Chapter 7 Revenue, Profits, and Price: Crash PDF

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Summary

Explicit and Implicit Costs, and Accounting and Economic Profit
7.2: Production in the Short Run
7.3: Costs in the Short Run
7.4: Production in the Long Run
7.5: Costs in the Long Run...

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CHAPTER 7: COST AND INDUSTRY STRUCTURE –REVIEW QUESTIONS 1.

What are explicit and implicit costs? An explicit cost is one that you consciously pay, whereas an implicit cost is a foregone opportunity to do something else with your resources.

2.

Would you consider an interest payment on a loan to be an explicit or implicit cost? Interest payments are explicit costs, because the firm has to consciously pay them out of pocket.

3.

What is the difference between accounting and economic profit? Accounting profit is the difference between revenues and explicit costs, whereas economic profit is the difference between revenues and total costs, explicit and implicit.

4.

What is a production function? A production function is the mathematical equation that tells how much output a firm can product with given amounts of time.

5.

What is the difference between a fixed input and a variable input? A fixed input is a factor of production that can’t be easily increased of decreased in a short period of time. Conversely, a variable input is a factor of production a firm can easily increase or decrease in a short period of time.

6.

How do we calculate marginal product? Marginal product is the change in a firm’s output when its employs more labor. The marginal product is calculated by dividing the change in total product by the change in labor. It is represented by the following formula: MP=ΔTP/ΔL.

7.

What shapes would you generally expect a total product curve and a marginal product curve to have? In economics, it is generally accepted that the total cost curve is typically U-shaped and a marginal cost curve is typically upward-sloping. The total product curve is generally S shaped. A marginal product curve tends to be downward sloping.

8.

What are the factor payments for land, labor, and capital?

Factor payments are what a firm pays for the use of the factors of production. Factor payments for land include rent for land or buildings, factor payments for labor include wages and salaries, and factor payments for capital include interest and dividends. 9.

What is the difference between fixed costs and variable costs?

A fixed cost is one that does not vary with output, such as the cost of a building or land, whereas a variable cost increases with output, such as labor or supplies.

10.

How do we calculate each of the following: marginal cost, average total cost, and average variable cost? Marginal cost is the additional cost of producing one more unit. Average total cost is total cost divided by units produced and average variable cost is total variable cost divided by units produced.

11.

What shapes would you generally expect each of the following cost curves to have: fixed costs, variable costs, marginal costs, average total costs, and average variable costs?

Fixed costs are represented by a horizontal line, variable costs slope upward, marginal costs tend to slope upward, average total costs are U-shaped and average variable costs are U-shaped as well and lie below average total costs.

12.

Are there fixed costs in the long-run? Explain briefly.

There are no fixed costs in the long run, because anything can eventually be sold, expanded, modified or improved as necessary to vary with output. 13.

Are fixed costs also sunk costs? Explain.

Many fixed costs are also sunk costs. For example, when making the decision of whether to keep his restaurant open another hour, the businessman should not factor in the rent on his building, which will be the same regardless of whether he closes early. 14.

What are diminishing marginal returns as they relate to costs?

Diminishing marginal returns describe the reduced productivity that comes from employing additional workers or capital. Since additional workers have lower productivity, it takes more workers to raise the same quantity of output that fewer workers did before. Thus, diminishing marginal returns lead to an increase in marginal costs. 15.

Which costs are measured on per-unit basis: fixed costs, average cost, average variable cost, variable costs, and marginal cost? Marginal costs, average costs, and average variable costs are measure on a per-unit basis.

16.

What is a production technology?

A production technology is the combination of capital and labor used to produce a good. 17.

In choosing a production technology, how will firms react if one input becomes relatively more expensive? If, for example, the price of labor rises, firms will substitute to a production technology that uses more capital instead of labor.

18.

What is a long-run average cost curve? A long-run average cost curve assumes no fixed costs, because in the long run all costs are variable.

19.

What is the difference between economies of scale, constant returns to scale, and diseconomies of scale? Economies of scale occur when average costs decrease with increases in output. Constant returns to scale show no such decrease, and diseconomies of scale show increase in average costs as output rises.

20.

What shape of a long-run average cost curve illustrates economies of scale, constant returns to scale, and diseconomies of scale? A long-run average cost curve illustrating economies of scale will be downward sloping, constant returns to scale will be horizontal and diseconomies of scale will be upward sloping.

21.

Why will firms in most markets be located at or close to the bottom of the long-run average cost curve?

The minimum of the long run average cost curve represents an efficient level of output. Producing less than this misses out on cost savings, whereas producing more is overly costly, so most markets will be located near the minimum value on the curve. 22.

A firm had sales revenue of $1 million last year. It spent $600,000 on labor, $150,000 on capital and $200,000 on materials. What was the firm’s accounting profit? the firm’s factory sits on land owned by the firm that could be rented out for $30,000 per year. What was the firm’s economic profit last year?

Accounting profit = total revenues minus explicit costs = $1,000,000 – ($600,000 + $150,000 + $200,000) = $50,000. Economic profit = accounting profit minus implicit cost = $50,000 - $30,000 = $20,000.

23.The WipeOut Ski Company manufactures skis for beginners. Fixed costs are 30. Fill in the following table for total cost, average variable cost, average total cost, and marginal cost. Quantity Variable Fixed Cost Cost 0

0

1

$10

2

$25

3

$45

4

$70

5

$100

6

$135

Total Cost

Average Total Cost

Average Variable Cost

Marginal Cost

Solution: Quantity Variabl e Cost

Fixed Cost

Total Cost

0

$30

$30

0

Average Total Cost -

Average Variable Cost -

Marginal Cost

1

$10

$30

$40

$10

$40

$10

2

$25

$30

$55

$12.5

$27.5

$15

3

$45

$30

$75

$15

$25

$20

4

$70

$30

$100

$17.5

$25

$25

5

$100

$30

$130

$20

$26

$30

6

$135

$30

$165

$22.5

$27.5

$35

24.Based on your answers to the WipeOut Ski Company in the above question, now imagine a situation where the firm produces a quantity of 5 units that it sells for a price of $25 each. a. What will be the company’s profits or losses? b. How can you tell at a glance whether the company is making or losing money at this price by looking at average cost? c. At the given quantity and price, is the marginal unit produced adding to profits? Solution: a. Total revenues in this example will be a quantity of five units multiplied by the price of $25/unit, which equals $125. Total costs when producing five units are $130. Thus, at this level of quantity and output the firm experiences losses (or negative profits) of $5. b. If price is less than average cost, the firm is not making a profit. At an output of five units, the average cost is $26/unit. Thus, at a glance you can see the firm is making losses. At a second glance, you can see that it must be losing $1 for each unit produced (that is, average cost of $26/unit minus the price of $25/unit). With five units produced, this observation implies total losses of $5. c. When producing five units, marginal costs are $30/unit. Price is $25/unit. Thus, the marginal unit is not adding to profits, but is actually subtracting from profits, which suggests that the firm should reduce its quantity produced. 25.Based on your answers to the WipeOut Ski Company in the above question, now imagine a situation where the firm produces a quantity of 5 units that it sells for a price of $25 each. a. What will be the company’s profits or losses?

b. How can you tell at a glance whether the company is making or losing money at this price by looking at average cost? c. At the given quantity and price, is the marginal unit produced adding to profits? Solution: a. Total revenues in this example will be a quantity of five units multiplied by the price of $25/unit, which equals $125. Total costs when producing five units are $130. Thus, at this level of quantity and output the firm experiences losses (or negative profits) of $5. b. If price is less than average cost, the firm is not making a profit. At an output of five units, the average cost is $26/unit. Thus, at a glance you can see the firm is making losses. At a second glance, you can see that it must be losing $1 for each unit produced (that is, average cost of $26/unit minus the price of $25/unit). With five units produced, this observation implies total losses of $5. c. When producing five units, marginal costs are $30/unit. Price is $25/unit. Thus, the marginal unit is not adding to profits, but is actually subtracting from profits, which suggests that the firm should reduce its quantity produced.

26.

If two painters can paint 200 square feet of wall in an hour, and three painters can paint 275 square feet, what is the marginal product of the third painter marginal product = change in total product/change in variable input change in total product = 275 square feet - 200 square feet change in total product = 75 square feet marginal product = 75 square feet/ 1 worker marginal product = 75

27.

Automobile manufacturing is an industry subject to significant economies of scale. Suppose there are four domestic auto manufacturers, but the demand for domestic autos is no more than 2.5 times the quantity produced at the bottom of the long-run average cost curve. What do you expect will happen to the domestic auto industry in the long run?

This is the situation that existed in the United States in the 1970s. Since there is only demand enough for 2.5 firms to reach the bottom of the average cost curve, you would expect one firm will not be around in the long run, and at least one firm will be struggling.

Critical Thinking Questions 28.

Small “Mom and Pop firms,” like inner city grocery stores, sometimes exist even though they do not earn economic profits. How can you explain this?

A firm need not earn economic profits to exist. Since leisure time is counted as an implicit cost, a firm can break even economically, and still earn an accounting profit, while paying acceptable wages to all its employees. 29.

A common name for fixed cost is “overhead.” If you divide fixed cost by the quantity of output produced, you get average fixed cost. Supposed fixed cost is $1000. What does the average fixed cost curve look like? Use your response to explain what “spreading the overhead” means.

Since fixed costs do not increase with output, the average fixed cost curve is continually downward sloping. Spreading the overhead means increasing output so that the fixed cost per unit is very small. 30.

How does fixed cost affect marginal cost? Why is this relationship important?

Fixed cost only has an effect on marginal cost at certain key points. For example, you would have to incur huge fixed costs to produce one car, but once the factory is built, the marginal cost of the second car is very small and fixed costs have no effect on marginal cost. Fixed cost only affects marginal cost again when output becomes too great for the factory to manage, and a second one has to be purchased as well. 31.

Average cost curves (except for average fixed cost) tend to be U-shaped, decreasing and then increasing. Marginal cost curves have the same shape, though this may be harder to see since most of the marginal cost curve is increasing. Why do you think that average and marginal cost curves have the same general shape?

The average cost curve depends directly on the marginal cost curve, since rising marginal costs must necessarily increase average costs. 32.

Do you think that the taxicab industry in large cities would be subject to significant economies of scale? Why or why not?

Most of the costs involved in the taxicab industry vary at a constant rate with output, such as driver wages, gasoline and the cars themselves. To increase output, more cars have to be bought, more drivers employed and more gasoline purchased. Given this, it does not seem likely that there are significant economies of scale in the taxi industry.

33.

A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment?

Since the bank is able to command an 8% rate of return on its loans, presumably the firm should be able to do the same. To invest at only a 6% rate of return would result in an economic loss, due to the foregone opportunity to earn 8%....