Chapter7:ProductionandCostTheoryAppendix

CHAPTER7
PRODUCTIONANDCOSTTHEORY
AMATHEMATICALTREATMENT
EXERCISES
1.Ofthefollowingproductionfunctions,whichexhibitincreasing,constant,ordecreasing
returnstoscale?
a. F(K,L)=K2L
b. F(K,L)=10K+5L
c. F(K,L)=(KL)0.5
Returnstoscalerefertotherelationshipbetweenoutputandproportionalincreasesin
allinputs.Thisisrepresentedinthefollowingmanner:

F(K,L)>F(K,L)impliesincreasingreturnstoscale;

F(K,L)=F(K,L)impliesconstantreturnstoscale;and

F(K,L)<F(K,L)impliesdecreasingreturnstoscale.

a.ApplyingthistoF(K,L)=K2L,

F(K,L)=(K)2(L)=3K2L=3F(K,L).

Thisisgreaterthan F(K,L);therefore,thisproductionfunctionexhibitsincreasing
returnstoscale.

b.ApplyingthesametechniquetoF(K,L)=10K+5L,

F(K,L)=10K+5L=F(K,L).
Thisproductionfunctionexhibitsconstantreturnstoscale.

c.ApplyingthesametechniquetoF(K,L)=(KL)0.5,

F(K,L)=(KL)0.5=(2)0.5(KL)0.5=(KL)0.5=F(K,L).
Thisproductionfunctionexhibitsconstantreturnstoscale.
2.TheproductionfunctionforaproductisgivenbyQ=100KL.Ifthepriceofcapitalis
$120perdayandthepriceoflabor$30perday,whatistheminimumcostofproducing
1000unitsofoutput?
Thecostminimizingcombinationofcapitalandlaboristheonewhere
MPL w
MRTS .
MPK r
dQ
The marginal product of labor is 100 K . The marginal product of capital is
dL
dQ
100L .Therefore,themarginalrateoftechnicalsubstitutionis
dK
100 K K
.
100L L

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To determine the optimal capitallabor ratio set the marginal rate of technical
substitutionequaltotheratioofthewageratetotherentalrateofcapital:
K 30
,orL=4K.
L 120

SubstituteforLintheproductionfunctionandsolvewhereKyieldsanoutputof1,000
units:
1,000=(100)(K)(4K),orK=1.58.

BecauseLequals4KthismeansLequals6.32.
Withtheselevelsofthetwoinputs,totalcostis:

TC=wL+rK,or

TC=(30)(6.32)+(120)(1.58)=$379.20.

ToseeifK=1.58andL=6.32arethecostminimizinglevelsofinputs,considersmall
changesin K and L.around1.58and6.32. At K =1.6and L =6.32,totalcostis
$381.60,andatK=1.58andL=6.4,totalcostis$381.6,bothgreaterthan$379.20.
WehavefoundthecostminimizinglevelsofKandL.
3.SupposeaproductionfunctionisgivenbyF(K,L)=KL 2,thepriceofcapitalis$10,and
the price of labor $15. What combination of labor and capital minimizes the cost of
producinganygivenoutput?
Thecostminimizingcombinationofcapitalandlaboristheonewhere
MPL w
MRTS .
MPK r
dQ
The marginal product of labor is 2 KL . The marginal product of capital is
dL
dQ
L2 .
dK
Set the marginal rate of technical substitution equal to the input price ratio to
determinetheoptimalcapitallaborratio:
2 KL 15
,orK=0.75L.
L2 10
Therefore,thecapitallaborratioshouldbe0.75tominimizethecostofproducingany
givenoutput.

4. SupposetheprocessofproducinglightweightparkasbyPollysParkasisdescribed
bythefunction:
Q=10K.8(L40).2
where Q is the number of parkas produced, K the number of computerized stitching
machinehours,and L thenumberofpersonhoursoflabor. Inadditiontocapitaland
labor,$10worthofrawmaterialsareusedintheproductionofeachparka.
Wearegiventheproductionfunction:Q=F(K,L)=10K .8(L40).2
Wealsoknowthatthecostofproduction,inadditiontothecostofcapitalandlabor,
includes$10ofrawmaterialperunitofoutput.Thisyieldsthefollowingtotalcost
function:

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TC(Q)=wL+rK+10Q
a. By minimizing cost subject to the production function, derive the costminimizing
demands for K and L as a function of output (Q),wage rates (w), and rental rates on
machines (r). Use these results to derive the total cost function, that is costs as a
functionofQ,r,w,andtheconstant$10perunitmaterialscost.
WeneedtofindthecombinationsofKandLwhichwillminimizethiscostfunction
foranygivenlevelofoutputQandfactorpricesrandw.Todothis,wesetupthe
Lagrangian:
=wL+rK+10Q[10K.8(L40).2Q]
DifferentiatingwithrespecttoK,L,and,andsettingthederivativesequaltozero:

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(1)

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(2)

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(3)

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Thefirst2equationsimply:

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or

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Chapter7:ProductionandCostTheoryAppendix

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Thisfurtherimplies:

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.
SubstitutingtheaboveequationsforKandL40intoequation(3)yieldssolutionsfor
KandL:

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or

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Wecannowobtainthetotalcostfunctionintermsofonlyr,w,andQbysubstituting
thesecostminimizingvaluesforKandLintothetotalcostfunction:

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Chapter7:ProductionandCostTheoryAppendix

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b.Thisprocessrequiresskilledworkers,whoearn$32perhour.Therentalrateonthe
machinesusedintheprocessis$64perhour.Atthesefactorprices,whataretotalcosts
as a function of Q? Does this technology exhibit decreasing, constant, or increasing
returnstoscale?
Giventhevaluesw=32andr=64,thetotalcostfunctionbecomes:
TC(Q)=19.2Q+1280.
Theaveragecostfunctionisthengivenby
AC(Q)=19.2+1280/Q.
Tofindreturnstoscale,chooseaninputcombinationandfindthelevelofoutput,
and thendoubleallinputs andcompare thenew andoldoutputlevels. Assume
K=50andL=60.ThenQ1=10(50)0.8(6040)0.2=416.3.WhenK=100andL=120,Q 2=
10(100)0.8(12040)0.2 = 956. Since Q 2/Q1 > 2, the production function exhibits
increasingreturnstoscale.
c. Pollys Parkas plans to produce 2000 parkas per week. At the factor prices given
above, howmanyworkersshouldthefirmhire(at40hoursperweek)andhowmany
machinesshoulditrent(at40machineshoursperweek)? Whatarethemarginaland
averagecostsatthislevelofproduction?
GivenQ=2,000perweek,wecancalculatetherequiredamountofinputsKandL
usingtheformulasderivedinparta:

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ThusL=154.9workerhoursandK=2,000/8.7=229.9machinehours.Assuminga
40hourweek,L=154.9/40=3.87workersperweek,andK=229.9/40=5.74
machinesperweek.PollysParkasshouldhire4workersandrent6machinesper
week.
Weknowthatthetotalcostandaveragecostfunctionsaregivenby:
TC(Q) =19.2Q+1280
AC(Q)=19.2+1280/Q,
sothemarginalcostfunctionis
MC(Q)=dTC(Q)/dQ=19.2.
Marginalcostsareconstantat$19.2perparkaandaveragecostsare
19.2+1280/2000or$19.84perparka.

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