Rice BE 500

Due December 10 Fall 2003

Homework #5: Inputs and Oil Drilling in Utopia

Consider firm A using capital and labor to produce shoes. Let the number of machines
employed be input K (capital) with rental price r, and let the number of hours of labor employed be
input L with wage rate W. The number of pairs of shoes produced and sold is represented as output
x. The production function for firm A is given by
x = f(K,L) = 2K1/2L1/2.

I. Suppose in the short run the number of machines is fixed at 4.

A) Find the short run total product of labor at all integer L from 0 to 5.

B) Estimate the marginal product of labor at L = 1, 2, 3, and 4. (You may use jumps in L of
1 to estimate marginals from your answer to part A.) Verify that the estimate is
reasonably close to the true exact marginal product of labor, MPL = 2/(L1/2).

C) Graph the MPL, APL (average product of labor), and TPL (total product of labor) curves.

II. In the long run, firm A is free to vary both K and L.

A) With K on the y-axis and L on the x-axis, draw the x = 2 and x = 8 isoquants.

B) It can be shown that for any level of L, MPK = L1/2/ K1/2. It can also be shown that for
any level of K, MPL = K1/2/ L1/2. Find the algebraic formula for the marginal rate of
technical substitution between labor and capital, MRTSLK at any point (L,K).

C) Is there increasing, constant, or decreasing returns to scale for firm A?

III. A) Suppose r = $1 and W = $4. Find the minimum cost of producing 8 pairs of shoes.
What will K and L be at the minimum cost production point?

B) With prices as in part A, find the marginal cost at x = 8.

C) Suppose the wage rate falls to $2. What is the cheapest way to produce 8 units now (in
terms of the total cost, the optimal level of K, and the optimal level of L)? What is
the new marginal cost at 8 units?

PLEASE TURN PAGE OVER

IV. Suppose that the oil industry in Utopia is perfectly competitive and that all firms draw oil from
a single pool. The pool consists of a number of individual wells. Each well is operated by a
different individual producer and the number of wells can take on any value from zero to 700.
Assume that each competitor believes that it can sell all the oil it can produce at a stable world
price of $10 per barrel, and that the cost of operating a well for one year is $1000. (For this
question, interpret all "should" questions as if we all "should" maximize total social surplus.)

Total output per year (Q) of the oil field is a function of the number of wells (N) operating in the
field. In particular,

Q = 700N - N2 ,

and the amount of oil produced by each well (q) is equal across wells and is therefore given by:

q = Q/N = 700 - N.

Output per well falls as the number of wells increases because operating an additional well lowers
the pressure in the pool for all wells. Also, from the above we can calculate the extra output from
the Nth well as
MPN = 700 - 2N.

A) Describe the equilibrium output and the equilibrium number of wells in this perfectly
competitive case, assuming that each individual producer maximizes his own
separate profit. Is there a divergence between the private and social marginal cost of
a well in this industry? Why or why not?

B) Suppose now that the government nationalizes the oil field. How many oil wells should
it operate? What will total output be? What will the output per well be?

C) As an alternative to nationalization, the Utopian government is considering imposing on

oil producers an annual per well license fee to discourage excessive drilling. How
large should this license fee be to prompt the industry to drill the optimal number of
wells?

D) Another possibility suggested is that the government does not interfere at all, except by
establishing property rights and facilitating private negotiations between the drillers.
Could this policy result in the optimal number of wells drilled? Why and how, or
why not?