Managerial Economics Foundations of Business Analysis and Strategy 12th Edition Thomas Solut

Managerial Economics Foundations of Business

Analysis and Strategy 12th Edition Thomas Solutions
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 Chapter 8:
PRODUCTION AND COST IN THE SHORT RUN
Essential Concepts

1. A production function shows the maximum amount of output that can be produced from any specified
set of inputs, given the existing technology.
2. Technical efficiency is achieved when the maximum possible amount of output is being produced
with a given combination of inputs. Economic efficiency is achieved when the firm is producing a
given amount of output at the lowest possible total cost.
3. Production inputs can be either variable or fixed:
(a) variable input: an input for which the level of usage may be readily varied in order to change the
level output. Payments for variable inputs are called variable costs. Examples of variable inputs
are labor, raw materials, and energy.
(b) fixed input: an input for which the level of usage cannot be readily changed and which must be
paid even if no output is produced. Payments for fixed inputs are called fixed costs. Examples of
fixed inputs are buildings and other inputs that a firm leases and capital equipment that cannot be
readily varied with changes in output.
(c) quasi-fixed input: A lumpy or indivisible input for which a fixed amount must be employed for
any positive level of output, and none of the input must be purchased when output is zero.
Payments for quasi-fixed inputs are called quasi-fixed costs. Fixed and quasi-fixed inputs are
both used in constant amounts as output varies, but fixed inputs must be paid for even if output is
zero while quasi-fixed inputs need not be purchased when output is zero. Examples of quasi-fixed
inputs are railroad tracks, antenna towers for radio stations, and electricity for lighting an office.
4. The short run refers to a time span during which the firm employs at least one fixed input, which, by
definition, must be paid even when output is zero in the short run. In the short run, quasi-fixed inputs
may or may not be employed.
5. The long run, also called the firm’s planning horizon, refers to the time period just far enough in the
future to allow all fixed inputs to become variable inputs. For any quasi-fixed inputs that might be
needed, their levels are fixed in the long run at whatever lump amount is required.
6. A sunk cost of production is a payment for an input that, once made, cannot be recovered should the
manager no longer wish to employ the input. Sunk input costs should be ignored for decision making
purposes because sunk costs are not part of the economic cost of production. Once the sunk payment
is made, the economic (opportunity) cost of using the input thereafter is zero.
7. In contrast to a sunk cost of production, an avoidable cost of production is a payment for an input that
a firm can recover or avoid paying should the manager no longer wish to employ the input.
Avoidable costs do matter in decision making and should not be ignored. Avoidable costs reflect the
opportunity costs of resource use. Table 8.1 summarizes properties of inputs:
TABLE 8.1
Inputs in Production
Relation to Avoidable or Employed in short run
Input type Payment output sunk? (SR) or long run (LR)?
Variable input Variable cost Direct Avoidable Both SR and LR
Fixed input Fixed costs Constant Sunk Only SR
Quasi-fixed input Quasi-fixed cost Constant Avoidable If required: SR and LR

Chapter 8: Production and Cost in the Short Run

2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
8. Average product ( AP = Q / L ) and marginal product ( MP = DQ / DL ) are related as follows:
When AP is rising (falling), MP is greater (less) than AP. When AP reaches its maximum value,
AP = MP.
9. The law of diminishing marginal product states that as the usage of a variable input increases, a point
is reached beyond which its marginal product decreases.

10. Panel A in the preceding figure shows the typical total product curve (TP) when production
occurs with only one variable input. The total product curve reflects the following relations:
a. No output can be produced with zero workers.
b. Output increases at an increasing rate until L0 workers are employed producing Q0 units of
output. Over this range marginal product is increasing.
c. Total product then increases but at a decreasing rate when the firm hires between L0 and L2
workers. Over this range MP is decreasing.
d. Average product reaches its maximum value at L1, where AP equals MP.
e. Finally a point will be reached beyond which output will decline, indicating a negative
Chapter 8: Production and Cost in the Short Run
2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 marginal product. In Panel A, this occurs for employment levels greater than L2. The
maximum possible total product is thus Q2.

11. Panel B in the figure shows the AP and MP curves that correspond to TP in Panel A. Notice that
a. both curves first rise, reach a maximum, then decline.
b. marginal product attains a maximum (at L0 ) at a lower input level than the level at which
average product attains its maximum (at L1 ).
c. while AP is always positive, MP is zero at L2 units of labor and is negative thereafter.

12. Short-run total cost (TC) is the sum of total variable cost (TVC) and total fixed cost (TFC):
TC = TVC + TFC
13. Average fixed cost (AFC) is equal to total fixed cost divided by output:
TFC
AFC =
Q
14. Average variable cost (AVC) is equal to total variable cost divided by output:
TVC
AVC =
Q
15. Average total cost is equal to total cost divided by output or the sum of average variable and
average fixed cost:
TC
ATC = = AVC + AFC
Q
16. Short-run marginal cost (SMC) measures the rate of change in TC as output varies:
DTC DTVC
SMC = =
DQ DQ
17. The following figure shows the typical set of short-run average and marginal cost curves. Note
the following relations:
a. AFC decreases continuously as output increases (AFC is not shown in the figure above, but it
is equal to vertical distance between ATC and AVC).
b. AVC is -shaped and AVC equals SMC at AVC ’ s minimum.
c. ATC is -shaped and ATC equals SMC at ATC ’ s minimum.
d. SMC is -shaped and intersects AVC and ATC at their minimum points. SMC lies below
(above) ATC and AVC when ATC and AVC are falling (rising).

Chapter 8: Production and Cost in the Short Run

2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Answers to Applied Problems

1. a. Monthly fixed costs: The only fixed cost payment made each month is the $1,000 monthly lease
payment for camera and lighting equipment. This payment is a fixed cost because it does not
vary the number of portrait photos produced each month and the $1,000 payment (each month for
12 months) must be made even if the studio shuts down (i.e., all twelve monthly payments are
unavoidable or sunk due to the “ironclad” lease).
Monthly quasi-fixed costs: Quasi-fixed costs each month include: (i) $1,400 for rent on the
office/studio, (ii) $45 per month for the fixed amount of electricity needed for office lighting and
the coffee pot, and (iii) $5,000 per month opportunity cost of her time – presuming she can return
to her bank job at the beginning of any month.
Monthly variable costs: The only variable cost specifically mentioned is the cost of electricity
for burning the high-wattage studio lights during portrait shoots. Perhaps she would also incur
some other variable costs such as photo processing expenditures or lollipops to make babies
smile, but these are not revealed in the question.
b. Sunk costs: If the studio shuts down at the end of August and the owner returns to work at the
bank for the remainder of the year, then the sunk costs include: (i) $200 for business cards, (ii)
$1,000 for the listing in Yellow Pages, (iii) $250 for the business license, and (iv) the $12,000 of
lease payments for the camera and lighting equipment (remember that the lease is ironclad and
she must pay for all 12 months).
Avoidable costs: By closing the business for the remaining four months of the year, she can
avoid incurring (i) $1,400 per month in rent, (ii) all the costs of electricity to run the office,
including the electricity cost of burning the studio lights, and (iii) $5,000 per month opportunity
cost of her time, as she can return to her bank job.
c. All sunk costs should be ignored, not only in August, but also in every time period after they are
paid because sunk costs can never be recovered no matter what decision the manager makes on
the matter of shutting down or continuing to operate. Thus, sunk costs play no role in making the
decision to go out of business in August, as these costs are irrelevant for all decisions made after
these payments become sunk costs on January 1st.
d. Entering into a new business involves making a risky decision because at the time you decide to
enter the new business you cannot know with certainty the amount of revenue you will earn, the
level of costs you will incur and thus the profit you will earn. You will find it “harder” to decide
to enter if you run the risk of losing a large amount of sunk costs should you have to shut down
the business due to unexpectedly low profits.
Chapter 8: Production and Cost in the Short Run
2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 Prior to starting her business on January 1st, no costs are yet sunk. However, she knows that
once she begins her business on January 1st and makes payments that immediately become
unrecoverable, she cannot recoup these costs should she decide later in the year to shut down the
business. Thus, she would view the sunk costs as the cost of entering the portrait business. The
higher the cost of entering the business (i.e., the higher are the sunk costs), the more difficult it
will be for her to justify opening her own portrait studio because she must expect that her total
revenue will be high enough since she will lose all of the sunk costs if she later goes out of
business.
2. Diminishing returns begin when a new worker adds less to total product than the previous worker.
When diminishing returns set in, marginal product begins to decrease; total product is still increasing,
but at a decreasing rate. The managers may be confusing diminishing returns and negative marginal
product; a company should not hire a worker if the new person has negative marginal product– i.e.,
causes total output to decrease.

3. a. Energy efficiency in the context of this problem simply means producing a mile of transportation
with the least amount of a particular input, namely gasoline. Economic efficiency means
producing the mile of transportation at the lowest possible total cost. These are generally
different objectives.
b. If gasoline is extremely expensive relative to the other inputs needed to produce transportation
miles (such as aluminum, rubber, glass, plastic, and highly trained design engineers), then is may
be economically efficient to use more of these other scarce resources to reduce the amount of
gasoline needed to drive a mile.
c. Economic efficiency looks at the total cost of all scarce resources. After all, the various resources
used to reduce the amount of gasoline burned cannot be used to produce other socially desirable
goods such as food, clothing, and shelter.

4. a. All the sheet metal workers at CF&D could be working as “hard” as they can, and the firm could
still experience diminishing productivity as suggested by the law of diminishing marginal
productivity. If the production increases at CF&D were achieved without adding new machinery
(keeping capital constant), then beyond some level of employment, marginal productivity of sheet
metal workers will fall. The decline in productivity embodied in the law of diminishing
productivity is not the result of worker laziness. Remember, the production function assumes
technical efficiency, so the downward sloping portion of the MP curve cannot be caused by lazy
workers or poor management of workers. If the plant is technically efficient, no amount of
“cracking down” on labor can increase productivity.

b. Adding new sheet metal working machines will cause the MP and AP curves to shift upward.
Workers will have more (and perhaps better) with which to work, thereby increasing their
productivity levels (measured as either MP or AP).

5. Improvements in productivity, as measured by increases in MP and AP, directly result in reductions in

SMC and AVC, respectively. Lower costs make it possible to maintain, and possibly even increase,
profits in the face of falling prices.
6. The move was economically efficient if the same amount of furniture was produced at a lower total
cost after the change. Throwing away wood scrap costs the factory money, but so does reducing the
amount of wood scrap. The decision was economically efficient only if the cost of reducing the wood
scrap was less than $93,000 (the cost savings from the change).
7. The lease payments for the 2014 lease can only be considered sunk costs if the lease contract offers
no means of partial payment of the $144,000 lease amount should Digital Advantage wish to vacate
the retail space before making the last payment of $12,000 on December 1, 2014. If there is no
Chapter 8: Production and Cost in the Short Run
2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
 provision for breaking the 12-month term of the lease, then the $144,000 cost of leasing retail space
in 2014 should be ignored when making decisions such as pricing, advertising, hiring, or shutting
down. When economic profit for 2014 is calculated, $144,000 must be treated as part of the total
economic cost of doing business in 2014 since the cost of leasing retail space in the Tacoma mall
could have been saved or avoided by choosing not to do business in Tacoma in 2014.
On the other hand, if the lease provides for early termination –probably with some form of
financial penalty—then the lease costs are not entirely sunk, and the avoidable lease payments (less
the dollar amount of the penalty) do indeed represent economic costs of doing business that cannot be
ignored.
8. The tractor-trailer rig can be viewed as a lumpy and indivisible input, since Oversize Transport must
employ an entire 275-long rig in order to haul even one Caterpillar 740 dump truck and huge rigs
probably come only in 50-foot increments—200-, 250-, or 300-foot sizes. However, in the short run,
during the 5-year period of the lease, the tractor-trailer rig is a fixed cost, because the $5,500 monthly
lease payment is sunk and must be paid each month no matter how many deliveries it makes each
month (between 0 and 20). Only in the long run, is the tractor-trailer rig an avoidable cost. And since
it is a lumpy input, it is a quasi-fixed input in the long run. Notice also, that if Oversize Transport
wishes to expand its capacity to supply more than 20 deliveries per month, it can in the long run add
additional lumps of capital in the form of 250-foot tractor-trailer rigs, each one requiring another
driver.

Answers to Mathematical Exercises

1. a. f(L,16) = g(L) = 20  4  L2 = 80L2.

b. AP = Q/L = 80L – 2

c. MP = dg(L)/dL = 40L – 2

d. dMP/dL = g”(L) = – 20L – 1.5 , which is negative for all L.

2. a. From equation (9) in the Math Appendix, the slope of ATC = 1/Q(SMC – ATC). Similarly, it can
be shown that the slope of AVC, dAVC/dQ, is equal to 1/Q(SMC – AVC). Clearly, the slopes of
ATC and AVC are not equal for any given Q.

b. Let D = slope AVC – slope ATC. It is easy to show that D is positive for all output levels:
D = slope AVC – slope ATC = 1/Q(SMC – AVC) – 1/Q(SMC – ATC)
= 1/Q (AFC) > 0 for all Q.
When both AVC and ATC are falling, both slopes are negative. The algebraic difference between
the two slopes, D, cannot be positive unless |slope ATC| > |slope AVC|; that is, ATC falls faster
than AVC falls. In contrast, when both are rising, AVC rises faster than ATC [D is positive].

3. a. AVC = AVC(Q) = TVC/Q = 20L/Q. Solving for L in the production function, L = L(Q) = Q2/6400.
Substituting into AVC, AVC = [20(Q2/6400)]/Q = Q/320.

b. L = (160)2/6400 = 4 units of labor; AP = 160/4 = 40; AVC = (20  40)/160 = $0.50

c. SMC = SMC(Q) = dTVC(Q)/dQ = d[20L(Q)]/dQ = d[Q2/320]/dQ = Q/160.

Chapter 8: Production and Cost in the Short Run

2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Managerial Economics Foundations of Business Analysis and Strategy 12th Edition Thomas Solut

d. When Q = 160, L = 40 (from 3b). So MP = 40(4) – 2 = 20; SMC = 20/20 = $1 ✓; or SMC = 1/160
(160) = $1 ✓ [Verified at ✓ marks.]

Chapter 8: Production and Cost in the Short Run

2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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