Week 3

Question 1

Assumptions about a firms production behaviors

Answer 1

1) The firm produces a single good.
2) The firm has already chosen which good to produce.
3) For whatever quantity it makes, the firm’s goal is to minimize the cost of producing it.
4) The firm only uses two inputs to make its product: capital and labor.
5) In the short run, a firm can choose to employ as much or as little labor as it wants but cannot change its capital. In the long run, a firm can freely choose both.
6) The more inputs the firm uses, the more output it makes.
7) A firm’s production exhibits diminishing marginal returns to labor and capital.
8) The firm can buy as many capital or labor inputs as it wants at fixed prices.
9) If there is a well functioning capital market, the firm does not have a budget constraint.

Question 2

Marginal product

Answer 2

Holding all else fixed, how much more output will be produced for an additional unit of input.

MP_L = delta Q / delta L

Question 3

Diminishing marginal product/returns.

Answer 3

As a firm hires additional units of a given input the marginal product of that input falls.

Question 4

Average product

Answer 4

The quantity of output produced per unit of input. Measured at a point.

AP_L = Q/L

Question 5

Isoquant

Answer 5

A curve representing all combinations of inputs that allow a firm to make a particular quantity of output.

Look similar to indifference curves but are cardinal instead of ordinal.

Question 6

Marginal rate of technical substitution

Answer 6

MRTS_xy - The rate at which the firm can trade input X for input Y holding output constant.

Delta Q = MP_L * delta L + MP_K * delta K = 0

MRTS at any point on an isoquant tells you the relative marginal products of capital and labor at that point.

MRTS is the ratio of the marginal productivities of labor and capital. ( dK/dL = -MP_L/MP_K )

Question 7

The firms objective goal is to maximize its economic profits. Describe economic profits and how to maximize them.

Answer 7

The difference between Total Revenues (TR) and Total Economic Costs (TC).

Pi = TR - TC.

Economic costs include opportunity costs. Or the value of the best forgone alternative.

To maximize profits, take the derivative with respect to Q and set to zero ( this is the highest point on the curve of economic profits ).

Which is the same as MR = MC.

Question 8

What does MR = MC represent?

Answer 8

Where profits are maximized.

Question 9

Given a demand curve, how do you draw total revenue?

Answer 9

Total revenue would be the area of the rectangle with a base of Q and height of P.

TR = P * Q

Question 10

What is Marginal Revenue? How do you find MR?

Answer 10

• changed in total revenue from selling an additional unit by lowering the price.
• MR is found by taking the derivative of TR with respect to Q,
• MR = (dTR/dQ)
• = P (1 + 1/e) where e is elasticity.

Question 11

When MR < 0, elasticity is…

Answer 11

Elasticity is > -1.

Question 12

When MR > 0, elasticity is…

Answer 12

Elasticity is e < -1

Question 13

When MR = 0, elasticity is…

Answer 13

Elasticity is e = -1 and TR is maximized.

Question 14

Where are profits maximized?

Where is total revenue maximized?

Answer 14

Profits are maximized when MR = MC.

Total revenue is maximized when MR = 0.

If operating in a no cost environment, they are the same.

Question 15

When demand is linear, what’s the marginal revenue?

Answer 15

Where demand is P = a - bQ,
MR = a - 2bQ.

This means MR has the same intercept and twice the slope.

Question 16

What is the short run and how does it differ from the long run?

Answer 16

The short run is typically a shorter time period and is considered one in which capital (K) is held constant but labor (L) can fluctuate.

In the long run, both of those variables can be changed. In fact all inputs can be varied.

Question 17

Define marginal product of an input and average product of an input.

Answer 17

The increase in the output that arises from employing an additional unit of input holding all else constant.

MP_L = delta Q/delta L

Average product of an input is the ratio of output to the amount of input employed.

AP_L = Q/L

Question 18

Define specialization and crowding.

Answer 18

Specialization - adding more workers will have a strong positive impact on quantity produced. Production is split into tasks and workers can specialize. The contribution of an additional employee is increasing, though at a decreasing rate.

Crowding is the opposite - since K is fixed in the short term, once you have a certain number of employees, the contribution of an additional employee will start to go down (MP_L falls at an increasing rate). At some point, adding another employee will actually destroy value (MP_L negative)

Question 19

Why is MP_L (marginal product of Labor) rising at a decreasing rate?

Answer 19

Specialization. It’s typically a lower level of input.

Question 20

Why is MP_L (Marginal Product of Labor) falling at an increasing rate?

Answer 20

Because of crowding. Happens where there are too much labor given the capital.

Question 21

Opportunity cost is

Answer 21

The value of the best forgone alternative.

Question 22

What are avoidable costs?

Answer 22

Avoidable costs are an expenditure that once made can be recovered. You can recoup costs by reselling equipment.

Question 23

What are sunk costs? Can you give an example?

Answer 23

Sunk costs are an expenditure that once made cannot be recovered.

An example of sunk costs is a non-transferable license, ticket, etc.

Question 24

Three things to know about sunk costs.

Answer 24

1) Should not be taken into account when making decisions.
2) Should not be considered when calculating costs.
3) Matter only before sinking them!

Question 25

What are the 7 cost curves?

Answer 25

Total costs

Fixed costs

Variable costs

Marginal costs

Average fixed costs

Average variable costs

Average total costs

Question 26

What’s the relationship between TC, FC, and VC?

Answer 26

TC = FC + VC

Question 27

Define marginal costs

Answer 27

Marginal costs is the additional cost of increasing Q by a very small number.

MC = dTC/dQ = dFC/dQ + dVC/dQ = dVC/dQ

This also means that VC is the area under the MC curve!

Question 28

What is the relationship between the marginal and the average and how does that translate to marginal costs and average costs?

Answer 28

If the marginal is below the average, the average is falling.

If the marginal is above the average, the average is rising.

The marginal must intersect the average at exactly the minimum point.

This leads to be that the marginal cost curve intersects the ATC and AVC at the minimum of those cost curves.

Question 29

Isocost lines are like budget constraints except…

Answer 29

There is no constraint! There are many of these lines. The only represent given a certain expenditure, how we could allocate costs between labor and capital.

Question 30

What is the optimal input choice?

Answer 30

The firm will choose its inputs in an optimal way by setting the MRTS equal to the input ratio.

MP_L/MP_K = w/r

Question 31

What is the expansion path?

Answer 31

The expansion path highlights the optimal use of capital and labor for each possible quantity.

This is the long run total cost curve.

Question 32

What is the relationship between the LR ATC and the SR ATC?

Answer 32

The LR ATC will be the lower envelope of the SR ATC holding K fixed at some level.

Question 33

What is the economies of scale and what does it look like graphed?

Answer 33

Economies of scale is where ATC falls as output increases.

This is the downward sloping section of the ATC curve.

Question 34

What is the diseconomies of scale and what does it look like graphed?

Answer 34

The diseconomies of scale is where ATC increases as output increases.

This is the upward sloping part of the ATC curve.

Question 35

What is the constant returns of scale and what does it look like on the graph?

Answer 35

Constant returns of scale is where ATC stays the same as the output increases.

This is the “flat” part, or the bottom of the ATC curve. Comes after economies of scale and before diseconomies of scale.

Question 36

What is the minimum efficient scale?

Answer 36

The minimum efficient scale measures the smallest level of output at which LR ATC is minimized.

Determines how many firms can fit in the market.