1. You own a pizza shop and you use both labor and capital to make your pizzas.
ID: 2495100 • Letter: 1
Question
1. You own a pizza shop and you use both labor and capital to make your pizzas. Currently the marginal product of labor is 5 pizzas per hour, while the marginal product of you capital is 2 pizzas per hour. You pay your labour $10 per hour, and your capital costs you $5 per hour. The price of pizza is $2.50. Is you little shop using its inputs efficiently? Explain.
2. What is the difference between a profit and a rent? If a firm is interested in maximizing profits, why would it stay in an industry if profits are zero?
3. The “Vintage Sisters” collect old junk, fix it up, and sell it at craft fairs as a hobby. All of their costs are covered by their poor father who lets them use his shop, tools, and paint for free. When pricing their stuff, what elasticity of demand should they aim for? Why?
4. Solve for the equilibrium price and quantity (P* and Q*) both algebraically and graphically (using graph paper), for these four markets:
Market 1:
QD = 10 – P
QS = 5
Market 2:
QD = 10 – P
QS = 5 + P
Market 3:
QD = 10 – ½ P
QS = 5 + 2 P
Market 4:
P = 10 – 2QD
QS = 1 + P
Explanation / Answer
(1)
Cost is minimized when: (Marginal product of capital / Rental price) = (Marginal product of labor / Wage rate)
(Marginal product of capital / Rental price) = 2 / 5 = 0.4
(Marginal product of labor / Wage rate) = 5 / 10 = 0.5
Since (Marginal product of labor / Wage rate) > (Marginal product of capital / Rental price), current allocation is inefficient. I would hire less quantity of labor and/or more quantity of capital (ovens) until these ratios are equal.
(2)
Rent is the factor payment to the capital used in production process, whereas Profit is the residual income left after paying all factors of production. Mathematically,
Profit = Revenue - (Price of labor x Quantity of labor + Price of capital (rent) x Quantity of capital) [Assuming only 2 factors: Labor and capital are used].
Even if profits are zero, firms often stay in business because they earn normal profit, which is included as a payment to the factor called "Entrepreneurship". So, absence of excess profit does not mean firms are making losses, therefore they choose to stay in business.
NOTE: First 2 questions are answered.
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