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Final

BUS 207 Chapter Notes - Chapter 7: Average Variable Cost, Average Cost, Diminishing ReturnsExam


Department
Business Administration
Course Code
BUS 207
Professor
Bernie Maroney
Study Guide
Final

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Chapter 7: Producers in the Short Run
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Answers to Study Exercises
Fill-in-the-Blank Questions
Question 1
a) production function
b) implicit costs
c) capital; time
d) economic profits
e) short run; long run
Question 2
a) diminishing returns (to the variable factor)
b) marginal product
c) above; below
d) maximum
e) fall; negative
Question 3
a) minimum
b) increase
c) increasing
d) increasing
e) capacity
f) marginal cost; average variable cost; average total cost
Review Questions

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Question 4
a) Hourly wages are an explicit cost. These are subtracted from revenues for computing both
accounting and economic profits.
b) Depreciation of physical capital is an explicit cost. It is subtracted from revenues for
computing both accounting and economic profits.
c) The risk-free 2% return is part of the alternative return that investors could have earned if they
did not invest in this firm. This is an implicit (opportunity) cost, and is subtracted from revenues
to compute economic profit. It is ignored in the computation of accounting profit.
d) Rental payments for a production facility are an explicit cost. It is subtracted from revenues
for computing both accounting and economic profits.
e) The additional wages the owner could have received in alternative employment is an implicit
(opportunity) cost. It is subtracted from revenues to compute economic profit, but ignored in the
computation of accounting profit.
f) The risk premium of 3% is part of what owners could have earned if they invested elsewhere
rather than in this firm. It is an implicit (opportunity) cost and is subtracted from revenues to get
economic profit, but ignored in the computation of accounting profit.
Question 5
Note that the opportunity cost of remaining in business is not only the $70 000 in explicit expenses
the carpenter incurs, but also the income from the furniture factory that the carpenter cannot
receive because he has made the decision to operate his own shop. If this forgone salary is any
larger than $30 000, then the carpenter should go back to the factory. Another way to say this is
that his (accounting) profits are $30 000 per year when he runs his own business. So if his salary at
his first job is higher than $30 000, he should go back to the factory.
Question 6
There is no reason provided for why the “usual” diminishing returns does not apply in this
situation. We are told that the minimum ATC occurs with at least 8 workers, so ATC is declining
as output rises from zero to the level consistent with 8 workers (given the capital stock). It
follows that the AP curve is rising and reaches a maximum at 8 workers. With diminishing
returns, the AP curve then begins to fall as the number of workers rises from 8 to 16 (and so the
ATC curve rises). The MP curve must be above the AP curve when the latter is rising, and it is
also likely rising. When AP begins to fall, however, MP must be below it. The MP curve will
begin falling (diminishing returns) at a lower number of workers than 8, and it will intersect the
AP curve at its maximum.

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Question 7
LeBron Jamesaverage score is 25 points per game (computed over the total number of games
he has played this season). His points from the last game of the season are 12; this is his
marginal score. When his average is re-calculated after the last game, it will be lower than 25
points (although we don’t know how much lower unless we know how many games he played
this season). His average score falls because his marginal score is below his averagethe
usually marginal-average relationship.
Question 8
a) At this level of output, note that MC is above ATC, which means that ATC must be rising as
output increases. This further implies that we are at a level of output beyond which ATC and
AVC reach their minimum points. So we are on the upward-sloping portion of the MC curve and
thus are already encountering diminishing marginal returns, and also on the upward-sloping
portion of the AVC curve and so are encountering diminishing average returns.
b) Since the firm is on the upward-sloping portion of the ATC curve, it is operating beyond its
level of capacity.
c) At this level of output, note that MC is below ATC, which means that ATC must be falling as
output increases. This further implies that we are at a level of output below which ATC and AVC
reach their minimum points. So we are on the downward-sloping portion of the marginal and
average curves. The firm has not yet encountered diminishing marginal or average returns.
d) Since ATC is falling, the firm is producing below its capacity.
Question 9
For a firm producing physical products such as steel or lumber or appliances or furniture, the law
of diminishing returns almost certainly applies and so the firm’s cost curves would be like those
discussed in the chapter. In particular, the firm’s MC curve will be U-shapedalthough whether
it is “sharply” so or “gradually” so depends crucially on the nature of the firm’s technology.
But for a firm making digital products such as apps or movies or online courses or ebooks, the
nature of costs is quite different. In these situations, the firm will typically have large fixed costs
associated with the initial development of the product. But once the product is developed,
additional units of the product can be produced and distributed at very low costs, and this cost
will typically not increase as the level of output increases. In other words, the firm’s MC curve
will be flat (horizontal) at a very low level; diminishing returns is absent. See the box in this
chapter for further discussion.
Problems
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