(a) A firm faces the following Marginal Rate of Technical Substitution and relat
ID: 1150993 • Letter: #
Question
(a) A firm faces the following Marginal Rate of Technical Substitution and relative input prices: MRTS-3 and w/r -4. Explain whether the firm is minimising its costs. What can the firm do to improve the situation? (b) Suppose that the wage rate (w) is S10 and the rental rate (r) is $25 per hour. Write an expression for the isocost line for a firm. What is the slope the isocost line? Provide an economic interpretation for the slope. (c) Describe the causes of the firm level: i) economies of scale ii) diseconomies of scaleExplanation / Answer
(a) The cost-minimizing condition for the firm is MRTS = w/r. In this case, sine MRTS is lower than (w/r), firm is not minimizing costs.
Since MRTS (= MPL/MPK) < (w/r), firm will minimize costs by using more labor and less capital, until the ratios are equalized.
(b) Isocost line: TC ($) = wL + rK = 10L + 25K
Slope of isocost line = - w/r = - $10/$25 = - 0.4
The slope of isocost line is the relative price of capital and labor, which determines the optimal amount of capital and labor that can be used to produce a fixed level of output.
(c)
(i) Economies of scale arises when, with increase in production and output, average cost keeps falling. This becomes possible when the firm can buy inputs at a cheaper rate (due to bulk discounts) and continuous process improvements as output increases.
(ii) Diseconomies of scale arises when, with increase in production and output, average cost keeps rising. This becomes possible when the firm is unable to buy inputs with lower price as input volume rises (which is typically true of lower-size firms or new entrants in a market) and inefficiency in production process and productivity as output increases.
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