EM 3 - Suppliers and costs

Under what circumstances should the entrepreneur in the previous question open the new hotel? Recall that the incumbent hotel has costs of $50 per guest, of which $30 is variable, and consumers would be indifferent between the two hotels.

The entrepreneur should open the new hotel if it can be operated at an average cost per guest of $30 or less. is correct Since the incumbent will be willing to lower prices to $30, the new hotel will only be profitable if its total costs per guest are $30 or less.

A tutoring business pays $15,000 per year in rent and utilities, which are all fixed costs. It sells 5,000 hours of tutoring per year, and for each hour of tutoring it incurs variable costs of $30 (to pay the tutor's wages). What is the average cost per hour of tutoring?

$33 is correct Average cost can be calculated as fixed cost per unit ($15,000/5,000 = $3) plus variable cost per unit ($30). Another way to calculate it is to find total cost ($15,000 + $30*5,000 = $165,000) and divide it by quantity (5,000).

Now suppose that the fish and chips restaurant has already been opened. The entrepreneur paid the upfront fixed costs to set up the restaurant, and those fixed costs amount to about $1 per serving of fish and chips, as estimated. The actual variable costs, as were anticipated, are $4 per serving. Unfortunately, consumers don't want to pay as much for fish and chips as the entrepreneur anticipated. What is the lowest price the entrepreneur would be willing to charge for a serving of fish and chips?

$4 is correct The fixed costs are sunk, and only variable costs should be taken into account at this point.

An entrepreneur wants to open a fish and chips shop selling fried fish and potatoes. The entrepreneur estimates that average cost per serving of fish and chips would be $5. Of that, $4 would be variable costs and $1 would be fixed costs per unit. What is the minimum price per serving the entrepreneur would need to be able to charge for it to make sense to open the shop in the first place?

$5 is correct The entrepreneur needs to be able to recover total costs.

A ticket broker purchases two tickets to an upcoming concert for $30 each, although the original ticket holder would have been willing to sell each ticket for $10. The ticket broker later sells the tickets to a new buyer for $50 each. If the new buyer would have been willing to pay up to $90 for each ticket, what fraction of the total value created is captured by the broker?

1/4 is correct The ticket reseller captures $20 in profit on each ticket ($50 - $30). The total value created is $80 per ticket ($90 - $10).

A hot dog stand operator wants to add a snow cone machine to his business. He anticipates that the snow cone machine will cost $500 and will last for 2 years before he needs to purchase a new one. Each snow cone he sells will incur variable costs of $0.50. If each snow cone sells for $2.50, how many snow cones would he have to sell each year for the machine to be worth the purchase?

125 is correct Each snow cone will earn $2 more than its variable costs, so it will take 250 snow cones to recover the cost of the machine. That translates to 125 snow cones per year.

Which of the following firms would benefit most from having dominant market share on a national level?

A pharmaceutical company that produces a drug at very low variable cost once it has incurred enormous fixed costs in research and development on the drug. is correct This company's fixed costs scale well as it expands nationally.

A college has found that some of its graduating students accept offers from Amazon that pay less than offers at other companies. Which of the following is the most likely explanation for this scenario?

Amazon has been able to lower some of its employees' WTS for their labor. is correct Students may be willing to work for Amazon for a lower salary because of the work culture, or benefits of having Amazon on their resumes, or for other reasons.

Which of the following regarding fixed costs is/are true? Select all that apply

Companies that incur fixed costs primarily at the level of an individual store are likely to face difficulties scaling their businesses. is correct True—these companies will necessarily incur fixed costs for every new store, decreasing the benefits of scaling and/or making it more difficult to do so. Fixed costs do not always imply that the bigger firm will experience cost advantages. is correct True—bigger does not necessarily imply better. Bigger firms may suffer from various inefficiencies related to increased production or scale, potentially driving up costs. Industries that don't have high fixed costs will have few barriers to entry. is incorrect This is not necessarily the case. For example, some firms may be barred from entering an industry due to endogenous fixed costs not having to do with industry structure, for example marketing, advertising, incumbent relationships with suppliers, brand name, etc. While higher fixed costs alone mean lower profits, high fixed costs also create barriers to entry for other firms. This can result in higher market shares for firms already in an industry, meaning high revenues and greater profits. So the effect of high fixed costs on profits can be ambiguous. Companies that experience fixed costs mainly at the local level gain no benefits in scaling up operations to the national level. is incorrect Such companies may experience fewer benefits from scaling than other firms, but could still see some benefits. For example, the benefits from certain fixed costs such as advertising, brand awareness, and others would not be confined to just the local level.

Which of the following regarding fixed costs is/are true? Select all that apply.

Companies that incur fixed costs primarily at the level of an individual store are likely to face difficulties scaling their businesses. is correct True—these companies will necessarily incur fixed costs for every new store, decreasing the benefits of scaling and/or making it more difficult to do so. Fixed costs do not always imply that the bigger firm will experience cost advantages. is correct True—bigger does not necessarily imply better. Bigger firms may suffer from various inefficiencies related to increased production or scale, potentially driving up costs. The higher the fixed costs it experiences, the lower a firm's profits will be. is incorrect While higher fixed costs alone mean lower profits, high fixed costs also create barriers to entry for other firms. This can result in higher market shares for firms already in an industry, meaning high revenues and greater profits. So the effect of high fixed costs on profits can be ambiguous. Industries that don't have high fixed costs will have few barriers to entry. is incorrect This is not necessarily the case. For example, some firms may be barred from entering an industry due to endogenous fixed costs not having to do with industry structure, for example marketing, advertising, incumbent relationships with suppliers, brand name, etc. Companies that experience fixed costs mainly at the local level gain no benefits in scaling up operations to the national level. Such companies may experience fewer benefits from scaling than other firms, but could still see some benefits. For example, the benefits from certain fixed costs such as advertising, brand awareness, and others would not be confined to just the local level.

Which of the following statements is true regarding the differences between economic and accounting costs?

Economic costs include all direct and opportunity costs. is correct Economic costs include all costs of a decision, direct and opportunity costs, whereas accounting costs do not include opportunity costs.

Which of the following developments will cause an increase in the value created by a firm? Select all that apply.

Employees at the firm are willing to take a pay cut to work for the company. is correct This would decrease suppliers' willingness to sell a key input, creating more value overall. Consumer preferences change and average WTP for the company's products increases. is correct If customers' are willing to pay more, but the company leaves prices the same, it is creating more value for its customers without decreasing the value captured by the firm or its suppliers. The company is able to increase the price of its main product without a significant decrease in sales. While this would lead to more value captured by the company, it would not create more value overall. The company discovers a new production technology, allowing it to produce its products more efficiently. While this would lead to more value captured by the company, it would not create more value overall. The rate at which the company is taxed is decreased by the government. is incorrect While this would lead to more value captured by the company, it would not create more value overall.

Which of the following regarding economies of scale is true?

Firms will continue to benefit from scale economies up until a certain point in production, after which other factors such as bureaucracy, complacency, decreased efficiency, or greater input costs due to scarce materials may cause average costs to rise. Scale economies can exist at any level of scale depending on where fixed costs reside. Scale economies can be either positive or negative, or both, based on a firm's size. is correct A firm or industry can exhibit both economies and diseconomies (negative economies) of scale depending on its level of output. Economies of scale tend to benefit firms/industries most as they increase output from low levels, while diseconomies of scale occur as they continue to increase production from high to even higher levels. While economies of scale are mainly based on firm size, a firm may also experience decreased costs from increasing output for other reasons than lower fixed costs per unit. For example, as it scales a firm may be able to increase operational efficiency as well, leading to lower variable costs per unit than previously.

An entrepreneur is seeing if he should enter into a new market. His new plant would have double the capacity of the other plant currently in the market. He estimates that his average cost per product will be $400, $200 of those variable costs. He estimates that the other plant currently in the business has average costs of $600, $300 of those variable costs. Should he build his plant?

He should not build the plant. is correct Since his average costs are higher than the incumbent company's variable costs, he should not enter the industry. If the entrant tried to do so, the incumbent could drop prices down to its own marginal costs.

Which of the following regarding supply curves is NOT true?

In the short run, a steep fall in prices will force the least efficient producers to exit the industry. is correct In the short run, a firm is only able to make decisions on its volume of production. Entry/exit decisions are long run considerations. Thus the least efficient producers will stop producing but will not be able to exit the industry in the short term. In the long run, the industry supply curve should take into account both variable costs and fixed costs. In the long run, a firm must decide whether to enter/remain in/exit an industry as well as its level of production.

You are earning $40,000 per year as a branch manager at Dunkin Donuts. You are planning on leaving your job and going back to college; upon learning this, your branch manager offers you a 10% increase in salary to stay. Knowing this, how does the opportunity cost of going to college change?

It increases because you are foregoing more money for college. is correct The rise in salary increases the opportunity cost of going to college because you are foregoing a higher cost that you could have been earned by not going to college.

Which of the following conditions could cause an industry to have a small number of firms? Select all that apply.

Network effects is correct If a product exhibits network effects, the dominant suppliers in the industry grow more and moreHigh fixed costs is correct High fixed costs can act as a barrier to entry. New firms will be less willing to enter an industry if they will have to incur large fixed costs in order to compete with incumbent firms. successful as existing customers draw in new customers. This leads to industries with a few large competitors rather than many small ones.

An entrepreneur wants to open a new hotel. There is one other hotel operating in the region, and the entrepreneur has estimated that its costs per guest are approximately $50 per guest, of which $30 is variable cost. The entrepreneur forecasts that total costs per guest in the new hotel would be $42, of which $25 would be variable. Assuming consumers will be indifferent between the two hotels, should the entrepreneur open the hotel?

No is correct The new hotel will have to charge at least $42 per guest to be profitable. However, the incumbent hotel will be willing to cut prices to $30.

Suppose that you are the CEO of a national pizza chain. Your business has experienced increases in production costs over the past few years due to a continual increase in the price of cheese. When the price increases first started, your business was able to maintain its profitability by passing the higher costs on to consumers in the form of higher pizza prices. Now, however, your consumers are refusing to pay more for your product. One of your company's executives suggests acquiring your supplier of cheese in order to control input costs. By doing so, she guarantees that your company will retain your customers and stop losing money. Should you take her advice?

No—in doing so, you may retain your customers, but you will still continue to lose money overall. is correct Your colleague is forgetting to include opportunity costs in her reasoning. Even if you acquire the supplier, you will continue to lose money from an economic point of view. This is because you could have sold the cheese to others for a higher price than what you are receiving for it by putting it in your pizzas.

Despite having sufficient snow, a local ski mountain has decided to close in early March for the end of the ski season. What is the most likely reason to shut down in this situation?

Owners expect that revenue earned won't cover variable costs. is correct If the revenue is not enough to cover operating costs, the ski resort would have no reason to stay open.

A ticket reseller purchases a ticket to a football game for $40 and offers it for sale at a price of $75. A consumer is willing to pay $90 at most for the ticket, and purchases it at $75. What does the $50 difference (between $40 and $90) represent?

Profit + consumer surplus is correct The difference between WTP and price is consumer surplus, and the difference between price and cost is the profit.

Which of the following is true about "volume businesses?"

Such businesses need to produce large volumes to spread their fixed costs over large volumes in order to have any chance of recovering their large fixed investments. Volume businesses typically exist in markets with few to no competitors, because of the high fixed costs of producing the product or service. Such businesses need to produce large volumes to recover their fixed costs. Even small drops in prices can ruin a firm's profitability and make it not worthwhile to remain in an industry. Even with high volumes, it often takes businesses a long amount of time to recover their high fixed costs. If recovering these costs were easy, more firms would be present in the industry producing.

Which of the following costs should an archery equipment manufacturer consider when deciding whether to introduce a new type of arrow? Select all that apply.

The cost of materials that will go into each arrow is correct These raw materials are a variable cost. The costs of a marketing research study the company ran in order to determine demand for the arrows Since the study has already been conducted, these costs are sunk. The new machinery the company will need to purchase in order to manufacture the arrows is correct Although this is a fixed cost, it is not yet sunk. The rent that will be paid for a facility to manufacture the arrows in is correct Although this is a fixed cost, it is not yet sunk. The research and development costs that the company incurred while designing the new arrow. Since the arrow has already been designed, these costs are sunk.

Christine is a tax accountant in the United States. Due to the complexity of the U.S. tax code, many Americans often experience difficulties filing their taxes each year. Thus, in the past, Christine has made a large sum of money on the side offering her services during tax season. This year, however, a new computer software is being sold, designed to assist Americans with their taxes for a fraction of the cost that Christine has been charging her customers. At first glance, the software appears to be quite popular. What impact will this new software have on Christine's profitability?

The impact on Christine's profitability is unclear. is correct It's unclear how the presence of the software will affect Christine's profitability. While the introduction of the software will almost surely force Christine to charge a lower price for her services to compete, Christine's profitability also depends on her own costs. If Christine is able to use the service to improve her own productivity, her costs may also go down. If costs fall low enough, Christine may be able to maintain the same profitability or even improve her profitability if the software allows her to save time per customer and take on more customers.

A shop near the ocean sells kites for people to fly on the popular beach nearby. Each kite costs the shop $10, $8 of which is variable costs (for materials and wages for the kite-maker). Another kite-maker wants to enter the market. The potential entrant can make kites for $7 each in variable costs, but adding in the cost of opening a store, the total cost per kite would be $10. Should the new kite-maker open a shop?

The kite-maker should open a shop only if customers will be willing to pay at least $2 more for the new kites than they are willing to pay for the existing kites. is correct The new kite-maker should compare its total costs ($10 per kite) to the incumbent's variable costs ($8 per kite). Since the incumbent will be willing to lower its prices to $8, the new kite-maker should only enter the market if customers' WTP for the new kites is at least $2 higher than their WTP for the existing kites.

Which of the following represents an economic cost, but not an accounting cost, of building and running a summer resort? (Select all that apply.)

The wages lost by the owner in pursuing his own venture, instead of working for an already established resort. is correct This is an opportunity cost for the new owner and should be taken into consideration when determining the economic cost of the new resort. The money foregone by using the land on which the resort will stand, instead of selling it or using it for another venture. is correct This is an opportunity cost and should be included in the economic cost.

An increase in the popularity of corn ethanol as a fuel increases the demand for corn around the world, causing the price to rise. What is the reason behind the higher price?

To meet higher demand, the industry relies more on less cost efficient producers of corn. is correct As more corn is demanded, the additional corn will be produced by less efficient suppliers, and prices will increase to cover their costs.

A manufacturing company has seen a decline in its physical sales over the past few years, leaving a portion of its fixed infrastructure underutilized. What are some reasonable measures the company could potentially take to maintain its profitability? Select all that apply

Try to cut fixed costs in other areas where possible is correct Cutting other fixed costs, such as salaries, could decrease costs enough so that the company is able to capture the same amount of value (profits). Rent out the underutilized space to other companies for additional revenues is correct This could help improve profitability as the space is not being utilized anyway. If demand does pick back up, the company could take back the space or rent out more space itself.

A factory currently manufactures and sells 800 boats per year. Each boat costs $5,000 to produce. $4,000 of the per-boat costs are for materials and other variable costs, while the per-boat fixed costs (incurred on yearly rent, administrative, and other fixed costs) are $1,000. If boat orders increase to 1000 boats per year, how do per-unit costs change?

Variable costs are unchanged at $4,000 per boat and fixed costs fall to $800 per boat is correct The $800,000 in fixed costs is now spread across 1,000 boats. This results in $800 in fixed costs per boat. Variable costs are unchanged.

A startup company is currently selling each unit of its product for $10.00 less than its total costs per unit. If the startup has an opportunity to expand its customer base by 10% through a marketing campaign, should the company consider the campaign?

Yes, if the additional customers would lower the average cost enough to make the firm profitable. is correct As output increases, fixed costs per unit will decrease. This may lead to low enough average costs that the firm will be profitable.

As an entrepreneur, you should only enter a market if:

Your average cost is less than your competitors' variable cost per unit. is correct Incumbents will be willing to sell their product for prices as low as their variable cost, whereas it is not profitable to enter a market if you will not be able to recover your total costs.