ECO101A: Introduction to Economics

Tutorial 2: Solution
1. A firm has a production process in which the inputs to production are perfectly
substitutable in the long run. Can you tell whether the marginal rate of technical
substitution is high or low, or is further information necessary? Discuss.
Solution: The marginal rate of technical substitution, MRTS, is the absolute value of the slope
of an isoquant. If the inputs are perfect substitutes, the isoquants will be linear. To calculate
the slope of the isoquant, and hence the MRTS, we need to know the rate at which one input
may be substituted for the other. In this case, we do not know whether the MRTS is high or
low. All we know is that it is a constant number. We need to know the marginal product of
each input to determine the MRTS.
2. The marginal product of labor in the production of computer chips is 50 chips per
hour. The marginal rate of technical substitution of hours of labor for hours of
machine capital is 1/4. What is the marginal product of capital?
The marginal rate of technical substitution is defined at the ratio of the two marginal products.
Here, we are given the marginal product of labor and the marginal rate of technical substitution.
To determine the marginal product of capital, substitute the given values for the marginal
product of labor and the marginal rate of technical substitution into the following formula:
𝑀𝑃𝐿 50 1
= 𝑀𝑅𝑇𝑆, 𝑜𝑟 = 𝑜𝑟,
𝑀𝑃𝐾 𝑀𝑃𝐾 4
MPK = 200 computer chips per hour.
3. Do the following functions exhibit increasing, constant, or decreasing returns to
scale? What happens to the marginal product of each individual factor as that
factor is increased, and the other factor is held constant at some level?
a. q = 3L + 2K
This function exhibits constant returns to scale. For example, if L is 2 and K is 2 then q is 10.
If L is 4 and K is 4 then q is 20. When the inputs are doubled, output will double. Each marginal
product is constant for this production function. When L increases by 1 q will increase by 3.
When K increases by 1 q will increase by 2.
b. q = (2L + 2K)1/2
This function exhibits decreasing returns to scale. For example, if L is 2 and K is 2 then q is
2.8. If L is 4 and K is 4 then q is 4. When the inputs are doubled, output will less than double.
The marginal product of each input is decreasing. This can be determined using calculus by
differentiating the production function with respect to either input, while holding the other
input constant. For example, the marginal product of labor is
𝜕𝑞 2
= 1
𝜕𝑙 2(2𝐿 + 2𝐾) ⁄2
Since L is in the denominator, as L gets bigger, the marginal product gets smaller. If you do
not know calculus, then you can choose several values for L, find q (for some fixed value of
K), and then find the marginal product. For example, if L=4 and K=4 then q=4. If L=5 and K=4
then q=4.24. If L=6 and K=4 then q= 4.47. Marginal product of labor falls from 0.24 to 0.23.
c. q = 3LK2
This function exhibits increasing returns to scale. For example, if L is 2 and K is 2 then q is 24.
If L is 4 and K is 4 then q is 192. When the inputs are doubled, output will more than double.
Notice also that if we increase each input by the same factor λ then we get the following:
q'= 3(λ L) (λ K)2 = λ3 3LK2 = λ3q.
Since λ is raised to a power greater than 1, we have increasing returns to scale. The marginal
product of labor is constant and the marginal product of capital is increasing. For any given
value of K, when L is increased by 1 unit, q will go up by 3K2 units, which is a constant number.
Using calculus, the marginal product of capital is MPK=2*3*L*K. As K increases, MPK will
increase. If you do not know calculus then you can fix the value of L, choose a starting value
for K, and find q. Now increase K by 1 unit and find the new q. Do this a few more times and
you can calculate marginal product. This was done in part b above, and is done in part d below.
𝟏 𝟏
d. 𝒒 = 𝑳𝟐 𝑲𝟐

This function exhibits constant returns to scale. For example, if L is 2 and K is 2 then q is 2. If L is
4 and K is 4 then q is 4. When the inputs are doubled, output will exactly double. Notice also that
if we increase each input by the same factor λ then we get the following:
1 1 1 1
𝑞 ′ = (λ𝐿)2 (λ𝐾)2 = λ 𝐿2 𝐾 2 = λ q.

Since λ is raised to the power 1, we have constant returns to scale. The marginal product of
labor is decreasing and the marginal product of capital is decreasing. Using calculus, the
marginal product of capital is
1
𝐿2
𝑞= 1
2𝐾 2

For any given value of L, as K increases, MPK will increase. If you do not know calculus then
you can fix the value of L, choose a starting value for K, and find q. Let L=4 for example. If K
is 4 then q is 4, if K is 5 then q is 4.47, and if K is 6 then q is 4.89. The marginal product of the
5th unit of K is 4.47-4=0.47, and the marginal product of the 6th unit of K is 4.89-4.47=0.42.
Hence, we have diminishing marginal product of capital. You can do the same thing for the
marginal product of labor.
𝟏
e. 𝒒 = 𝟒𝑳𝟐 + 𝟒𝑲

This function exhibits decreasing returns to scale. For example, if L is 2 and K is 2 then q is
13.66. If L is 4 and K is 4 then q is 24. When the inputs are doubled, output will less than
double.
The marginal product of labor is decreasing, and the marginal product of capital is constant.
For any given value of L, when K is increased by 1 unit, q will go up by 4 units, which is a
constant number. To see that the marginal product of labor is decreasing, fix K=1 and choose
values for L. If L=1 then q=8, if L=2 then q=9.65, and if L=3 then q=10.93. The marginal
product of the second unit of labor is 9.65-8=1.65 and the marginal product of the third unit of
labor is 10.93-9.65=1.28. Marginal product of labor is diminishing.

4. The production function for the personal computers of DISK, Inc., is given by q
= 10K0.5L0.5, where q is the number of computers produced per day, K is hours of
machine time, and L is hours of labor input. DISK’s competitor, FLOPPY, Inc.,
is using the production function q = 10K0.6L0.4.

a. If both companies use the same amounts of capital and labor, which will generate
more output?
Let Q be the output of DISK, Inc., q2, be the output of FLOPPY, Inc., and X be the same
equal amounts of capital and labor for the two firms. Then, according to their production
functions,
q = 10X0.5X0.5 = 10X(0.5 + 0.5) = 10X
and
q2 = 10X0.6X0.4 = 10X(0.6 + 0.4) = 10X.
Because q = q2, both firms generate the same output with the same inputs. Note that if the
two firms both used the same amount of capital and the same amount of labor, but the amount
of capital was not equal to the amount of labor, then the two firms would not produce the
same level of output. In fact if K>L then q2>q.

b. Assume that capital is limited to 9 machine hours but labor is unlimited in supply.
In which company is the marginal product of labor greater? Explain.

With capital limited to 9 machine units, the production functions become q = 30L0.5 and q2 =
37.372L0.4. To determine the production function with the highest marginal productivity of
labor, consider the following table:

For each unit of labor above 1, the marginal productivity of labor is greater for the first firm,
DISK, Inc.

5. 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.
 6. 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.

7. Please explain whether the following statements are true or false.

a. If the owner of a business pays himself no salary, then the accounting cost is zero,
but the economic cost is positive.

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 and reflecting the opportunity cost of the owner’s time. The
economic cost is the value of the next best alternative, or the amount that the owner would earn
if he took the next best job.

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 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 resources are not being put to their best use.

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 is unlikely to be
zero. Though the worker was temporarily unemployed, the 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, such as care of a child or elderly
person at home, which would have had a value to those receiving the service.

8. 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 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).

9. 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.