EC 203 - INTERMEDIATE MICROECONOMICS

Boğaziçi University - Department of Economics

Fall 2019
Problem Set 6 - Solutions

1. Suppose that a firm is required to produce 200 units of output using quantities of labor and capital L = 8
and K = 10. For each of the production function given below, (1) state whether it is feasible to produce
the required output with the given input combination, and (2) if it is feasible, state whether the input
combination is efficient or not.

(a) f (L, K) = KL + 2L + 100

Solution: q = 80 + 16 + 100 = 196 < 200. Not feasible.
(b) f (L, K) = 2KL + 40
Solution: q = 160 + 40 = 200. Feasible and efficient.
(c) f (L, K) = 12 min{3L, 2K}
Solution: q = 12 min{24, 20} = 12 · 20 = 240 > 200. Feasible and inefficient.
(d) f (L, K) = 10L1/3 K
Solution: q = 10 · 81/3 10 = 200. Feasible and efficient.
(e) f (L, K) = 10L + 8K
Solution: q = 80 + 80 = 160 < 200. Not feasible.

2. For each of the following production functions, (1) find M PL and M PK , (2) state whether M RT SL,K is
diminishing or not, and (3) state whether it has increasing returns to scale, decreasing returns to scale or
constant returns to scale.

(a) f (L, K) = KL2 + L

2KL+1 2K 1
Solution: M PL = 2KL + 1 and M PK = L2 . Then |M RT S| = L2
= L + L2
. As L goes up,
both terms go down. Thus, MRTS is diminishing. Now for any α > 1, f (αL, αK) = αK(αL)2 + αL =
α3 KL2 + αL > αKL2 + αL = α[KL2 + L] = αf (L, K). Thus it exhibits IRTS.
(b) f (L, K) = 7L + 12K − 4
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Solution: M PL = 7 and M PK = 12. Then |M RT S| = 12 , which is constant. Thus, MRTS is not
diminishing. Now for any α > 1, f (αL, αK) = 7(αL)+12(αK)−4 > 7(αL)+12(αK)−4α = αf (L, K).
Thus it exhibits IRTS.
(c) f (L, K) = 3L1/3 K
L−2/3 K
Solution: M PL = L−2/3 K and M PK = 3L1/3 . Then |M RT S| = 3L1/3
= K
3L . As L goes up, it
decreases. Thus, MRTS is diminishing. Now for any α > 1, we have f (αL, αK) = 3(αL)1/3 (αK) =
α(1/3+1) 3L1/3 K = α4/3 f (L, K) > αf (L, K). Thus it exhibits IRTS.
(d) f (L, K) = min{3L, K}
Solution: If 3L > K then f (L, K) = K, and M PL = 0 and M PK = 1, where |M RT S| = 0. If 3L < K
then f (L, K) = 3L, and M PL = 3 and M PK = 0, where |M RT S| = ∞. If 3L = K, then MRTS not
defined. Now for any α > 1, we have f (αL, αK) = min{3αL, αK} = α min{3L, K} = αf (L, K). Thus
it exhibits CRTS.

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3. Suppose production function is given as

K L c
 
f (L, K) = min( , ) ,
a b
where a, b, c > 0 are all positive constants. The input prices are r and w, for K and L, respectively.

(a) Does this production function exhibit increasing, decreasing or constant returns to scale, when a = 1/2
and b = 1/3?
Solution: Let us pick some arbitrary pair (K.L) and assume for now that min(2K, 3L) = 2K. Then, for
any α > 1, min{2αK, 3αL} = 2αK. Then, we have that f (αK, αL) = (min{2αK, 3αL})c = (2αK)c =
αc (2K)c = αc (min{2K, 3L})c = αc f (K, L) Note that this calculation would have worked exactly the
same way if we had assumed min(2K, 3L) = 3L. This production function exhibits decreasing, constant,
and increasing returns to scale when αc is less than, equal to, and greater than 1, respectively. That
is, it exhibits DRTS if c < 1, CRTS if c = 1 and IRTS if c > 1.
(b) Without specifying a and b, find the conditional input demand functions K(q, w, r), L(q, w, r) and the
cost function c(q, w, r).
Solution: Recall first that the conditional factor demands K(q, w, r), L(q, w, r) are the solutions, K ≥ 0
and L ≥ 0, to the cost minimization problem
 c
K L
min rK + wL subj. to min( , ) ≥q
{L,K} a b
K L
In this case, because only the minimum of a and b contributes to production, the firm minimizes cost
K L
to produce where a = b. We therefore have that

K L c
 
q = min( , )
a b
 c  c
K L
= =
a b

We can then solve for K, L as follows:

K
q 1/c = ⇐⇒ K = aq 1/c ,
a

and
L
q 1/c = ⇐⇒ L = bq 1/c ,
b
and so
K(q, w, r) = aq 1/c ,
L(q, w, r) = bq 1/c .

The resulting cost function is

c(q, w, r) = rK (q, w, r) + wL (q, w, r) = raq 1/c + wbq 1/c

= (ra + wb)q 1/c .

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(c) How are the conditional factor demands K(q, w, r), L(q, r, w) and the cost function c(q, w, r) affected
by the prices of the inputs, r and w? Using our economic intuition, what can we say about why this is
so?
Solution: We observe that the conditional factor demands, K(q, w, r) = ay 1/c and L(q, w, r) = by 1/c ,
are both independent of the input prices r and w, while the cost function is increasing in both r and
w. The reason for this is as follows. Because (a units of) capital and (b units of) labor act as perfect
complements for this “fixed proportion” production function (meaning the isoquants look exactly like
indifference curves for perfect complements, with the slope being either zero or infinity everywhere),
K L
the firm will always choose a pair K, L such that a = b in order to minimize cost. This equation thus
fixes the relationship between the optimal level of K and the optimal level of L. In other problems we
have seen, the firm had the option of trading off capital for labor in order to produce the same amount.
(In such cases, isoquants have some slope between zero and infinity and so such a trade-off is possible.)
When this is the case, the relationship between K and L depends on input prices r and w because
those prices yield the cost of making such a trade-off. Here, because no trade-off exists, input prices
do not affect the cost minimizing input levels K and L. However, once K and L are chosen, the firm
still has to pay for them, which of course affects its cost function, which is why the cost function is
increasing in r and w.
(d) Let’s now fix r and w and rewrite the cost function c (q, w, r) as a function of q only. Assume there is no
fixed cost. More specifically, define the constant A such that A = ra + wb and write the cost function
as c(q). What is the marginal cost function, M C(q), for this firm? What is the marginal cost function,
AT C(q), for this firm? What are the slopes of the respective cost curves M C(q) and AT C(q)?
Solution: The cost function can now be written as

c (q) = Aq 1/c .

The firm’s marginal cost is given by

M C (q) = c0 (q)
 
A (1−c)/c
= q .
c

The firm’s average total cost is given by

c(q)
AT C (q) =
q
= Aq (1−c)/c
= c · M C (q) .

The slope of the cost curves is given by

 
∂M C (q) A
= (1 − c) q (1−2c)/c
∂q c2 | {z }
| {z } >0
>0

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 and

∂AT C (q) ∂ [c · M C (q)]

=
∂q ∂q
∂M C (q)
= c·
∂q
A
= (1 − c) q (1−2c)/c ,
c | {z }
>0
|{z}
>0

(e) Describe the relationship between returns to scale and the shape of the cost curves M C(q) and AT C(q)?
Solution: Recall that f (L, K) exhibits...

DRTS if c < 1

CRTS if c = 1

IRTS if c > 1.

Notice the sign of the slope of both M C and AT C is the same as the sign of 1 − c. When f exhibits
IRTS (CRTS) (DRTS), we have that c > 1 (c = 1) (c < 1) and therefore both M C and AT C will
be downward sloping (constant) (upward sloping). Furthermore, when f has CRTS, we have that
M C = AT C. When it has IRTS, AC will be above M C, and when it has DRTS, M C will be above
AT C, confirming the relationship between the slope of AT C and whether it is above or below M C.

4. Suppose that a firm has a production function f (L, K) = 3LK + K and the input prices are w = 6 and
r = 10

(a) If the firm is targeting q = 125, then find the long-run cost minimizing labor and capital combination.
Write the total cost function.
Solution: The problem is to minimize 6L + 10K subject to 3LK + K = 125. Let’s first check M RT S.
3K
We have M PL = 3K and M PK = 3L + 1. Then, |M RT S| = 3L+1 which is diminishing as L goes up.
3K w 6
So we can look at tangency condition. |M RT S| = 3L+1 = r = 10 , that is, 5K = 3L + 1. So we have
5K−1
L= 3 . Plug this into the production constraint: 125 = 3LK + K = 3 5K−1
3 K + K and solve for
K. We get K∗ = 5. Then we obtain L∗ = 5K−1
3 = 8. Finally, the total cost of producing 125 units is
wL∗ + rK ∗ = 6 · 8 + 10 · 5 = 98.
(b) If the firm is targeting q = 20, then find the long-run cost minimizing labor and capital combination.
Write the total cost function.
5K−1
Solution: We still have L = 3 . Plugging this to the new production constraint gives 20 =
3LK + K = 3 5K−1
3 K + K. Solving for K we get K ∗ = 2. Then we get L∗ = 3. And the total cost of
producing 20 units is then 6 · 3 + 10 · 2 = 38.
(c) Suppose the wage rate increases and is now w0 = 10 and the rent is r = 10, find the long-run cost
minimizing inputs bundle for q = 125. Compare them to your findings in part (a) and (b).
3K 10
Solution: Since w changes, the tangency condition also changes. We have 3L+1 = 10 = 1. Thus,
3K−1 3K−1
L= 3 . Plugging this into the production constraint we get 125 = 3LK + K = 3 3 K + K and

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 solving for K we get K ∗ = 6.5. Then L∗ = 6.1. Comparing (L = 6.1, K = 6.5) with the original input
levels (L = 8, K = 5), we can say that as w goes up, the producer substitutes L with K since K is
relatively cheaper now.

5. Producing ice cream requires both capital (K) and labor (L). Suppose that the production function for the
ice cream is given by f (L, K) = KL2 .

(a) If the wage rate is w = 40 and the rental rate of capital is r = 1, what is the least costly way (how
much capital and how much labor) to produce 20 units of ice cream?
Solution: We have that the marginal product functions are

M PL = 2KL
M PK = L2

and so
M PL 2K
|M RT SLK | = = .
M PK L
Note that MRTS is diminishing as L increases and K decreases. Setting this equal to the ratio of input
prices,
w
|M RT SLK | = ,
r
w 40
where r = 1 = 40, yields
2K
= 40, or K = 20L.
L
Plugging this into the production function for q = 20 yields

20 = (20L)L2 ⇒ 20 = 20L3
⇒ 1 = L3
⇒ L=1
⇒ K = 20.

(b) What is the total cost using the least costly method?
Solution: The total cost is given by rK + wL = 1(20) + 40(1) = 60.
(c) Suppose ice cream makers suddenly become more productive, changing the production function for
the ice cream to f (L, K) = KL3 . At the same time, the wage rate for the ice cream making workers
also changed from w = 40 to a new wage rate of w.
b The firm producing ice cream finds that that
the cheapest combination of capital and labor to produce 20 units of ice cream has not changed from
before. That is, the least costly way of making 20 units is the same as in part (a). What must the new
wage level w
b be on order for this to be the case?
Solution: We now have that

M PL 3KL2 3K
|M RT SLK | = = = .
M PK L3 L

We know that at the optimal combination of capital labor it must hold that |M RT S| = w/r, and so

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 with r = 1 and w = w
b we have that

w 3K w
|M RT S| = ⇒
b
= ,
r L 1

and since we know the optimal capital and labor levels are still K = 20 and L = 1, we can simply plug
these in to get
3(20) w
⇒w
b
= b = 60.
1 1
(d) Give some intuition for your answer to part (c), comparing the new wage w
b to the old wage of 40. If
the wages of the workers depended only on their productivity, would the scenario described in part (c)
be likely to occur?
Solution: The new wage is w
b = 60 > 40, so the wage of workers has increased along with the increase
in their productivity. This scenario is indeed likely and consistent with labor economic theory which
states that workers are compensated for their productivity. In this case, the wage increase happens to
exactly offset the increase in productivity, in the sense that firms choose to still hire the same number
of workers as before the productivity and wage increases occurred.
(e) Suppose for the rest of the question that production has gone back to f (L, K) = KL2 , the wage rate
is back to w = 40, and the rental rate of capital is r = 1. Furthermore the firm is stuck with having
exactly 20 units of capital. What is the short run total cost curve for the firm when K = 20? What
are its total costs when producing 20 units with capital fixed at K = 20?
Solution: From the production function, we have that
r
q
L= ,
K

so the short run total cost of producing y units is when K = 20 is given by

SRT CK=20 (q) = wL + rK

r
q
= 40 + 1(K)
K
r
q
= 40 + 20
20

The cost of producing 20 units can then be obtained by plugging in q = 20 to get

SRT CK=20 (20) = 60.

(f) What is the long run total cost curve for makers ice cream? What is the total cost of producing 20
units when both capital and labor can be altered?
Solution: Recall from part (a) that |M RT S| = w/r yields K = 20L, which when plugged into the
production function yields

q = (20L)L2 ⇒ q = 20L3
 q 1/3  q 1/3
⇒ L= ⇒ K = 20 ,
20 20

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 and so the long run total cost is given by

LRT C(q) = wL + rK
= 40L + K
 q 1/3  q 1/3
= 40 + 20
20 20
 q 1/3
= 60 .
20

The cost of producing 20 units can then be obtained by plugging in q = 20 to get

LRT C(20) = 60,

which indeed is the same as what we got in part (b).

(g) Is the total cost in part (e) (with K = 20 fixed) less, more, or the same as in parts (b) and (f) (in which
K can be altered)? Explain why.
Solution: The total cost in part (e) is the same as that of (b) and (f) That is, SRT CK=20 (20) = 60 =
LRT C(20). This is because the level of capital (K = 20) at which the firm is “stuck” in the short run
just happens to be exactly the optimal level of capital for producing 20 units of ice cream.

6. Consider a firm with a production function f (L, K) = ln (K) + L. Let r, w be the input prices for inputs K
and L, respectively, and let p be the price of the output q. Find the firm’s cost function c (q, w, r).
Solution: The firm’s cost minimization problem is

min rK + wL
K,L≥0
subj. to ln (K) + L ≥ q,

and writing the production constraint as an equality and using the substitution method yields L = q−ln (K) ,
and so the firm chooses K to minimize

rK + w (q − ln (K)) .

w w w w



The first order condition is r − K = 0, yielding K = r and L = q − ln r . However q − ln r may be
negative and so we have the following conditional input demands:

w w



 r if q ≥ ln r
K (q, w, r) =

if q < ln wr
eq



w w




 q − ln r if q ≥ ln r
L (q, w, r) =

w


0 if q < ln ,

r

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 and so the cost function becomes

c (q, w, r) = rK (q, w, r) + wL (q, w, r)


w w




 w 1 + q − ln
 r if q ≥ ln r
=

w
req


if q < ln ,

r

7. Suppose a firm has the following production function, which takes three inputs, L, K and M , and produces
a single output: f (L, K, M ) = 3L1/3 K 1/3 + M . Suppose the input prices are given by w for L, r for K and
1 for M. Find the conditional input demand functions L(q, w, r), K(q, w, r) and M (q, w, r), and the cost
function c(q, w, r). Assume interior solutions.
Solution: Firm’s cost minimization problem to produce q units is given by

min wL + rK + M
L,K,M ≥0
subj. to 3 (L)1/3 (K)1/3 + M = q.

The Lagrangian is
 
L (L, K, M, w, r, q, λ) = wL + rL + M + λ q − 3 (L)1/3 (K)1/3 − M .

The FOCs are

∂L
= w − λ (L)−2/3 (K)1/3 = 0, (1)
∂L
∂L
= r − λ (K)−2/3 (L)1/3 = 0, (2)
∂K
∂L
= 1 − λ = 0, (3)
∂M
∂L
= q − 3 (L)1/3 (K)1/3 − M = 0. (4)
∂λ

Equation (3) yields λ = 1, which plugged into (1) yields

(L)−2/3 (K)1/3 = w
 1/3
K
= w
L2
K = w 3 L2 , (5)

which then plugged into a similarly rearranged version of (2) yields

(K)−2/3 (L)1/3 = r
L 1/3
 
= r
K2
L = r3 K 2 , (6)

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 That is, L = r3 K 2 = r3 (w3 L2 )2 . Solving for L we get

1
L=
w2 r
which plugged back into (5) yields
 2
3 2 3 1 1
K = w L =w = ,
rw2 wr2

which finally all plugged into (4) yields

M = q − 3 (L)1/3 (K)1/3
1 1/3 1 1/3
   
= q−3
w2 r wr2
3
= q− .
wr

Thus, L(q, w, r), K(q, w, r) and M (q, w, r)

 
1 1 3
(L(q, w, r), K(q, w, r), M (q, w, r)) = 2
, 2
, q−
w r wr wr

Now the cost function is given by

c(q, w, r) = wL(q, w, r) + rK(q, w, r) + M (q, w, r)

1 1 3
= w 2 +r 2 +q−
w r wr wr
1 1 3
= + +q−
wr wr wr
1
= q−
wr

8. For each of the total cost functions given below, (1) find the AC, AV C, AF C and M C, and (2) show that
M C intersects the AV C at its minimum.

(a) T C(q) = 2q 2 − q + 4
Solution: AC = 2q − 1 + 4/q, AV C = 2q − 1, AF C = 4/q, M C = 4q − 1.
(b) T C(q) = 1000 + 50q 2
Solution: AC = 50q + 1000/q, AV C = 50q, AF C = 1000/q, M C = 100q.
(c) T C(q) = q 3 + 1
Solution: AC = q 2 + 1/q, AV C = q 2 , AF C = 1/q, M C = 3q 2 .
To verify that the minimum of AC is on the MC curve you need to find the q that minimizes AC and
the minimized value of AC, and show that this q and the minimized value is on the MC curve. But it
is usually a bit of a messy algebra.