Econ 3070-001

Fall 2014
Problem Set 4 Solutions

Ch, Problem 5 5.20

1. Lou’s preferences over (x) and other goods (y) are given by U(x, y) = xy.
His income is $120. You can use your calculations from HW 3 Problem 1
where you found the demand function for this type of utility function:
I
X= demand function for X
2PX
I
Y= demand function for Y
2PY

a. Calculate his optimal basket when Px = 4 and Py = 1.(Note you the

demand function given or or you can practice optimizing again).

Plugging in the values into the demand functions :

120
X= demand function for X
2(4)
120
Y= demand function for Y
2(1)

(X*, Y*)=(15, 60)

b. What is Lou’s utility if he consumes the optimal basket determined in a?

U(X,Y)= X*Y*=(15*60) = 900

c. Graph the budget line and indifference curve and mark the optimal point,
call this point A. Call the budget line BL1 and indifference curve U1. You
can just approximate the indifference curve but get the shape right.

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Fall 2014

B
A U2
C
U1
BL2
BL1 BL’2 X
D
15 X X2

d. Now the price of pizza falls to $3. On the Graphs put on a new budget
line and indifference curve for the new optimal bundle, and call the bundle
B. Call the budget line BL2 and indifference curve U2. Don’t
worry about calculating the exact bundle. Mark the quantity of X
consumed in this bundle as X2 on the X axis.

e. The decomposition bundle is (17.3,51.9). Show on the graph how you

would calculate this decomposition bundle. What indifference curve and
budget line are tangent to find this point? Mark this tangency point as C on
the graph. Mark the quantity of X consumed by XD on the X axis.

You need to find point C, you need to find a tangency where the original utility
U1, and a budget line with the new prices price, BL’2 , are tangent. This is the
decomposition bundle. I’ve given it to you as it is a little tricky to figure out as
you can tell by the decimal points.

f. Calculate the compensating variation of the price change.

The compensating variation is the amount of income Lou would be willing to give
up after the price change to maintain the level of utility he had before the price
change. This equals the difference between the consumer’s actual income, $120,
and the income needed to buy the decomposition basket at the new prices. This
latter income equals: 3*17.3 + 1*51.9 = 103.8. The compensating variation thus
equals 120 – 103.8 = $16.2.

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Ch 6, Problem 6.1

1. A firm uses the inputs of fertilizer, labor, and hothouses to produce roses.
Suppose that when the quantity of labor and hothouses is fixed, the
relationship between the quantity of fertilizer and the number of roses
produced is given by the following table:

a. What is the average product of fertilizer when 4 tons are used?

Q 2200
APF = = = 550 .
F 4

b. What is the marginal product of the sixth ton of fertilizer?

ΔQ 2600 − 2500
MPF = = = 100
ΔF 6−5

c. Does this total product function exhibit diminishing marginal returns? If so,
over what quantities of fertilizer do they occur?

Diminishing marginal returns set in when MPF for some unit is lower than MPF
for the previous unit. This occurs for F > 3 .

d. Does this total product function exhibit diminishing total returns? If so, over
what quantities of fertilizer do they occur?

Diminishing total returns set in at the point where total output begins to fall. This
occurs for F > 6 .

Ch 6, Problem 6.5
2. Are the following statements correct or incorrect?
a. If average product is increasing, marginal product must be less than
average product.

Incorrect. When MP > AP we know that AP is increasing. When MP < AP we

know that AP is decreasing.

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b. If marginal product is negative, average product must be negative.

Incorrect. If MP is negative, MP < 0. But AP = Q / L can never be negative

since total product Q and the level of input L can never be negative. Thus, MP <
0 < AP, which only implies that AP is falling.

c. If average product is positive, total product must be rising.

Incorrect. Average product is always positive, so this tells us nothing about the
change in total product. Whether or not total product is rising depends on
whether or not marginal product is positive.

d. If total product is increasing, marginal product must also be increasing.

Incorrect. If total product is increasing we know that MP > 0 . If diminishing

marginal returns have set in, however, marginal product will be positive but
decreasing, but that does not preclude MP > 0.

Ch 6, Problem 6.4
3. Suppose the production function for lava lamps is given by

Q = KL2 − L3 ,
where Q is the number of lamps produced per year, K is the machine-hours of
capital, and L is the man-hours of labor.

Suppose K = 600.

a. Draw a graph of the production function over the range L = 0 to L = 500,

putting L on the horizontal axis and Q on the vertical axis. Over what range
of L does the production function exhibit increasing marginal returns?
Diminishing marginal returns? Diminishing total returns?

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Fall 2014

35000000

30000000

25000000
Output (Q )

20000000

15000000

10000000

5000000

0
0 50 100 150 200 250 300 350 400 450 500
Labor (L )

To identify the region of increasing total returns and the region of diminishing total
returns, we need to take the first derivative of the production function:
∂Q
MPL = = 1200 L − 3L2 .
∂L
When MPL > 0 , the production function is exhibiting increasing total returns; when
MPL < 0 , the production function is exhibiting diminishing total returns.
Therefore, the we have increasing total returns when 0 < L < 400 , and we have
diminishing total returns when 400 < L < 500 .

To identify the region of increasing marginal returns and the region of diminishing
marginal returns, we need to take the second derivative of the production function:
∂MPL ∂ 2Q
= 2 = 1200 − 6 L .
∂L ∂L
When dMPL dL > 0 , the production function is exhibiting increasing marginal
returns; when dMPL dL < 0 , the production function is exhibiting diminishing
marginal returns. Therefore, we have increasing marginal returns when
0 < L < 200 , and we have diminishing marginal returns when 200 < L < 500 .

b. Derive the equation for average product of labor and graph the average
product of labor curve. At what level of labor does the average product curve
reach its maximum?

The equation for average product of labor is given by

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Fall 2014

Q 600L2 − L3
APL = = = 600L − L2 .
L L

Graphing this equation yields the average product of labor curve:

100000
90000
80000
70000
Output (Q )

60000
50000
40000
30000
20000
10000
0
0 50 100 150 200 250 300 350 400 450 500
Labor (L )

To find the level of labor at which the average product curve reaches its maximum,
we need to take the derivative and set it equal to zero:
∂APL
= 600 − 2 L
∂L
600 − 2 L = 0
L = 300
So, the average product curve reaches its maximum when L = 300 .

c. Derive the equation for marginal product of labor. On the same graph you
drew for part b, sketch the graph of the marginal product of labor curve. At
what level of labor does the marginal product curve appear to reach its
maximum? At what level does the marginal product equal zero?

We derived the equation for marginal product of labor in part a. We rewrite it here
for convenience:
MPL = 1200 L − 3L2 .

Graphing this equation yields the marginal product of labor curve. It is shown
below in pink (the average product of labor curve is shown in yellow) :

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Fall 2014

150000

100000

50000
Output (Q )

0
APL
0
50
100
150
200
250
300
350
400
450
500
-50000 MPL

-100000

-150000

-200000
Labor (L )

To find the level of labor at which the marginal product curve reaches its maximum,
we need to take the derivative and set it equal to zero:
∂MPL
= 1200 − 6 L
∂L
1200 − 6 L = 0
L = 200
So, the marginal product curve reaches its maximum when L = 200 .

The marginal product equals zero when L = 400 .

d. Relate your answer to part c to your answer to part a.

In part c, we saw that marginal product is positive over the range 0 < L < 400 . This
means that increases in labor lead to increases in output over this range. So it
follows that this range coincides with the region of increasing total returns identified
in part a.

In part c, we saw that marginal product is equal to zero when L = 400 and is then
negative over the range 400 < L < 500 . This means that increases in labor lead to
decreases in output over this range. So it follows that this range coincides with the
region of diminishing total returns identified in part a.

In part c, we saw that the marginal product curve was increasing over the range
0 < L < 200 . And this is precisely the range identified as the region of increasing
marginal returns in part a.

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And finally, in part c, we saw that the marginal product curve peaked at L = 200
and was then decreasing over the range 200 < L < 500 . And this is precisely the
range identified as the region of diminishing marginal returns in part a.

Ch 6, Problem 6.12
4. Suppose the production function is given by the following equation (where a
and b are positive constants): Q = aL + bK. What is the marginal rate of
technical substitution of labor for capital (MRTS L,K ) at any point along
an isoquant?

For this production function MPL = a and MPK = b . The MRTS L , K is therefore

MPL a
MRTS L , K = =
MPK b

5. For each of the following production functions, graph a typical isoquant and
determine whether the marginal rate of technical substitution of labor for capital
( MRTS L ,K ) is diminishing, constant, increasing, or none of these.

a. Q = LK

2
1 Q =4
1 2 4 L

Since the isoquants are bowed towards the origin, MRTS L ,K is diminishing.

b. Q = L K

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1 Q =2

1 2 L

Since the isoquants are bowed towards the origin, MRTS L ,K is diminishing.

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c. Q = L2 3 K 1 3

512

8
1 Q =8

1 8 512 L

Since the isoquants are bowed towards the origin, MRTS L ,K is diminishing.

d. Q = 3L + K

Slope = -3

Q =3
1 L
Since the isoquants are straight lines, MRTS L ,K is constant.

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e. Q = min{3L , K }

Q =3
3

1 L

MRTS L ,K is ∞ along the vertical portion of the isoquant and 0 along the horizontal
portion of the isoquant; it is undefined at the “elbow point.” So, although MRTS L ,K
decreases from ∞ to 0 as we pass through the “elbow point” of the isoquant, it is
not decreasing everywhere: MRTS L ,K is constant along the vertical leg and constant
along the horizontal leg. Therefore, the answer is none of these.

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