ECON 3400H Managerial Economics Instructor: Sharif F.

Khan

Department of Economics Trent University Fall 2012

Suggested Solutions to Assignment 6 (Optional)

Read each part of the question very carefully. Show all the steps of your calculations to get full marks. 1. End-of-chapter Problems # 1 of Chapter 8 of the textbook Salvatore (7e). 2. End-of-chapter Problems # 2 of Chapter 8 of the textbook Salvatore (7e). 3. End-of-chapter Problems # 5 of Chapter 8 of the textbook Salvatore (7e). 4. End-of-chapter Problems # 6 of Chapter 8 of the textbook Salvatore (7e). 5. End-of-chapter Problems # 7 of Chapter 8 of the textbook Salvatore (7e). 6. End-of-chapter Problems # 8 of Chapter 8 of the textbook Salvatore (7e). 7. End-of-chapter Problems # 9 of Chapter 8 of the textbook Salvatore (7e). 8. End-of-chapter Problems # 10 of Chapter 8 of the textbook Salvatore (7e). 9. End-of-chapter Problems # 11 of Chapter 8 of the textbook Salvatore (7e). 10. End-of-chapter Problems # 12 of Chapter 8 of the textbook Salvatore (7e). 11. End-of-chapter Problems # 13 of Chapter 8 of the textbook Salvatore (7e). 12. End-of-chapter Problems # 14 of Chapter 8 of the textbook Salvatore (7e). 13. End-of-chapter Problems # 15 of Chapter 8 of the textbook Salvatore (7e). 14. End-of-chapter Appendix Problems # 1 of Appendix to Chapter 8 of the textbook Salvatore (7e). 15. End-of-chapter Appendix Problems # 2 of Appendix to Chapter 8 of the textbook Salvatore (7e).

ANSWERS TO PROBLEMS 1. (a) The explicit costs are $10,000 + $20,000 + $15,000 + $5,000 = $50,000. (b) The accounting costs would be equal to the explicit costs of $50,000. The implicit costs are $60,000 (the earnings that would be foregone from his present occupation). The economic costs are the sum of the explicit costs of $50,000 and implicit costs of $60,000 or $110,000. (c) Since the estimated total revenues from opening his own law practice are $100,000 while the total estimated economic costs are $110,000, Kevin Coughlin should not start his own law practice. 2. (a) TFC = $30. These are the total costs that the firm incurs at Q = 0. Subtracting TFC from the TC schedule gives the TVC schedule. AFC = TFC/Q; AVC = TVC/Q; ATC = TC/Q; MC = TVC/Q = TC/Q. All of these schedules are shown in Table 1. Table 1 Total and Per-Unit Cost Schedules Quantity of Output 0 1 2 3 4 5 Total Fixed Costs $30 30 30 30 30 30 Total Variable Costs $ 0 20 30 51 88 150 Total Costs $ 30 50 60 81 118 180 Average Fixed Cost $30 15 10 7.50 6 Average Variable Cost $20 15 17 22 30 Average Total Cost $50 30 27 29.50 36 Marginal Cost $20 10 21 37 62

(b) See Figure 1. 3. (a) Running the night flight leads to an extra revenue of $2,000 (from the 10 extra passengers) and an extra cost of $1,200 in overnight charges for the plane remaining in New York in comparison to a morning flight. Since the extra revenue exceeds the extra costs, it pays for the airline to maintain its night flight rather than replacing it with a morning flight.

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(b) The total cost of running the plane for a day is $25,000 ($11,000 in operating costs for the two flights per day plus the $3,000 of fixed costs). Also, the airline pays $1,200 per day to remain in New York overnight. Thus, total costs equal $26,200. Since the total revenue of the airline is $26,000 for each day (the 80 passengers for the night flight plus the 50 passengers in the afternoon flight, each paying $200 for a one-way ticket), it pays for the airline to remain in business in the short run even though it incurs a loss of $200 per day. Unless the airline could find a more profitable use for the plane, it would incur the larger loss of $3,000 equal to the fixed costs of the plane if it kept the plane idle. In the long run, all costs are variable and it would be better for the airline to discontinue its Los Angeles to New York service altogether. 4. (a) Since to expand output in the short run to meet peak electricity demand electrical companies bring into operation older and less efficient equipment, their short-run marginal costs rise sharply. (b) New generating equipment would have to be run continuously (i.e., around the clock), or nearly so, for the AFC to be sufficiently low to make the ATC lower than for older equipment. Thus, to meet only peak demand, older and fully depreciated generating equipment is cheaper. 5. (a) The firm is not maximizing output or minimizing costs because MPL/w = 300/$50 = 6 is not equal to MPK/r = 200/$25 = 8. (b) The firm can maximize output or minimize costs by hiring fewer workers and renting more machines. Since the firm produces in stage II of production for both labor and capital, as the firm employs fewer workers, the MP of the last remaining worker rises. On the other hand, as the firm rents more machines, the MP of the last machine rented declines. The process should continue until MPL/w = MPK/r. One such point of output maximization or cost minimization might be at MPL/w = 350/$50 = MPK/r = 175/$25 = 7. 6. (a) See Figure 2 on the page after next. Note that in the top panel of Figure 2, the isoquant for 3Q is not shown in order not to clutter the figure. The LTC, LAC, and LMC schedules are calculated in Table 2 and shown in the middle and bottom panels of Figure 2. Note that the LMC values are plotted halfway between the various levels of output, the LMC curve intersects the LAC curve from below at the lowest point on the LAC curve, and the SAC curves are tangent to the LAC curve.

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Table 2 L 0 2 3 3.45 4 6 9 K 0 2 3 3.45 4 6 9 Q 0 1 2 3 4 5 6 LTC $ 0 40 60 69 80 120 180 LAC $40 30 23 20 24 30 LMC $40 20 9 11 40 60

(b) If the firm could build only the four plants indicated by the short-run average cost curves shown in the bottom panel of Figure 2, the long-run average cost curve of the firm would be AB*CE*GJ*R. If, on the other hand, the firm could build a very large or infinite number of plants in the long run, the LAC curve of the firm would be the smooth curve ACEJR. 7. See Figure 3 on the page after next. The top panel of Figure 3 shows a total output curve that exhibits first increasing returns to scale (increases at an increasing rate) and then decreasing returns to scale (increases at a decreasing rate). This corresponds to the LTC curve in the bottom panel that first increases at a decreasing rate (so that LAC falls) and then increases at an increasing rate (so that LAC rises). 8. With constant returns to scale, the LTC curve is a straight line through the origin. This is shown in the left panel of Figure 4 on the page after next. Since the LTC curve is a straight line is through the origin, LAC = LMC and equals the constant slope of the LTC curve. This is shown in the middle panel of Figure 4. Finally, since the LAC is horizontal, the SAC curves are tangent to the LAC curve at the lowest points on the SAC curves (see the right panel of Figure 4). 9. See Figure 5 on the page after next. The figure shows that to produce output level 2Q, the plant represented by SAC is better (i.e., it leads to lower per-unit costs) than the plant indicated by SAC'. However, for outputs smaller than 1Q or larger than 3Q, plant SAC' leads to lower per-unit costs. Thus, if the firm is not sure that its output will be between Q1 and Q3, it may prefer to build plant SAC'.

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Figure 3

Figure 4

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10. (a) For Q = 1, log C = 3-0.31log(1) = 3-0.3(0); thus, C = $1,000. For Q = 2, log C = 3-0.31log(2) = 3-0.3(0.30103) = 2.909691; thus, C = 812.25. For Q = 4, log C = 3-0.31log(4) = 3-0.3(.60206) = 2.819382; thus, C = 659.75. (b) From Q = 1 to Q = 2, C declines by ($1,000 $812.25)/$1,000 = 0.188 or 18.8%. From Q = 2 to Q = 4, C declines by ($812.25 659.75)/$812.25 = 0.188 or 18.8%. Thus, C declines at a constant rate for each doubling in cumulative total output. 11. (a) With TFC = $100,000, P = $30, and AVC = $20,
QB = TFC $100,000 = = 10,000 P - AVC $30 - $20

At QB = 10,000 and P = $30, TR = ($30)(10,000) = $300,000. These are shown in Figure 6 on page 167. (b) With TFC = $100,000, = $60,000, P = $30, and AVC = $20,
QT = TFC + T $100,000 + $60,000 $160,000 = = = 16,000 P - AVC $30 - $20 $10

At QT = 16,000 and P =$30, TR = ($30)(16,000) = $480,000 These are shown in Figure 7 on page 167. 12. (a) With TFC' = $40,000, P = $30, and AVC = $20,
Q B = T FC $40,000 $40,000 = = = 4,000 P - AVC $30 - $20 $10

QT =

T FC + T $40,000 + $60,000 $100,000 = = = 10,000 P - AVC $30 - $20 $10

These are shown in Figure 8 on page 167.

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(b) With TFC = $100,000, P = $30, and AVC' = $10,

Q B" = TFC $100,000 $100,000 = = = 5,000 P - AVC $30 - $10 $20

QT" =

TFC + T $100,000 + $60,000 $160,000 = = = 8,000 P - AVC $30 - $10 $20

These are shown in Figure 9. (c) With TFC = $100,000, P* = $40, and AVC = $20,
Q B* = TFC $100,000 $100,000 = = = 5,000 P * -AVC $40 - $20 $20

QT* =

TFC + T $100,000 + $60,000 $160,000 = = = 8,000 P * -AVC $40 - $20 $20

These are shown in Figure 10. 13. (a) The breakeven output for the first (QB) and the second firm (QB') are QB = QB' = TFC _ = $100 _ = 25 P AVC $10 $6 TFC' _ P AVC' = $300 _ = 45 $10 $3.33

These are shown in Figure 11. The breakeven output of the second firm (i.e., the more highly leveraged firm) is larger than that for the first firm because the second firm has larger overhead costs. Thus, it takes a greater level of output for the second firm to cover its larger overhead costs. (b) At Q = 60, the degree of operating leverage of firm 1 (DOL) and firm 2 (D'OL) are DOL = Q(P - AVC) 60($10 - $6) $240 = = = 1.71 Q(P - AVC) - TFC 60($10 - $6) - $100 $140 Q(P - A VC) 60($10 - $3.33) $400 = = =4 Q(P - A VC) - T FC 60($10 - $3.33) - $300 $100

D OL =

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Thus, the more highly leveraged firm has a higher DOL (i.e., greater variability of profits) than the less highly leveraged firm. The reason for this is that firm 2 has a larger contribution margin per unit (i.e., P AVC) than firm 1. Graphically, this is reflected in a larger difference between the slopes of TR and TC' than between TR and TC. At Q = 70, DOL and D'OL are, respectively, DOL = 70($10 - $6) $280 = = 1.56 70($10 - $6) - $100 $180 70($10 - $3.33) $467 = = 2.8 70($10 - $3.33) - $300 $167

DOL =

Thus, the larger the level of output, the smaller are DOL and D'OL. The reason is that the farther we are from the breakeven point, the smaller is the percentage change in profits (since the level of profits is higher). 14. (a) Substituting W = 10 into the estimated regression equation, we get TVC = 0.5 + 0.8Q Thus, the TVC function is a straight line with a vertical intercept of $0.50. The AVC function is then AVC = TVC 0.5 = + 0.8 Q Q

The MC function is the slope of the TVC curve. That is, MC = 0.8 (b) The AVC curve declines rapidly and gets closer and closer to the horizontal MC curve, as in the right bottom panel of Figure 8-10 in the text. (c) Anderson fit a linear TVC function to the data because he was aware that most empirical studies found that the linear formulation fit the data better than the quadratic or cubic forms.

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(d)

Based on the excellent results obtained, Anderson seems to have made the correct decision in fitting a linear TVC function to the data. All estimated coefficients are statistically significant at better than the 1 percent level, the regression "explains" 92 percent of the variation in TVC, and the DW statistic indicates the absence of autocorrelation.

15. (a) TVC = aQ + bQ2 + cQ3 = 60Q 12Q2 + 1Q3 AVC = a + bQ + cQ2 = 60 12Q + Q2 MC = a + 2bQ + 3cQ2 = 60 24Q + 3Q2 When the AVC and MC curves cross, AVC = MC. Setting the AVC function equal to the MC function, we get 60 12Q + Q2 = 60 24Q + 3Q2 12Q 2Q2 = 0 Q(12 2Q) = 0 so that Q = 0 and Q = 6 Thus, the AVC = MC = $60 at Q = 0 and Q = 6. The AVC and MC curves of the firm are plotted in Figure 12 on page 171. (b) The breakeven and profit-maximizing levels of output of the firm can be found by comparing the total costs and total revenues of the firm at various levels of output. TC = TFC + TVC = $100 + 60Q 12Q2 + Q3 and TR = (P)(Q) = $60Q

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Q 0 1 2 3 4 5 6 7 8 9 10 11 12

100 100 100 100 100 100 100 100 100 100 100 100 100 100

+60Q 0 + 60 +120 +180 +240 +300 +360 +420 +480 +540 +600 +660 +720

12Q2 0 12 48 108 192 300 432 588 768 972 1200 1452 1728

+Q3 0 + 1 + 8 + 27 + 64 + 125 + 216 + 343 + 512 + 729 +1000 +1331 +1728

TC $100 149 180 199 212 225 244 275 324 397 500 639 820

TR $ 0 60 120 180 240 300 360 420 480 540 600 660 720

$-100 89 60 19 28 75 116 145 156 143 100 21 100

Thus, the firm breaks even between Q = 3 and Q = 4 and between Q = 11 and Q = 12. The firm maximizes total profits at Q = 8. The profit-maximizing level of output can also be found by setting MC = P: 60 24Q + 3Q2 = $60 24Q + 3Q2 = 0 Q(24 + 3Q) = 0 so that Q = 0 and Q = 8 and the firm maximizes profits at Q = 8. (c) With w = $20 and r = $10, TC = 50 + 20Q + 2w + 3r = 50 + 20Q + 2($20) + 3($10) = 120 + 20Q

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LAC

TC = 120 + 20 Q Q

LMC = 20 (the slope of the TC curve) The LAC and LMC curves are plotted in Figure 13 on the next page. The LAC and LMC curves are similar to those found in other empirical studies. (d) The corporation should adopt the new technology; otherwise, it will be unable to compete with other firms that do at any level of output. The LAC curve of the firm would continue to fall and get closer and closer to LMC = $20 as the firm expands output. Since the firm can sell cameras at $60, its profits will increase as output increases until it may capture the entire market for cameras.

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APPENDIX PROBLEMS 1. (a) Given: then TC = 100 + 60Q 12Q2 + Q3 TVC = 60Q 12Q2 + Q3 AVC = TVC = 60 12Q + Q2 Q MC = d(TC) = d(TVC) = 60 24Q + 3Q2 dQ dQ (b) The AVC is minimum when d(AVC) = 12 + 2Q = 0 dQ so that Q=6 At Q = 6, AVC is minimum and the AVC curve is U shaped because d2(AVC) = 2 > 0 dQ2 The MC is minimum when d(MC) = 24 + 6Q = 0 dQ so that Q=4 At Q = 4, MC is minimum and the MC curve is U shaped because d2(MC) = 6 > 0 dQ2 ( c) The MC curve intersects the AVC at the lowest point on the latter. Substituting Q = 6 into the equation for the AVC curve, we get AVC = 60 12(6) + 36 = $24 = MC 2. (a) Given: TC = 120 + 50Q 10Q2 + Q3

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then

TVC = 50Q 10Q2 + Q3 AVC = TVC = 50 10Q + Q2 Q MC = d(TC) = d(TVC) = 50 20Q + 3Q2 dQ dQ

(b)

The AVC is minimum when d(AVC) = 10 + 2Q = 0 dQ so that Q=5 At Q = 5, AVC is minimum and the AVC curve is U shaped because d2(AVC) = 2 > 0 dQ2 The MC is minimum when d(MC) = 20 + 6Q = 0 dQ so that Q = 3.3 At Q = 3.3, MC is minimum and the MC curve is U shaped because d2(MC) = 6 > 0 dQ2

( c)

The MC curve intersects the AVC at the lowest point on the latter. Substituting Q = 5 into the equation for the AVC curve, we get AVC = 50 10(5) + 25 = $25 = MC

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