Ch. 3 The costs of production and profit maximization

the accountants hired by cost a law firm have calculated that at the profit maximizing quantity, total fixed costs equal $56,791, total variable costs equal $113,555 and total revenue equals $112,000. What should the firm do?

Shut down; Total revenue is $112K and variable cost is $113,555. Because total variable cost exceed total revenue, they should shut down

four categories of short run data

average fixed cost, average variable cost, average total cost and marginal cost

price takers

businesses operating in perfectly competitive industries

constant economies of scale

constant average total cost as output increases

the profit maximizing rule states that a business maximizes profits when it produces where total revenue equals total cost

false; the profit maximizing rules states that a business maximizes profits when it produces a quantity where the marginal revenue from selling another unit equals the marginal cost of producing an additional unit

total revenue

multiple price by quantity

the accountants hired by Bling, Blong & Blatt law firm have calculated that at the profit maximizing quantity total fixed costs equal %56,272,000 total variable costs equal $213, 235,000 and total revenue equals $213,236,000. hey decide to

stay open because shutting down would be more expensive; the shutdown rule states that a business should shut down in the short run only if total revenue is less than total variable costs.

in a competitive industry implies that no business may influence the market price of the product they sell

true

marginal cost is the increase in total cost that arises from an extra unit in production (t/f)

true; Marginal cost is equal to the change in the total cost that arises from an extra unit of production; it is calculated by taking the change in total cost and dividing it by the change in the quantity produced

A production process has diseconomies of scale if average total costs increase as output increases (t/f)

true; the production of a product has either economies of scale, constant economies of scale or diseconomies of scale over particular ranges of production.

profit maximizing rule

when a business maximizes profits when it produces where the marginal revenue from selling another unit equals the marginal cost of producing an additional unit

two constraints of maximizing profit in monopoloes

(1)expense data and cost curves (2)market demand

2 business owner constraints to maximizing profit

(1) competencies and input prices determine the data, (2) the price that a perfectly competitive business can change is determined by the market and not the business owner

sunk cost

a cost that cannot be recovered

short run

a time horizon where some fixed costs exist; a situation where there are fixed costs and these fixed costs (inputs) cannot be changed - economists think this way

In a monopolistic business more product equals

lower cost (buy in bulk gets a lower price)

economies of scale

products with large fixed costs and relatively low marginal costs; as production of these products increases, average total cost decreases

whenever the marginal cost curve crosses the average variable or total cost curve

then the variables are equal

average total cost

total cost divided by the quantity produced or the sum of the average fixed costs plus variable cost

price setters

another name for monopolistic firms because they are the only ones that sell the product and go through a process of setting the price of the product

diseconomies of scale

as output increases over this range, average total costs begin to increase

three characteristics of a perfectly competitive industry (perfect competition)

(1) there are many buyers and sellers, (2) the good is homogeneous (trees or peas) and (3) all who want to enter the industry are free to do so and any business may exit at a time of their choosing

Three decisions for monopoly managers

(1)determine the profit maximizing quantity to produce (2)decide what price to charge (3) decide whether to produce or to shut down the business for a short period of time

marginal cost

change in the total cost that arises from an extra unit of production; = change in total cost/change in quantity produced

joint costs

costs that do not change with the scope of production in economies of scope

fixed costs

costs that do not vary with increases in the quantity produced (rent); what the producer must pay if the # produced is 0

variable costs

costs that do vary with increases in the quantity produced (tools)

a business should shut down if production at the profit maximizing quantity generates total revenues that are less than total fixed costs

false; a business should shut down when the losses from operating are greater than the total fixed costs

a sunk cost is a cost that has already been committed and can be recovered (t/f)

false; the cost of a product that can never be recovered is a sunk cost. In contrast, any product that can be re-sold for a positive dollar amount would not be considered a sunk cost

a business always maximizes profits when it produces where total revenue equals total cost (t/f)

false; the profit maximizing rule states that a business maximizes profits when it produces a quantity where the marginal revenue from selling another unit equals the marginal cost of producing an additional unit. If profit is positive, then total revenue would be greater than total cost. Total revenue equals total costs only when profit is equal to zero.

when an organization can produce several different products together at greater cost than could a group of single product firms operating independently, the organization has economies of scaale

false; when an organization can produce several products together at a lower cost than the sum of the costs of a group of single product firms operating independently, then the organization has economies of scope

average fixed cost

fixed cost divided by quantity produced

long run exit decision

occurs when prices remain low for very long periods of time; states that a business should exit the industry if production at the profit maximizing quantity (where MR=MC) generates total revenues that are less than total cost, otherwise stay open

long run

situation where the fixed costs (inputs) become variable. (very theoretical -if a company shuts down a plant there are no costs)

whenever the marginal cost is higher than average variable cost or average total cost then

the average variable cost or average total cost must decrease

marginal revenue

the change in total revenue generated from an additional unit sold (=change in total revenue/change in quantity sold)

If a company's average total costs remain constant as output increases, then the company has constant economies of scale (t/f)

true;

a production process has economies of scale if average total cost decreases as production increases(t/f)

true; the production of a product such as a pharmaceutical pill has economies of scale because it has significant fixed costs and relatively low marginal costs. As production of this type of production increases, its average total cost decreases.

a fixed cost is a cost that does not vary with changes in the quantity produced (t/f)

true; there are two basic types of costs: fixed costs and variable costs. Costs that do not vary with increases in the quantity produced are called fixed costs. Costs that do vary with increases in the quantity produced are called variable costs.

average variable cost

variable cost divided by quantity produced

economies of scope

when an organization can produce several products together at less cost than could a group of single product firms opening independently

shut down rule

when the production at the profit maximizing quantity (where MR=MC) generates total revenues that are less than variable costs, in all other cases the business would stay open (when a business does shut down it is usually for a short period like winter)

business owner key two decisions

(1) determine the profit maximizing quantity to produce, (2) in the short run - decide whether to produce or to shut down the business for a short period of time OR in the long run - decide whether to produce or exit the industry, forever

three characteristics that define monopolistic industry

(1) there are many buyers and only one seller (2) the good is heterogeneous (microsoft is different than other software)and (3) barriers to entering the market exist (patents prevent people from developing the same thing)