Chapter 3: The Costs of Production and Profit Maximization
Consider the following decision made by New Century Power Company. In electricity production, once electricity has been generated at a power plant, distribution networks are needed to bring the electricity to the customer. Suppose the New Century Power Company has decided to build its own electricity distribution network, but it has also decided to purchase electricity from many different independent electric power producers. In making this decision, New Century Power Company has calculated that diseconomies of scale or diseconomies of scope exist when electricity generation and electricity distribution are integrated under unified ownership?
diseconomies of scope
In a Wall Street Journal article it was reported that "Mitsubishi Motors is seeking a buyer for its U.S. operations, a move that may well signal the company's intent to exit the world's largest car market." The potential move by Mitsubishi is a matter of economies of scale or economies of scope?
economies of scale
Smith and Sons, Inc. is a profit maximizing company. The business's accountants have calculated the following costs and revenue at the company's current profit maximizing level of production: Fixed cost: $150,000 Variable cost: $500,000 Sunk cost: $50,000 Total cost: $650,000 Total revenue: $550,000 $__________ of Smith and Sons, Inc.'s fixed cost is not a sunk cost.
$100,000 = fixed cost - sunk cost
Smith and Sons, Inc. is a profit maximizing company. The business's accountants have calculated the following costs and revenue at the company's current profit maximizing level of production: Fixed cost: $150,000 Variable cost: $500,000 Sunk cost: $50,000 Total cost: $650,000 Total revenue: $550,000 The profit (or loss) at the current level of production is __________
-$100,000 = total revenue - total cost
shut-down rule
A business should shut down if production at the profit maximizing quantity generates total revenues that are less than variable costs, in all other cases the business should stay open
Smith and Sons, Inc. is a profit maximizing company. The business's accountants have calculated the following costs and revenue at the company's current profit maximizing level of production: Fixed cost: $150,000 Variable cost: $500,000 Sunk cost: $50,000 Total cost: $650,000 Total revenue: $550,000 Smith and Sons, Inc., should: A. shut down operations for a short period of time B. stay open and continue operating at their profit maximizing level of production
B
The accountants hired by Costa, Costa & Costa 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. Because of this information, Costa, Costa & Costa Law Firm decides: A. to exit the industry B. to shut down C. decides to stay open because shutting down would be more expensive D. decides to stay open because they are making an economic profit
B
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. Because of this information, ling, Blong & Blatt Law Firm decides A. to exit the industry B. to shut down C. decides to stay open because shutting down would be more expensive D. decides to stay open because they are making an economic profit
C
fixed costs FC
Costs that do not vary with increases in the quantity produced are called fixed costs. What expenses must be paid even if product equals zero?
variable costs VC
Costs that do vary with increases in the quantity produced are called variable costs
T/F: A business always maximizes profits when it produces where total revenue equals total cost.
False
T/F: A business should shut down if production at the profit maximizing quantity generates total revenues that are less than total fixed costs. s
False
T/F: A sunk cost is a cost that has already been committed and can be recovered.
False
T/F: The profit maximizing rule states that a business maximizes profits when it produces where marginal revenue equals average variable cost.
False
T/F: The profit maximizing rule states that a business maximizes profits when it produces where total revenue equals total cost.
False
T/F: When an organization can produce several different products together at greater cost than could a group of single product firms operating independently, then the organization has economies of scale.
False
price setters
In a monopolistic industry, because there is only one seller of a product, the business owner actually goes through a process of setting the price of its product, a task that competitive firms are unable to do. Thus monopolistic firms are called price setters.
economics of scale
Information technology such as Microsoft's operating system, a pharmaceutical pill, and even newspapers are all products that have economies of scale.
Smith and Sons, Inc. is a profit maximizing company. The business's accountants have calculated the following costs and revenue at the company's current profit maximizing level of production: Fixed cost: $150,000 Variable cost: $500,000 Sunk cost: $50,000 Total cost: $650,000 Total revenue: $550,000 Smith and Sons, Inc. is currently operating in the short run or in the long run?
Short run
T/F: A fixed cost is a cost that does not vary with changes in the quantity produced.
True
T/F: A production process has diseconomies of scale if average total costs increase as output increases.
True
T/F: A production process has economies of scale if average total cost decreases as production increases.
True
T/F: If a company's average total costs remains constant as output increases, then the company has constant economies of scale.
True
T/F: Marginal cost is the increase in total cost that arises from an extra unit of production.
True
the shut-down rule
a business should shut down if production at the profit maximizing quantity (where MR=MC) generates total revenues that are less than variable costs. In all other cases the business should stay open.
sunk cost SC
a cost that is already committed and cannot be recovered
monopoly
an industry that is controlled by a monopolist is called a monopoly. A monopolist is a firm that is the only seller of a good. The good the monopolist sells is heterogeneous (because they are the only one that sells the good). And the market that the monopolist sells its product in has barriers to entry.
joint costs
are costs that do not change with the scope of production
At EYZ Corporation, a larger quantity of output means that individual workers can limit themselves to more specialized tasks and through this process they become more skilled and efficient at doing their specialized tasks. Does the concept of economies of scope or the concept of economies of scale best capture what is happening at EYZ Corporation?
economies of scale
Banks and insurers both need distribution networks to sell products and serve their customers. Bank of America sells both insurance and banking services. Does the concept of economies of scope or the concept of economies of scale explain the business decision to combine banking and insurance services at Bank of America?
economies of scope
Consider the following decision made by Old Century Power Company. In electricity production, once electricity has been generated at a power plant, distribution networks are needed to bring electricity to the customer. Suppose Old Century Power Company has decided to build its own electricity generating plants and its own electricity distribution network. In making this decision, Old Century Power Company has calculated that economies of scale or economies of scope exist when electricity generation and electricity distribution are integrated under unified ownership?
economies of scope
average fixed cost AFC
equals fixed cost divided by the quantity produced
average total cost ATC
equals the total cost divided by the quantity produced or the sum of average fixed cost plus average variable cost
average variable cost AVC
equals the variable cost divided by the quantity produced
short run
is a time horizon where some fixed costs exist
short run
is a time horizon within which a business is unable to adjust at least one input because there is a fixed cost of some kind.
total revenue
is calculated by multiplying price and quantity
constant economies of scale
is defined by constant average total cost as output increases
first constraint
is described in the expense data and cost curves of section 2.
marginal cost MC
is equal to the change in the total cost that arises from an extra unit of production
marginal revenue
is the change in total revenue generated from an additional unit sold
second constraint
is the market demand
second decision
is to decide what price to charge
third decision
is to decide whether to produce or to shut down the business for a short period of time
first decision
is to determine the profit maximizing quantity to produce
perfect competition
occurs in an industry in which there are many buyers and many sellers -- an industry in which the good is homogeneous, and an industry in which all who want to enter the industry are free to do so and any business may exit at a time of their choosing.
profit maximizing rule
states that a business maximizes profits when it produces where the marginal revenue from selling another unit equals the marginal cost of producing an additional unit
long run exit decision
states that a business should exit the industry if production at the profit maximizing quantity generates total revenues that are less than total cost, otherwise stay open
profit maximization
the objective of every private business owner is to maximize her or his profits. He or she does this by using the profit maximizing rule. The profit maximizing rule states that a business maximizes profits when it produces where the marginal revenue from selling another unit equals the marginal cost of producing an additional unit.
long run
the situation where the fixed costs (the inputs) become variable
total cost
the sum of fixed costs and variable costs
