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  1. Chapter 7: The Costs of Production Formatted: Font: Times New Roman, 13 pt Formatted: Space Before: 1.2 line, CHAPTER 7 After: 1.2 line, Line spacing: 1.5 lines THE COST OF PRODUCTION QUESTIONS FOR REVIEW 1. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost? Explicit costs are actual outlays. They include all costs that involve a monetary transaction. An implicit cost is an economic cost that does not necessarily involve a monetary transaction, but still involves the use of resources. When a firm pays an annual retainer of $10,000, there is a monetary transaction. The accountant trades his or her time in return for money. Therefore, an annual retainer is an explicit cost. 2. The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work? Opportunity costs are measured by comparing the use of a resource with its alternative uses. The opportunity cost of doing accounting work is the time not spent in other ways, i.e., time such as running a small business or participating in leisure activity. The economic, or opportunity, cost of doing accounting work is measured by computing the monetary amount that the owner’s time would be worth in its next best use. 3. Please explain whether the following statements are true or false. 84
  2. Chapter 7: The Costs of Production a. If the owner of a business pays himself no salary, then the accounting cost is zero, but the economic cost is positive. Deleted: This is True. Since there is no monetary transaction, there is no accounting, or explicit, cost. However, since the owner of the business could be employed elsewhere, there is an economic cost. The economic cost is positive, Deleted: and reflecting the opportunity cost of the owner’s time. The economic cost is Deleted: s the value of the next best alternative, or the amount that the owner would earn if he took the next best job. Formatted: Bullets and Numbering b. A firm that has positive accounting profit does not necessarily have positive economic profit. True. Accounting profit considers only the explicit, monetary costs. Since Deleted: considered there may be some opportunity costs that were not fully realized as explicit monetary costs, it is possible that when the opportunity costs are added in, economic profit will become negative. This indicates that the firm’s Deleted: Subtracting extra costs could make the profit negative, in economic terms. resources are not being put to their best use. Formatted: Bullets and Numbering c. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the worker’s services is zero. False. The opportunity cost measures the value of the worker’s time, which Deleted: not is unlikely to be zero. Though the worker was temporarily unemployed, the Deleted: possesses certain worker still possesses skills, which have a value and make the opportunity cost of hiring the worker greater than zero. In addition, since opportunity cost is the equivalent of the worker’s next best option, it is possible that the worker might have been able to get a better job that utilizes his skills more efficiently. Alternatively, the worker could have been doing unpaid work, 85
  3. Chapter 7: The Costs of Production such as care of a child or elderly person at home, which would have had a value to those receiving the service. Formatted: Bullets and Numbering 4. 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, Deleted: (the variable input) what can you say about the marginal product of labor ? Deleted: rising The marginal product of labor must be increasing. The marginal cost of production measures the extra cost of producing one more unit of output. If this cost is diminishing, then it must be taking fewer units of labor to produce the extra unit of output, since the extra cost refers to the extra cost of the labor. If fewer units of labor are required to produce a unit of output, then the marginal product (extra output produced by an extra unit of labor) must be increasing. Note also, that MC=w/MPL, so that if MC is diminishing then MPL must be increasing for any given w. 5. Suppose a chair manufacturer finds that the marginal rate of technical substitution of capital for labor in his production process is substantially greater than the ratio of the rental rate on machinery to the wage rate for assembly-line labor. How should he alter his use of capital and labor to minimize the cost of production? To minimize cost, the manufacturer should use a combination of capital and labor so the rate at which he can trade capital for labor in his production process is the same as the rate at which he can trade capital for labor in external markets. The manufacturer would be better off if he increased his use of capital and decreased his use of labor, decreasing the marginal rate of technical substitution, MRTS. He should continue this substitution until his 86
  4. Chapter 7: The Costs of Production MRTS equals the ratio of the rental rate to the wage rate. The MRTS in this case is equal to MPK/MPL. As the manufacturer uses more K and less L, the MPK will diminish and the MPL will increase, both of which will decrease the MRTS until it is equal to the ratio of the input prices (rental rate on capital divided by wage rate). 6. Why are isocost lines straight lines? The isocost line represents all possible combinations of labor and capital that may be purchased for a given total cost. The slope of the isocost line is the ratio of the input prices of labor and capital. If input prices are fixed, then the ratio of these prices is clearly fixed and the isocost line is straight. Only when the ratio or factor prices change as the quantities of inputs change is the isocost line not straight. 7. Assume the marginal cost of production is increasing. Can you determine whether the average variable cost is increasing or decreasing? Explain. Marginal cost can be increasing while average variable cost is either increasing or decreasing. If marginal cost is less (greater) than average variable cost, then each additional unit is adding less (more) to total cost than previous units added to the total cost, which implies that the AVC declines (increases). Therefore, we need to know whether marginal cost is greater than average variable cost to determine whether the AVC is increasing or decreasing. 8. Assume the marginal cost of production is greater than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing? Explain. 87
  5. Chapter 7: The Costs of Production If the average variable cost is increasing (decreasing), then the last unit produced is adding more (less) to total variable cost than the previous units did, on average. Therefore, marginal cost is above (below) average variable cost. In fact, the point where marginal cost exceeds average variable cost is also the point where average variable cost starts to rise. 9. 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? Total cost is equal to fixed plus variable cost. Average total cost is equal to average fixed plus average variable cost. When graphed, the difference between the U-shaped total cost and average variable cost curves is the average fixed cost curve. Thus, falling average variable cost and average fixed cost sum up to a falling average total cost curve. Since average fixed cost continues to fall as more output is produced, average total cost will continue to fall even after average variable cost has reached its minimum because the drop in average fixed cost exceeds the increase in the average variable cost. Eventually, the fall in average fixed cost becomes small enough so that the rise in average variable cost causes average total cost to begin to rise. Formatted: Bullets and Numbering 10. If a firm enjoys economies of scale up to a certain output level, and then cost increases proportionately with output, what can you say about the shape of the long- run average cost curve? When the firm experiences increasing returns to scale, its long-run average cost curve is downward sloping. When the firm experiences constant returns to scale, its long-run average cost curve is horizontal. If the firm experiences 88
  6. Chapter 7: The Costs of Production increasing returns to scale, then constant returns to scale, its long-run average cost curve falls, then becomes horizontal. 11. How does a change in the price of one input change the firm’s long-run expansion path? The expansion path describes the combination of inputs that the firm chooses to minimize cost for every output level. This combination depends on the ratio of input prices: if the price of one input changes, the price ratio also changes. For example, if the price of an input increases, less of the input can be purchased for the same total cost, and the intercept of the isocost line on that input’s axis moves closer to the origin. Also, the slope of the isocost line, the price ratio, changes. As the price ratio changes, the firm substitutes away from the now more expensive input toward the cheaper input. Thus, the expansion path bends toward the axis of the now cheaper input. 12. Distinguish between economies of scale and economies of scope. Why can one be present without the other? Economies of scale refer to the production of one good and occur when proportionate increases in all inputs lead to a more-than-proportionate increase in output. Economies of scope refer to the production of more than one good and occur when joint output is less costly than the sum of the costs of producing each good or service separately. There is no direct relationship between increasing returns to scale and economies of scope, so production can exhibit one without the other. See Exercise (14) for a case with constant product-specific returns to scale and multiproduct economies of scope. Formatted: Bullets and Numbering 13. Is the firm’s expansion path always a straight line? 89
  7. Chapter 7: The Costs of Production No. If the long run expansion path is a straight line this means that the firm always uses capital and labor in the same proportion. If the capital labor ratio changes as output is increased then the expansion path is not a straight line. Deleted: Also, in the short run the expansion path may be horizontal if capital is fixed. Formatted: Bullets and Numbering 14. What is the difference between economies of scale and returns to scale? Deleted: what happens to Deleted: when outpu Economies of scale measures the relationship between cost and output, i.e., when output is doubled, does cost double, less then double, or more than Deleted: t is doubled. double. Returns to scale measures what happens to output when all inputs are doubled. economies of scope. 90
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