Practice Questions and Answers from Lesson III-1: Inputs and Costs. Practice Questions and Answers from Lesson III-1: Inputs and Costs

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1 Practice Questions and Answers from Lesson III-1: Inputs and Costs The following questions practice these skills: Identify total cost, variable cost, fixed cost, marginal cost, and average total cost. Graph marginal cost and average total cost and average variable cost. Identify fixed inputs and variable inputs. Compute the marginal product of labor. Compute marginal cost, variable cost, average fixed cost, average variable cost, and average total cost. Identify the implications of the principle of diminishing returns. Distinguish between the short run and the long run by identifying whether some inputs are fixed. Identify increasing returns to scale, and decreasing returns to scale Question: Changes in the prices of key commodities can have a significant impact on a company s bottom line. According to a September 27, 2007, article in the Wall Street Journal, Now, with oil, gas and electricity prices soaring, companies are beginning to realize that saving energy can translate into dramatically lower cogs. Another Wall Street Journal article, dated September 9, 2007, states, Higher grain prices are taking an increasing financial toll. Energy Is an input into virtually all types of production; corn is an input into the production of beef, chicken, high-fructose corn syrup, and ethanol (the gasoline substitute fuel). a. Explain how the cost of energy can be both a fixed cost and a variable cost for a company. b. Suppose energy is a fixed cost and energy prices rise. What happens to the company s average total cost curve? What happens to its marginal cost curve? Illustrate your answer with a diagram. c. Explain why the cost of corn is a variable cost but not a fixed cost for an ethanol producer. d. When the cost of corn goes up, what happens to the average total cost curve of an ethanol producer? What happens to its marginal cost curve? Illustrate your answer with a diagram. a. Energy required to keep a company operating regardless of how much output is produced represents a fixed cost, such as the energy costs of operating office buildings, factories, and stores that must be maintained Independent of the amount of output produced. In addition, energy is a variable cost because produci ng more output almost always requires using more energy. b. When fixed costs increase, so will average total costs The average total cost curve will shift upward. In panel (a) of the accompanying diagram, this is illustrated by the movement of the average total cost curve from its initial position, ATC1, to its new position, ATC. The marginal cost curve is not affected if the variable costs do not change. So the marginal cost curve remains at its initial position, MC. c. Since corn is an input into the production of ethanol, producing a larger quantity of ethanol requires a larger quantity of corn, making corn a variable cost.

2 d. When variable costs increase, so do average total costs and marginal costs. Both curves will shift upward. In panel (b) of the accompanying diagram, the movement of the average total cost curve is illustrated by the shift from its initial position, ATC 1 to its new position, ATC 2. The movement of the marginal cost curve is illustrated by the shift from its initial position, MC 1, to its new position, MC 2. Question: Marty s Frozen Yogurt is a small shop that sells cups of frozen yogurt in a university town. Marty owns three frozen-yogurt machines. His other inputs are refrigerators, frozen-yogurt mix, cups, sprinkle toppings, and, of course, workers. He estimates that his daily production function when he varies the number of workers employed (and at the same time, of course, yogurt mix, cups, and so on) is as shown in the accompanying table. Quantity of labor (workers) Quantity of frozen yogurt (cups) a. What are the fixed inputs and variable inputs in the production of cups of frozen yogurt? b. Draw the total product curve. Put the quantity of labor on the horizontal axis and the quantity of frozen yogurt on the vertical axis. c. What is the marginal product of the first worker? The second worker? The third worker? Why does marginal product decline as the number of workers increases? a. The fixed inputs are those whose quantities do not change as the quantity of output changes: frozen-yogurt machines, refrigerators, and the shop. The variable inputs are those whose quantities do change as the quantity of output changes: frozen-yogurt mix, cups, sprinkle toppings, and workers. b. The following graph illustrates the total product curve. c. The marginal product, MPL, of the first worker is 110 cups. The MPL of the second worker is 90 cups. The MPL of the third worker is 70 cups. The MPL of labor declines as more and more workers are added due to the principle of diminishing returns to labor. Since the number of frozen-yogurt machines is fixed, as workers are added there are fewer and fewer machines for each worker to work with, making each additional worker less and less productive. Question: The production function for Marty s Frozen Yogurt is given in Problem 2. Marty pays each

3 of his workers \$80 per day. The cost of his other variable inputs is \$0.50 per cup of yogurt. His fixed cost is \$100 per day. a. What is Marty s variable cost and total cost when he produces 110 cups of yogurt? 200 cups? Calculate variable and total cost for every level of output given in Problem 2. b. Draw Marty s variable cost curve. On the same diagram, draw his total cost curve. c. What is the marginal cost per cup for the first 110 cups of yogurt? For the next 90 cups? Calculate the marginal cost for all remaining levels of output. a. Marty s variable cost, VC, is his wage cost (\$80 per worker per day) and his other input costs (\$0.50 per cup). His total cost, TC, is the sum of the variable cost and his fixed cost of \$100 per day. The answers are given in the following table: Quantity of labor Quantity of frozen VC TC MC of cup (workers) yogurt (cups) 0 0 \$0 \$ x80+110x0.5 = \$135 \$235 ( )/110 = \$ x80+200x0.5 = \$260 \$360 ( )/90 = \$ x80+270x0.5 = \$375 \$475 ( )/70 = \$ x80+300x0.5 = \$470 \$570 ( )/30 = \$ x80+320x0.5 = \$560 \$660 ( )/20 = \$ x80+330x0.5 = \$645 \$745 ( )/10 = \$8.50 b. The following graph shows the variable cost and total cost curves. c. Marginal cost, MC, per cup of frozen yogurt is shown in the table in part a; it is the change in total cost divided by the change in quantity of output. Question: The production function for Marty s Frozen Yogurt is given in Problem 2 above. The costs are given in Problem 3 above. a. For each of the given levels of output, calculate the average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) per cup of frozen yogurt. b. On one diagram, draw the AFC, AVC, and ATC curves. c. What principle explains why the AFC declines as output increases? What principle explains why the

4 AVC increases as output increases? Explain your answers. d. How many cups of frozen yogurt are produced when average total cost is minimized? a. The average fixed cost, average variable cost, and average total cost per cup of yogurt are given in the following table. (Numbers are rounded.) Quantity of frozen yogurt (cups) 0 ATC of cup VC \$0 TC \$100 AFC of cup AVC of cup \$0.91 \$1.23 \$ b. The following graph shows the AFC, AVC, and ATC curves: c. AFC declines as output increases due to the spreading effect. The fixed cost is spread over more and more units of output as output increases. AVC increases as output increases due to the diminishing returns effect. Due to diminishing returns to labor, it costs more to produce each additional unit of output. d. Average total cost is minimized when 270 cups of yogurt are produced. At lower quantities of output, the fall attributable to the spreading effect dominates changes in average total cost. At higher quantities of output, the rise attributable to the diminishing returns effect dominates changes in average total cost. Question: The following table shows a car manufacturer s total cost of producing cars: Quantity of cars TC 0 \$500,000 1 \$540,000 2 \$560,000 3 \$570,000 4 \$590,000 5 \$620,000 6 \$660,000 7 \$720,000 8 \$800,000 9 \$920, \$1,100,000 a. What is this manufacturer s fixed cost? b. For each level of output, calculate the variable cost (VC). For each level of output except zero output,

5 calculate the average variable cost (AVC), average total cost (ATC), and average fixed cost (AFC). What is the minimum-cost output? c. For each level of output, calculate this manufacturer s marginal cost (MC). d. On one diagram, draw the manufacturer s AVC, ATC, and MC curves. a. The manufacturer s fixed cost is \$500,000. Even when no output is produced, the manufacturer has a cost of \$500,000. b. The following table shows VC, calculated as TC FC; AVC, calculated as VC/Q; ATC, calculated as TC/Q; and AFC, calculated as FC/Q. (Numbers are rounded.) The minimum-cost output is 8 cars, the level at which ATC is minimized. c. The table also shows MC, the additional cost per additional car produced. Notice that MC is below ATC for levels of output less than the minimum-cost output and above ATC for levels of output greater than the minimum-cost output. Quantity of cars TC MC VC AVC ATC AFC 0 \$500,000 1 \$540,000 \$40,000 \$40,000 \$40,000 \$540,000 \$500,000 2 \$560,000 \$20,000 \$60,000 \$30,000 \$280,000 \$250,000 3 \$570,000 \$10,000 \$70,000 \$23,333 \$190,000 \$166,667 4 \$590,000 \$20,000 \$90,000 \$22,500 \$147,500 \$125,000 5 \$620,000 \$30,000 \$120,000 \$24,000 \$124,000 \$100,000 6 \$660,000 \$40,000 \$160,000 \$26,667 \$110,000 \$83,333 7 \$720,000 \$60,000 \$220,000 \$31,429 \$102,857 \$71,429 8 \$800,000 \$80,000 \$300,000 \$37,500 \$100,000 \$62,500 9 \$920,000 \$120,000 \$420,000 \$46,667 \$102,222 \$55, \$1,100,000 \$180,000 \$600,000 \$60,000 \$110,000 \$50,000 d. The AVC, ATC, and MC curves are shown in the following graph: Question: Labor costs represent a large percentage of total costs for many firms. According to a September 1, 2007, Wall Street Journal article, U.S. labor costs were up 0.9% during the preceding three months and 0.8% over the three months preceding those. a. When labor costs increase, what happens to average total cost and marginal cost? Consider a case in which labor costs are only variable costs and a case in which they are both variable and fixed costs. An increase in labor productivity means each worker can produce more output. Recent data on productivity show that labor productivity in the U.S. nonfarm business sector grew 2% for each of the years 2005, 2006, and Annual growth in labor productivity averaged 1.5% from the mid-1970s to mid-1990s, 2.6% in the past decade, and 4% for a couple of years in the early 2000s.

6 b. When productivity growth is positive, what happens to the total product curve and the marginal product of labor curve? Illustrate your answer with a diagram. c. When productivity growth is positive, what happens to the marginal cost curve and the average total cost curve? Illustrate your answer with a diagram. d. If labor costs are rising over time on average, why would a company want to adopt equipment and methods that increase labor productivity? a. When labor costs are a variable cost but not a fixed cost, an increase in labor costs leads to an increase in both average total cost and marginal cost. When labor costs are a variable cost and a fixed cost, the result is the same: both the average total cost and the marginal cost increase. b. When productivity growth is positive, any given quantity of labor can produce more output, causing the total product curve to shift upward. Since each unit of labor can produce more output, the marginal product of labor will increase and the marginal product of labor curve will shift upward. In panel (a) of the accompanying diagram, the upward shift of the total product curve is illustrated by the movement from its initial position, TP 1, to its new position, TP 2. In panel (b), the upward shift of the marginal product of labor curve is illustrated by the movement from its initial position, MPL 1, to its new position, MPL 2. c. When productivity growth is positive, the marginal cost curve and the average total cost curve will both shift downward, assuming labor costs have not changed. In the accompanying diagram, the movement of the average total cost curve is illustrated by the shift from its initial position, ATC 1, to its new position, ATC 2. The movement of the marginal cost curve is illustrated by the shift from its initial position, MC 1, to its new position, MC 2. d. Rising labor costs will shift the average total cost and marginal cost curves upward. Productivity growth will counteract this, shifting the average total cost and marginal cost curves downward. Question: Magnificent Blooms is a florist specializing in floral arrangements for weddings, graduations, and other events. Magnificent Blooms has a fixed cost associated with space and equipment of \$100 per day. Each worker is paid \$50 per day. The daily production function for Magnificent Blooms is shown in the accompanying table.

7 Quantity of labor (workers) Quantity of floral arrangements a. Calculate the marginal product of each worker. What principle explains why the marginal product per worker declines as the number of workers employed increases? b. Calculate the marginal cost of each level of output. What principle explains why the marginal cost per floral arrangement increases as the number of arrangements increases? a. MPL, shown in the following table for the five workers, is the change in output resulting from the employment of one additional worker per day. MPL falls as the quantity of labor increases due to the principle of diminishing returns. Quantity of labor (workers) Quantity of floral arrangements Marginal product of labor Variable Cost VC = #workers x wage rate Total Cost TC = FC+VC Marginal cost of floral arrangement = 50/ = 50/ = 50/ = 50/ = 50/1 b. The marginal cost, MC, of floral arrangements is the change in total cost divided by the change in output. So, to compute MC, we first need to compute total cost, TC = FC + VC, as shown in the table. MC per floral arrangement is also shown in the table. MC increases as output increases due again to the principle of diminishing returns. Question: You have the information shown in the accompanying table about a firm s costs. Complete the missing data. Quantity TC MC ATC AVC 0 \$ ? \$20?? 2? \$10?? 3? \$16?? 4? \$20?? 5? \$24?? The accompanying table contains the complete cost data. The total cost of producing one unit of output is the total cost of producing zero units of output plus the marginal cost of increasing output from zero to one, and so forth. The average total cost is just the total cost divided by output. Since the total cost of producing zero output is \$20, the variable cost is TC \$20. The average variable cost is then just the variable cost divided by output.

10 Quantity of trucks VC 40 orders FC 20 orders 60 orders 2 \$6,000 \$2,000 \$5,000 \$12, ,000 1,800 3,800 10, ,000 1,200 3,600 8,400 a. For each level of fixed cost, calculate Don s total cost for producing 20, 40, and 60 orders per week. b. If Don is producing 20 orders per week, how many trucks should he purchase and what will his average total cost be? Answer the same questions for 40 and 60 orders per week. a. The answers are given in the accompanying table. Quantity of trucks 20 orders 40 orders 60 orders 2 \$8,000 \$11,000 \$18, ,800 10,800 17, ,200 11,600 16,400 b. Don should choose the number of trucks that minimizes average total cost for each level of output. Given this, Don should buy two trucks if he is producing 20 orders per week. His average total cost per order will be \$400. He should buy three trucks if he is producing 40 orders per week. His average total cost per order will then be \$270. He should buy four trucks if he is producing 60 orders per week. His average total cost per order will then be \$273. Question: Consider Don s concrete-mixing business described in the previous question. Assume that Don purchased 3 trucks, expecting to produce 40 orders per week. a. Suppose that, in the short run, business declines to 20 orders per week. What is Don s average total cost per order in the short run? What will his average total cost per order in the short run be if his business booms to 60 orders per week? b. What is Don s long-run average total cost for 20 orders per week? Explain why his short-run average total cost of producing 20 orders per week when the number of trucks is fixed at 3 is greater than his long-run average total cost of producing 20 orders per week. c. Draw Don s long-run average total cost curve. Draw his short-run average total cost curve if he owns 3 trucks. a. In the short run, producing 20 orders per week with 3 trucks, Don s average total cost per order will be (\$7,000 + \$1,800)/20 = \$440. If he instead produces 60 orders per week with three trucks, his average total cost per order will be \$297. b. The long-run average total cost of producing 20 orders per week is \$400 because Don would choose the number of trucks (2 trucks) that minimizes the total cost of producing 20 orders. His short-run average total cost is greater than the long-run minimum because, using 3 trucks, the level of the fixed input is greater than he needs to optimally produce 20 orders per week. c. The following graph shows Don s LRATC and ATC.

11 Question: Wolfsburg Wagon (WW) is a small automaker. The accompanying table shows WW s long-run average total cost. Quantity of cars 1 2 LRATC of car \$30,000 20, , , , , , ,000 a. For which levels of output does WW experience increasing returns to scale? b. For which levels of output does WW experience decreasing returns to scale? c. For which levels of output does WW experience constant returns to scale? a. WW s long-run average total cost is decreasing over the range of output between 1and 4 cars. So over that range, WW experiences increasing returns to scale. b. WW s long-run average total cost is increasing over the range of output between 6 and 8 cars. So over that range, WW experiences decreasing returns to scale. c. WW s long-run average total cost is constant over the range of output between 4 and 6 cars. So over that range, WW experiences constant returns to scale.

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