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EC202: Intermediate Microeconomics

Semester 2, 2022
Tutorial 6 Solution
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Question 1

a) How does an increase in the price of an input affect the slope of an isocost line?
A firm’s total costs are TC = rK + wL, so the equation for a typical isocost line is
TC w
K= − L.
r r
Since the slope of the isocost line is given by − w / r , if the price of labour increases the
isocost line will become steeper and if the price of capital increases the isocost line will
become flatter.

b) What is the difference between the expansion path and the input demand curve?
The expansion path traces out the cost-minimizing combinations of all inputs as the
level of output is increased (expanded) holding the prices of the inputs fixed. An input
demand curve traces out a firm’s cost-minimizing quantity of one input as the price
of that input varies holding the level of output and the prices of the other inputs fixed.

c) Could the solution to the firm’s cost-minimization problem ever occur off the isoquant
representing the required level of output?

The solution to the firm’s cost minimization problem must lie on an isoquant. While
the firm could produce a given output with a combination of inputs, not on the
isoquant, say by using more labour and more capital than necessary, a combination
such as this would not be efficient and therefore not cost-minimizing.

d) For a given quantity of output, under what conditions would the short-run quantity
demanded for a variable input (such as labour) equal the quantity demanded in the long
run?
Assuming quantity is fixed, then the short-run demand for a variable input would
equal its long-run demand if the level of the fixed input in the short run was cost-
minimizing for the quantity of output being produced in the long run.

e) What is the relationship between the solution to the firm’s long-run cost-minimization
problem and the long-run total cost curve?
 The long-run total cost curve plots the minimized total cost for each level of output
holding input prices fixed. In other words, for a given set of input prices, the long-run
total cost curve represents the total cost associated with the solution to the long-run
cost minimization problem for each level of output.

f) What is an experience curve? What is the difference between economies of experience

and economies of scale?

The experience curve represents the relationship between average variable cost and
cumulative production volume over time. One would expect that as cumulative
production volume increased; the average variable cost would fall. Economies of scale
refer to a situation when average cost declines as the level of output for that product
increases within a given time frame.

In general, economies of scale would occur if the average cost curve declined as the
level of output increased. Economies of experience would occur if, as cumulative
production volume increased, the average cost curve shifted downward for all levels
of output. So, economies of scale refer to lower average costs that occur as output
increases and economies of experience refer to lower average costs for all levels of
output as cumulative production volume increases.

Question 2

a) Why are isocost lines straight lines?

The isocost line represents all possible combinations of two inputs that may be
purchased for a given total cost. The slope of the isocost line is the negative of the ratio
of the input prices. If the input prices are fixed, their ratio is constant and the isocost
line is therefore straight. Only if the ratio of the input prices changes as the quantities
of the inputs change is the isocost line not straight.

b) If the firm’s average cost curves are U-shaped, why does its average variable cost curve
achieve its minimum at a lower level of output than the average total cost curve?

Average total cost is equal to average fixed cost plus average variable cost: ATC =
AVC + AFC. When graphed, the difference between the U-shaped average total cost
and the U-shaped average variable cost curve is the average fixed cost, and AFC is
downward sloping at all output levels. When AVC is falling, ATC will also fall because
both AVC and AFC are declining as output increases. When AVC reaches its
minimum (the bottom of its U), ATC will continue to fall because AFC is falling. Even
as AVC gradually begins to rise, ATC will still fall because of AFC’s decline.
Eventually, however, as AVC rises more rapidly, the increases in AVC will outstrip
the declines in AFC, and ATC will reach its minimum and then begin to rise.
 c) Is the firm’s expansion path always a straight line?

No. If the firm always uses capital and labour in the same proportion, the long run
expansion path is a straight line. But if the optimal capital-labour ratio changes as
output is increased, the expansion path is not a straight line. Also, in the short run,
the expansion path may be horizontal if capital is fixed.

d) What is the difference between economies of scale and returns to scale?

Economies of scale depend on the relationship between what happens to cost and
when output ! i.e., how does cost change when output is doubled? Returns to scale
depend on what happens to output when all inputs are doubled. The difference is that
economies of scale reflect input proportions that change optimally as output is
increased, while returns to scale are based on fixed input proportions (such as two
units of labour for every unit of capital) as output increases.

e) Distinguish between economies of scale and economies of scope. Why can one be present
without the other?

Economies of scale refer to the production of one good and occur when total cost
increases by a smaller proportion than output. Economies of scope refer to the
production of more than one good and occur when joint production is less costly than
the sum of the costs of producing each good or service separately. There is no direct
relationship between economies of scale and economies of scope, so production can
exhibit one without the other. For example, there are economies of scale producing
computers and economies of scale producing carpeting, but if one company produced
both, there would probably be no synergies associated with joint production and
hence no economies of scope.

Question 3

What is the difference between economies of scope and economies of scale? Is it possible for a
two-product firm to enjoy economies of scope but not economies of scale? Is it possible for a firm
to have economies of scale but not economies of scope?

Economies of scale refer to a situation when the average total cost for a single product decline
as the level of output for that product increases. These economies of scale might occur, for
example, because workers can specialize in tasks as the level of output increases and the
workers’ productivity may increase. Economies of scope refer to efficiencies that arise when
a firm produces more than one product. In particular, economies of scope exist if one firm
producing N products does so at a lower total cost than N separate firms producing the same
quantities of each product individually. The notion of economies of scale can be applied to a
multi-product firm as well. We can use this extension to further refine the distinction
between economies of scale and scope. Suppose a firm is producing N products, with output
levels measured by Q1, Q2… QN. If it operates with economies of scale, the total cost of
production will rise by less than 1% when the production of all outputs increases by 1%.

If it operates with diseconomies of scale, the total cost of production will rise by more than
1% when the production of all outputs increases by 1%. By contrast, economies of scope
exist if it is less costly to have the outputs produced by one firm instead of by N firms, each
specializing in the production of one of the outputs.

Note that information about economies of scope does not tell us whether the firm has
economies of scale. If a production process has economies of scope, there may not be
economies of scale. Further, information about economies of scale does not tell us whether
the firm has economies of scope. If a production process has economies of scale, there may
not be economies of scope.

Question 4

A firm operates with a technology that is characterized by a diminishing marginal rate of technical
substitution of labour for capital. It is currently producing 32 units of output using 4 units of capital
and 5 units of labour. At that operating point, the marginal product of labour is 4 and the marginal
product of capital is 2. The rental price of a unit of capital is 2 when the wage rate is 1. Is the firm
minimizing its total long-run cost of producing the 32 units of output? If so, how do you know? If
not, show why not and indicate whether the firm should be using (i) more capital and less labour,
or (ii) less capital and more labour to produce an output of 32.

Recall the tangency condition for cost minimization: MPL/w = MPK/r

Therefore, we have:

MPL/w = 4/1 = 4 > MPK/r = 2/2 = 1.

Thus, the firm cannot be minimizing its long-run total cost. By employing more labour and
less capital, it could maintain 32 units of output while lowering total costs.

Question 5

The short-run cost function of a company is given by the equation TC = 200 + 55q, where TC is
the total cost and q is the total quantity of output, both measured in thousands.

a) What is the company’s fixed cost?

When q = 0, TC = 200, so fixed cost is equal to 200 (or $200,000).

 b) If the company produced 100,000 units of goods, what would be its average variable
cost?

With 100,000 units, q = 100. Variable cost is 55q = (55)(100) = 5500 (or $5,500,000).
The average cost is : TVC/q =
$5500/100 = $55, or $55,000.

c) What would be its marginal cost of production?

With constant average variable cost, marginal cost is equal to average variable cost,
$55 (or $55,000).

d) What would be its average fixed cost?

At q = 100,
= average fixed cost is TFC/q
=$200/100
= $2 or ($2,000).

e) Suppose the company borrows money and expands its factory. Its fixed cost rises by
$50,000, but its variable cost falls to $45,000 per 1000 units. The cost of interest (i) also
enters into the equation. Each 1-point increase in the interest rate raises costs by $3,000.
Write the new cost equation.

Fixed cost changes from 200 to 250, measured in thousands. Variable cost decreases
from 55 to 45, also measured in thousands. Fixed cost also includes interest charges:
3i. The cost equation is :
TC = 250 + 45q + 3i.

Question 6

A firm has fixed production costs of $5,000 and a constant marginal cost of production equal to
$500 per unit produced. What is the firm’s total cost function? Average cost?

The variable cost of producing an additional unit, marginal cost, is constant at $500, so
VC = 500q, and AVC =VC/q = 500q/q = 500

Fixed cost is $5,000 and therefore average fixed cost is AFC = 5,000/q . The total cost function
is fixed cost plus variable cost or TC = 5,000 + 500q. Average total cost is the sum of average
variable cost and average fixed cost: ATC = 500 + 5,000 /q.
Question 7

You manage a plant that mass-produces engines by teams of workers using assembly machines.
The technology is summarized by the production function

q = 5 KL

where q is the number of engines per week, K is the number of assembly machines, and L is the
number of labour teams. Each assembly machine rents for r = $10,000 per week, and each team
costs w = $5000 per week. Engine costs are given by the cost of labour teams and machines, plus
$2000 per engine for raw materials. Your plant has a fixed installation of 5 assembly machines as
part of its design.

a) What is the cost function for your plant — namely, how much would it cost to produce q
engines? What are the average and marginal costs for producing q engines? How do
average costs vary with the output?

The short-run production function is q = 5(5)L = 25L, because K is fixed at 5. This

implies that for any level of output q, the number of labour teams hired will be

L = q / 25

The total cost function is thus given by the sum of the costs of capital, labour, and raw
materials:

𝑻𝑪(𝒒) = 𝒓𝑲 + 𝒘𝑳 + 𝟐𝟎𝟎𝟎𝒒
𝒒
𝑻𝑪(𝒒) = (𝟏𝟎𝟎𝟎𝟎)𝟓 + 𝟓𝟎𝟎𝟎( 𝟐𝟓 ) + 𝟐𝟎𝟎𝟎𝒒
𝑻𝑪(𝒒) = 𝟓𝟎𝟎𝟎𝟎 + 𝟐𝟐𝟎𝟎𝒒

The average cost function is then given by:

𝑻𝑪(𝒒) 𝟓𝟎𝟎𝟎𝟎 + 𝟐𝟐𝟎𝟎𝒒

𝑨𝑪(𝒒) = =
𝒒 𝒒

and the marginal cost function is given by:

𝒅𝑻𝑪
𝑴𝑪 (𝒒) = = 𝟐𝟐𝟎𝟎
𝒅𝒒

Marginal costs are constant at $2200 per engine and average costs will decrease as
quantity increases because the average fixed cost of capital decreases.
b) How many teams are required to produce 250 engines? What is the average cost per
engine?

To produce q = 250 engines, we need L = q / 25 or L = 10 labour teams. Average

costs are given by

𝟓𝟎 𝟎𝟎𝟎 + 𝟐𝟐𝟎𝟎 (𝟐𝟓𝟎)

𝑨𝑪 (𝒒 = 𝟐𝟓𝟎) = = 𝟐𝟒𝟎𝟎
𝟐𝟓𝟎

c) You are asked to make recommendations for the design of a new production facility. What
capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize the total
cost of producing at any level of output q?

We no longer assume that K is fixed at 5. We need to find the combination of K and

L that minimizes costs at any level of output q. The cost-minimization rule is given
by

𝑴𝑷𝑲 𝑴𝑷𝑳
=
𝒓 𝒘

To find the marginal product of capital, observe that increasing K by 1 unit increases
q by 5L, so MPK = 5L. Similarly, observe that increasing L by 1 unit increases q by
5K, so MPL = 5K. Mathematically,

𝝏𝒒 𝝏𝒒
𝑴𝑷𝒌 = = 𝟓𝑳 ; 𝑴𝑷𝑳 = = 𝟓𝑲
𝝏𝑲 𝝏𝑳

Using these formulas in the cost-minimization rule, we obtain:

𝟓𝑳 𝟓𝑲 𝑲 𝒘 𝟓𝟎𝟎𝟎 𝟏
= ⟹ = = =
𝒓 𝒘 𝑳 𝒓 𝟏𝟎 𝟎𝟎𝟎 𝟐

The new plant should accommodate a capital to labor ratio of 1 to 2, and this is the
same regardless of the number of units produced.

***The End***