CHAPTER 5

PRODUCTION

The following table shows the five topic sections of this chapter and the associated study
guide problems that pertain to each topic section.
Section Topic
1 Basic Production Concepts
Problems M1-M3.
2 Production with One Variable Input
Problems M4-M6, S1-S4, L1-L2.
3 Production in the Long Run
Problems M8-M13, S5-S6, L3-L5.
4 Measuring Production Functions
Problems M14-M15, S7-S9, L6.
5 Other Production Decisions
Problems M16-M18, S10, L7-L9.

Multiple Choice

M1 Production can be thought of as

a. Transforming inputs into outputs of goods and services.
b. Transforming ideas into actions.
c. Factories at work.
d. Combining inputs such as labor and capital.
e. Creating manufactured goods.

M2 Which of the following is the best definition of a production function?

a. A function that lists all possible production methods.
b. A function showing the maximum output the firm can produce for any
combination of inputs.
c. A measure of the firm’s production costs for a given set of inputs.
d. A measure of the minimum technology needed to produce a given level of output.
e. A function that shows maximum outputs obtained from a production facility.

M3 Are production technologies fixed in the short run?

a. Yes, they do not change.
b. Yes mainly, but technologies can change slowly over the course of years.
c. No, but changes tend to be small and predictable.
d. No, but when analyzing a given production function, we assume that technology
is fixed and is the best available at the time.
e. Though technologies change, it is impossible to predict these changes.
Managerial Economics Study Guide

M4 In the short run, is it possible for a firm to change inputs?

a. Yes, any and all inputs can be changed.
b. Yes, although only small input changes are possible.
c. No, all inputs are fixed in the short run.
d. Not completely; one or more inputs are fixed.
e. It depends on the duration of the short run.

M5 As labor usage increases, the marginal product of labor

a. First falls, then rises.
b. First falls, reaches a flat portion, then rises rapidly.
c. First rises, then falls.
d. First rises, then reaches a plateau.
e. First rises, then falls, then rises again.

M6 In the short run, a firm should expand the use of a variable input until
a. Its marginal product is zero.
b. Its marginal revenue product is zero.
c. Its marginal revenue product is at a maximum.
d. Its marginal revenue product equals the input’s marginal cost.
e. None of the above answers is correct.

M7 Firm X sells output at P = $4 per unit and pays labor a wage of $20 per hour. The marginal
product of labor is given by: MPL = 30 - .1L. The profit-maximizing quantity of labor is:
a. L = 100 hours.
b. L = 180 hours.
c. L = 250 hours.
d. L = 300 hours.
e. L = 320 hours.

M8 In the long run, do firms face trade-offs in how they produce?

a. No, they have fully adjusted to all relevant factors; there are no more trade-offs.
b. No, their options to modify production are limited.
c. Yes, but the trade-offs only involve fixed inputs.
d. Yes, because they have the maximum flexibility to trade off inputs.
e. Yes, but only when there is a major change in technology.

M9 In the long run, the firm produces a given level of output at least cost by
a. Equating the ratios of marginal products to input prices across all inputs.
b. Ensuring equality of marginal products across inputs.
c. Using a greater proportion of the cheaper input.
d. Intensively applying more and more labor to its fixed plant.
e. None of these answers is correct.
 Production Chapter 5

M10 Which of the following is likely to be a cause of increasing returns to scale?

a. A change to production methods not feasible at low levels of output.
b. Increased specialization of labor.
c. A one-time fall in labor costs.
d. Answers a and b are both correct.
e. Answers a, b, and c are all correct.

M11 Under constant returns to scale,

a. A given percentage change in one input implies an equal change in total output.
b. A given percentage change in all inputs implies constant marginal products for all
inputs.
c. A given percentage change in all inputs causes an equal percentage change in
output.
d. The production function varies linearly with all inputs.
e. A constant level of output is achieved with various combinations of inputs.

M12 In the long-run, a profit-maximizing firm produces such that

a. The marginal products of all inputs are zero.
b. The ratios of marginal products to input prices are equal across all inputs.
c. Each input’s marginal revenue product equals the input’s marginal cost.
d. Marginal products are equal for all inputs.
e. Both b and c are correct.

M13 The slope of an isoquant is referred to as the

a. Marginal efficiency of production.
b. Marginal product of each input.
c. Marginal rate of technical substitution.
d. Marginal rate of factor efficiency.
e. Ratio of input prices.

M14 In which of the following production functions are inputs perfect substitutes?
a. Fixed proportions
b. Multiplicative
c. Cobb-Douglas
d. Linear
e. Answers c and d are both correct.

M15 In a Cobb-Douglas production function, do inputs display diminishing marginal returns?

a. Yes, always.
b. Yes, provided the sum of the exponents is smaller than one.
c. Yes, provided each exponent is smaller than one.
d. Uncertain, depends on the nature of the technology.
e. No, never.
Managerial Economics Study Guide

M16 A firm produces a good in two factories. The marginal product of an input is greater at
one plant than at the other. How can the firm reallocate the input to increase profitability?
a. Increase use of the input at the plant with the lower marginal product; decrease
use of the input at the other plant.
b. Increase use of the input at the plant with the higher marginal product; decrease
use of the input at the other plant.
c. Increase use of the input at the plant with the greater amount of excess capacity,
decrease use of the input at other plant.
d. Increase input use at both factories as long as marginal products are positive.
e. No reallocation is necessary.

M17 Factory A produces output according to: QA = 120XA, where XA denotes the amount of
input allocated to the factory. Factory B produces output according to: QB = 200XB - QB2.
The available amount of input X is 100 units. The firm’s profit-maximizing allocation is
a. XA = 60 and XB = 40.
b. XA = 50 and XB = 50.
c. XA = 0 and XB = 100.
d. There is not enough information to determine the answer.
e. None of these answers is correct.

M18 The office supply firm’s optimal allocation of its sales force called for putting
a. More sales people on accounts with higher current profits.
b. More sales people on accounts with lower current profits.
c. More sales people on accounts with higher marginal profits.
d. More sales people on accounts with higher average profit per worker.
e. More sales people on accounts with positive marginal profit.

Short Problems and Questions

S1 Draw a graph that shows total product and marginal product in a short-run production
setting with one fixed input and one variable input. Carefully explain the shape of the
graph.

S2 Carefully explain why a firm should employ a variable input up to the point that its
marginal revenue product equals its marginal cost: MRP = MC.

S3 Suppose that a firm is producing in the short run with output given by:
Q = 10L - .25L2,
The firm hires labor at a wage of $16 per hour and sells the good in a competitive market
at P = $8 per unit. Find the firm’s optimal use of labor and associated level of output.

S4 Explain how a firm in the short run will respond to each of the following changes:
a. An increase in the price of the good or service that it sells.
b. An increase in the marginal cost of the variable input.
c. An increase in the productivity of the variable input.
 Production Chapter 5

S5 A firm produces two related goods in different divisions. Production of the first good is
characterized by a fixed-proportions production function; the second good is
characterized by Cobb-Douglas production. Which division is better able to respond to
changes in the prices of inputs?

S6 Carefully define and distinguish between short run and long run. Explain how each is
important to production decisions.

S7 Management of a firm has carefully measured output elasticity in the past three years and
has determined that it is 1.2. What sort of returns to scale does the firm face? Explain.

S8 Determine whether the following production functions are characterized by increasing,

decreasing, or constant returns to scale.
a. Q = 10 + 2K + 4L
b. Q = 40K.8L.8
c. Q = 100K.5L.5

S9 A firm performs accounting jobs using both labor (clerical workers) and specialized
software programs (S), according to the production function Q = .5L + 2K. The cost per
hour of labor (L) is $10 and the hourly cost of utilizing software is $30. What is the least-
cost way to complete 100 accounting jobs? Will the firm ever use both inputs to complete
jobs?

S10 Draw isoquants for production when: a) output follows the Cobb-Douglas production
function; b) inputs are perfect substitutes.

S11 A recent policy proposal regarding health care sought to require employers to cover an
increased share of the cost of health care for their employees. If such an employer
mandate were enacted, how might this affect firm hiring decisions?

Longer Problems and Discussion Questions

L1 Thayer Corporation. is a major defense contractor, producing artillery shells for the
Marine Corps landing craft. A recent study of production over the past year shows the
following relationship between labor inputs and output:
Month Labor Output
1 10 450
2 9 440
3 2 300
4 5 375
5 8 428
6 6 395
7 7 413
8 1 270
9 4 353
10 3 328
Managerial Economics Study Guide

a. Prepare a table that shows the average and marginal product of labor for Thayer,
over the range of labor inputs indicated above.
b. The Marine Corp has agreed to buy an unspecified number of shells from Thayer
at a price of $2 per shell. Labor costs are $38 per hour including fringe benefits.
How many shells should Thayer produce, and how much labor should it hire?

L2 Suppose that production at a facility uses a fixed amount of capital, and a variable
amount of labor. Output has been measured as: Q = 30L - .3L2.
a. Determine the amount of labor at which total output is maximized.
b. If labor can be hired at $24 per hour and the good sells at $4 per unit, determine
the optimal use of labor, the optimal level of output, and the firm’s final profit.

L3 A firm produces two goods. The figures show the current output levels and input
combinations for the respective goods. Confirm that the firm is not producing efficiently.
How should the firm reallocate inputs between the two goods in order to increase total
output and total profit? Explain.

Capital Capital
A

Labor Labor

L4 A firm uses two inputs to produce a final good. If the price of one of the inputs increases
and the price of the other remains the same, how will this affect the firm’s production
isoquants? Its isocost line? Its use of the two inputs?

L5 An agricultural economist has completed a study of corn production in a Midwestern

state. A farmer wishes to use the published results to select the most profitable breed of
corn to plant. Three are available: a basic seed (which the farmer has used in the past), an
old hybrid seed developed about ten years ago, and a much newer hybrid that was
developed last year.
The costs per acre and bushel yield per acre of each are as follows:
Cost Basic Old Hybrid New Hybrid
Seed $10 $25 $40
Labor $10 $18 $30
Fertilizer $18 $30 $12
Water $6 $12 $9
Fuel $19 $22 $30
Yield/Acre 40 70 85
 Production Chapter 5

a. Based on the data listed above, which is the most profitable type of seed to plant
this year?
b. A significant oil price shock doubles the costs of fuel and fertilizer. How does this
affect the decision about which seed to plant?
c. Finally, consider the following situation instead. Hybrid seeds are often poorly
resistant to insects, while the basic seeds have proven to be largely resistant. It is
probable that the new hybrid will require an insecticide application before the end
of the season costing $45 per acre. How would this affect the farmer’s planting
decision?

L6 The Federal Trade Commission must decide whether to contest a proposed merger of the
third and fourth largest firms in an industry. (The Commission is worried that the merger
might lead to higher prices.) Why is it important to examine whether production is
characterized by constant returns to scale or by increasing returns to scale?

L7 A firm produces according to the production function:

Q = K.3L.7.
where Q denotes units of output, K units of capital, and L units of labor. The price of
capital is $3 per unit, and the price of labor is $7 per unit. What is the optimal
capital/labor ratio?

L8 Sushico imports fresh fish from the Orient for use in the firm’s Japanese restaurant and
for packaging into prepared meals that are sold to customers. Because of limitations on
the availability of fish, Sushico can buy only 20 thousand pounds of fish per month.
Recent production data for the restaurant indicates that output can be described as:
QR = 25FR - .5F2R
where QR denotes quantity of restaurant meals and FR denotes the quantity of fish (in
thousands of pounds) allocated to restaurants. Similarly, production for the packaging
division shows that production takes place according to:
QP = 20FP - .25F2P
a. Fish sold in the restaurant or sold packaged bring the same price to the firm.
How should Sushico allocate fresh fish between the two uses?
b. Suppose an extra 12 thousand pounds of fish became available. Now, what is the
optimal division of the 32 thousand pounds of fish between the two divisions?

L9 Two division managers at King Size Manufacturing have been in an ongoing discussion
with top management about allocation of capital spending over the next three years. The
current tentative plan calls for the bulk of capital expenditure to go to Division H, which
historically has been the larger division of the firm. One manager defends this decision
because, he says, his division has been providing the bulk of the profits for the company.
Division J is smaller, and its manager says that it is time to make the divisions more equal
in size by allocating more capital and other resources to his division. Bonuses in the
divisions are based on total sales.
You have been asked to assist management in seeking a solution to this disagreement.
How would you go about making a recommendation?
Managerial Economics Study Guide

L10 A consulting firm is working all out to provide services to two major clients. Currently,
the firm is allocating 8 consultants to each firm’s account. According to the firm’s
accountants, it is earning an average net profit of $120 per consulting hour from work for
the first client and about $105 average profit per hour at the second. The firm’s managing
partner urges switching one or more consultants to the first client from the second. Would
such a move increase total consulting profit? Explain.

SOLUTIONS

Multiple Choice

M1 a
M2 b
M3 d For purposes of analysis, economists usually assume that production functions are
fixed. In the short run, this is reasonable.
M4 d The short run is the time period in which at least one input or factor is fixed.
M5 c See Figure 6.1b in text.
M6 d In the short run, the appropriate optimality condition is: MRP  PMPL = MC.
M7 c PMPL = MC implies 4(30 - .1L) = 20. Optimal labor usage is L = 250 hours.
M8 d
M9 a
M10 d
M11 c
M12 e In the long run, PMPL = MC and also MPL/PL = MPK/PK.
M13 c
M14 d
M15 c
M16 b Total production is maximized when the marginal product of the input is equal at
all production facilities.
M17 a
M18 c

Short Problems and Questions

S1 You should draw a graph similar to Figures 5.1a and 5.1b in the text. Marginal product of
labor first rises due to increasing specialization of labor, and with increased use of the
(initially) underutilized capital and machinery. As more labor is used, marginal product
begins to fall due to diminishing returns.

S2 The answer is an application of marginal analysis developed in Chapter 2. If the MRPL is

greater than the MCL, then the firm can increase profit by employing more labor. The
additional revenue from the output that the additional labor produces exceeds the cost of
the additional labor. If the MCL is greater than the MRPL, then the firm can increase profit
by cutting back on its use of labor. Therefore, profit from the input is maximized only at
the point such that MRPL = MCL.

S3 The firm maximizes profit when it equates MRPL = (MR)(MPL) = MCL.

 Production Chapter 5

MPL = dQ/dL = 10 - .5L. Therefore, (8)(10 - .5L) = 16. The solution is: L = 16.
In turn, Q = (10)(16) – (.25)(16)2 = 160 - 64 = 96.

S4 To maximize profit, the firm will equate MRPL = (MR)(MPL) = MCL. Examine how each
of the events affects the value of the variables in this equation.
a. An increase in the price of the good or service will increase MR (shifting the
MRP curve up). The firm will use more of the variable input and increase output.
b. An increase in the cost of the variable input will increase MCL (shifting the MC
curve up). The firm will decrease use of the variable input and cut output.
c. An increase in productivity of the input will increase MPL (again shifting the
MRP curve up). The firm will increase use of the variable input and raise output.

S5 The Cobb-Douglass production function is far more adaptable to input changes. In fact,
the fixed-proportions technology means that no adaptation is possible; the inputs must be
used in the same proportions even if one input has doubled in price. Under the C-D
technology, production will switch away from the increasingly expensive input to the less
expensive input (but this adaptation will be limited by diminishing returns in the latter).

S6 The short run is a period of time in which the amount of one or more of the firm’s inputs
is fixed, that is, cannot be varied. The long run is a period of time sufficiently long to
allow the firm to vary all of its inputs. When planning production or when making a
major change in scale of operations, the firm will adopt a long-run perspective and vary
all inputs. Once a scale of plant has been chosen and some inputs are fixed, the firm will
operate in the short run.

S7 Output elasticity of 1.2 implies increasing returns to scale. For instance, if all inputs are
increased 20 percent, output will increase by (1.2)(20) = 24 percent. By contrast, if output
elasticity is less than 1, there are decreasing returns to scale. Finally, when output
elasticity is exactly 1, we have constant returns to scale.

S8. a. At K = l, L = l, we have: Q = 10 + (2)(1) +(4)(1) = 16.

At K = 2, L = 2, we have: Q = 10 + (2)(2) + (4)(2) = 22.
Thus, there are decreasing returns to scale.
b. At K= 1, L = 1, we have: Q= 400(l).8(1).8 = 400.
At K = 2, L = 2, we have: Q = 400(2).8(2).8 = 1,212.6.
Thus, there are increasing returns to scale.
c. At K = l, L = l, we have: Q = 100(1).5 (1).5 = 100.
at K = 2, L = 2, we have: Q = 100(2).5(2).5 = 200.
Thus, there are constant returns to scale.

S9 The cost of completing 100 jobs using 200 labor hours is: ($10)(200) = $2,000. The cost
of completing 100 jobs using 50 software hours is ($30)(50) = $1,500. Using software is
more cost-effective, and more productive software will completely displace labor. Here,
the inputs are perfect substitutes. One software hour exactly substitutes for 4 labor hours.
Notice that labor will only be used if its cost falls to one-quarter (or less) of the cost of
software.
Managerial Economics Study Guide

S10 a. The Cobb-Douglas production function exhibits diminishing marginal products,

implying that production isoquants are convex to the origin. Your graph should
resemble Figure 5.2a.
b. Inputs are perfect substitutes when the production function is linear. Here, each
input’s marginal product is constant, implying that isoquants are linear (so that
isoquants resemble isocost lines). In other words, the slope of each isoquant is
constant as is the marginal rate of technical substitution, MRTS = MPL/MPK =
constant.

S11 An increase in the cost of hiring labor (to cover health-care costs) will make it less likely
that firms will employ labor and more likely that they will employ other inputs (capital,
raw materials) instead. This can be shown with isocost lines and isoquants, or by
examining the formula for optimal usage of labor: MRPL = MCL. When MCL increases,
the firm will employ less of the more expensive input, and more of other, less expensive
inputs.

Longer Problems and Discussion Questions

L1 a. The completed table is:

Labor Output APL MPL

1 270 270 --
2 300 150 30
3 328 109.33 28
4 353 88.25 25
5 375 75 22
6 395 65.83 20
7 413 59 18
8 428 53.5 15
9 440 48.89 12
10 450 45 10

b. Optimal use of an input requires that: MRPL = (MR)(MPL) = MCL implying ($2)
(MPL) = $38, or at the optimum, MPL should be: 38/2 = 19. From the table, we see
that it is worth increasing labor as long as MPL exceeds 19. Thus, labor should be
increased until L = 6. (Moving to 7 labor units drops MPL to18, i.e. below 19.) At
L = 6, the corresponding level of output is 395 shells.

L2 a. First, determine the marginal product of labor: MPL = dQ/dL = 30 - .6L.

Maximum total output occurs where MPL = 0. The result is L = 50. In turn,
maximum total output is: Q = (30)(50) - .3(50)2 = 1500 – 750 = 750 units.
b. Optimal use of an input requires that MRPL = (MR)(MPL) = MCL. Therefore,
MRPL = (4)(30 - .6L) = 24, which implies 120 – 2.4L = 24, or L = 40. The
corresponding output is Q = (30)(40) - .3(40)2 = 1,200 – 480 = 720 units.
The firm’s profit is ($4)(720) – ($24)(40) = $1,920.
 Production Chapter 5

L3 The firm is not producing efficiently. Efficiency requires that MPL/MPK = PL/PK, for each
good. Since PL/PK is fixed, each good must be produced with input combinations having the
same MRTS. But the input combinations in the figures show very different marginal rates
of technical substitution. The first good has a steep MRTS; the second has a flat MRTS.
The firm could reallocate capital or labor in producing both goods. For instance,
suppose MPL/MPK > PL/PK for the first good and MPL/MPK < PL/PK for the second good as
suggested in the figures. Then, the firm would gain by substituting labor for capital for
the first good and by substituting capital for labor for the second good.

L4 The accompanying figure shows the firm’s least-cost combination of inputs before (Point
A) and after (Point B) an increase in the price of labor (let’s say). Of course, the increase
in PL (1) has no effect on the firm’s production function and isoquants but (2) does cause
the isocost line to pivot downward as shown. With isoquants as shown in the figure, the
result is a new lower level of output produced (as one would expect) using many fewer
units of expensive labor and slightly more units of capital.

Capital

B
A

Labor

L5 a. The first step is to find the total cost of each type of corn, and then find the cost
per bushel. For basic, the total cost is $63, and the cost per bushel is $1.58. For
old hybrid, the total cost is $107, and the cost per bushel is $1.53. For new hybrid,
the total cost is $121, and the cost is $1.42 per bushel. The most profitable (i.e.
lowest-cost corn) is the new hybrid.
b. If fertilizer and fuel costs both double, the respective total costs change to $100,
$159, and $163. The most profitable corn is still the new hybrid (at a cost of $1.92
per bushel).
c. The insecticide raises the total cost of the new hybrid to $166 and raises the cost
per bushel to $1.95. Now, the old hybrid (at $1.53 per bushel) is most profitable.

L6 The FTC must decide whether the merger is likely to be anti-competitive (allowing the
new merged firm to exercise the power to raise price) or pro-competitive. The latter case
depends crucially on the nature of returns to scale. If constant returns prevail, there is no
reason to expect “bigger is better” in terms of driving down the average cost of
production. By contrast, if increasing returns are important, the merged firm could enjoy
Managerial Economics Study Guide

significantly lower average costs, and that reduction could be passed on in part to
consumers via lower final prices.

L7 The firm employs inputs in an optimal ratio when MPK/PK = MPL/PL. We have
MPK = .3K-.7L.7 and MPL = .7K.3L-..3. Therefore, .3K-.7L.7/3 = .7K.3L-.3/7. Collecting terms,
this simplifies to: .1L = .1K or: L = K. The optimal capital-to-labor ratio is one-to-one.

L8 a. Set up the objective function: Maximize QR + QP subject to FR + FP = 20 thousand.

Compute the marginal products of the two operations: MPR = 25 - FR for the
restaurant and MPP = 20 - .5FP for packaging. Equate the two marginal products,
and substitute FR = 20 - FP: 25 - [20 - FP] = 20 - .5FP, or FP = 15 - .5FP. Therefore,
FP = 10 thousand pounds. In turn, FR = 10 thousand pounds.
b. The solution is analogous but with the new constraint, FR + FP = 32 thousand.
Now we have: 25 - [32 - FP] = 20 - .5FP, or 1.5 FP = 27. Therefore, FP = 18
thousand pounds, and in turn, FR = 14 thousand pounds.

L9 Profits are maximized when the marginal revenue product for an input is equal in each of
the various uses to which it could be put. In this case, the input is capital spending. The
most important question to answer in making an allocation decision is: What is the
marginal revenue product of capital in the two divisions? Whichever has the higher
revenue product should receive additional capital resources. (Ultimately, an optimal
capital allocation will tend to equalize the marginal revenue products across the
divisions.) The statements of both division managers – one arguing big is best, the other
arguing equal is best – are irrelevant for gauging marginal revenue products.
Discerning where allocated capital will have “the biggest bang for the buck” is
crucial. In addition, it might be a good idea to base bonuses on profitability rather than
sales. This sort of change is likely to encourage managers to be efficient and would bring
manager goals into line with the goal of profit maximization for the firm as a whole.

L10 The firm’s managing partner believes that switching consultants to the client generating
the higher average profit per hour will necessarily increase total profitability. However,
comparing average profits per hour offers only an imperfect profit-maximizing test. The
correct test is to make the switch to the client with the higher marginal profit per hour.
Marginal profits for each client may or may not be in line with average profits, so the
firms should try out switching a consultant to the first client and see whether the
additional profit earned exceeds the reduction in profit from the second client.