D
strategy by Boeing depends upon the R&D strategy chosen by Airbus.

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(2) In the classic characterization of the prisoner's dilemma, two hypothetical suspects, Ken
Lay and Andy Fastow, are arrested by the FBI. Assume the FBI has insufficient evidence for a
conviction, and having separated both prisoners, visit each of them and offer the same deal: if one
agrees to confess and implicates the other, while the other remains silent, the silent accomplice
receives the full 10-year sentence and the confessor gets 1 year. If both stay silent, the FBI can only
gain a conviction on a lesser charge for which both prisoners will get 2 years in prison. If both
confess, they will each receive a 5-year sentence. Each prisoner has two options: to remain quiet
and not implicate the accomplice, or to betray the accomplice and confess. The outcome of each
choice depends on the choice of the accomplice. However, neither prisoner knows the choice of
the accomplice. Assume both prisoners are completely selfish and their only goal is to minimize
their own jail terms.

Prisoner #2: "Andy Fastow"

Confession Strategy Does not Implicate Implicates Other
Does not Implicate Both get 2 years Prisoner #1 gets 10 years;
Prisoner #1: Prisoner #2 gets 1 year
"Ken Lay" Implicates Other Prisoner #1 gets 1 year; Both get 5 years
Prisoner #2 gets 10 years

A Is there a dominant strategy in the classic prisoner's dilemma problem?

Solution:
Yes. In the classic prisoner's dilemma game, confessing and implicating one's
accomplice is a dominant strategy for both players. If either prisoner expects
their accomplice to remain quiet and not implicate them, the optimal personal
strategy for each accomplice is to confess and implicate the other accomplice.
Pursuing this strategy means getting the relatively light sentence of 1 year while
the accomplice lingers in jail for 10 years. If either prisoner expects their
accomplice to confess and implicate them, the best personal strategy choice for
each accomplice is to also confess and thereby avoid having to spend 10 years in
prison. In the event that both confess, both will spend 5 years in prison. If,
however, both prisoners deny their guilt (stay quiet), both would be able to get
convicted on a lesser charge and receive a relatively mild one-year sentence.

Therefore, in the classic prisoner's dilemma game, confessing is a dominant

strategy for both players. No matter the decision choice of the other player, each
player can always reduce their expected sentence by confessing. Unfortunately
for the prisoners involved, this leads to a poor outcome whereby both confess and
both get a heavy jail sentence of 5 years. This is the core of the classic prisoner's
dilemma. Independent rational behaviour leads to a suboptimal outcome for all.

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B. Illustrate how the classic prisoner's dilemma problem shows that independent rational
behaviour can sometimes lead to a suboptimal outcome for everybody.

Solution:

If reasoned from the perspective of the optimal interest for the group, the best
outcome would be for both prisoners to implicitly cooperate with each other,
continue to deny their guilt (stay quiet), and thereby reduce the total penalty
received by the group to fines and probation for both prisoners. Considered from
a group perspective, any other decision would be worse for the two prisoners
considered together. By each following their own selfish interests, the two
prisoners each receive a lengthy sentence of 5 years and thereby suffer from their
lack of cooperation.

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