Problem Set-3

P3.1

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)
R is the average annual rainfall (in inches).

Both QD and QS are in millions of bushels of potatoes.

A. At PW = $4, Y = $15,000 billion, PL = $8, and R = 20 inches

QD = -1,450 – 25*P + 12.5*4 + 0.1*15000 = 100 -25P

QS = -100 + 75P – 25*4 - 12.5*8 + 10*20 = -100+75P

B.
Quanity in millions
Price, $ Quantity Supplied, QS Quantiy Surplus or
Demaned, QD Shortage,
millions
1.5 12.5 62.5 Shortage by 50
2 50 50 Equilibrium
2.5 87.5 37.5 Surplus by 50

C.

Equilibirum is when QD=QS

100-25P=-100+75P
100P=200
P=2

QD= 50 (millions), QS= 50 (millions)

Q.2

Consider the following production function: 𝑄 = 100(𝐾 0.8 𝐿0.2 )

(a) Does this production function exhibit increasing, decreasing, or constant returns to scale?

Show using a generalised formula.

Using the formula

Qx = 100(xK)0.8(xL)0.2 = 100x0.8(K)0.8x0.2(L)0.2=100x(K0.80L0.2)

This shows if we increase all factors by x, the output will increase by x. Thus, there will be a
constant returns to scale.

(b) Show that capital and labour both exhibit diminishing marginal returns.

K is fixed
at 10
Q = 100(K^0.8
Labour L^0.2 MP
20 1148.698355
21 1159.962259 11.26390366
22 1170.804913 10.84265431
23 1181.260188 10.45527508
24 1191.357898 10.09771012

L is fixed
at 5
Q = 100(K^0.8
Capital L^0.2 MP
15 1084.471771
16 1098.560543 14.08877211
17 1111.961586 13.40104263
18 1124.746113 12.7845272
19 1136.974489 12.22837567

We can see that the marginal products are decreasing when K and L increases.

(c) Calculate the MRTS (of K for L).

MRTS is the marginal rate of technical substitution, it is the absolute value of the slope on the isoquant. Rate of
substitution

𝑄 = 100(𝐾 0.8 𝐿0.2 )

 𝑑𝐾 𝑀𝑃𝐿 (100 ∗ 𝐾 0.8 ∗ 0.2 ∗ 𝐿−0.8 ) 𝐾
𝑀𝑅𝑇𝑆 = − = = =
𝑑𝐿 𝑀𝑃𝐾 (100 ∗ 0.8 ∗ 𝐾 −0.2 𝐿0.2 ) 4𝐿

For any isoquant the MRTS is K/4L.

P7.2 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
εQ < 1.

TRUE. This equation shows that if percentage change in output is less than the percentage
change in all inputs increase, there is a diminishing returns to scale.

B. If the marginal product of capital falls as capital usage grows, the returns
to capital are decreasing.

TRUE. The marginal product shows the effect of increasing 1 unit of capital. If capital grows
by 1 unit but leads to a decrease in output then there is decreasing returns.

C. L-shaped isoquants describe production systems in which inputs are

perfect substitutes.

False. The isoquant shows the inputs that can be used efficiently to produce a specified
quantity of output. 


D. Marginal revenue product measures the profit earned through expanding

input usage.

False. The marginal revenue product (MRP) is the additional net revenue generated by the
last unit employed. To obtain profit, the MRP > MC

E. The marginal rate of technical substitution will be affected by a given

percentage increase in the marginal productivity of all inputs.

𝑑𝐾 𝑀𝑃𝐿
𝑀𝑅𝑇𝑆 = − =
𝑑𝐿 𝑀𝑃𝐾

False. The MRTS is the ratio of the two marginal products. Since we are using the ratio of
two marginal products it would not matter.