Question

State whether the following statements are true, false or uncertain and briefly explain the reason for your choice. Your grade will largely depend on the quality of your explanations. (a) If a production technology for a firm exhibits the increasing return to scale, then for a 10% increase in output the total long-run costs of production will increase by less than 10%.

(b) Consider a competitive firm’s elasticity demand for labor. Assume that the prices of all factors are given to the firm. In such a situation, the elasticity of demand for labor with respect to the wage rate is smaller if quantity of the final output is fixed than if the price of the output is fixed.

(c) Even if the output price is above the shutdown point, firms may not produce any output in the long-run.

(d) The long run supply curve of competitive industry must always be a horizontal line.

(e) To employ a factor of production efficiently a firm will set the value of the marginal product of each factor equal to the relevant price of the factor to the firm.

(f) Suppose that a firm uses capital, K and labor, L in order to produce output and that rental price of capital is v and wage rate of labor is w. If w decreases, then the demand for capital by the firm will decrease.

(g) A low elasticity of substitution between K and L means that relative prices of capital and labor (w/v) need to change by a small amount to change the ratio of (K/L) by a large amount.

Answer 1

(a) If a production technology for a firm exhibits the increasing return to scale, then for a 10% increase in output the total long-run costs of production will increase by less than 10% - TRUE

If a firm experiences economies of scale (increasing returns to scale), then average cost is falling as output increases. Due to this, a 10% increase in output will cause less than 10% increase in total costs as average cost per unit decreases with increasing output.

(b) Consider a competitive firm’s elasticity demand for labor. Assume that the prices of all factors are given to the firm. In such a situation, the elasticity of demand for labor with respect to the wage rate is smaller if quantity of the final output is fixed than if the price of the output is fixed - TRUE

If a firm is operating in a highly competitive market where final demand for the product is price elastic, they may have little market power to pass on higher wage costs to consumers through a higher price. The demand for labour may therefore be more elastic as a consequence. In contrast, a firm that sells a product where final demand is inelastic (quantity of the final output is fixed) will be better placed to pass on higher costs to consumers, and consequently, the elasticity of demand for labor will be smaller.

(c) Even if the output price is above the shutdown point, firms may not produce any output in the long-run - TRUE

If the perfectly competitive firm faces a market price above the shutdown point, then the firm is at least covering its average variable costs. At a price above the shutdown point, the firm is also making enough revenue to cover at least a portion of fixed costs, so it should limp ahead even if it is making losses in the short run, since at least those losses will be smaller than if the firm shuts down immediately and incurs a loss equal to total fixed costs.

However, in the end, the business is making losses, and no firm would keep incurring losses in the long run. Hence, in the long run, the firm would not remain in business if its average costs are greater than its average selling price.

(d) The long run supply curve of competitive industry must always be a horizontal line - FALSE

The long-run supply curve may be a horizontal straight line, sloping upwards or sloping downwards depending upon the fact whether the industry in question is a constant cost industry, increasing cost industry or decreasing cost industry.