Assume that both labor and capital exhibit diminishing returns. Suppose you can
ID: 2439099 • Letter: A
Question
Assume that both labor and capital exhibit diminishing returns. Suppose you can hire an additional unit of labor for $5, and she can product 50 units. You could also buy an additional machine at the cost of $200, and that machine would allow you to produce 1000 units. If your main concern is minimizing average cost, what should you do?
a) Hire more labor, because it is cheaper
b) Buy the machine, because it will allow you to produce more
c) Do nothing, because you've already minimized costs
d) There is not enough information to make a legitimate response
Explanation / Answer
Correct option is (b).
Average cost is minimized when
(Marginal product of labor / Wage rate) = (Marginal product of capital / Rental rate)
In this case,
Marginal product of labor / Wage rate = 50 / 5 = 10
Marginal product of capital / Rental rate = 1000 / 200 = 5
Since (Marginal product of labor / Wage rate) > (Marginal product of capital / Rental rate), I should buy the machine and use less labor.