2) (a) What is the distinction between marginal cost and incremental cost? (b) How are sunk costs treated in managerial decision making? Why
(a)Incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. While marginal cost refers to the change in total cost resulting from producing an additional unit of output, incremental cost refers to total additional cost associated with the decision to expand output or to add a new variety of product etc. It represents the difference between two alternatives. So both are concerned with the change in the total cost where marginal costs refers to the increase or decrease in that results from producing or distributing an additional unit of output and, incremental cost refers to the change in the total output as a result of change in the methods of production or distribution such as addition of a product or territory, use of improved technology or selection of a additional sales channel.
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(b)A sunk cost is a cost that has been already incurred and cannot be changed or altered by any decision made now or in future. For example , once it is decided to make incremental investment expenditure and funds are allocated and spent, all preceding cost are considered as sunk cost. Such cost are based on prior commitment and cannot be revised or recovered when there is a change in market condition or in business decision makings. The sunk cost are ignored in managerial decision making as they are irrelevant costs which will not affect the decision. Suppose a company paid $50000 to purchase machinery five years back. The machine was used to produce for last few years and now it is obsolete and no longer can be sold .The amount paid is already incurred and cannot be recovered. So the cost of the obsolete machine will not be considered in making managerial decisions.
(8) What shape of the LAC curve has been found in many empirical studies? What does this mean for the survival of small firms in the industry?
Answer: In the empirical studies the shape of long run average cost curve to be L-shaped with a scale of economics . This means largest firms tend to have cost advantage and the industry tends to become monopoly which is called natural monopoly. The L-shaped shows that per unit producing a product decline initially and then forms L- shaped which cost advantage for longer period resulting to economies of scale due to optimum utilization of recourses. It was believed that economics outstrips diseconomies of scale as firms expand from small size up to a certain size. For the smaller firms in the industry will face diseconomies of scale and no economic profit as there will be lesser amount of recourses and output level.As marginal cost are raising function of rate of out and falling function of the volume.
(9) (a) What is the meaning of economies of scope? How do they differ from economies of scale? (b) What do learning curves show? How do they differ from economies of scale? What is the usefulness of learning curves as a managerial tool? What is the reason for rising international trade in inputs and the use of foreign skilled labor?
(a) Economies of scope exist if a firm can produce several product lines at a given output level more cheaply than a combination of separate firms each producing a single product at the same output level. Economies of scope occur where it is cheaper to produce a wider range of products rather than specialize in just a handful of products. Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope. E.g. Amazon expanding into selling toys, sports goods or McDonald’s expanding the range of their products to include salads and health foods. Economies of scope” is relatively a new approach to business strategy, and is heavily based on the development of high technology. Economies of scale are reductions in average costs imputable to production volume increases. Economies of scope differ from economies of scale in that a firm receives a cost advantage by producing a complementary variety of products with a concentration on a core competency. While economies of scope and scale are often positively correlated and interdependent, strictly speaking the benefits from scope have little to do with the size of output.
(b)The aircraft industry was the first to develop the learning curve. The curve that represents the declining trend in the long run average cost of production is called the learning curve. Economies of scale is the are the reduction in average cost as the result of increase in production volume whereas learning curve shows the graphical presentation of the falling average cost curve with respect to increase in production. The learning curve is widely used by business managers and serves as an important managerial tool to foresee and predict the possible trend in long run average cost of production and plan production accordingly. The basic purpose behind the use learning curve is to forecast the unit cost with cumulative increase in output. It is also used to forecast manpower, machinery, material needs of the company, to determine and quote the future competitive price of the product and for planning production.
(c) International trade is the exchange of goods, services and capital across the international territory or borders. The use of foreign labor will be more costly due to the reason that borders imposes additional costs such as tariffs , time costs due to border delays and costs associated country difference . A rise in the use of foreign skilled labor will have a direct impact in the international trade resulting in an increase in the imports which may affect the balance of trade.
Chapter 7 Problems
2) Given the following total cost schedule of a firm, (a) derive the total fixed cost and total variable cost schedule of the firm, and from them derive the average fixed cost, average variable cost, average total cost, and marginal cost schedules of the firm.
Q 0 1 2 3 4 5
TC $30 50 60 81 118 180
Total cost = Total fixed cost +Total variable cost
Marginal cost= Total cost of producing additional unit – total cost of producing the previous unit.
Average variable cost=Total variable cost/Number of units
Average fixed cost=Total fixed cost / Number of units
Total average cost=Average fixed cost + Average variable cost
Q 0 1 2 3 4 5
TC $30 50 60 81 118 180
TFC $30 30 30 30 30 3
TVC $0 20 30 51 88 150
MC $ – 20 10 21 37 62
ATC $ – 50 30 27 29.5 36
AFC $ – 30 15 10 7.5 6
AVC $ – 20 15 17 22 36
3) Airway Express has an evening flight from Los Angeles to New York with an average of 80 passengers and a return flight the next afternoon with an average of 50 passengers. The plan makes no other trip. The charge for the plane remaining in New York overnight is $1,200 and would be $0 in Los Angeles. The airline is considering eliminating the night flight out of Los Angeles and replacing it with a morning flight. The estimated number of passengers is 70 in the morning flight and 50 in the return afternoon flight. The one-way ticket is $200 for any flight. The operating cost of the plane for each flight is $11,000. The fixed costs for the plane are $3000 a day whether it flies or not.
3(a): Please calculate and compare the profit under each flight. 3(b) is asking should Airway Express continue providing the flight between Los Angeles and New York. Even Airway Express decides not to fly, it still have to pay the fixed costs of $3,000 per day.
Cost of the ticket =$200
Operating cost =$11,000
Total cost = $11,000+$3,000+$1,200=$15,200
I. Profit for the evening flight from Los Angeles to New York which has average passengers of 80 and cost of the tickets is given as $200 so the average revenue will be $16,000.
Thus, average Profit for the flight is $800
II. Profit for the afternoon flight next day from New York to Los Angeles carrying average passengers of 50, so the average revenue will be $10000
The fight is showing average loss of $5,200
III. Profit for the morning flight eliminating with the night flight from Los Angeles to New York carrying an average passengers of 70, the revenue will be $14,000.
Cost of operation =fixed cost + operating cost
Profit=Revenue earned – cost incurred
$14000 – $14000
The flight is nor earning average profit or average loss.
IV. Profit for the afternoon flight from New York to Los Angeles with estimated passengers of 50, the revenue will be $10,000
The flight is incurring loss of $4000.
(b)The Airway express flying evening flight from Los Angeles is earning a profit of $800 with average passengers of 80 and whereas incurring loss of $5,200 in the return trip. In the next case, the airline is making no profit and no loss in the morning flight from Los Angeles to New York, whereas making a loss of $4000 in the return trip . The airline should discontinue providing flights between Los Angeles and New York. Although, it has a fixed cost of $3000 per day which come to $90,000 but the airline will be incurring huge cost of $14000 per day which comes to $42, 00,000 in a month. So it would be a better option to discontinue the operation of the airline from Los Angeles to New York.
4) Electric utility companies usually operate their most modern and efficient equipment continuously (i.e. around the clock) and use their older less efficient equipment only to meet periods of peak demand.
4(a) Will the short-run marginal cost decrease or increase?
Answer: Electric Utility firms retire old plants, modernize generating units, and occasionally build new plants, generally after a lengthy period of licensing, regulatory review, and construction. But this not possible in short run as in short run there are fixed factors which cannot be changed in short run as they tend to use their older less efficient equipment to meet the periods of peak demand. In Electric utility companies variable cost consist mainly energy costs. Fixed cost are the cost which cannot be changed with the level of output and in electric utility companies fixed are analogues to capacity cost. As a result the marginal cost in the short run decreases . The reason is the marginal cost curve will turn up when utility will be forced to less efficient during on peak-periods.
11) The Goldberg-Scheinman Publishing Company is publishing a new managerial economics text for which it has estimated the following total fixed and average variable costs:
Total fixed costs:
Copy editing $10,000
Selling and promotion $20,000
Total fixed cost $100,000
Average Variable cost:
Printing and binding $6
Administrative costs $2
Sales commission $1
Bookstore discounts $7
Author’s royalties $4
Average variable cost $20
Project selling price $30
Determine the breakeven output and total sales revenues. (b) Determine the output that would generate a total profit of $60,000 and the total sales revenues at that output level.
(a)At the breakeven point is the point where cost and revenue are equal.
Breakeven point (sales) =Fixed cost/(Selling price -Variable cost)
(b)Sales=Variable cost + fixed cost +profit
Chapter 8 Discussion
2) (a) Under what conditions should a firm continue to produce in the short run if it incurs losses at the best level of output? (b) Are the normal returns on investment included as part of costs or as part of profits in managerial economics? Why
In short run, there is only one variable input (labor) and other inputs (especially capital) are held constant. In other words, the size of labor may increase or decrease but the capital and other inputs will remain fixed. If the Incurs losses at its best level of output then, the firm should try to reduce marginal cost and operate at the level where marginal and average product are positive or increasing. If price falls below average total cost, but remains above average variable cost, the firm will continue to operate in the short run, producing the quantity where MR = MC doing so minimizes its losses. Whereas If price falls below average variable cost, the firm will shut down in the short run, reducing output to zero. The lowest point on the average variable cost curve is called the shutdown point.
(b)Normal returns on investment is also referred as normal profit, is the level of profit required to keep the engaged in a particular activity .The normal rate of return is the Average profit necessary to attract and retain investment .A normal rate of return, or profit, is necessary to induce individuals to invest funds rather than spend them for current consumption. Normal profit is simply a cost for capital as it is no different from the cost of other recourses (materials, energy or labor).As a result , the normal rate of return are included as a part of cost in managerial economics.
8) What happen to the Dollar price that a U.S. (a) importer pays and (b) exporter receives if prices are agreed in Euros and the Dollar then appreciates by 10 percent with respect to the Euro?
The exchange rate is the price of one currency expressed in terms of another. If the importer pays i.e. in dollars to the foreign country and the value of the foreign country currency is devalued the dollar value of promised payment will fall. Whereas if the foreign currency value appreciates the dollar value of the promised payment will rise resulting to a disfavor to the importer country.
If prices are agreed in Euros and the Dollar then appreciates by 10 percent with respect to the Euro and the exporters pay, the value of the promised payment will fall.
13) (a) What are the choice-related variables for a firm under monopolistic competition? (b) What is non-price competition? (c) Product Variation? (d) Selling expenses?
(a)Monopolistic competition is defined as market setting in which large number of sellers sells differentiated products. A firm will produce output where MR=MC. The consumers are willing to purchase given amount of product for the given price. The price is determined by demand curve. In short run firms can give positive profits .Positive profits encourages new firms to enter in the market. In the long run due to the entrance of new firms economic profit is zero i.e. P=AC. The main objective of firms under monopolistic competition is profit maximization.
(b)Non price competition- The market situation in which firms or the competitors will not lower the price for a fear of price war. So, instead they focus on extensive promotion to highlight distinctive features or benefit of the products. It refers to the competition among firms that choose to distinguish between their products on the basis of attribute, design are non price means e.g. promotions, style etc. It is often used by firms that want to differentiate between virtually identical products. The reason for this is that firms are that operate in monopolistic competition are the price taker as they do not have the influence in changing the price of their goods. Consequently to distinguish themselves they use the strategy of non price such as product innovation and advertisement.
(c) Product variations-Product variation is the change in the product properties or features in timing. For example, passenger cars companies bring new models out in the exiting class’s e.g. Gulf I, gulf II. Product variation is the modification by changing one or more features of the product to enhance consumer appeal .It will provide a competitive advantage as the company may be able to charge a higher price and enhance loyalty. The variation is made on quality, performance and design. The product variation is, thus, the improvements in the existing product line with new features, appearance, better quality, better performance etc giving a new outlook to it.
(d)Selling expenses-Selling expenses are the part of operating expenses along with administrative expenses. Selling expense is the cost incurred to sell or distribute merchandise .Selling expenses includes advertising, sales commission, promotional materials distributed, salaries and fringe benefits of sales personnel , rent of sales office, utilities usage in the sales department.
Chapter 8 Problems:-
2) Starting with the market demand and supply functions in Problem 1, determine algebraically the new equilibrium price and quantity if the demand function changes to QD’= 12,000- 1,000P or to QD’= 8,000- 1,000P. (b) the market supply function changes to QS*= -4,000+1,000P or to QS**= 1,000P.
We know , at the equilibrium point Quantity supplied equals quantity demanded i.e. QD=QS or QS=QD
If demand function changes to QD=12000-1000P or QD=8000-1000
We get ,
– P = – 12000
The new equilibrium price will be $12000
BY substituting the value of P in the demand function and supply function,
The new equilibrium quantity is 14000
For market supply function, QS= – 4000 +1000P or QS=1000P
Now, the equation will be
-1000P-1000P= -4000- 10000
The equilibrium price is $16000
By substituting the value of P, will be ,
The equilibrium quantity will be 6000
7) From Figure 8-4, determine the effect of a 33 percent import tariff on commodity X.
* The tariff-inclusive price will be $3(1+.33) = $4. What are the impacts of tariff on domestic consumption, domestic production, imports, and government’s tariff revenue? Please show the numbers, for example, the domestic consumption will decrease from 600X to 500X.
Solution: The tariff inclusive price will be $3(1+.33)=$4 , the price of the commodity will be $4 and as a result the price of the commodity X will rise from $3 to $4.Tariff is a tax added to the costs imported goods and sometimes to exported goods. The domestic consumption will decrease due to the addition of tariff which will result to an increase in the price of the commodity. As the price of the commodity will increase, the demand for the commodity will decline which will result in a reduction in consumption from 600X to 500X. The domestic production will increase as the producers in the importing country will experience an increase in well-being as a result of tariff from 200X to 300X. The increase in the price of their product on the domestic market increases producer surplus in the industry. The government tariffs revenue will increase as a result of increase in tariffs as governments receives the tariff and also depends on the way how the government spends.
9) Starting from Figure 8-6 showing the short-run price and output determination by the monopolist, suppose that the average fixed costs of the monopolist increase by $5 and that its AVC is $6 less than the new ATC at the best level of output.
ATC=AFC+AVC. After AFC increases by $5, ATC will increase by $5 (ATC curve moves up vertically by $5 for every output Q) and MC, D and MR stay the same. The AFC for 500 units is $6, in other words, the TFC is $3,000.
Answer: Average total cost-Average fixed cost + Average variable cost
Given ATC=$8, a increase in average fixed cost $5 and AVC is $6 less then,
After the increase in AFC the ATC will be appreciated by $5 as a result of this ATC curve will move upwards vertically by $5 for every level of output. The best level of out is where MC=MR which is 500 units. AFC for best level of output i.e. 500 is $6 and TFC is $30,000.