Chapter 3--The Costs of Production and Profit Maximization

Question 1

What are the two types of Costs of Production? What do they sum to?

Answer 1

1. Fixed costs (FC), which do not vary based upon the quantity produced (so, they are present when production is 0) and
2. Variable costs (VC), which do vary with different quantities produced

Fixed cost plus Variable Cost = Total Cost

Question 2

What is a Sunk Cost (SC)?

Answer 2

A cost that has already been committed and cannot be recovered (e.g.: a proprietary piece of equipment that is not useful to anyone but the company)

Question 3

What is the “short run?”

Answer 3

A time horizon in which there are some fixed costs

Question 4

What is the “long run?”

Answer 4

A situation where previously fixed costs (in the short run) become variable

Question 5

What is Average Fixed Cost (AFC)?

Answer 5

Fixed Cost / Quantity Produced

Tells us what each item costs in terms of fixed cost

Question 6

What is Average Variable Cost (AVC)?

Answer 6

Variable Cost / Quantity Produced

Tells us what each item costs in terms of variable cost

Question 7

What is Average Total Cost (ATC)?

Answer 7

Total Cost / Quantity Produced
or
Average Variable Cost + Average Fixed Cost

Question 8

What is Marginal Cost (MC)?

Answer 8

The change in the total cost that arises per extra unit of production

(New total cost - old total cost) / (New quantity produced - old quantity produced)

Question 9

What happens when marginal cost is higher than average variable cost or average total cost?

Answer 9

The cost of the AVC or ATC (respectively) must increase with increase quantity produced

Question 10

What are the three characteristics of a perfectly competitive industry? What is the implication?

Answer 10

1) There are many buyers and sellers
2) The good is homogeneous, and
3) Businesses are free to enter and exit the industry at their choosing

The implication is that no businesses operating in the industry may influence the price of the product it sells

Question 11

What is a Price Taker?

Answer 11

A business operating in a perfectly competitive industry

Question 12

What sets market price in a perfectly competitive industry?

Answer 12

The interaction of market demand and market supply

Question 13

What is Total Revenue (TR)?

Answer 13

The price of a good sold X the quantity of a good sold

Question 14

What is Marginal Revenue (MR)?

Answer 14

The change in the total revenue generated by an additional unit sold

(New total revenue - old total revenue) / (new quantity sold - old quantity sold)

Question 15

What is Marginal Revenue in a perfectly competitive industry?

Answer 15

The market price of the product

Question 16

When attempting to maximize profits in a perfectly competitive industry, what two things constrain business owners?

Answer 16

1) The cost of producing output is based on some factors out of his control (i.e.: competency of employees, and market prices for inputs into the production process), and
2) The price that can be charged is determined by the market, not the business owner

Question 17

Taking constraints into consideration, what are the two decisions a business owner must make in a perfectly competitive industry to maximize profits?

Answer 17

1) Determine the quantity to produce that is profit-maximizing, and
2a) In the short run, determine whether to produce, or shut down the company for a short period of time; or
2b) In the long run, determine whether to produce, or exit the industry forever

Question 18

What is the Profit Maximizing Rule?

Answer 18

A business maximizes profits when it produces where the Marginal Revenue from selling another unit equals the Marginal Cost of producing another unit to sell

Question 19

Shut-Down Rule: When should a company shut down in the short run?

Answer 19

When the losses from operating are greater than fixed costs

or

When production at the Profit Maximizing Quantity generates total revenues that are less than variable costs

Question 20

When does the Long-Run Exit Decision come into consideration? What are is the Rule?

Answer 20

When prices remain low for very long periods of time.

A business should exit the industry if production at the profit maximizing quantity generates total revenue less than total costs (since there are no fixed costs in the long run)

Question 21

What three characteristics define a monopolistic industry?

Answer 21

1) There are many buyers and only one seller;
2) The good is heterogeneous; and
3) Barriers to entering the market exist

Question 22

What is a Price Setter?

Answer 22

A business operating in a monopolistic industry, since the lack of competition allows the seller to set the market price

Question 23

When attempting to maximize profits in a monopolistic industry, what two things constrain business owners?

Answer 23

1) Its expenses and costs

2) Market demand

Question 24

Taking constraints into consideration, what are the three decisions a business owner must make in a monopolistic industry to maximize profits?

Answer 24

1) Determine the quantity to produce that is profit-maximizing (done in the same way as under competitive circumstances);
2) Decide what price to charge; and
3) Decide whether to produce or shut down the business for a short period of time (done in the same way as under competitive circumstances)

Question 25

What price is charged in a monopolistic industry?

Answer 25

The price that people will pay at the profit-maximizing quantity (according to the demand schedule)

Question 26

What is an Economy of Scale?

Answer 26

A product that has a large fixed cost and a relatively low marginal cost (e.g.: high R&D to develop a product, but inexpensive to produce once developed).

Thus, as production of these products increase, average total cost decreases.

So, if market demand is large, this company should produce as much of its product as possible to reduce average cost.

Question 27

What is a Diseconomy of Scale?

Answer 27

A production quantity range within which production of products causes an increase in average total cost.

Question 28

What is a Constant Economy of Scale?

Answer 28

An economy with a constant average total cost as production increases

Question 29

What is Economy of Scope?

Answer 29

A situation where a company can produce several products together at less cost than a group of single-purpose companies operating independently

Question 30

What is a Joint Cost? What are the implications of significant Joint Costs?

Answer 30

A cost that does not change with the scope of production

When joint costs are considerable, it makes sense for companies to consolidate and share them, operating under economies of scope