PRACTICE QUESTIONS

1. The marginal product of labor in the production of computer chips is 50 chips per
hour. The marginal rate of technical substitution of hours of labor for hours of
machine capital is 1/4. What is the marginal product of capital?

MRTSL,K = MPL/MPK

MPK = 200

2. Do the following functions exhibit increasing, constant, or decreasing returns to

scale? What happens to the marginal product of each individual factor as that
factor is increased and the other factor held constant?
a.

q(λL, λK)= 3 (λ L) + 2 ( λ K)

= λ ( 3L +2K)

= λ q (L,K)

=> constant returns to scale.

Here, M P L =3∧M PK =2. So marginal product of each factor remains the same
as that factor is increased.

b.

q ( λ L, λ K) = { 2 ( λ L) + 2 ( λ K) }1/2

= λ1/2 (2L + 2k)1/2

= λ1/2 q ( L, K)

=> decreasing returns to scale.

−1
1 2 1
Here, M P L = ∗ ( 2 L+2 K ) ∗2= =¿ M P L decreases as L increases at a fixed K.
2 √ ( 2 L+ 2 K )
Similarly for M P K .

c.
 q ( λ L, λ K) = 3 ( λ L) (λK)2

= λ3(3LK2)

= λ3 q (L,K)

If λ> 1=¿ increasing returns¿ scale

And, if λ< 1=¿ de creasingreturns¿ scale

M P L =3 K 2=¿ remains ¿ as L i s increased at a ¿ K .

M P K =6 LK =¿ increases as K i s increased at a ¿ L .

3. The production function for the personal computers of DISK Inc. is given by
Q = 10K0.5L0.5
Where q is the number of computers produced per day, K is hours of machine time,
and L is hours of labour input. DISK’s competitor, FLOPPY Inc. is using production
function
Q = 10K0.6L0.4

a) If both companies use the same amounts of capital and labour, which one will
generate more output?

i. Case I: K = L = C (say)

Qd = 10K0.5L0.5
Qd = 10C0.5C0.5 = 10C

Qf = 10K0.6L0.4
Qf = 10C0.6C0.4 = 10C

 Qd = Qf when K = L

ii. Case II: K < L

Qd 10∗K 0.5∗L0.5 L 0.1

= 0.6
Qf 10∗K ∗L 0. 4
=
K ( ) >1

iii. Case III: K > L

 Qd 10∗K 0.5∗L0.5 L 0.1
= 0.6
Qf 10∗K ∗L 0.4
=
K ( ) <1

b) Assume that capital is limited to 9 machine hours, but labor is unlimited in

supply. In which company is the marginal product of labor greater? Explain.

Qd = 30 L0.5
dQd /dL = 15L -0.5

Qf = 37.37 L0.4
dQf /dL = 14.97 L-0.6
M PL of Disk Inc 0.1
≅ L >1
M P L of Floppy Inc
MPL of Disk Inc. is higher for any values of L.

4. Many mining and mineral extraction processes tend to exhibit increasing returns to
scale. Suppose copper mines have increasing returns, and the existing copper
mines reduce their capital and labor inputs by 25 percent in response to a global
recession. What is the expected impact on copper output?

Output decreases by more than 25 percent.

For instance, in the above diagram, increase in inputs= (10- 7.5/7.5) 100 = 33.33 %. The
corresponding increase in output= (134- 100/100) 100 = 34%. Thus, the above function
exhibits increasing returns to scale.
Now, say there is a decrease in inputs= (10 – 7.5/10) 100 = 25%. The corresponding
decrease in output= (134-100/134)100=25.37 %. Therefore, output decreases by more than
25%.

5. Draw a utility function over income U(I) that describes a man who is a risk lover
when his income is low but risk averse when his income is high. Can you explain
why such a utility function might reasonably describe a person’s preferences?
The utility function will be S-shaped as illustrated below. Preferences might be like this
for an individual who needs a certain level of income, I*, in order to stay alive. An
increase in income above I* will have diminishing marginal utility. Below I*, the
individual will be a risk lover and will take unfavorable gambles in an effort to make
large gains in income. Above I*, the individual will purchase insurance against losses
and below I* will gamble.

6. A city is considering how much to spend to hire people to monitor its parking meters.
The following information is available to the city manager:

 Hiring each meter monitor costs $10,000 per year.

 With one monitoring person hired, the probability of a driver getting a
ticket each time he or she parks illegally is equal to 0.25.
 With two monitors, the probability of getting a ticket is 0.5; with three
monitors, the probability is 0.75; and with four, it’s equal to 1.
 With two monitors hired, the current fine for overtime parking is $20.

a) Assume first that all drivers are risk neutral. What parking fine would you levy, and
how many meter monitors would you hire (1, 2, 3, or 4) to achieve the current
level of deterrence against illegal parking at the minimum cost?
If drivers are risk neutral, their behavior is influenced only by their expected fine. Currently,
with two meter monitors, the probability of detection is 0.5 and the fine is $20. So, the
expected fine is (0.5)($20)+(0.5)(0) = $10.
To maintain this current level of deterrence, the city can hire one meter monitor and
increase the fine to $40, or hire three meter monitors and decrease the fine to $13.33, or
hire four meter monitors and decrease the fine to $10.
If the only cost to be minimized is the cost of hiring meter monitors at $10,000 per year, you

(as the city manager) should minimize the number of meter monitors. Hire only one monitor
and increase the fine to $40 to maintain the current level of deterrence.
b. Now assume that drivers are highly risk averse. How would your answer to (a) change?
If drivers are risk averse, they would want to avoid the possibility of paying parking fines
even more than would risk-neutral drivers. Therefore, a fine of less than $40 should
maintain the current level of deterrence.
7) Consider a person with a current wealth of $100,000 who faces a 25% chance of losing
his car worth $20,000. Suppose also that the utility function is U(X) = ln(X) where X>0

a. Expected value of the lottery?

1,00,000*0.75 + 80,000*0.25 = $95,000

 b. What is the expected utility of the lottery?

0.25(ln 80,000) + 0.75(ln 1,00,000) = 11.457

c. What is the individual’s certainty equivalent and risk premium?

0.25(ln(80,000)) + 0.75(ln(1,00,000)) = ln(X)

X = $ 94,574.16
So, C.E. = 94,574.16
R.P. = E(X) – C.E.
= $ 425.83

d. Suppose an insurance company sets the price of the insurance to be

$5600, would this person buy the insurance? Why or why not?

$1,00,000 - $5600 = $94,400, will not buy the insurance because lesser
than CE

e. Suppose an insurance company sets the price of the insurance be $5300,

would this person buy the insurance? Why or why not?

$10000 - $5300 = $94700, will buy because greater than CE

f. What is the maximum that the person will be willing to pay to buy an
insurance for the loss of car?

$1,00,000 - $94,574.16 = $5425.84

8) Describe Larry, Judy and Carol's risk preferences. Their utility as a function of income is
given as follows

Larry: UL(I) = 10 .

It’s a concave utility function. So, Larry is risk averse.

2
Judy: UJ (I) = 3I .

It’s a convex utility function. So, Judy is risk lover.

Carol: UC (I) = 20I.
It’s linear utility function. So, Carol is risk neutral.