Microeconomics 8th Edition Perloff

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Chapter 7
Costs

„ Chapter Outline
Challenge: Technology Choice at Home Versus Abroad
7.1 The Nature of Costs
Opportunity Costs
Application: The Opportunity Cost of an MBA
Solved Problem 7.1
Opportunity Costs of Capital
Sunk Costs

7.2 Short-Run Costs

Short-Run Cost Measures
Fixed Cost, Variable Cost, and Total Cost
Application: The Sharing Economy and the Short Run
Marginal Cost
Average Costs
Short-Run Cost Curves
Production Functions and the Shape of Cost Curves
Shape of the Variable Cost Curve
Shape of the Marginal Cost Curve
Shape of the Average Cost Curves
Application: A Beer Manufacturer’s Short-Run Cost Curves
Effects of Taxes on Costs
Solved Problem 7.2
Short-Run Cost Summary

7.3 Long-Run Costs

All Costs Are Avoidable in the Long Run
Minimizing Cost
Isocost Line
Combining Cost and Production Information
Lowest-Isocost Rule
Tangency Rule
Solved Problem 7.3
Last-Dollar Rule
Factor Price Changes
Solved Problem 7.4

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110 Perloff • Microeconomics, Eighth Edition

The Long-Run Expansion Path and the Long-Run Cost Function

Solved Problem 7.5
The Shape of Long-Run Cost Curves
Application: 3D Printing
Estimating Cost Curves Versus Introspection

7.4 Lower Costs in the Long Run

Long-Run Average Cost as the Envelope of Short-Run Average Cost Curves
Application: A Beer Manufacturer’s Long-Run Cost Curves
Application: Should You Buy an Inkjet or a Laser Printer?
Short-Run and Long-Run Expansion Paths
The Learning Curve

7.5 Cost of Producing Multiple Goods

Application: Medical Economies of Scope

„ Teaching Tips
The concepts of cost and cost curves are very important for students to understand. If students are to have
any significant level of understanding of how firms make production decisions when faced with various
industry structures and levels of market power, they must have a sound understanding of cost.

You might begin by asking the class for the kinds of costs that firms must consider. You are likely to get
most or all of the private, explicit costs—labor, materials, and capital—but you may or may not get
suggestions of opportunity costs and social costs. Once you have completed a list, you can distinguish
between cost types and discuss the importance of measuring cost as opportunity costs. Finally, some
students may question the lack of attention paid to materials as an input and question the assumption that
material use is independent of the capital–labor mix.
The Challenge is a good introduction to how firms make production decisions. In countries where the
opportunity cost of labor is high, a more capital-intensive production process might be used, whereas if the
opportunity cost of labor is low, the production process might be more labor-intensive.
As with the production definitions, you can use a running example of output and cost figures that are
presented in a table and, subsequently, in graphs. Remind students whenever possible that the information
here is related directly to the production function. There are Seven short-run cost concepts and three long-
run cost concepts, so it is easy for students to forget where they come from.

The text makes specific note of the shape of the variable cost curve and its relationship to the diminishing
marginal returns to labor. This link is reinforced further by Equations 7.1 (MC = w/MPL ) and 7.2 (AVC =
w/APL ). Marginal cost and marginal product curves can be described as inverted images of one another,
noting that the characteristic “check-mark” or “fish hook” shape is always there in one if it is there in the
other for any given production function. The same applies to the average product and average cost curves
(as well as their intersection with their respective marginal curves).When covering long-run cost, you
shouldn’t need to spend too much time on isocost lines, other than to show the equation for the definition
of cost and note the similarity to the budget constraint. The one point worth emphasizing here is that,
unlike the budget constraint in utility maximization, the isocost line is the objective function rather than the
constraint. Graphically you can explain how in the consumer’s problem it is the budget constraint that is
fixed, while the indifference curve can move; and in the firm’s problem, the production isoquant is fixed for
a given quantity, while the isocost curve moves. The comparison of the minimization of cost to the
maximization of utility can be continued throughout the discussion of the tangency rule (MRTS = w/r).

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 Chapter 7 Costs 111

The section on the shape of the long-run cost curves and the relationship between long- and short-run cost
is where you may need to slow down significantly. You may need to spend a good deal of time describing
how long-run cost curves are related to the different short-run curves and presenting a verbal and graphical
depiction of the envelope theorem. I make a set of correctly drawn graphs available online. That way,
students can take notes right on the handouts. The students should understand intuitively why the short-run
cost curve can never lie below the long-run cost curve. If this were possible, the firm would not be
minimizing costs in the long run.
This is a great place to make use of a computer-equipped classroom. By entering a cost function such as
C = 2/3q3 – 12q2 + 90q, which has ranges of increasing and decreasing returns, you can show the total,
average, and marginal cost curves for a typical cost function and discuss points of inflection, intersection,
and the relationship between the curves. If you decide to use this specific function, you will need to
compute values for C, AC, and MC through an output level of 16 to see the curve shapes well.

A discussion of the learning curve can help students understand why firms might overproduce in the
current period in order to reap lower costs next period. You can ask students why cumulative production
might lead to lower average costs and draw a parallel between the learning curve and technical change.

Section 7.5 introduces scope economies. The presentation in the text is brief and straightforward. You may
choose to introduce more of the technical material associated with scope economies, such as incremental
cost and stand-alone cost, but at the intermediate level, conceptual understanding is most important. You
might begin the discussion by asking the class if they can think of any single-product firms (they frequently
cannot). Ask them why this is so. Although they do not use the terminology of scope economies, the class
often gives responses that refer to these types of savings. Once you get through the basic terminology, you
can choose several large firms, such as Ford or GE, and ask the class for possible sources of scope
economies. The nuclear power plant application provides an opportunity to talk about the benefits of
economies of scope versus the costs of consolidation and increased market power.

„ Additional Applications
Economies of Scale and Scope in Teaching
Is it less expensive per head to teach more students—that is, are there scale economies in teaching? Nelson
and Hevert (1992) estimate a short-run cost function for departments at the University of Delaware, where
output is measured as the number of student credit hours.1
We expect short-run scale economies if the fixed costs of administration, physical plant, libraries, and
computer centers are large. If so, the average fixed costs are a major component of average total cost.
Nelson and Hevert (1992) do not find evidence of economies or diseconomies of scale if a department
increases quantity by increasing the number of classes (holding class size fixed). In contrast, they find
substantial economies of scale if output is increased by increasing class size.
What are the implications of these findings for marginal cost? In a lecture class, if enrollment is increased
by 50%, holding class size constant, the marginal cost falls by 7% for a lower-level undergraduate course,
22% for an upper-level undergraduate course, and 21% for a graduate course. If class size is increased by
50% and enrollment is held constant, the corresponding changes are 17%, 12%, and 5%. That is, increasing
either class size or enrollment lowers marginal cost.
Cohn, Rhine, and Santos (1989) studied economies of scope in teaching in schools across the country.2
They measure teaching output as the number of undergraduate and graduate full-time enrollments (that is,

1
Randy Nelson, and Kathleen T. Hevert, “Effect of Class Size on Economies of Scale and Marginal Costs in Higher Education,”
Applied Economics, 24(5), May 1992:473–82.

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112 Perloff • Microeconomics, Eighth Edition

they do not control for qualitative differences). They measure research output indirectly using funds raised
for sponsored research (presumably, if more funds are available, more good research is produced). At
public colleges and universities, they find virtually no scope economies (SC = –0.064) at average output
levels. For higher levels of output, however, they do find scope economies. At private schools, they find
economies of scope at average levels of output (SC = 0.179) and much higher levels of scope economies at
larger output levels. These results indicate that it is less expensive to produce large amounts of teaching
and research at the same institution as separate ones. Put differently, teaching and research are complementary.
The cost savings from scope are larger at larger institutions.

1. How might the results in these two studies change if quality of education were introduced as an
additional variable? How might this be accomplished?

2. What do you believe are possible sources of scope economies in education and research? Might they
be more prevalent in some disciplines than others?

Entrée Economics—The Cost of a Meal3

Recently, at an upscale New York restaurant, a patron was served a pork chop that cost the eatery about
$6.25, including the chop, spices, garnish, and assorted vegetables, and sauce. The price? $23.50. While a
nearly 400% markup may seem exorbitant, it is commonplace in the restaurant industry. Even worse is the
markup for salmon. Brian Buckley, director of management studies at Peter Kump’s New York Cooking
School, noted that while people believe salmon is an elegant dish, and while some even have visions
of Alaska when ordering, they are actually purchasing farm-raised fish that costs the restaurant about
$2.50 per pound. The resulting markup comes to about 900%. Markups vary substantially from food to
food even within the same restaurant. At the Sunset Grille in Nashville, demand restricts the restaurant’s
ability to mark up its best tenderloin, thus the fairly small markup of 200%. However, like many restaurants,
the Grille has a target markup of 300%. It makes up the difference on vegetables—both side dishes and
vegetarian entrées are marked up by as much as 500%.

Why do these markups seem so outrageous? Eating out as opposed to eating the same food at home
involves many other costs, such as labor, capital (including lease payments, which can be extraordinary in
popular downtown locations), and atmosphere. Nevertheless, some restaurants track costs of materials
down to the last pinch of spice. In addition, if all these markups make it seem like the restaurant business
is a no-lose proposition, think again. According to H.G. Parsa, a hospitality professor at Ohio State
University, nearly 60% of new restaurants close or change ownership within three years.

1. Do ingredients represent a variable cost for restaurants? (Can they be substituted with labor or
capital?)

2. If materials represent such a small fraction of total cost, then why would firms bother to look for
employees who are “heavy handed” with the side orders?

Daylight Saving Time4

Daylight Saving Time (DST) begins for most of the United States at 2 A.M. on the second Sunday of
March. Time reverts to standard time at 2 A.M. on the first Sunday of November.

2
Elchanan Cohn, Sherrie L. W. Rhine, and Maria C. Santos, “Institutions of Higher Education as Multi-product Firms: Economies
of Scale and Scope,” Review of Economics and Statistics, 71(2), May 1989:284–90.
3
Based on Eileen Daspin, “Entrée Economics,” Wall Street Journal, March 10, 2000, W1, W4.
4
Bob Aldrich, “Daylight Saving Time, Its History and Why We Use It,” www.energy.ca.gov, California Energy Commission,
website accessed on Mon, 25 Apr. 2005.

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 Chapter 7 Costs 113

Daylight Saving Time—for the United State and its territories—is not observed in Hawaii, American
Samoa, Guam, Puerto Rico, the Virgin Islands, the Eastern Time Zone portion of the state of Indiana, and
by most of Arizona (with the exception of the Navajo Indian Reservation in Arizona). California even
asked for federal “approval” to move to a “year-round” DST in 2001–2002 because of its energy crisis.
DST is also observed in about 70 countries.
One of the biggest reasons we change our clocks to DST is that it saves energy. Energy use and the demand
for electricity for lighting our homes is directly connected to when we go to bed and when we get up.
Bedtime for most of us is late evening through the year. When we go to bed, we turn off the lights and TV.
In the average home, 25% of all the electricity we use is for lighting and small appliances, such as TVs,
VCRs, and stereos. A good percentage of energy consumed by lighting and appliances occurs in the
evening, when families are home. By moving the clock ahead one hour, we can cut the amount of electricity
we consume each day.
Studies done in the 1970s by the U.S. Department of Transportation show that we trim the entire country’s
electricity usage by about 1% each day with DST. While the amounts of energy saved per household are
small, added up they can be very large.

1. How does DST change a typical household’s “production function” in terms of energy usage?

2. In addition to saving energy, can you think of other potential benefits of DST?

„ Discussion Questions
1. In the short run, are the following examples of fixed or variable costs?
a. A manufacturing firm builds a new plant
b. A doctor rents an office on a month-to-month basis
c. A firm hires an unskilled worker
d. A firm hires an engineer

2. When would you expect a production possibility curve to be a straight line, and when would you
expect that it would be bowed out away from the origin?

3. Does cost of production depend on demand for a product?

4. Give some examples of joint production where you would expect to see economies of scope, no
economies of scope, and diseconomies of scope. Explain why in each case.

5. Why might labor not be a variable input in a hospital setting (such as an operating room)?

6. In what industries might we see a learning curve where workers’ productivity increases with the
cumulative output?

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114 Perloff • Microeconomics, Eighth Edition

„ Additional Questions and Problems

1. Suppose a firm employs labor as its only variable input. All workers are paid $20 per day. Output
per day and variable cost are shown in Table 7.1 below. Complete the table, showing labor, average
variable cost, and marginal cost for the first eight units of output. Draw a graph showing average and
marginal cost.
Table 7.1

q VC L AVC MC

1 20
2 40
3 60
4 80
5 120
6 160
7 240
8 320

2. True or False, explain your answer. “I paid $25 for the materials to make these flower arrangements,
and sold them at the craft fair for $25, so I just broke even.”

3. Suppose a firm treats capital improvement projects as expenses rather than as investments (which are
amortized). How might this affect the firm’s input usage decisions?
4. Suppose a firm’s average cost curve is described by the equation AC = 2q2 – 16q + 90. At what output
level does the marginal cost curve cross the average cost curve?
5. Explain the relationship between the shape of the marginal cost curve and the marginal product of
labor curve.
6. Suppose the cost of producing milkshakes is C = 0.333Q3 – 3Q2 + 15Q + 50. What is the equation for
marginal cost? At what point is marginal cost minimized?
7. Use a graph to show the marginal cost of attendance for a movie theater (not including the cost of
snacks, just attendance).
8. If input prices are w = 4, and r = 1, and q = 4K 0.5L0.5, what is the least-cost input combination required
to produce 40 units of output? Suppose instead that capital was fixed at 16 units. What would be the
implications for labor usage and total cost?
9. If input prices are w = 3, and r = 2, and q = 10KL, what is the least cost input combination required to
produce 60 units of output? How would input usage change if output is increased to 240 units? Sketch
the solutions on a graph.

10. In Question 8, suppose the government, in an effort to increase employment, offers firms in this
industry a $1 subsidy per unit of labor. How would this affect input usage (assume q = 60)? How is
this likely to affect employment in the capital goods (K) industry?

11. Two firms currently produce the goods q1 and q2 separately. Their cost functions are C(q1) = 25 + q1,
and C(q2) = 35 + 2q2. By merging, they can produce the two goods jointly with costs described by the
function C(q1, q2) = 45 + q1 + q2. Are there scope economies in this case that would justify the merger?

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 Chapter 7 C
Costs 115

12. Suppose
S the production
p funnction is Q = a min(K, L), where a is a positive consstant, the pricee of
capital
c good is
i $10 per uniit, and labor cost
c is $10 perr worker hourr. What is thee optimal com mbination
of
o capital and
d labor?

13. In
I Question 12, suppose thhe production function is Q = ac min(K, L), where a iis a positive cconstant
and
a c > 1. Thee price of cap
pital good is $10
$ per unit, aand labor costt is $10 per w
worker hour. WWhat is the
optimal
o comb
bination of cappital and labo
or? Does the pproduction fuunction have aan increasing,, constant,
or
o diminishing return to scale?

„ Answers
s to Addittional Que
estions a
and Probllems
1. See
S Table 7.2
2 and Figure 7.1.
7
Table
T 7.2

q VC L AVC
A MC
C
1 20 1 20
2 20
2 40 2 20
2 20
3 60 3 20
2 20
4 80 4 20
2 20
5 120 6 24
2 40
6 160 8 26.67
2 40
7 240 12 34.29 80
8 320 16 40
4 80

Figure
F 7.1

2. The
T statementt is false becaause the indiv vidual has failled to accountt for the oppoortunity cost oof his or
her
h time. Unleess the activitty of craft maaking producees utility as w well (which forr many, it doees), this
person
p has losst the value off his or her waage times the hhours requiredd to make thee flower arranggements.

3. By
B expensing g all costs of capital
c improv
vements in thhe current periiod, the firm w will be biasedd toward
increases
i in laabor rather th
han capital. Caapital improvvements will oonly be made when their coost is less
than
t the valuee of the increaase in output in a single peeriod, which iis rarely the case. For this rreason,
firms
f must bee careful to recognize the difference
d betwween expendditures that onnly increase ouutput in
the
t current peeriod, and investments in capital goods tthat will increease output ovver several peeriods.

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1116 Perloff • Microeconomicss, Eighth Edition
n

44. To find thhis point, recaall that the maarginal cost cu

urve crosses tthe average coost curve at thhe minimum
point of th
he average cost curve. To find
f the minim mum, take the derivative off AC, and set itt equal to zeroo.
dAC/dq = 4q − 16 = 0
q* = 4

C = AC when output is fourr units.

Thus, MC

55. MC and MPM L are invertted images off one another.. For a typicall production ffunction, withh fixed input
prices, maarginal produ
uct rises at firsst, then falls as
a diminishingg returns set iin. The margiinal cost curvve
falls while marginal prroduct is risin
ng because additional unitss of labor, purrchased at a fiixed price,
produce increasing quaantities of outtput. When marginal
m produuct begins to fall, marginall cost rises
because more
m and morre units of labor are requireed to producee an addition uunit of outputt.

66. The equattion for marginal cost is Q2 – 6Q + 15. To

T find the mminimum, youu could either take the
derivativee dMC/dQ = 2Q
2 – 6 and seet it equal to zero,
z or constrruct a table. IIn either case,, you should
discover that
t the margiinal cost is minimized
m wheen Q = 3.

utput level Q* represents caapacity.

77. See Figurre 7.2. The ou

Figure 7.2

88. As shown n in Equation 7B.7, minimiizing cost req quires that MR RTS = w/r. Beecause MRTSS = MPL /MPK,
set the rattio of marginaal products eq
qual to the rattio of input prrices, then subbstitute into thhe output
constraintt.
K /L = 4/1
40 = 4(4 L )0.5 L0.5 = 8 L
L* = 5
K * = 20
C = 4(5) + 1(20) = 40

If capital is fixed at 16
6 units, least-ccost productio
on is not poss ible. Instead, labor must be increased too
6.25 unitss. Total cost in
ncreases from m $40 to $41.

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n Education, Inc.
 Chapter 7 C
Costs 117

9. Solve
S as in Prroblem 6. L* = 2, K* = 3. Iff output is inccreased but innput prices rem
main the samee with a
Cobb-Dougla
C he input ratio does not channge. L* = 4, K* = 6. See Figgure 7.3.
as function, th

Figure
F 7.3

10. The
T effective wage rate forr the firm is reeduced to $2 pper unit. Re-soolving with thhe new lower rrate yields
K /L = 2/2
K=L
60 = 10( L ) L
L* = 2.444
K * = 2.444

Although
A the lower rate increases emplo mployment is likely to fall in the
oyment in thiis industry, em
capital
c industry because feewer capital goods are dem
manded with ssubsidized waage rates.

11. Using
U the equuation for scop
pe economiess given in Secction 7.5 of thhe chapter, scope economiees exist if
SC
S > 0. In this case, scope economies do exist as the following exxpression is grreater than zeero for all
values
v of both
h outputs.
SC = [25 + q1 + 35 + q2 – (45 + q1 + q2)]/455 + q1 + q2

12. The
T optimal combination
c of
o is one unit of capital goood to one worrker hour, as the productioon function
is
i a Leontief production
p fu
unction.

13. With
W differen nt price for cap
pital and labo
or, the optimaal combinationn is still one uunit of capitall good to
one
o worker ho our, as the Leeontief producction functionn’s input commbination is innvariant to chaange in
input
i price. The
T production n function hass a constant rreturn to scalee; the differennce between thhis
production
p an
nd the one in Question
Q 12 is
i that the connstant a has been raised to the power off c, but that
does
d not chan
nge its return to
t scale.

„ Answers
s to Textb
book Que
estions
1.1 t return to Asia are halff or completelly empty; therefore, the coost of having m
The ships that more
merchandiise in them is almost zero. Hence, it is leess expensivee to ship winee to Asia.

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118 Perloff • Microeconomics, Eighth Edition

1.2 The opportunity cost of a resource is the value of the best alternative use of that resource. In this
instance, the opportunity cost of attending the Hives concert is the net value of hearing Colbert.
Because the value of hearing Colbert is $100 but it only costs $40 for admission to his talk, the net
opportunity cost of attending the Hives concert is $60.
1.3 If the plane cannot be resold, its purchase price is a sunk cost, which is unaffected by the number
of times the plane is flown. Consequently, the average cost per flight falls with the number of
flights, but the total cost of owning and operating the plane rises because of extra consumption of
gasoline and maintenance. Thus, the more frequently someone has a reason to fly, the more likely
that flying one’s own plane costs less per flight than a ticket on a commercial airline. However, by
making extra (“unnecessary”) trips, Mr. Agassi raises his total cost of owning and operating the
airplane.
1.4 The opportunity cost of a resource is the value of the next best alternative use of that resource.
Thus, the opportunity cost of the pipe is $10 because that is the amount that it could otherwise be
sold for. A sunk cost is a past expenditure that cannot be recovered. The pipe’s sunk cost is $9
because this the original cost of the pipe, but this amount cannot be recovered.
1.5 If the dozer can be rented, it becomes a variable cost rather than a fixed cost.
1.6 The true cost of the hamburger is now $8. The explicit cost is $3, and the opportunity cost is $5.
2.1 a. The incremental cost is the marginal cost to a corporation of an additional flight. Some of
these marginal costs are the costs of fuel, flight attendants (if they are paid for each flight),
landing and taking off fees, etc.
b. The marginal opportunity cost of an executive’s flight is the price the company could have
earned from leasing the jet to someone else.
2.2 C = VC + F; AC = AVC + AF = VC/q + F/q. By going to one supermarket, a consumer can lower
the fixed cost F, thus also lowering the average cost, AC.
2.3 Because the tax is a lump sum rather than a per-unit tax, variable and marginal costs are not
affected. The only columns where changes occur are F, C, AFC, and AC. See table below.
Q F C AFC AC
0 78 78
1 78 103 78 103
2 78 124 39 62
3 78 144 26 48
4 78 160 19.5 40
5 78 178 15.6 35.6
6 78 198 13 33
7 78 219 11.14 31.28
8 78 246 9.75 30.75
9 78 276 8.67 30.66
10 78 308 7.8 30.8
11 78 350 7.09 31.82
12 78 399 6.5 33.25

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 Chapter 7 C
Costs 119

2.4
TC = 900 + 5q,
AFC = 9000/q,
AVC = 5 ,
ATC = 900/qq + 5,
MC = 5..
a.
a The graaphs are produ
uced in the au
udio-PowerPooint presentattion.
b.
b Note th
hat ATC becommes smaller as
a the producttion increasess, so there is aan advantage to having
only on
ne big music publisher.
p Thiis is because tthe fixed costt is spread ovver a larger prooduction,
althoug
gh the MC is constant
c and equal
e to 5.
c.
c Revenuue – publishinng cost = 300 × 15 – (900 + 5 × 300) = 44,500 – 2,4000 = 2,100. Thee
publish
her is willing to
t pay up to 2,100
2 pfenniggs to the compposer.

2.5 Let
L q equal th he number of offices cleaneed per hour. T Then C = 2q ((15 minutes oof labor is reqquired per
office).
o Variable cost is alsso 2q becausee there are no fixed costs. A
Average variaable cost and marginal
cost
c are $2. See the follow wing figure.

2.6
a.. AFC = 10//q.
MC = 10.
AVC = 10.
AC = 10/q + 10.

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1220 Perloff • Microeconomicss, Eighth Edition
n

b. AFC = 10/q.
MC = 2q.
AVC = q.
AC = 10/q
1 +q

c. AFC = 10/q.
3 2.
MC = 10 + 8q + 3q
AVC = 10 + 4q + q2.
AC = 10/q + 10 + 4q + q2.

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n Education, Inc.
 Chapter 7 Costs 121

2.7 Assume that Gail can only work in 1 hour increments. C = q, MC = AVC = AC = 1 for q less than or
equal to 80 per day. C = 80 + 1.5 (q − 80) = 1.5q − 40, MC = 1.5, AVC = AC = 1.5 − 40/q for all q
greater than 80 per day. See the following figures.

2.8 a. Variable cost is

VC(q) = 10q – bq2 + q3.

Average variable cost is

AVC(q) = 10 – bq + q2.

For this to be positive,

10 – bq + q2 > 0

10 + q2 > bq

b < 10/q + q,
b. The average cost curve is U-shaped. AC is minimized at dAC/dq = −Fq−2 − b + 2q = 0.
c. MC crosses AC when the functions are equal. MC = AC where 10 − 2bq + 3q2 = F/q + 10 − bq + q2.
MC = AVC where 10 − 2bq + 3q2 = 10 − bq + q2, or where q = b/2.
d. AVC is minimized where dAVC/dq = 0.
dAVC/dq = – b + 2q = 0
or b = 2q
MC = AVC
where
10 − 2bq + 3q2 = 10 − bq + q2.
Substituting 2q for b on both sides yields
10 − q2 = 10 − q2

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122 Perloff • Microeconomics, Eighth Edition

2.9 a. You must set dAC/dq = 0 for each firm. The minimum point of AC1 is at q = 2. At plant 2, the
minimum point is at q = 1.

b. The cost is minimized where

MC1(q1) = MC2(q2).
Solve the system of equations:
q1 = q2 = 4
MC1(q1) = MC2(q2) → 10 − 8q1 + 3q12 = 10 − 4 q2 + 3q22 .
Solving the equations,
q1 = 8/3 and q2 = 4/3.
2.10 The total cost of building a 1-cubic-foot crate is $6. It costs four times as much to build an 8-
cubic-foot crate, $24. In general, as the height of a cube increases, the total cost of building it rises
with the square of the height, but the volume increases with the cube of the height. Thus the cost
per unit of volume falls.
2.11 Let K be fixed in the short run.
First, use the production function to derive variable cost, where K is fixed at K. Solving for L as a
function of output (and capital, which is fixed):
q
L0.28 =
10 K 0.64
3.57
⎛ q ⎞
L =⎜ 0.64 ⎟
.
⎝ 10 K ⎠
If the only variable input is labor and the wage is w, then variable cost as a function of w and L is
VC = wL. Variable cost therefore equals
3.57
⎛ q ⎞
VC = w ⎜ 0.64 ⎟
⎝ 10 K ⎠
3.57
⎛ q ⎞
VC = 10 ⎜ 0.64 ⎟
.
⎝ 10 K ⎠
Average variable cost as a function of output, AVC, is variable cost, VC, divided by q:
3.57
⎛ q ⎞
AVC = 10 ⎜ 0.64 ⎟
/q
⎝ 10 K ⎠
3.57
⎛ 1 ⎞
AVC = 10 ⎜ 0.64 ⎟
(q)2.57 .
⎝ 10 K ⎠
To obtain marginal cost as a function of output, MC, differentiate variable cost, VC, with respect
to output:
3.57
⎛ 1 ⎞
MC = 35.7 ⎜ 0.64 ⎟
(q)2.57 .
⎝ 10 K ⎠

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 Chapter 7 Costs 123

2.12 Because the tax is unrelated to how much output is produced, the marginal cost and average
variable cost are unaffected. The annual fee has the effect of increasing fixed cost, which shifts the
average cost curve upward.

2.13 A variable cost (VC) is a cost that changes as the quantity of output changes. For example, if
output is 550, then VC = 37.71.
A firm’s cost is the sum of a firm’s variable cost (VC) and fixed cost (F):
C = VC + F
C = 37.71 + 600 = 637.71.
A firm’s marginal cost (MC) is the amount by which a firm’s cost changes if the firm produces
one more unit of output. The marginal cost is
ΔVC
MC =
Δq
MC = 0.3685q–0.33
MC = 0.05.
The average fixed cost (AFC) is the fixed cost divided by the units of output produced: 600/550 =
1.09. Average variable cost (AVC) or variable cost per unit of output is the variable cost divided
by the units of output produced: 37.71/550 = 0.07.
Similarly, if output increases to 600, then VC = 39.97, C = 639.97, MC = 0.04, AFC = 1.00, and
AVC = 0.07.

3.1 An isocost line shows all the combinations of inputs that require the same total expenditure or
w
cost. The slope of an isocost line is − . When w = 10 and r = 10, this slope is –1.0. When the
r
wage doubles, it becomes w = 20 and the slope of the isocost line becomes –2.0. That is, when the
wage doubles, the isocost line becomes steeper (and its slope increases in absolute value).

3.2 You produce your output, exam points, using as inputs the time spent on Question 1, t1, and the
time spent on Question 2, t2. If you have diminishing marginal returns to extra time on each
problem, your isoquants have the usual shapes: They curve away from the origin. You face a
constraint that you may spend no more than 60 minutes on the two questions: 60 = t1 + t2 . The
slope of the 60-minute isocost curve is –1: For every extra minute you spend on Question 1, you
have one less minute to spend on Question 2.
To maximize your test score, given that you can spend no more than 60 minutes on the exam, you
want to pick the highest isoquant that is tangent to your 60-minute isocost curve. At the tangency,
the slope of your isocost curve, –1, equals the slope of your isoquant, –MP1/MP2. That is, your
score on the exam is maximized when MP1 = MP2, where the last minute spent on Question 1
would increase your score by as much as spending it on Question 2 would. Therefore, you have
allocated your time on the exam wisely if you are indifferent as to which question to work on
during the last minute of the exam.

3.3 According to Equation 7.7, if the firm were minimizing its cost, the extra output it gets from the
last dollar spent on labor, MPL /w = 200
50
= 0.25, should equal the extra output it derives from the
last dollar spent on capital, MPK /r = 1000
200
= 0.2. Thus, the firm is not minimizing its costs. It would

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124 Perloff • Microeconomics, Eighth Edition

do better if it used relatively less capital and more labor, from which it gets more extra output
from the last dollar spent.
3.4 The tangency rules states that the firm chooses the input bundle where the relevant isoquant is
tangent to an isocost line to produce a given level of output at the lowest cost. The slope of a
Cobb-Douglas isoquant is the marginal rate of technical substitution (MRTS):
K
MRTS= − .
L
w
We know that cost is minimized if the MRTS equals the slope of the isocost, − :
r
K w
− =− .
L r
Rearranging this expression, we find that at the cost-minimizing bundle,
w
K= L
r
10
K= L
10
K = L.
If w = 20 and r = 10, then
20
K= L
10
K = 2L.
3.5 For this Cobb-Douglas function, MRTS = (K/L).
The optimum combination of K and L for the United States is found by solving the following
system of equation:
(K/L) = (10/10) and 100 = K0.5L0.5 → K* = L* = 100.
Thus
TC = $2000.
The optimum combination of K and L for Mexico is found by solving the following system of
equation:
(K/L) = (5/10) and 100 = K0.5L0.5 → K* = 70.7, L* = 141.4.
Thus
TC = $1414.2.
3.6 The firm chooses its optimal labor/capital ratio using Equation 7.7: MPL/w = MPK/r. That is,
0.5q/(wL) = 0.5q/(rK), or L/K = r/w. Thus, in the United States where w = r = 10, the optimal L/K
= 1, or L = K. Making use of L = K, the U.S. plant produces where q = 100 = L0.5K0.5 = K 0.5K 0.5 =
K. Therefore, K = 100 = L. The cost is C = wL = rK = (10 × 100) = (10 × 100) = 2000. At its Asian
plant, the optimal input ratio is L*/K* = r*/w* = 11/(10/1.1) = 1.21. That is, L* = 1.21K*, so
therefore, K* = 100/1.1 and L* = 110. The cost is C* = [(10/1.1) × 110]  [11 × (100/1.1)] = 2000.
That is, the firm will use a different factor ratio in Asia, but the cost will be the same. If the firm
could not substitute toward the less expensive input, its cost in Asia would be C** = [(10/1.1) ×
100] = [11 × 100] = 2009.09.

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 Chapter 7 C
Costs 125

3.7 From the information given and assu uming that theere are no ecoonomies of sccale in shippinng
baseballs, it appears thaat balls are prooduced usingg a constant reeturn to scale,, fixed-proporrtion
productionn function. Th he correspondding cost funcction is C(q) = (w + s + m)qq, where w is the wage
for the perriod it takes to
o stitch one baall, s is the coost of shippingg one ball, annd m is the priice of all
material to
o produce a baall. Because thet cost of all inputs other than labor annd transportatiion are the
same every ywhere, the cost differencee between Geeorgia and Coosta Rica depeends on w + s in both
locations. As
A firms choo ose to producce in Costa Riica, the extra shipping costt must be lesss than the
labor savinngs in Costa Rica.
R
3.8 The price of
o labor (w) is now 25% ch heaper. Assumming that the price of capiital (r) does not change
and remainns the same, the
t isocost facced by produccers becomess less steep (––w/r before thhe subsidy
as compareed to –0.75w//r after the su
ubsidy). Assumming a strictlyy convex techhnology, at thhe
optimum, the
t producer will use less of both workeers and capitaal than beforee for the samee output.
However, since labor iss now cheaperr relative to c apital (relativvely cheaper) the firm will now
employ rellatively more labor than caapital.
3.9 See the folllowing figuree. Because the two flavorinngs are perfecct substitutes,, we can draw
w a linear
isoquant. Assuming
A thee alcohol-baseed flavoring pproduces moree flavor per oounce than thee
nonalcoholic flavoring (we can use less of it) we ddraw our isoqquant with a | MRTS| >1. Iff the cost
of each flaavoring is equ
ual, the isocosst curve has a slope of –1, aand the produucer will buy only the
alcohol-baased flavoringg. After the taxx, the alcoholl-based flavorring will be so much moree
expensive that the new isocost curvee’s slope will likely have ann absolute vaalue greater thhan the
| MRTS|, causing the pro oducer to buyy only nonalc ohol flavorinng.

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018 Pearson Educcation, Inc.
1226 Perloff • Microeconomicss, Eighth Edition
n

3..10 This iss a fixed-prop

portion producction function
n, where every
ry table tenniss set uses twoo paddles (P)
and onne net (N), thaat is, Q = Min
n{P, 2N}. Thee expansion ppath is P = 2N
N. The changee in relative
prices of paddles an n change thee expansion ppath. See the ffollowing figuure.
nd nets does not

3..11 Let’s denote

d boxes of cereal by B (on the verttical axis) andd cereal produuced by C (onn the
horizontal axis). Th
hen the expansion path is th
he ray B = C, which passess through origgin. The cost
functio
on is
C (Q) = (P
PB + PC) Q.
3..12 Let w beb the cost off a unit of L and r be the coost of a unit oof K. Because the two inpuuts are perfectt
substittutes in the prroduction proccess, the firm
m uses only thee less expensiive of the twoo inputs.
Thereffore, the long--run cost funcction is C(q) = wq if w ≤ r;; otherwise, itt is C(q) = rqq.
3..13 If theree are constantt returns to sccale, the long--run expansioon path will be a straight line, indicatingg
a constant capital–labor ratio. Ass the firm exp pands under cconstant returnns, proportionnal increases
in both
h inputs yield the same pro words, they inccrease by
oportional inccrease in outpuut. In other w
equal amounts.
a For example, thee doubling of both inputs ddoubles outpuut.
3..14
a. Seee the followin
ng figure.
b. MPL/MPK = (1/2
2q/L)/(1/2q/K
K) = K/L = w/rr = ¼; thus K = L/4.
c. c = wL + rK = L + 4L/4 = 2L
L;
q = 10(LK)1/2 = 10[(1/4)L2]1/2= 5L = > L = q/5;
c = 2L = 2q/5 = 0.4q

(T
There is no qu
uestion 3.15)

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n Education, Inc.
 Chapter 7 Costs 127

3.16 Referring to Figure 7.9 in the chapter, a restriction on the size of a store might restrict output to the
left of the minimum point in the long-run cost curve, q2. (This is likely because stores in other
countries are larger than in the United Kingdom.) Thus, in the long-run the stores will not be able
to take advantage of economies of scale and economies of scope to lower average fixed costs and
total average costs of carrying a large amount of any single item, or a wider range of items.
4.1 When the long-run curve is sloping downward, the short-run curve touches the long-run curve to
the left of its minimum. When the long-run curve is upward sloping, the short-run curve touches
the long-run curve to the right of its minimum. At the minimum of the long-run curve, the short-
run curve touches the long-run curve at its minimum.
4.2 The average cost of producing one unit is α (regardless of the value of β). If β ≥ 0, the average cost
does not change with volume. If learning by doing increases with volume, β < 0, so the average
cost falls with volume. Here the average cost falls exponentially (a smooth curve that
asymptotically approaches the quantity axis).

4.3 Learning by doing is where the productive skills and knowledge that workers and managers gain
from experience lowers the average cost of production. Workers who are given a new task perform
it slowly the first few times they try, but their speed increases with practice. Managers may learn
how to organize production more efficiently, discover which workers to assign to which tasks, and
determine where more inventories are needed and where they can be reduced. Engineers may
optimize product designs by experimenting with various production methods. For these reasons,
the average cost of production tends to fall over time, and the effect is particularly strong with new
products.

4.4 A firm’s learning curve, which shows the relationship between average cost and cumulative output
(the sum of its output since the firm started producing), is
AC = a + bN r ,
where AC is its average cost; N is its cumulative output; and a, b, and r are constants.
If r = 0, then AC = a + b. If r = 0, then average cost does not fall with cumulative output (average
cost remains constant with cumulative output), so there is no learning by doing.
If average cost decreases with output, then r < 0, which is a characteristic of learning by doing. If
N = 0, then
AC = a.
Therefore, a represents the average cost of production before any learning by doing.

5.1 If her production possibilities frontier is PPF1, she can pick 6 pints of mushrooms and 4 pints of
strawberries in one day. If there were no scope economies, she could only pick 2.67 pints of
mushrooms per day if she picks 4 pints of strawberries. Assuming she works eight-hour days,
scope economies produce the equivalent of an additional 3.33 hours of work, valued at $16.65.

5.2 Economies of scope is the situation in which it is less expensive to produce goods jointly than
separately. Diseconomies of scope is the situation in which it is less expensive to produce goods
separately than jointly. A measure of the degree to which there are economies of scope is
C (q1 ,0) + C (0, q2 ) − C (q1 , q2 )
SC = ,
C (q1 , q2 )
where C(q1,0) is the cost of producing q1 units of the first good by itself, C(0,q2) is the cost of
producing q2 units of the second good by itself, and C(q1,q2) is the cost of producing both goods

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1228 Perloff • Microeconomicss, Eighth Edition
n

together. If the costt of producingg the two goods separately is the same aas producing tthem togetherr,
then SC is 0. If it is cheaper to prroduce the go
oods jointly, SSC is positivee. If SC is neggative, there
are disseconomies off scope, and the
t two goodss should be prroduced separrately.
xample, if a firrm produces fuel and heatiing oil in fixeed proportionss, then it doess not producee
For ex
heatingg fuel withou
ut producing gasoline
g (or, alternatively,
a it does not coost any extra tto also
producce gasoline when
w producinng heating fueel). Similarly, the firm doess not producee gasoline
withouut producing heating
h fuel (or it does nott cost any extrra to also prodduce heating fuel when
produccing gasoline)). Therefore, the
t firm’s meeasure of econnomies of scoope is positivee and equal too
1 becaause C(q1,0) = C(0,q2) = C((q1,q2).

6..1 If –w/rr is the same as a the slope of

o the line seggment connectting the wafeer-handling steepper and
stepper technologiees, then the iso ocost will lie on that line s egment, and tthe firm will be indifferentt
betweeen using eitheer of the two technologies
t (or any combbination of thee two). In all the isocost
lines in
n the figure, the
t cost of cappital is the sam
me, and the wwage varies. T The wage such that the firmm
is indiffferent lies beetween the rellatively high wage
w on the C 2 isocost linne and the low
wer wage on
the C 3 isocost line.

6..2 a. Seee panel (a) off the followin

ng figure.
b. Seee panel (a) off the figure. The
T firm choo
oses labor-maachine technollogy.
c. Seee panel (b) off the figure.

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n Education, Inc.