B. Answers to Short-Answer, Essays, and Problems
1. Why are costs important in economics? Why don’t economists use the same cost data as accountants
use?
Costs are important in economics in determining the allocation of resources based on what firms are
willing to pay, which in turn depends on how much consumers are willing to pay for the products
produced by these resources. Costs reflect the market prices of the resources used in production, but
also economic costs include the opportunity cost of using some resources that may not have an
explicit market price. Economists argue that the cost of all resources should be considered when
determining the real cost of production.
Implicit costs are as important as the explicit costs which are generally the so-called “accounting
costs.” For example, economists (but not accountants) would count the income forgone in the use of
the owner’s time as an economic cost, the interest forgone by using one’s own funds, and so on.
These implicit costs should be counted so one can judge the true economic or opportunity cost of
production. If these costs are neglected, then an overallocation of resources could occur because not
all of the production costs are being measured. [text: E pp. 392-394; MI pp. 148-150]
2. What is the real cost of putting an unemployed laborer to work raking leaves or digging holes and
refilling them during a serious depression? Explain.
Since an unemployed laborer was not doing anything productive before giving him this menial task,
then the real cost of employing the person is zero. In other words, no other production is being
sacrificed in order to have this person rake leaves or dig holes. The only real cost is the opportunity
cost of the unemployed worker’s leisure. This answer assumes that there are no more productive
jobs available to the worker than raking leaves or digging holes that would be suitable for this
laborer. [text: E pp. 392-393; MI pp. 148-149]
3. Why is it important to distinguish between explicit and implicit costs?
Implicit costs are as important as the explicit costs which are generally the so-called “accounting
costs.” For example, economists (but not accountants) would count the income forgone in the use of
the owner’s time as an economic cost, the interest forgone by using one’s own funds, and so on.
These implicit costs should be counted so one can judge the true economic or opportunity cost of
production. If these costs are neglected, then an overallocation of resources could occur because not
all of the production costs are being measured. [text: E pp. 392-393; MI pp. 148-149]
New 4. Jane quit her job at IBM where she earned $50,000 a year. She cashed in $50,000 in corporate bonds
that earned 10% interest annually to buy a mini-bus. Jane has decided to buy the mini-bus and set up
a commuter service between Lincoln and Omaha. There are 1000 people who will pay $400 a year
each for the commuter service; $280 from each person goes for gas, maintenance, insurance,
depreciation, etc.
(a) Complete the following questions: (1) What are Jane’s total revenues? (2) What are Jane’s
explicit costs? (3) What is her accounting profit?
(b) List two important implicit costs that Jane has not included.
(c) What is Jane’s pure economic profit (loss)?
(a) (1) Total revenues are $400,000. (2) Explicit costs are $280,000. (3) The accounting profit is
$120,000.
(b) (1) Salary that could be earned at IBM ($50,000). (2) Interest on invested savings ($50,000 x
10% = $5,000). Total implicit costs are $55,000.
(c) Economic profit is $87,000. [$400,000 – ($280,000 + $55,000) = $65,000]. [text: E pp. 392-394;
MI pp. 148-150]
5. Why is the distinction between fixed and variable cost important?
The importance in distinguishing between fixed and variable costs will become more apparent in
later chapters when the firm’s decision about price and output determination is examined. For now,
the primary importance has to do with the distinction between the long run and the short run. Once
fixed costs are incurred, a short-run period has been determined by the length of time that those costs
are fixed, i.e., cannot be varied. The firm has no immediate control over these costs. Other costs that
vary with the level of output then are variable costs. Later we will learn that they are important in
determining the profit-maximizing or loss-minimizing level of output given the plant size and other
fixed costs. [text: E p. 394; MI p. 150]
6. Indicate whether the inputs below are variable (V) or fixed (F) in the short run.
_____
_____
_____
_____
_____
_____
Input
Meat
Fire insurance
Tires
Property tax
Gasoline
Depreciation
in
in
in
in
in
in
Output
hamburgers.
dry cleaning.
automobiles.
textile production.
trucking services.
aircraft production.
V
F
V
F
V
F
Input
Meat
Fire insurance
Tires
Property tax
Gasoline
Depreciation
in
in
in
in
in
in
Output
hamburgers.
dry cleaning.
automobiles.
textile production.
trucking services.
aircraft production.
[text: E p. 394; MI p. 150]
7. What is the difference between the short run and the long run?
The short run is a period too brief for a firm to alter its plant capacity, but it can still change the
degree to which the fixed plant is used. The long run is a period in which the firm can change all
resources including the size and number of plants. It is often stated that the short run is a “fixedplant” period and the long run is a “variable plant” period. [text: E p. 394; MI p. 150]
8. Explain the difference between total product, marginal product and average product.
Total product is the total product, or total output, of a particular good produced. Marginal product is
the change in total product resulting from each additional input of labor. Average product is the total
product divided by the total number of workers. It is also called labor productivity. [text: E pp. 394395; MI pp. 150-151]
9. What is the relationship between total product, marginal product, and average product shown by the
law of diminishing returns?
Total product first increases at an increasing rate, but then it increases at decreasing rate. After it
reaches a maximum, it then declines. The marginal product shows the slope of the total product
curve. When total product is rising at an increasing rate, marginal product is rising. When total
product is increasing at a decreasing rate, then marginal product is still positive, but diminishing.
When total product reaches a maximum, marginal product is zero. Total product declines when the
marginal product becomes negative. The average product has similar characteristics to marginal
product. It rises, reaches a maximum, and then declines. In the rising phase for average product,
marginal product is greater than average product. Average product declines at the point at which the
marginal product falls below average product. [text: E pp. 396-398; MI pp. 152-154]
10. Comment on the problem with this statement: “Of course, there are diminishing marginal returns
from adding more workers to a fixed quantity of plant and equipment because additional workers are
not as good as initial workers.”
The law of diminishing returns assumes all units of variable inputs, which would be workers in this
case, are of equal quality. Marginal product diminishes not because each additional worker who is
hired is inferior to the previous worker, but because more workers are being used relative to the fixed
plant and equipment that is available. Sunk costs should be disregarded in decision making. [text: E
pp. 395-396; MI pp. 151-152]
11. What is the law of diminishing returns? Give a descriptive example.
The law states that as additional units of a variable resource such as labor are added to a fixed
resource such as capital, beyond some point the additional, or marginal, product attributable to each
additional unit of the variable resource will decline. An example would be a factory assembly line.
The capital (assembly line) is fixed. As more and more workers (variable inputs) are assigned to
work on the assembly line, the output produced by each additional worker is likely to decline at some
point. The reasons for this decline are that the assembly line equipment may be fully utilized and
beyond some point of production additional workers would only cause problems for the existing
workers. Productivity, output per work hour, would fall as more workers are added. [text: E pp.
395-398; MI pp. 151-154]
New 12. (Consider This) How can total course learning and studying be related to the law of diminishing
returns?
Total course learning can be considered an output in the educational production process. The inputs
include intelligence or ability, quality of the course materials, instructor effectiveness, class time, and
study time. If you hold constant the other inputs, and just change study time, then you can use this
change to explain the law of diminishing returns. As study time is added to these other fixed resources,
the contribution made by each additional hour of study time to total course learning eventually starts to
fall. [text: E p. 395; MI p. 151]
13. Complete the following table by finding the average and marginal product. At what input-output
level will average variable cost begin to rise? Explain.
Inputs of
labor
0
1
2
3
4
5
6
Total
product
0
8
18
25
30
33
34
Average
product
0
8
9
8.33
7.50
6.60
5.67
Marginal
product
8
10
7
5
3
1
With equal pay for each worker, average variable cost will begin to rise for the third worker’s output
because that is the point where diminishing returns begin. [text: E pp. 395-396; MI pp. 151-152]
14. The table below shows the total production of a firm as the quantity of labor employed increases.
The quantities of all other resources employed are constant. Compute the marginal and average
products and enter them in the table.
Units
of Labor
0
1
2
3
4
5
6
7
8
Total
product
0
40
100
165
200
225
240
245
240
Marginal
product
of labor
–––
______
______
______
______
______
______
______
______
Average
product
of labor
–––
______
______
______
______
______
______
______
______
(a) At what levels are there increasing returns to labor and at what levels are there decreasing returns
to labor?
(b) Describe the relationship between the total product and marginal product.
(c) Describe the relationship between marginal and average product.
Marginal
Average
Units
Total
product
product
of Labor
product
of labor
of labor
0
0
1
40
40
40
2
100
60
50
3
165
65
55
4
200
35
50
5
225
25
45
6
240
15
40
7
245
5
35
8
240
–5
30
(a) There are increasing returns to labor through the third worker hired. Decreasing returns to labor
set in with the fourth worker.
(b) Where total product increases at an increasing rate, marginal product rises (from 0 to 65). Where
total product is increasing at a decreasing rate, marginal product is positive but falling (from 65 to 5).
Where total product declines, marginal product is negative from 5 to –5.
(c) Where marginal product is greater than average product, average product will rise. Where
marginal product is less than average product, average product will fall. Marginal product intersects
average product at maximum average product. [text: E pp. 395-398; MI pp. 151-154]
16. What is the relationship between marginal cost and marginal product?
Marginal cost is the change in total cost divided by the change in output. Marginal product is the
change in output divided by the change in input. Assume that each additional unit of a resource is
hired at a constant price, or that the change in total cost is constant. If input changes by 1 unit, then
marginal product is simply the change in output. Thus, marginal cost is simply a constant change in
total cost divided by marginal product. As marginal product increases, marginal costs decline. As
marginal product decreases, marginal costs increase. This increasing and decreasing relationship for
marginal product is suggested by the law of diminishing returns. [text: E pp. 401-402; MI pp. 157158]
17. Why does the short-run marginal-cost curve eventually increase for the typical firm?
The shape of the firm’s marginal cost curve is a result of the law of diminishing returns. If all units
of a variable resource are hired at the same price, the marginal cost of each additional unit of output
will fall as long as the marginal product of each additional resource is rising. Marginal cost is equal
to the marginal product of each additional unit of resource divided by the constant cost of each
additional unit. As diminishing returns set in, the marginal product of each additional resource falls
and when divided by the constant price for each unit of resource, the marginal cost will now rise.
18. Assume that a firm has a plant of fixed size and that it can vary its output only by varying the amount
of labor it employs. The table below shows the relationships between the amount of labor employed,
the output of the firm, the marginal product of labor, and the average product of labor.
(a) Assume each unit of labor costs the firm $20. Compute the total cost of labor for each quantity of
labor the firm might employ, and enter these figures in the table.
(b) Now determine the marginal cost of the firm’s product as the firm increases its output. Enter
these figures in the table.
(c) If labor is the only variable input, the total labor cost and total variable cost are equal. Find the
average variable cost of the firm’s product. Enter these figures in the table.
(d) Describe the relationship between the marginal product of labor and the marginal cost of the
firm’s product.
(e) Describe the relationship between the average product of labor and the average variable cost.
Quantity
of labor
employed
0
1
2
3
4
5
6
7
8
9
10
Total
output
0
10
22
36
48
58
66
72
76
78
78
Marginal
product
of labor
–––
10
12
14
12
10
8
6
4
2
0
Average
product
of labor
–––
10.00
11.00
12.00
12.00
11.60
11.00
10.28
9.50
8.66
7.80
Total
Average
variable Marginal variable
cost
cost
cost
–––
–––
$_____
$_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
Quantity
of labor
employed
0
1
2
3
4
5
6
7
8
9
10
Total
output
0
10
22
36
48
58
66
72
76
78
78
Marginal
product
of labor
–––
10
12
14
12
10
8
6
4
2
0
Average
product
of labor
–––
10.00
11.00
12.00
12.00
11.60
11.00
10.28
9.50
8.66
7.80
Total
Average
variable Marginal variable
cost
cost
cost
–––
–––
$ 20
$2.00
$2.00
40
1.67
1.82
60
1.43
1.67
80
1.67
1.67
100
2.00
1.72
120
2.50
1.82
140
3.33
1.94
160
5.00
2.10
180
10.00
2.31
200
–––
2.56
(a) See table above.
(b) Divide the increase in total labor cost by the increase in total output to get marginal cost.
(c) Divide total labor cost by total output to get average variable cost.
(d) As marginal product rises to a maximum, marginal cost falls to its minimum. As marginal
product falls from its maximum, marginal cost rises from its minimum.
(e) As average product rises to its maximum, average variable cost falls to its minimum. As average
product falls from its maximum, average variable cost rises from its minimum. [Note to instructors:
output increases by more than one unit in this problem, which differs from text example on p. 399.]
[text: E pp. 398-403; MI pp. 154-159]
19. You are given the following short-run information for an individual firm. Labor (L) is the only
variable input. The price of labor is $200/week. Fixed costs are $100/week. Complete the rest of
the table. Describe the relationship between the MP and MC. At which output level does the law of
diminishing returns set in?
Labor
L
0
1
2
3
4
5
6
7
8
9
10
11
12
Total
product
Q
0
20
55
100
150
200
230
250
263
270
275
278
280
MP
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
TVC
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
TFC
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
TC
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
MC
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
Labor
L
0
1
2
3
4
5
6
7
8
9
10
11
12
Total
product
Q
0
20
55
100
150
200
230
250
263
270
275
278
280
MP
$
20
35
45
50
50
30
20
13
7
5
3
2
TVC
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
2,200
2,400
TFC
$100
100
100
100
100
100
100
100
100
100
100
100
100
TC
$ 100
300
500
700
900
1,100
1,300
1,500
1,700
1,900
2,100
2,300
2,500
MC
$10.00
5.71
4.41
4.00
4.00
6.66
10.00
15.38
28.57
40.00
66.66
100.00
As marginal product rises from 0 to 50, marginal cost falls from $10 to $4. Then marginal product
falls from 50 to 2, as marginal cost increases from $4 to $100. Diminishing marginal returns set in
beyond output level 200. [Note to instructors: output increases by more than one unit, which differs
from text example on p. 399.] [text: E pp. 398-403; MI pp. 154-159]
20. Assume a firm has fixed costs of $80 and variable costs as indicated in the table below. Complete
the cost table.
Total
product
0
1
2
3
4
5
6
7
8
Total
variable
cost
$ 0
110
150
180
220
270
340
440
580
Total
cost
$ 80
190
230
260
300
350
420
520
660
AFC
–––
$______
______
______
______
______
______
______
______
AVC
–––
$______
______
______
______
______
______
______
______
ATC
–––
$______
______
______
______
______
______
______
______
MC
–––
$_____
_____
_____
_____
_____
_____
_____
_____
Total
product
0
1
2
3
4
5
6
7
8
Total
variable
cost
$ 0
110
150
180
220
270
340
440
580
Total
cost
$ 80
190
230
260
300
350
420
520
660
AFC
–––
$800
40
26.67
20
16
13.33
11.43
10
AVC
–––
$110
75
60
55
54
56.67
62.86
72.50
ATC
–––
$190
115
86.67
75
70
70
74.29
82.50
MC
–––
$110
40
30
40
50
70
100
140
21. Complete the following short-run cost table using the information provided.
Total
product
0
1
2
3
4
TFC
$____
____
____
____
____
AFC
–––
$____
12
____
____
TVC
$____
____
____
____
____
AVC
–––
$12
10
12
14
TC
$____
____
____
____
____
MC
$____
____
____
____
____
Total
product
0
1
2
3
4
TFC
$24
24
24
24
24
AFC
–––
$24
12
8
6
TVC
$ 0
12
20
36
56
AVC
–––
$12
10
12
14
TC
$24
36
44
60
80
MC
–––
$12
8
16
20
22.
In the table below you will find a schedule of a firm’s fixed cost and variable cost. Complete
the table by computing total cost, average fixed cost, average variable cost, average total cost, and
marginal cost.
Total
Total
Average
Total fixed variable Total
fixed
product cost
cost
cost
cost
0
$100
$ 0 $_____
–––
1
100
100
_____ $______
2
100
180
_____ ______
3
100
240
_____ ______
4
100
320
_____ ______
5
100
440
_____ ______
6
100
600
_____ ______
7
100
800
_____ ______
8
100
1040
_____ ______
9
100
1340
_____ ______
10
100
1800
_____ ______
Average Average
variable
total
Marginal
cost
cost
cost
–––
–––
–––
$______ $______
$_____
______
______
_____
______
______
_____
______
______
_____
______
______
_____
______
______
_____
______
______
_____
______
______
_____
______
______
_____
______
______
_____
Total
Total
Total fixed variable Total
product cost
cost
cost
0
$100 $ 0 $ 100
1
100
100
200
2
100
180
280
3
100
240
340
4
100
320
420
5
100
440
540
6
100
600
700
7
100
800
900
8
100
1040
1140
9
100
1340
1440
10
100
1800
1900
Average Average
variable
total
Marginal
cost
cost
cost
–––
–––
–––
$100.00 $200.00
$100
90.00
140.00
80
80.00
113.33
60
80.00
105.00
80
88.00
108.00
120
100.00
116.67
160
114.29
128.57
200
142.50
130.00
240
148.89
160.00
300
180.00
190.00
460
Average
fixed
cost
–––
$100.00
50.00
33.33
25.00
20.00
16.66
14.29
12.50
11.11
10.00
23. Complete the following short-run cost table using the information provided.
Q
0
1
2
3
4
5
6
7
TC
$ 4
7
9
10
11
13
17
22
TFC
$_____
_____
_____
_____
_____
_____
_____
_____
TVC
$_____
_____
_____
_____
_____
_____
_____
_____
AVC
$_____
_____
_____
_____
_____
_____
_____
_____
ATC
$_____
_____
_____
_____
_____
_____
_____
_____
MC
$_____
_____
_____
_____
_____
_____
_____
_____
Q
0
1
2
3
4
5
6
7
TC
$ 4
7
9
10
11
13
17
22
TFC
$4
4
4
4
4
4
4
4
TVC
$ 0
3
5
6
7
9
13
18
AVC
$0
3.00
2.50
2.00
1.75
1.80
2.17
2.57
ATC
$0
7.00
4.50
3.33
2.75
2.60
2.83
3.14
MC
-$3
2
1
1
2
4
5