1. Answer: TFC = 1000. TVC = 2Q. MC = 2. ATC = (1000 + 2Q)/Q = 2 + 1000/Q. AVC = 2. Notice

1. Answer: TFC = 1000. TVC = 2q. MC = 2. ATC = (1000 + 2q)/q = 2 + 1000/q. AVC = 2. Notice that AVC = MC in this case; that happens because the MC is constant. There is no difference between long-run and short-run in this case, because there would never be any reason to build a second well.

Try drawing graphs of these for yourself. TFC, MC, and AVC will all be horizontal lines, and TVC will be an upward-sloping line. ATC will be a curve that is always downward-sloping; it never reaches a minimum (though it approaches the value of 2 from above). You might conclude, therefore, that economies of scale exist at all levels of output – and according to Besanko, that would correct. But the declining ATC results entirely from fixed-cost spreading, so economies of scale are not involved (according to the definition used in class). The question’s description of the situation is purely short run, since only one input, labor, is variable. There’s not enough information to say anything about economies of scale. In the long run, you might (for example) choose to buy machinery that will bring up large quantities of water with less labor. Such machinery might result in economies of scale. But the question does not say whether or not this kind of technology exists.

2. Answer:

q2 q1 & q3 q 3. Answer:

q2 q1 & q3 q

Notice that the minimum of MC happens at q = 0. That’s because the slope of TC is always rising as quantity rises, so the slope is minimized at the lowest possible quantity.

4. Answer: (a) The horizontal axis should be quantity (q), not labor (L). (b) The curve starts at the origin, which means there are no fixed costs. That’s not impossible, but it is strange, unless this is a long-run TC curve. (c) Weirdest of all: the curve has a section that is downward-sloping, which means that the total cost of production actually falls as output rises. In that section, the MC is actually negative.

5. Answer: If L = labor, w = the wage of labor, and labor is the only variable input, then: AVC = wL/q AVC = w[1/(q/L)] AVC = w[1/APL], since APL = q/L by definition. Here’s the intuitive explanation: Average product of labor is the units-of-output per worker. If units per worker go up, then workers per unit must go down. If all workers are paid the same amount per hour, that means the wages paid per unit of output also go down. Since wages are the only source of variable costs (by assumption), we know that variable cost per unit of output – that is, average variable cost – must go down as well. And, of course, all this analysis works just as well with the “ups” and “downs” reversed.

6. Answer For Mike, the opportunity cost of 1 martini is 1.25 cosmos. For Ike, the opportunity cost of 1 martini is 1.2 cosmos. Since Ike has the lower opportunity cost of fixing martinis, he has the comparative advantage in martinis. Similar reasoning will show that Mike has the comparative advantage in cosmos. 7. Answer:

L Q APL MPL 0 0 -- 10 5 50 10 20 10 150 15 25 15 275 18.33 20 20 375 18.75 10 25 425 17 5 30 450 15

8. Answer:

Q TFC TVC TC ATC MC 0 100 0 100 -- 0.8 50 100 40 140 2.8 0.4 150 100 80 180 1.2 0.32 275 100 120 220 0.8 .4 375 100 160 260 0.69 0.8 425 100 200 300 0.71 1.6 450 100 240 340 0.75 9. Answer:

.10 MC

.06 .04

Notice that both the horizontal and vertical axes are dollars; this is because the firm’s output (loans) is measured in dollars. Also notice that the MC has jumps in it, because it is constant over certain ranges of quantity. $

.06 AVC .05 .04

$30 mil $60 mil q ($)

This picture is enlarged so you can see the turning points more easily. Notice that AVC is the same as MC for the first $30 million of loans; both are constant. But for any quantity of loans greater than $60 million, AVC is smaller than MC. This is because AVC takes into account the lower-cost loans that were made earlier (below the $30 million mark), while MC does not. By the time Fred’s has made $60 million in loans, half its funds were acquired at 4% interest and half at 6% interest, so the average interest rate is 5%. The AVC will continue to rise toward 10%, but it will never reach it; it will just get closer and closer. Suppose, for example, Fred’s makes $90 million in loans. With 1/3 of its funds acquired at 4%, 1/3 at 6%, and 1/3 at 10%, the average interest rate is 6.67%.

Do not confuse the interest rates above with the interest rates that Fred’s charges its customers. The interest charged to customers will constitute Fred’s revenues. Here, we are considering Fred’s costs, because it has to take out loans in order to make loans.

Which is more important to Fred’s choice of whether to make more loans, MC or AVC? Suppose that Fred’s has already made $90 million in loans. If it wants to make more loans, it will have to pay 10% interest on the funds. If it loans out the funds at anything less than 10% (the MC), it will be losing money on the loan – even if it charges the customer an interest rate greater than 6.67% (AVC). So the MC is the more important figure in deciding whether to make more loans.