WESS 2016 Intermediate Microeconomics

Problem set 1

Question 1
A cost minimizing firm’s production function is given by Q=LK . The price of labor services is
w and the price of capital services isr . Suppose you know that whenw=£ 4, andr =£ 2, the firm’s
total cost is £160. You are also told that when input prices change such that the wage rate of 8 times
the rental rate, the firm adjusts its input combination but leaves output unchanged. What would the
cost minimizing input combination be after the price change?

Using the tangency condition, obtain an expression for capital as a function of labor
K
=2→ K=2 L
L
The firm’s total cost function is such that

wL+rK =TC → 4 L+2 K=160

We have a system of two equations and two unknowns:

K=2 L (1)

4 L+ 2 K =160 (2)

Using (1) into (2), we get that L=20 , plugging back into (1), we get that K=40.

From the production function, we know that using this input combination the firm will be
producing Q=LK =20 × 40=800 units of output.

The wage rate changes so that it is now 8 times bigger than the rental rate, therefore we have
that: w=8 r .

Plugging this into the tangency condition gives us:

K 8r
= =8
L r
We also know that KL=800, giving us another system of two equation solving for: K=80 and
L=10 .

Question 2
2
Consider a production function of two inputs, labour and capital, given by Q=( √ L+ √ K ) . The
marginal products associated with this production function are as follows:
1 1
2 2
MP L =(L + K ) L−1 /3
1 1
MP K =( L 2 + K 2 ) K−1 /3
Assume also that w=2 andr =1.

Suppose the firm is required to produce Q units of output. Show how the cost minimising quantity
of labor depends on the quantity Q.

1. Show how the cost minimising quantity of capital depends on the quantity Q .

Again starting from the tangency condition we have

MP L w
=
MP K r
1 1 −1
(L + K )L
2 2 3
=
2
1 1 −1
1
(L +K ) K
2 2 3

K
=4
L
K=4 L
Using the production function, and plugging in the expression for capital:
1 1 2
Q=( L + ( 4 L ) )
2 2

1 2
Q= 3 L 2( )
Q=9 L
Q
L=
9
We know that K=4 L

4Q
K=
9
2. Find the equation for the firm’s long run total cost curve

Q 4Q 2Q
TC=w +r =
9 9 3

3. Find the equation for the firm’s long run average cost curve

2Q
TC 3 2
AC= = =
Q Q 3
4. Find the solution to the firm’s short run cost minimization production when capital is fixed at
a quantity of 9 units.
By setting Ḱ=9, we can obtain the labour demand function from the production function, by
setting the quantity of capital at 9 units (in the short run, the tangency condition does not apply):
2
Q= ( √ L+ √ 9 )

√ Q=√ L+3
√ L=√ Q−3
2
L=( √ Q−3 )
From this labour demand function, we know that when Q<9 the firm does not hire any labor,
while it does whenQ>9 .

Following from this, we have:

2
L=( √ Q−3 ) When Q>9
L=0 When Q<9

5. Find the short run total cost curve and graph it along with the long run total cost curve
2
TC=2 ( √Q−3 ) +9 When Q>9
TC=9 When Q<9
Total cost

10

10 Q, output

6. Find the associated long run average cost curve

 Total cost

Q, output

Question 3
A consulting firm has just finished a study for a manufacturer of wine. It has determined that
an additional man hour of labor would increase wine output by 1000 gallons per day, while an
additional machine hour of fermentation would increase output by 200 gallons a day. The price of a
man hour of labor is £10 per hour. The price of a machine hour of fermentation capacity if £0.25 per
hour. Is there a way for the wine manufacturer to lower its total costs of production and yet keep its
output constant? If so, what is it?

At the optimum it must be true that

MP K MP L
=
r w
Here, we have that:

200 1000
>
0.25 10
800>100
This implies that the firm receives more output per dollar spent on Capital than for an additional
hour spent on labor. Therefore, the firm could lower its cost but still producing the same amount
of output by using less labor and more capital.

Question 4
1. Suppose that the total cost of providing satellite television services is as follows:
TC ( Q1 , Q2) =0, if Q 1=0 and Q 2=0

TC ( Q 1 , Q 2) =1000+2 Q 1+ 3Q 2 , otherwise

Where Q 1 and Q 2 are the number of households that subscribe to a sports and movie channel
respectively. Does the provision of satellite television services exhibit economies of scope?

Economies of scope exist if it is true that:

TC ( Q 1 , Q 2) −TC ( Q 1 , 0 ) <TC ( 0 ,Q 2 ) −TC (0,0)

In the example above, we have that

TC ( Q 1 , Q 2) =1000+2 Q 1+ 3Q 2

TC ( Q 1 , 0 )=1000+ 2Q 1

TC ( 0 , Q 2 )=1000+ 3Q 2

TC ( 0,0 )=0

1000+2 Q1+ 3Q 2 −( 1000+2 Q1) < 1000+ 3Q 2−0

3 Q2 <1000+3 Q2

Given that the condition above is satisfied, in this case the cost of adding a movie channel when
the firm is already providing a sports channel is less costly than a new firm supplying a movie
channel from scratch. By 1000.

Question 5
Let B be the number of bicycles produced from F bicycle frames, and T tires. Every bicycle
requires two tires and one frame.

(a) Draw the isoquants for bicycle production. Are tires and frames perfect substitutes? Or
perfect complements?
They are perfect complements
 Tires

1 2 3 Frames
(b) Find a mathematical expression for the production function for bicycles.

For perfect complements, the production takes the general form:

Q=min ⁡(a , b)
In this case, as for each frame used in production, two tires are needed, the production
function can be represented as:

1
Q=min F , T
2 ( )

Question 6
Suppose the production function is given by the following equation (where a and b are positive
constants):Q=aL+ bK What is the marginal rate of technical substitution of labor for capital at any
point along the isoquant?

For this production function we have that MP L =a and MP K =b. Therefore we can write that the
marginal rate of technical substitution of labor for capital at any point along the isoquant is:

MP L a
MRTS L, K = =
MP K b

Question 7
A firm’s production function is initiallyQ 1= √ KL. Overtime, the production function changes to
Q 2=KL

(a) Verify that this change represents technological progress?

Starting from arbitrary inputs level such as K=10 and L=10, we can see that using this input
combination the firm produces more after the changes than before. This change therefore
represents technological progress.
Q1= √10 ×10=10
Q2=10 ×10=100
(b) Is this change labor saving, capital saving or neutral saving?
In order to see whether the change is labor saving, capital saving or neutral saving. We
first need to find the marginal product of labor and capital for both functions, and obtain
the MRTS L, K before and after the change:

MP1K =0.5 √L
√K
K
MP1L =0.5 √
√L

MP2L =K

MP2K =L
Which gives us:
K
0.5 √
MRTS1L, K = √L = K
0.5
√L L
√K
K
MRTS2L, K =
L
The Marginal rate of technical substitution hasn’t changed, therefore there was neutral
technological progress. The marginal product of labor and capital have both increased at
the same rate.