Week 6 - Firm Behaviour: Costs, Factor Demands and Innovation

Question 1

What are the two inputs of the costs function?

Answer 1

Labour, L
Capital, K

Question 2

What is the function of output?

Answer 2

Function of the amount of labour and capital used.
Y = F(L,K)

Question 3

How is the average product of labour (or capital) calculated?

Answer 3

APL=Y÷L

Question 4

How is marginal product of labour calculated and what is it?

Answer 4

MPL is the extra output produced by one more worker.
MPL=(change in output)÷(change in employment)

Question 5

What is the average value product and how is it calculated?

Answer 5

How much revenue is produced.
AVPL=PY÷L

Question 6

What is the marginal value product and how is it calculated?

Answer 6

The extra output produced by one more worker
MVPL=Price x (change in output÷change in employment)

Question 7

What is diminishing returns to individual factors of production and draw the diagram?

Answer 7

Increasing the Amount of Labour Holding Capital Constant Reduces the Marginal Product of Labour – diminishing returns to individual factors

Question 8

What do isoquants show?

Answer 8

Different input combinations that produce the same output.

Question 9

Where is the optimal point in a isoquant?

Answer 9

Where an isoquant touches the lowest isocost line.

Question 10

What is the slope of the isoquant called?

Answer 10

The marginal rate of transformation.

Question 11

Why is the isoquant bowed?

Answer 11

As one uses more labour and less capital to produce a given level of output the marginal product of labour falls and capital rises - need ever more labour as one reduces the amount of capital

Question 12

What does the isoquant look like if capital and labour are perfect substitutes - draw the diagram?

Answer 12

45 degrees
\

Question 13

What does the isoquant look like if capital and labour are perfect compliments - draw the diagram?

Answer 13

Like an L meeting where the line showing 45 degrees

Question 14

What would perfect substitutes show?

Answer 14

Labour and capital are interchangeable

Question 15

What would perfect compliments show?

Answer 15

They have to be used in fixed proportions. E.g. each machine needs one worker.

Question 16

How is the costs function given?

Answer 16

WL + RK
where W is wage, and R is the cost of capital

Question 17

What does the firm aim to do with cost function?

Answer 17

minimise it giving the lowest combination of capital and labour.

Question 18

Why is the cost of capital difficult to calculate?

Answer 18

Capital is not used up within each period (but does depreciate)
If machine depreciates faster over time then capital is more expensive e.g. if it works for 10 years and then fails, it costs 1/10th of purchase price each year
But also cost because you have to tie wealth up in buying the machine rather than investing elsewhere (where it could earn a return r) – this is an opportunity cost

Question 19

What is the formula for the cost of capital?

Answer 19

(r+d)P
Where P is the cost of machine
r is the interest rate
d is the depreciation rate

Question 20

What do isocost lines show?

Answer 20

Combinations of labour and capital that have the same level of cost

Question 21

What does the slope of the iso-cost line show?

Answer 21

The relative cost of the two inputs
Slope is -(W/R)

Question 22

Draw a isocost and isoquant diagram?

Question 23

What happens when relative prices change - suppose wages go up?
Draw it

Answer 23

It becomes more steep

Question 24

What happens to factor demands if there is a rise in wage and what does it depend on?

Answer 24

Rise in wage encourages firms to substitute labour for capital in producing output
For a given level of output, demand for labour falls and capital rises
The shape of the isoquant affects how much the demand for labour falls.

Question 25

In which case does a rise in wage lead to a bigger change in employment?

Answer 25

If they are close substitutes.

Question 26

In which case would a rise in wages lead to a large rise in total costs?

Answer 26

If they are complementary and have to be used in fixed ratios then they cannot alter factor demands when factor prices change.

Question 27

What is the formula for the profit maximising point?

Answer 27

MR=MC

Question 28

What is the real wage and draw the diagram?

Answer 28

W/P
Axis: Real wage on Y and Employment on X

Question 29

Draw a minimum wage diagram?

Question 30

What is a monopsonist?

Answer 30

When there is a single buyer in the market often in the labour market.

Question 31

What type of supply curve do monopsonists face?

Answer 31

They face an upward-sloping supply curve – the more of the input they buy, the higher the price they pay

Question 32

Draw the diagram of a monopsonist?

Answer 32

Axis: Wage on Y Employment on X
MCL on steeper / and supply on other /
MPL \

Question 33

What do gender pay gaps represent?

Answer 33

Market imperfections
Women earn a lot less than men – 15.4% less in the UK in 2021.

Question 34

What are the labour inequalities for women and ethnic miniorities?

Answer 34

For women the gap is in earnings not unemployment
For ethnic minorities the gap is in employment more than earnings.

Question 35

What is the impact of technological change on labour?

Answer 35

Increases productivity, reduces demand for specific skills and shifts labour demand in

Question 36

What is innovation and why do firms do it?

Answer 36

A lower cost way of producing output
firms who reduce costs will make higher profits which is attractive for firms
But innovation is also costly (R and D)

Question 37

What would happen in this case in a perfectly competitive market?
Innovating firm cannot prevent other firms from using the new technology

Answer 37

All firms will adopt the new technology and now have costs C’ (why wouldn’t they?)
Price will fall from C to C’
Profits will still be zero
No firm has gained and innovating firm has lost its investment I.
Knowing this it would not invest in the first place i.e. incentives to innovate are weak

But consumers have gained from innovation as price has fallen from C to C’
They would like to encourage investment in R+D
How might they do this?
Pay for R+D in publicly-funded universities
Subsidise R+D (UK has an R+D tax credit)
Grant rights to exclusive use of new technology for innovating firms (e.g. patents/trade secret laws)

Question 38

What happens in this case in a perfectly competitive market? Suppose only the innovating firm is allowed to use the new technology

Answer 38

Suppose innovating firm keeps price at C and produces same level of output Y
Profits are now Y(C-C’)>0 so will be a return to innovating if Y(C-C’)>I
Note that incentives to innovate depend on the size of the market (an example: drugs are often not approved for use on children because the market is small and it is not worth while for pharmaceutical companies to spend the money to get the approval)
But could do better than this – charge a price a bit below C, under-cut your rivals, get the whole market and become a monopolist