Question

Subject: Managerial Ecnomics ANSWER ONLY 1.3!

Assume that the marginal benefit of a contract is $80 regardless of its length. Determine the optimal length (L) in years of the contract given that the marginal costs of writing the contract is

1.1 MC(L) = 40 + 4L

1.2 MC(L) = 20 + 2L

1.3 Draw a graph and explains how the optimal length of the contract changes when marginal cost increases and when marginal cost decreases given that marginal benefit is constant.

Answer 1

With marginal benefit being a constant and horizontal line, the optimal length of the contract rises when marginal cost decreases and the length decreases when the marginal cost increases The diagram is shown below

Intially the optimal length is L0 and marginal cost is MC0 and marginal benefit is MB. When marginal cost rises and reaches MC2 the optimal length falls to L2 and similarly when marginal cost falls and reaches MC1 the optimal length rises to L1