Economics Model Answers Six - 2013
1. Fixed costs can be easily identified by seeing what the total costs are when output is _______. Separately, give an example of a variable cost.
- Zero. Examples of variable costs include the electricity or heating bill, and wages.
2. Apple Computer probably has ______________ returns of scale for its production of iPhones. Explain briefly.
- Many students are missing this question. The point is this: if Apple doubles its inputs (factory size, number of workers, etc.), does it output increase by more than a factor of 2 or less than a factor of two?
- Wal-Mart increased its sales by more than a factor of 2 when it doubled its inputs, because there are greater efficiencies with bigger stores.
- So a correct answer would be this: increasing returns of scale (also called "economics of scale"), because bigger factories can produce vastly more quantities of the product. Doubling the factory size and number of workers may result in tripling the output, for example. Apple can also buy the parts at a lower average cost because Apple would be buying in very large quantities if it increases its size ("scale"). (Other answers are possible)
3. Give an example of a "short run" cost for a firm, and give an example of a "long run" cost. This can refer to any type of firm, from a grocery store to a baseball team to homeschooling.
- A short run cost would be to fix a leak in the roof, while a long run cost would be to replace the roof. Another short run cost is to rend a car, while a long run cost would be to buy a car.
4. Suppose you own a mechanics' shop that fixes cars, and you have 4 employees whom you pay $12 per hour. On average your 4th employee can fix 3 cars an hour. What is your marginal product (MP) and marginal cost (MC), and what is the minimum on average that you need to charge customers (your marginal revenue) for fixing cars? (Assume your only cost is labor, and the customer pays the cost of any parts.)
- The marginal product (MP) for the 4th employee is 3 cars. Why? Because that employee can fix 3 cars in an hour. Marginal cost (MC) = wage/MP, so the MC would be 12/3 = $4 per car. As a result, you would need to charge your customers at least $4 per car, or else you would be losing money in making the car.
5. Earlier in this course we learned that someone who obtains a college degree earns, over the course of his life, about $500,000 more than someone who does not. How can you explain this fact in terms of the advantages of "long run" costs over "short run" costs?
- Making decisions for the "long run" is usually more profitable than "short run" decisions, and the example of a college degree illustrates that. It costs more initially, but college degrees do not cost as much as $500,000, which the average extra amount someone makes when he has a college degree.
6. Suppose you spent one million dollars to build your factory, and another million dollars for materials and labor and electricity to make 50 cars. What is your fixed cost, average variable cost, and average total cost? Now suppose it costs you $18,000 to make a 51st car. What is your marginal cost?
- The fixed cost (FC) is $1,000,000 (the cost of the factory, which is the total cost when output is zero). The average variable cost (AVC) is the next $1 million divided by 50 cars, which is $20,000 per car. The average total cost (ATC) is the total cost (TC) of $2 million divided by 50 cars, which equals $40,000 per car. The 51st car costs $18,000 extra to make it, so the marginal cost (MC) at that point is $18,000.
7. Suppose you could earn $8 an hour. Instead, you watch television for an hour. What is your accounting profit or loss, and what is your economic profit or loss, for that hour?
- Accounting profit or loss is how much actual money is gained or lost, and no money is received or given by someone who watches an hour of television. So the accounting loss is zero. But economic profit and loss is a broader concept that includes opportunity cost. You could have earned $8 for that hour instead of earning nothing by watching television, so you have an economic loss of $8.
Provide brief answers to any four of the following questions:
8. Suppose there is a sudden increase in the market price for a firm's widget. The firm will hire more employees to produce more output until the point where the value of its marginal product of labor equals its _____________. [Hint: the answer is NOT simply "marginal cost"].
- The wage rate, which is the marginal cost of labor. Match the marginal product of labor to the marginal cost of that same input, which is labor.
9. Explain the following from the lecture: if inflation is 10% per year for three years, but one particular good keeps the same price during those three years, then its opportunity cost and real price actually decreased.
- The real price decreases once an adjustment is made for inflation. This is discussed more in the next lecture.
10. Are "long run" average costs lower than "short run" average costs and, if so, why?
- The long run has more flexibility to make the most efficient decisions with respect to costs, as in hiring a new employee at the minimum wage rather than paying overtime to an existing employee to work. In the short run all that an owner can do is to increase input or the number of employees, but in the long run a better factory can be built and other improvements in fixed costs can be made. Hence the long run average costs are usually lower than short run average costs.
11. (Difficult, but try): Your firm seeks to produce a certain level of output in the most efficient way (the lowest cost). It should use its resources in which of the following ways:
(a) use materials that generate the highest marginal product
(b) use materials that have increasing returns to scale
(c) use as much material as possible until there are diminishing returns
(d) use resources such that their marginal products per unit cost are equal
- (d) is the correct choice because if the marginal product per unit cost for any input were lower than the others, then there would be an inefficiency because that input would not be producing as much as the others. The amount of that input should be adjusted to increase its marginal product per unit cost up to the level of the others, for greater overall profit.
12. The greater the number of substitutes for a good, is it more or less price elastic? Explain briefly.
- More elastic, because when the price of the good increases, many people can buy the substitutes instead, which causes a large decrease in demand for the original good.
13. The smaller the proportion of income consumed by the purchase of a good, is it more or less income elastic? Explain briefly.
- The less income elastic the good would be, because an increase in income would not have a big effect.
- Examples: chewing gum is probably not very income elastic, because in increase in income is not likely to have a big effect on whether someone will buy chewing gum. But expensive yachts are probably very income elastic, because an increase in income might make the difference whether someone buys the yacht or not.
14. Would government prefer taxing a good that is price elastic or price inelastic? Explain briefly.
- Government prefers to tax goods that are price inelastic, because people will still buy the goods and pay the taxes as the price of the goods increase. As government taxes these goods more and more, people still buy the goods and pay the taxes on them.
15. Suppose french fries cost $1 and ketchup 10 cents. When the price of ketchup goes up to 20 cents, the quantity demanded for french fries falls by 10%. What is the cross elasticity of demand for french fries with respect to ketchup? Show your work and state whether these goods are complements or substitutes.
- Cross-elasticity of demand is how much the demand for one good changes when the price of another good changes. Here, Xed = -10%/100% = -.1 The two goods are complements because their cross-elasticity of demand is a negative number.