Managerial Economics

Amjad Toukan
Fall 2019
PROBLEM SET #2
To be submitted by Saturday December 7th

Problem 1:
A firm uses two variable inputs, labor (L) and raw material (M), in producing its output. At its
current level of inputs:
CL = $10/unit, MPL = 25
CM = $2/unit, MPM = 4
1. Determine whether the firm is operating efficiently, given that its objective is to minimize the
cost of producing the given level of output.
2. Determine what changes (if any) in the relative proportions of a labor and raw materials need to
be made to operate efficiently.

Problem 2:
Suppose that a firm’s production function is given by the following relationship:
Q = 2.5 L 0.5 K0.5
Where Q = output, L = Labor input, and K = capital input.
1. Determine the percentage increase in output if labor input is increased by 10 percent (assuming
that capital input is held constant).
2. Determine the percentage increase in output if capital input is increased by 2.5 percent (assuming
that labor is held constant).
3. Determine the percentage increase in output if both labor and capital are increased by 20 percent.

Problem 3:
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 is held constant?

a. q=2 L+2 K
1
2
b. q=(2 L+2 K )

c. q=3 LK 2
1 1
2 2
d. q=L K
1
2
e. q=4 L +4 K

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Problem 4:
During the last few days the Superior Company has been running into problems with its
computer system. The last run of the production cost schedule resulted in the incomplete listing
shown below. From your knowledge of cost theory, fill in the blanks.

Q TC TFC TVC ATC AFC AVC MC

0       40 _____ _____         X         x         x         x
1 _____ _____ _____       52 _____ _____ _____
2 _____ _____       20 _____ _____ _____ _____
3 _____ _____ _____ 21.33 _____ _____ _____
4 _____ _____ _____ _____ _____ _____         4
5 _____ _____       40 _____ _____ _____ _____
6 _____ _____ _____ 15.67 _____ _____ _____
7 _____ _____ _____ _____ _____       10 _____
8 _____ _____       96 _____ _____ _____ _____
9 _____ _____ _____ _____ _____       15 _____
10 _____ _____ _____ _____ _____ _____       45

Problem 5:
Howard Bowen is a large-scale cotton farmer. The land and machinery he owns has a current
market value of $4 million. Bowen owes his local bank $3 million. Last year Bowen sold $5
million worth of cotton. His variable operating costs were $4.5 million; accounting depreciation
was $40,000, although the actual decline in value of Bowen’s machinery was $60,000 last year.
Bowen paid himself a salary of $50,000, which is not considered part of his variable operating
costs. Interest on his bank loan was $400,000. If Bowen worked for another farmer or a local
manufacturer, his annual income would be about $30,000. Bowen can invest any funds that
would be derived, if the farm were sold, to earn 10 percent annually. (Ignore taxes.)

a. Compute Bowen’s accounting profits.

b. Compute Bowen’s economic profits.

Problem 6:
The Blair Company’s three assembly plants are located in California, Georgia, and New Jersey.
Previously, the company purchased a major subassembly, which becomes part of the final
product, from an outside firm. Blair has decided to manufacture the subassemblies within the
company and must now consider whether to rent one centrally located facility (e.g., in Missouri,
where all the subassemblies would be manufactured) or to rent three separate facilities, each
located near one of the assembly plants, where each facility would manufacture only the
subassemblies needed for the nearby assembly plant. A single, centrally located facility, with a
production capacity of 18,000 units per year, would have fixed costs of $900,000 per year and a
variable cost of $250 per unit. Three separate decentralized facilities, with production capacities
of 8,000, 6,000, and 4,000 units per year, would have fixed costs of $475,000, $425,000, and
$400,000, respectively, and variable costs per unit of only $225 per unit, owing primarily to the
reduction in shipping costs. The current production rates at the three assembly plants are 6,000,
4,500, and 3,000 units, respectively.

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 a. Assuming that the current production rates are maintained at the three assembly plants,
which alternative should management select?
b. If demand for the final product were to increase to production capacity, which alternative
would be more attractive?
c. What additional information would be useful before making a decision?

Problem 7:
Consider the following table of long-run total cost for three different firms:
Quantity 1 2 3 4 5 6 7
Firm A 60 70 80 90 100 110 120
Firm B 11 24 39 56 75 96 119
Firm C 21 34 49 66 85 106 129

Does each of these firms experience economies of scale or diseconomies of scale?

Problem 8:
Fill in the type of cost that best completes each sentence:

a. What you give up for taking some action is called the _____________.
b. _____________is falling when marginal cost is below it and rising when marginal cost is
above it.
c. A cost that does not depend on the quantity produced is a ____________________
d. In the ice-cream industry in the short run, _____________includes the cost of cream and sugar
but not the cost of the factory.
e. Profits equal total revenue less _____________________________________.
f. The cost of producing and extra unit of output is the _____________________.

Problem 9:
The market demand schedule for cassettes is:

Price (dollar per cassette) Quantity demanded (thousands of

cassettes per week)
3.65 500
5.20 450
6.80 400
8.40 350
10.00 300
11.60 250
13.20 200
14.80 150

The market is perfectly competitive, and each firm has the following cost structure:

Output (cassettes Marginal cost (dollars Average variable Average total

per week) per additional cassette) cost (dollars per cost (dollars per

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 cassette) cassette)
150 6.00 8.80 15.47
200 6.40 7.80 12.80
250 7.00 7.00 11.00
300 7.65 7.10 10.43
350 8.4 7.20 10.06
400 10.00 7.50 10.00
450 12.40 8.00 10.22
500 12.7 9.00 11.00

There are 1,000 firms in the industry.

a. (5) What is the market price?

b. (5) What is the industry’s output?
c. (5) What is the output produced by each firm?
d. (5) What is the economic profit made by each firm?
e. (5) Do firms enter or exit the industry?
f. (5) What is the number of firms in the long run?

Problem 10:

Suppose you are given the following information about a particular industry:
Q D  6500  100 P Market demand
Q S  1200 P Market supply
q
2
C (q )  722  Firm total cost function
200
2q
MC (q )  Firm marginal cost function.
200
Assume that all firms are identical, and that the market is characterized by perfect
competition.
a. (10) Find the equilibrium price, the equilibrium quantity, the output supplied by the firm,
the profit of each firm, and the number of firms in the industry.
b. (10) Would you expect to see entry into or exit from the industry in the long run? Explain.
What effect will entry or exit have on market equilibrium?
c. (10) What is the lowest price at which each firm would sell its output in the long run? Is
profit positive, negative, or zero at this price? Explain.
d. (10) Suppose that all of the firm’s fixed costs are sunk, what is the lowest price at which
each firm would sell its output in the short run? Is profit positive, negative, or zero at this
price? Explain.

e. (5) Suppose that a tax of $1 is assessed for every unit of output and is imposed on only
one firm in the industry. Find the new profit maximizing output for the firm.

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f. (5) Now suppose that the tax of $1 is imposed on every firm in the industry. Find the new
profit maximizing output for the firm. Is the effect of the tax on the firm’s output larger
when the tax is imposed only on one firm or when the tax is imposed on every firm?
Explain.