Econ by cWKDK9Ot

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```									Econ. 410
Spring 2008
Tauchen/Biglaiser
Practice Problems on Long Run Costs -- Answers

Unless otherwise mentioned, assume that a firm’s technology satisfies the usual assumptions.
Specifically, the marginal product for each input is positive and satisfies diminishing marginal returns.
Also, the production function satisfies diminishing marginal rate of technical substitution. As usual, w
denotes the price of a unit of labor and r denotes the price of a unit of capital.

1. The graph below shows the isoquants for output levels q=10, 20, 30, and 40 units of output with the
isoquants for higher outputs farther from the origin. The price of labor is \$2 and the price of capital is \$8.

a. Construct the isocost lines and identify the cost-minimizing input combinations for producing 10, 20,
30, and 40 units of output (approximately). What is the marginal rate of technical substitution between
labor and capital at each of the cost-minimizing input combinations?

Ans. The straight lines are the isocost lines. The cost minimizing input combination for each isoquant is
marked with a dot. The cost minimizing input combinations are:

10 units output        2L and .5 K
20 units output        4L and 1K
30 units output        6L and 1.5 K
40 units output        8L and 2 K
Units Capital/Day

8

6

4

2

0
0     2        4       6          8    10      12      14      16
Workers/Day

The marginal rate of technical substitution between labor and capital equals minus the slope of the
isoquant. At a cost-minimizing input combination, the slope of the isoquant equals the slope of the
isocost line. Thus, the marginal rate of technical substitution between labor and capital at a cost
minimizing input combination equals w/r which is .25 in this example.

b. What is the minimum cost at which the firm can produce 10 units, 20 units, 30 units, and 40 units of
output? Ans. There are two equivalent ways to determine the LR cost. First, we could compute the cost
of purchasing each of the cost minimizing bundles listed above. The LR costs for 10, 20, 30, and 40 units
are \$8, 16, 24, and 32 respectively. Equivalently, we compute the cost level associated with the isocost
line that is tangent to the isoquant. For example, the isoquant for 10 units is tangent to the isocost line
with a labor intercept of 4 and a capital intercept of 1, which is the isocost line for \$8.

c. What is the LRAC for producing 10, 20, 30, and 40 units of output? Ans. The LRAC for each of
these quantities is \$.80 .

d. The isoquant map is consistent with diminishing marginal returns to labor. Suppose, for example, that
the amount of capital is fixed at one unit.
Increasing output by 10 units from 10 to 20 units requires about 3 more units of labor (from 1 to 4 units).
Increasing output by 10 units from 20 to 30 units requires about 5 more units of labor.
Increasing output by 10 units from 30 to 40 units requires about 7 more units of labor.
Thus, as labor use increases, the amount of labor required to increase output by 10 units increases.
The same reasoning applies for capital fixed at some other value.

2. Suppose now that the firm’s capital is fixed at the optimal level of capital for producing 30 units of
output. The input prices are again w=\$2 and r=\$8. What is the short-run cost of producing 10, 20, 30,
and 40 units of output with the fixed capital stock?

Ans. The cost-minimizing input combination for producing 30 units of output is 6 labor and 1.5 capital.
We can read the isoquant graph to determine (approximately) the amount of capital required to produce
each quantity with the amount of capital fixed at 1 unit.
With 1.5 units of capital, 2/3 of a unit of labor is required to produce 10 units of output. The cost
of this input combination is \$13.33. The SR average total cost for producing 10 units of output is \$1.33
With 1.5 units of capital, 2 2/3 units of labor are required to produce 20 units of output. The cost
of this input combination is \$17.33. The SR average total cost for producing 20 units of output is \$.87
With 1.5 units of capital, 6 units of labor are required to produce 30 units of output. The cost of
this input combination is \$24. The SR average total cost is \$.80
With 1.5 units of capital, 10 2/3 units of labor are required to produce 40 units of output. The cost
of this input combination is \$33.33. The SR average total cost is \$.83

3 Graph the LRAC from question #1 and the short-run ATC for a firm that has the amount of capital that
is optimal for producing 20 units of output.
\$/unit output   \$1.50

SR ATC with optimal K for
producing 30 units

\$1.00

LRAC

\$0.50

\$0.00
0     10                20                30               40
output/day
4. The graph below shows the same isoquant map as for the previous problems. The isoquants are for
output levels q=10, 20, 30, and 40 units of output with the isoquants for higher outputs farther from the
origin. Construct the isocost line that allows you to identify the cost minimizing input combination for
producing 20 units of output with the input prices of w=\$2 and r=\$8. What is the cost associated with this
isocost line? Let’s refer to this cost as C2.

Now suppose that the price of labor increases to \$8. Construct the isocost line for the new input price and
for cost C2 . Is it possible to produce 20 units of output with any of the input combinations on this isocost
line? Does the cost or producing 20 units of output necessarily increase as the price of one input
increases (assuming that the firm uses both inputs)?

Ans. Initially the input prices are w=\$2 and r=\$8. The graph below shows the lowest isocost line for
which it is possible to produce 20 units with w=\$2 and r=\$8. This is the isocost line with a labor intercept
of 8 and a capital intercept of 2. It is the isocost line for \$16 at the initial input prices..

The price of labor then increases to w=\$8. The isocost line for \$16 with w=\$8 and r=\$8 has a labor
intercept of 2 and a capital intercept of 2. The firm cannot produce 20 units of output using any of the
input combinations on this line. Keep in mind that there is an entire family of isocost lines for the new
input prices. In order to produce 20 units of output at the new input prices, the firm must move to an
isocost line for a cost level greater than \$16.
Units Capital/Day

8

6
Isocost Line for Cost=\$16
w=\$2; r=\$8

4
Isocost Line for Cost=\$16
w=\$8; r=\$8

2

0
0   2   4       6        8        10        12        14        16

Workers/Day

5. In the previous problem, you used a specific isoquant map and numerical values for the input prices to
show that the cost of producing 20 units of output increases if the price of one of the inputs increases
(assuming that the firm uses both inputs). Use the same line of reasoning to show that the cost of
producing any output level increases if one of the input prices increases (assuming that the firm uses both
inputs).

Ans. We can use the same type graph to reason that an increase in one of the input prices necessarily
increases the cost of producing output Q even without using specific numerical values. (We are assuming
the case in which the firm uses positive amounts of both inputs.) The graph below shows the isoquant for
output Q. The graph also chows the lowest attainable isocost line at the initial inputs prices. The cost
level for this isocost is denoted c.

Now suppose that the price of labor increases. The price of capital remains constant. The new
isocost line for cost level c has the same vertical intercept as the initial isocost line for cost level c, but the
new isocost line is steeper. This isocost line is shown as the dotted isocost line on the graph. With the
new higher price of labor, none of the input combinations on the isocost line for cost level c (dotted line)
allows the firm to produce output Q. The firm must move to a higher isocost line in order to produce
output Q.
Units Capital/Day

Isocost Line for Cost=c
Lowest Isocost at which Q units can be produced
Initial input prices

Isocost Line for Cost=c
Higher price of labor

Isoquant for Q

Workers/Day

6. The graph below shows the same isoquant map as for problem #1.

a.       Show the expansion path for w=\$1 and r=\$8.
b.       Show the expansion path for w=\$4 and r=\$32.
c.       Show the expansion path for w=\$2 and r=\$1.
d.       Provide an intuitive explanation for the differences and similarities in the expansion paths for parts a.,
b., and c.

Ans. a. and b. The graph below shows the isoquant map with isoquants for output 10, 20, 30, and 40.
The isocost lines are the straight lines with slope = -1/8 for both a. and b. Although the slopes of the
isocost lines are the same for a. and b., the cost level associated with each of the isocost lines shown on
the graph differs for a. and b. For example, the straight line with a labor intercept of 16 and a capital
intercept of 2 is an isocost line for both a and b. The line is the isocost line for cost level \$16 for a., and
the isocost line for cost level \$64 for b.

The cost-minimizing input combinations for output 10, 20, 30, and 40 are marked with dots. If we had the
isoquants for more output levels (11, 12, 13,…..) we could construct the entire expansion line shown.
Units Capital/Day
12

10

8

6

4

2

0
0   2   4                                6       8       10       12      14      16
Workers/Day
c. The expansion path for w=\$2 and r=\$1 is shown below.

d. Since the isocost lines                                12
Units Capital/Day

for a. and b. are the same,
the expansion path for a.
and b. are the same. The                                  10
relative price of labor is
higher in part c. than for
parts a. and b. The bundles                               8
on the expansion path for
part c. involve relatively
more capital and less labor                               6
than those on the expansion
path for parts a. and b.
4

2

0
0       2       4   6    8        10   12     14     16
Workers/Day
7. A firm’s production function is Q=K1/3 L1/3 . The price of a unit of capital is r and of a unit of labor is
w.

a. Determine the cost-minimizing input combination for producing Q units of output.

The two conditions for the cost minimizing input combination (L,K) for producing output Q at input
prices w and r are that

(i)      it is possible to produce Q units of output with the input combination (L,K) or Q=F(L,K)

(ii)     the MRTS between labor and capital at the input combination (L,K) equals w/r. Since
the MRTS between labor and capital at the input combination (L,K) equals the ratio of the MP of labor to
the MP of capital at (L,K) the conditions can be written as MPL(L,K)/MPK(L,K)=w/r.

We need to compute both the MP of labor and of capital. To find the MP of labor, we take the
derivative of K1/3 L1/3 with respect to L. In taking the derivative with respect to L, we treat the term
involving capital as a constant. Thus the MP of labor is (1/3)*K1/3 L-2/3 . Similarly, the MP of capital is
(1/3)*K-2/3 L1/3 . The MRTS between labor and capital is

(1/3)*K1/3 L-2/3                   K1/3 L-2/3                    K
=                             =
(1/3)*K-2/3 L1/3                   K-2/3 L1/3                    L

For the production function given in this problem, the two conditions for identifying the cost-minimizing
input combination for producing Q units of output at input prices w and r can be written as
(i)     Q=K1/3 L1/3
(ii)    K/L=w/r

We need to use any correct algebraic steps in order to solve for K and L. Let’s begin by solving the
second equation for K to find K=wL/r. Then substitute this expression for K into the first equation to
obtain
Q= (w/r) 1/3 L1/3 L1/3 .

Combining the two L terms (and remembering that xb xa = xa+b ) ,

Q= (w/r) 1/3 L2/3 .

Now solve for L. The first step is that

L2/3 = Q/(w/r) 1/3
or
L2/3 = Q(r/w) 1/3

Raising both sides of the equality to the 3/2 power yields

L= Q3/2 (r/w) 1/2.

Since K= wL/r,
K= Q3/2 (w/r) 1/2.
b. Determine the firm’s long run cost function. Also determine the firm’s long run average and marginal
cost curves

The firm’s long run cost for producing output Q with input price w and r is

C(Q,w,r)= w * cost minimizing amount of L for producing output Q at input price w and r
+ r * cost minimizing amount of K for producing output Q at input price w and r.

Substitute the cost minimizing amount of labor and capital derived in part a. to obtain.

C(Q,w,r) = w * Q3/2 (r/w) 1/2 + r* Q3/2 (w/r) 1/2 ,

which equals 2 (wr) 1/2 Q3/2    .

To find the LRAC divide the cost by Q to obtain LRAC(Q,w,r)= 2 (wr) 1/2 Q1/2 . To find the
LRMC take the derivative of LR cost with respect to Q to obtain

LRMC(Q,w,r) = 3 (wr) 1/2 Q1/2 .

Notice that the LRAC is increasing with Q. And, the LRMC for any Q is a larger number than LRAC.
Or, in other words, the LRMC curve lies above the LRAC curve.

8. A firm selects its inputs to minimize the cost of producing its output. Recently, the firm increased
each of its inputs by 10 percent. As a result, its output increased from 100 units to 120 units. Indicate
whether each of the following statements is true, false, or uncertain. Explain your answer.

a. At q=100, there are increasing returns to scale.

Ans. True. The firm increased its inputs by 10 percent and output increased by 20 percent. The firm’s
production function exhibits increasing returns.

b. At q=100, the LRAC curve is downward sloping.

Ans. True. If the production function exhibits increasing returns, the LRAC is downward sloping.

c. At q=100, LRMC exceeds LRAC.

Ans. False. If the LRAC curve is downward sloping, then the LRMC curve lies below it.

9. A firm uses two inputs – capital and labor. When w=\$10 and r=\$10, the cost-minimizing input
combination for producing 100 units of output is 20 units of labor and 20 units of capital. When w=\$8
and r=\$10, the cost-minimizing bundle for 100 units of output is 28 units of labor and 19 units of capital.
Indicate whether each of the following statements is true, false, or uncertain. Explain your answer.

a. When w=\$10 and r=\$10, the LRAC for producing 100 units of output is \$4.

Ans. True. The cost minimizing input combination is 20 units of labor and 20 of capital. The cost of
purchasing this input combination is \$400. Thus the LRAC of producing 100 units is \$4.

b. The output expansion path is downward sloping.
Ans. Uncertain. We have insufficient information to determine the slope of the expansion path. We are
given information only about the cost-minimizing input combinations for producing 100. In order to
determine the slope of the expansion path, we would need information about the cost-minimizing input
combinations for several different output levels.

c. When w=\$5 and r=\$5, the LRAC for producing 100 units of output is \$2.

Ans. True. The slopes of the isocost lines for a. and c. are the same. Thus the cost-minimizing input
combination for w=\$5 and r=\$5 is the same as for w=\$10 and r=\$10. The cost-min. input combination is
therefore 20 labor and 20 capital. The cost of purchasing the input combination at w=\$5 and r=\$5 is
\$200. The LRAC for producing 100 units is \$2.

10. The practice problem web page provides a link to both this homework assignment and the
accompanying excel file that allows you to investigate the relationship between long-run and short-run
average cost curves. When you open the excel file, you will see the LRAC curve for a production
function of the form Q=Ka Lb .

a. When the two exponents (a and b) sum to one, the production function exhibits constant returns to
scale, and the LRAC curve is horizontal. If the sum of the two exponents is greater than one, the
production function exhibits increasing returns and the LRAC curve is downward sloping. Finally, if the
sum of the two exponents is less than one, the LRAC curve is upward sloping.

Try several other values of a and b for which a+b=1. For example, type in .5 in the yellow cell under “a”
and .5 in the yellow cell under “b”. Note that the LRAC curve remains horizontal. Then change the
values of a and b so that the sum is greater than one. Observe the new shape of the LRAC curve.

Comment: If the coefficients a and b sum to one, then the production function exhibits constant returns
to scale. The LRAC curve for a constant returns to scale production function is horizontal.

b. We can also use the excel graphs to investigate the cost disadvantage of capital being fixed in the
short-run. What is the minimum cost at which the firm can produce 5 units of output?

Ans. approx \$3.30

Suppose that the firm misestimated the amount it would be producing. For example, suppose that the
firm expected to be producing five units of output and acquired the optimal amount of capital for
producing five units of output. How much does it cost the firm to produce 1 unit of output in a plant with
the amount of capital optimal for producing 5 units of output?

Ans. approx. \$13

How much does it cost a firm to produce 8 units of output in a plant with the amount of capital optimal
for producing 5 units of output?

Ans. approx. \$6

c. Finally, we can use the graphs to investigate the effects of change in the input prices. Try changing
both of the input prices proportionality. For example, you might double both input prices. Do long run
costs increase proportionately? Provide an intuitive explanation for your answer. (If you change the
input prices too much, the long run average cost curves will be higher than can be shown on the graph.
If you want to investigate very high input prices, then you will need to change the scale on the vertical
axis.)

Ans. If both prices increase proportionately, the expansion path is unaffected. Increasing all input prices
proportionately leaves the cost-minimizing input combination for each output level unaffected. But the
cost of purchasing the input combination increases proportionately. So, if the input prices double, then
the LRAC doubles.

Also investigate the effect of changing only one of the input prices.

Ans. The LRAC curve shifts up.

11.

a. Any input combination on the isoquant is a cost minimizing input combination. The isoquants are
linear with slope = -1/3. Since w=\$10 and r=\$30, the slope of an isocost line is also -1/3. The isoquant
for producing 120 gadgets is identical to the isocost line for \$300.

b. The text seems to have asked the same question as in part a. So let’s assume that they intended to ask
us to identify the cost-minimizing input combination for producing 120 gadgets if it costs the firm \$30 per
hour for a worker and \$10 per hour to use a machine. With these input prices, the isocost lines have slope
3. The firm uses only capital. To produce 120 gadgets, it uses 10 units of capital.

Graph to accompany part a.                            Graph to accompany part b

The isoquant for output 120 is identical to the       The isoquant for output 120 is the line from 10 on
isocost line for \$300                                 the vertical to 30 on the horizontal axis. The isocost
line for cost \$100 is the straight line from 10 on the
vertical to 3.33 on the horizontal axis. The firm uses
only capital to produce 120 gadgets.

c. The production function is G=12K +4 L.
Answer to Question 7.18 To produce 10 units of output, the firm uses 10 units of labor and 10 units of
capital for any w or r. Thus, the demand curve of labor is vertical at L=10.

Answer to Question 7.20: The isoquants are linear with slope equal to -1/5.

If the iscost lines are steeper than the isoquants, then the firm uses only capital. If the isocost lines are
flatter, then the firm uses only labor. If the slopes are the same, then the firm is indifferent between using
labor and capital.

The slope of the isocost lines is –w/r. Thus if w/r>1/5, the firm uses only capital. In order to produce 80
units of output, the firm uses 8 units of capital. If w/r<1/5, the firm uses only labor. To produce 80 units
of output, the firm uses 40 units of labor.

In this problem, w=1. We reasoned above that if w/r>1/5, the firm uses only capital. For w=1, this
inequality implies that r<5. For r<5, the firm demand 8 units of capital. For r>5, the firm demands no
capital. At r=5, the firm uses between 0 and 8 units of capital.

#11 – Long Run and Short Run Costs

Question 6. a., b (2 pts.)

Question 11. (2 pts)

#12 – Short Run Costs

Question 3. a. (1 pt) b. (1 pt) c. (1 pt) d. (.5 pts) e. (.5 pts)

Question 6. (2 pts.)

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