Chapter 7: The Cost of Production

Suppose that labor is the only variable input to the production process. If the marginal cost of production is diminishing as more units of output are produced, what can you say about the marginal product of labor?

is increasing.

Jose rent office space for $20000 per year. He uses the office to fill out tax returns for 1000 clients per year. If the office rent increases to $25000 per year, the marginal cost of filling out tax returns will

not change. (Fixed costs such as rent does not affect marginal cost)

How does a change in the price of one input change the firm's long-run expansion path? If the price of an input changes then the

slope of the isocost lines will change, and the firm will substitute towards the relatively cheaper input, pivoting the expansion path towards the axis of the relatively cheaper input.

Is the firm's expansion path always a straight line? A firm's expansion path

will NOT be a straight line, if the ratio of inputs used changes with output.

Please explain whether the following statements are true or false. #1 If the owner of a business pays himself no salary, then the accounting costs is zero but the economic cost is positive. #2 A firm has positive accounting profit does not necessarily have positive economic profit. #3 If a firm hires a currently unemployed worker, the opportunity cost of utilizing the worker's service is zero

#1 TRUE because economic costs include opportunity costs such as the value of the business owner's time. #2 TRUE because economic costs will be greater than accounting costs if implicit costs exists #3 FALSE because the worker's time spent in leisure (or unpaid household work) has value.

The cost of flying a passenger plane from point A to point B is $50,000. The airline flies this route for times per day. The first and last flights are filled to capacity with 300 people. The second and third flights are only half-full. Find the average cost per passenger for each flight. 1) The average cost per passenger for rush-hour flights (first and last) is 2) The average cost per passenger for off peak flights (middle two flights) is 3) Suppose the airline hires you as marketing consultant and wants to know which type of customer it should try to attract - the off peak customers or the rush-hour customers. What advice would you offer?

1) 166.66 50000/300=166.6667 2) 333.33 50000/150=333.3333 3) off-peak (to lower average cost)

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. 1) Fixed cost of production is: 2) If the company produces 80 units of goods, the average variable cost is 3) The marginal cost of production would be 4) The average fixed cost would be 5) Suppose the company borrows money and expands its factory. It fixed costs rise by $30 but its variable costs fall by $3. The cost of interest (i) also enters in the equation. Each 1-point increase in the interest rate raises cost by $5. Write the new cost equation

1) 200 2) 55 | (55*80)=4,400 & 4,400/80=55 = VC 3) 55 | VC = MC 4) 2.50| (200/80) 5) TC = 230 + 20q + 5i (200+30)+(55-35)q+5i

Joe quits his computer programming job, where he was earning a salary of $65.000 per year, to start his own computer software business in a building that he owns and war previously renting out for $27.000 per year. In his first year of business he has the following expenses: Salary paid to himself: 47,500 Rent : 0 Other expenses 15,000 1) The accounting costs of Joe's business is: 2) The economic costs of Joe's business is:

1) 62500 (47500+0+15000=62500) 2) 107000 (15000+65000+27000=107000) Other expenses + Forgone salary+Forgone Rent

A firm has fixed production cost of $5000 and a constant marginal cost of production of $300 per unit produced. 1) What is the the firm's total cost function? 2) The firm's average total cost (ATC) of production is? 3) If the firm wanted to minimize the average total cost, would it chose to be very large or very small? Explain.

1) TC = 5000+(300q) 2) ATC = (5000+(300q))/q 3) very large because the average total cost of production falls with output.

Suppose a firm must pay an annual tax, which is a fixed sum, independent of whether it produces any output. 1) How does this tax affect the firm's fixed, marginal, and average costs? 1) With a lump-sum tax, a) the fixed cost of production will b) the marginal cost will c) the average cost will 2) Now suppose the firm is charged a tax that is proportional to the number of items it produces. Again, how does this tax affects: a) the fixed cost will b) the marginal cost will c) the average cost will

1) lump-sum tax a) fixed cost of will: INCREASE b) marginal cost will: REMAIN UNCHANGED c) average cost will: INCREASE 2) Proportional tax a) the fixed cost will: REMAIN UNCHANGED b) the marginal cost will: INCREASE c) the average cost will: INCREASE

Distinguish between economies of scale and economies of scope. Why can one be present without the other? 1) Economies of scale occurs when: 2) There is no direct relationship between economies of scale and economies of scope because.

1) output can be doubled for than a doubling of costs; however, economies of scope occur when joint output is less costly than the sum of the costs of producing multiple outputs separately. 2) economies of scale pertain to one output and economies of scope pertain to more than one output.

Fred quits his job with a big accounting firm, where he was earning 85000 a year, to start his own accounting business in a building he owns. He previously rented the building to someone who paid him rent of $2400 per year, but now Fred collects no rent because he is using the building himself. Fred pays himself a salary of of 32000 and has other expenses of 31000. The yearly economic cost for Fred's accounting business is

140000 (85000+24000+31000=140000) Forgone salary+Forgone Rent + Other expenses

Assume that the marginal cost of production is LESS than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing?

Average variable cost is FALLING because the cost of the last unit produced is adding LESS to the total variable cost than the previous unit did on average.

Assume that the marginal cost of production is GREATER than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing?

Average variable cost is rising because the cost of the last unit produced is adding more to the total variable cost than the previous unit did on average.

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

Economies of scale define how cost changes with output, and returns to scale define how output changes with input usage.

A firm produces two product, A and Y. The product transformation curve for these two products is Y=40-0.X^1, where x is the number of units of product X and Y is the number of units of product Y produced on one day. The firm can produce no units of X and 40 units of Y or 20 units of X and no units of Y or various combinations of X and Y between these two extremes. We can conclude from the product transformation curve that this firm faces

Economies of scope.

A firm pays its accountant an annual retainer of $25000. Is this an economic cost?

Is an economic cost because it is an explicit cost.

Assume the marginal cost (MC) of production is increasing. Can you determine whether the average variable cost is increasing or decreasing? Explain?

Regardless of whether MC is increasing, AVC could be increasing or decreasing depending on whather MC is greater than or less than AVC

The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work?

The monetary amount that her time would have been worth in its next best use.

A recent issue of Business week reported the following: During the recent auto sales slump, GM, Ford, and Chrysler decided it was cheaper to sell cars to rental companies at a loss than to lay off workers. That's because closing and reopening plants is expensive, partly because the auto makers' current union contracts obligate them to pay many workers even if they're not working. When the article discusses selling cars "at a loss," is it referring to accounting profit or economic profit? How will the two differ in this case? Explain briefly.

accounting profit, which includes the sunk cost of the workers and is therefore lower than economic profit.

A product transformation curve shows

all combinations of two different products that can be produced with a given set of inputs.

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? The average variable cost curve will achieve its minimum at a lower level of output than the average total cost curve because

average total cost equals average variable cost plus average fixed cost, and the average fixed curve continuous to fall as more output is produced.

If a firm enjoys economies of scale up to a certain output level, and cost then increases proportionally with output, what can you say about the shape of the long-run average cost curve? The long-run average cost curve...

decreases initially and then is horizontal.

Firm 1 produces product A only, and firm 2 product B only. Firm 3 produces the same amount of A as firm a AND the same amount of B as firm 2. All three firms use state of the art production techniques, but firm 3s total cost are less than the sum of the other two firm's total cost. We can conclude that there are

economies of scope in producing products A and B.