Block 5: The Firm

MCQs

1. Anita owns a grocery shop. These are her annual revenues and costs:

Revenues: £250,000
Supplies: £25,000
Electricity and heating: £6,000
Employees’ salaries: £75,000

In addition to the above, Anita pays herself a salary of £80,000 and accumulates any
remaining profits. If she closed her shop, she could rent out the land and building for
£100,000. Due to her experience at running her own shop the local supermarket would
offer her a job and pay her £95,000.

a) Anita’s revenue exceeds her economic costs so she should continue running her
business.
b) Anita’s economic costs exceed her accounting costs so she should shut down her
business.
c) Anita’s economic costs exceed her revenue so she should shut down her business.
d) Anita’s salary is less than what the supermarket would pay so she should shut down
her business.

(c) is the correct answer.

2. Suppose the short-run total cost of producing T-shirts can be represented as 𝑆𝑇𝐶 = 50 +
2𝑞 where 𝑞 is the level of output. The average and marginal costs of the 5th T-shirt are:

a) £50 and £2.

b) £12 and £2.
c) £50 and £10.
d) £12 and £10.

(b) Is the correct answer.

True/False/Uncertain

1. A publishing company is selling books. To do so they need to employ proof-readers and

assign them computers. Hiring more proof-readers without assigning them computers
cannot increase the number of books produced.

Uncertain. We do not know the production function of the publishing company. Proof-
readers and computers could be complements, but the question does not state it.

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 2. When long-run costs for a firm are at a minimum the extra output we get from the last
dollar spent on an input must be the same for all inputs.

True. If that is not the case the costs are not minimized. An excellent answer could either
show the tangency condition not being respected otherwise or explain through a diagram.

3. A car manufacturer invests in a factory and machinery (capital), which they cannot modify
in the short run. They also employ workers on a yearly contract. If the rent needed for the
factory and machinery, the wages paid to the employees and prices do not change, the
long run cost of producing a good must be lower than the short run cost of producing the
same good, as no inputs are fixed in the long run.

Uncertain. While long run costs can never be higher than short run costs if the input prices
do not change, they could be equal (if the firm has optimally chosen the inputs in the short
run).

Long questions

Bob Smith manages a branch office of a large financial services firm. He uses computers (capital,
𝐾) and people (labour, 𝐿) to produce consulting advice 𝑄, according to the production function:
𝑄 = 𝐾𝐿. The marginal product of labour is equal to 𝐾 and the marginal product of capital is equal
to 𝐿. Employing people costs the wage rate 𝑤 = 1 while renting computers costs the rental rate
𝑟. Suppose computers cost twice what people do (i.e., 𝑟 = 2𝑤 = 2). The number of computers
Z.
in the branch is fixed at 𝐾 = 𝐾

a) How much labour does Mr Smith employ if he needs to produce output 𝑄? Show that
$
total cost is 𝐶(𝑄) = 2𝐾 + . .
"
b) Given that the first derivative of the total cost function above is ., derive average and
marginal cost. How do average and marginal cost vary with output? Explain using a
graph.
c) Corporate headquarters has just authorised Mr Smith to upgrade the branch office by
varying the quantity of computers. What is the optimal (cost-minimising) mix of capital
and labour?

Guideline

Z ∗ 𝐿 so 𝐿 = $ and 𝑇𝐶 = 𝑤𝐿 + 𝑟𝐾 = 1 ∗ N$ O + 2 ∗ 𝐾
a) 𝑄 = 𝐾 ∗ 𝐿 = 𝐾 Z+$
Z = 2𝐾
/
. /
. /
.
01 / 3&
2#. (4 /
#. "
b) Average cost: 𝐴𝐶 = $
= $
'
= $
+ ./
"
Marginal cost: 𝑀𝐶 = /
.
Average cost declines with output but marginal cost is constant.
c) At the cost-minimising mix of capital and labour, the slope of the isoquant is equal to the
slope of the isocost line. The slope of the isoquant is the marginal rate of technical
substitution. The slope of the isocost line is the ratio of the factor prices of capital and
labour. Slope of isoquant = −𝑀𝑃𝐾/𝑀𝑃𝐿 = −𝐿/𝐾 Slope of isocost line = −𝑟/𝑤 =
−2/1 = −2 As such, 𝐿/𝐾 = 2 so 𝐿 = 2𝐾. Mr Smith should use two workers for every

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 computer.

2. A firm manufactures quad bikes (“quads”). Each quad is made using one frame (𝒙𝟏 ) and
four wheels (𝒙𝟐 ). Each frame costs £10 and each wheel costs £3. The firm cannot use extra
wheels on their own, or extra frames on their own. Hence the output of the firm can be
represented by the function

𝟏
𝐦𝐢𝐧 _𝒙𝟏 , 𝒙𝟐 b
𝟒
𝟏
(Hint: this is similar to working with 𝐦𝐢𝐧 S𝑲, 𝟒 𝑳T, but instead of considering prices 𝒓 and 𝒘
you may consider prices 𝒑𝟏 and 𝒑𝟐 for the inputs)

a) What is an isoquant? Show the isoquants for producing two quads, three quads and
seven quads.
b) Derive the input demands for frames and wheels for the firm. How do they depend on
the input prices? What is the maximum amount of quads the firm can produce if the
number of wheels is fixed at 12? Assume that the firm is producing the maximum
amount of quads. What is the marginal product of adding an extra frame?
c) Define the firm’s cost function and derive it. Assume that each wheel costs £4 and
each frame costs £10. What is the cost of producing 7 quads?
d) Assume that the firm needs to pay £50 per day to rent the factory to produce quads
(this is a fixed cost). Continue to assume that each wheel costs £4 and each frame
costs £10. Suppose that the firm can only produce 10 quads per day and the rent has
already been paid for today. If the price at which the firm can sell quads is £30 should
the firm produce today? Explain your reasoning.
e) Continue to assume that the daily rent is £50, each wheel costs £4 and each frame
costs £10. Suppose that the firm can only produce 10 quads per day and the rent can
be stopped (so the cost of producing zero quads is zero). If the price at which the firm
can sell quads is £30 should the firm produce today? Explain your reasoning.

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Guideline

a) An isoquant shows all the combinations of inputs that allow the firm to produce a
given quantity of the output. Isoquants will be L-shaped with kinks at (2,8), (3,12)
and (7,28). Many students plotted L-shaped curves on the diagram but failed to
show the optimal bundles and the line 𝑥# = 4𝑥" where all the optimal bundles (the
kinks) lie. The figure should show the isoquants corresponding to the production of
2, 3 and 7 quad bikes (see below). All the optimal bundles are chosen so that 𝑥" =
"
𝑥 or, equivalently, 4𝑥" = 𝑥# .
8 #

"" = 4"!
!"

28 Q=7

12 Q=3

8 Q=2

2 3 7 !!

b) The demands for frames and wheels do not depend on prices. The firm will always
"
need to demand 𝑥" = 8 𝑥# or it would be demanding too many wheels/frames and
not using resources optimally. This implies that the input factor demands are 𝑥" =
𝑄 and 𝑥# = 4𝑄. This also shows us that a change in the price of either of the inputs
does not imply a reduction for the quantity of that input the firm will need to
produce quads. Here there is no possibility for substitution. Because of this, the firm
cannot produce more than 3 quads when the number of wheels is fixed at 12. If the
firm were to add extra frames after the third one the output would not increase.
Many students attempted to answer this question by taking a partial derivative.
Finally, if we have 12 wheels adding a fourth frame cannot make the output
increase, as frames without wheels cannot produce a quad. Hence, the marginal
product of wheels (i.e. how much increasing the amount of wheels would make
output change) when the firm is producing 3 quads is zero.

c) The firm’s cost function is the minimum amount needed to spend on inputs to
produce a given amount of output. Excellent answers would include an expression
for the cost function for any level of production 𝑄. We know from part (b) that the
input factor demands are 𝑥" = 𝑄 and 𝑥# = 4𝑄 . The corresponding cost function is:

𝐶(𝑄) = 𝑝" 𝑥" + 𝑝# 𝑥# = 𝑝" 𝑄 + 𝑝# 4𝑄 = 𝑄(𝑝" + 4𝑝# )

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 To produce 7 quads the firm needs 28 wheels and 7 frames so the overall cost
function is 7(10 + 4 ∗ 4) = 182.

d) The marginal cost of producing a quad is £26 (i.e. the cost of one frame and four
wheels), so if the firm produces today it will cover all its variable cost and can
recover part of the fixed cost. Hence the firm should be producing today.
One way to see this is to compare the options the firm has. If the firm doesn’t
produce the profits will be Π(0) = −£50, as it still needs to pay rent.
Producing the maximum of amount of quads (10) instead yields Π(20) = −£50 +
£(30 − 26) ∗ 10 = −£10. This loss is smaller than if the firm were to shut down
and hence the firm should produce today.
Stating that the firm is making a loss is not enough here, as in the short run the firm
will keep producing whenever 𝑃 ≥ 𝐴𝑉𝐶, which is true in this case, as 𝑃 = 30 and
𝐴𝑉𝐶 = 26. Intuitively, while the firm is not making a profit, it is avoiding a bigger
loss due to the need to pay for rent costs even if 𝑄 = 0.
e) Here there was no need for another calculation as the marginal cost of a quad is the
same as in part (d).This time the firm should not produce, as producing the
maximum amount of quads (10) yields a profit of Π(10) = −£10 (we know this
from part (d)), whereas producing zero costs zero. The firm is better off shutting
down.

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