Module 3 – Suppliers and Cost

Question 1

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 presence of the software will make Christine’s business less profitable.
• The presence of the software will make Christine’s business more profitable.
• The presence of the software will not affect Christine’s profitability.
• The impact on Christine’s profitability is unclear.

Answer 1

The presence of the software will make Christine’s business less profitable.

See correct answer for explanation.

The presence of the software will make Christine’s business more profitable.

See correct answer for explanation.

The presence of the software will not affect Christine’s profitability.

See correct answer for explanation.

The impact on Christine’s profitability is unclear.

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.

Question 2

A pool supply store is considering eliminating its physical locations and offering its products completely online. Which of the following costs would the store be able to eliminate from this transition? Select all that apply.

• The costs of rent and utilities from its physical shops
• The salaries of pool specialists responsible for assisting customers
• The costs of rubber used to produce pool floats
• The shelving costs needed to display its product offerings
• The costs of advertising the store brand and its products

Answer 2

The costs of rent and utilities from its physical shops

These costs would disappear once the store transitioned online.

The salaries of pool specialists responsible for assisting customers

While salaries are fixed costs, it’s not clear that the store would be able to eliminate these costs from its business model.

The costs of rubber used to produce pool floats

This cost depends only on whether the store continues to produce pool floats, a decision which is not affected by the transition online.

The shelving costs needed to display its product offerings

These costs would disappear once the store transitioned online.

The costs of advertising the store brand and its products

These costs would not necessarily disappear and may even increase since the store no longer has its physical stores to provide visibility.

Question 3

Al’s Autos, a car rental company, spends $2.1 million per year on car purchases, routine maintenance and other fixed costs. The company rents out cars at an average rate of $100 per day, and incurs variable costs of $70 per day for each rental. In past years, the business has rented out 100,000 cars per year. However, the city in which the company is located has become a less popular tourist destination, causing consumers to travel there less frequently. The rental company anticipates that it will have 25% fewer customers in coming years. What should Al’s do?

• Definitely stay in business
• Decrease prices to $70 per day
• Exit the car rental industry

Answer 3

Definitely stay in business

Despite the large drop in rentals from 100,000 to 75,000, Al’s is still able to cover both variable and fixed costs. It should remain in business for the time being, unless it continues to lose customers to the point at which it can no longer cover its total yearly costs.

Decrease prices to $70 per day

At $70 per day, Al’s is just making enough money to cover variable costs. This will not be enough to cover his yearly costs.

Exit the car rental industry

Al’s should remain in business for the time being, unless it continues to lose customers to the point at which it can no longer cover its total yearly costs.

Question 4

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
• Produce more of the product and save the excess supply as inventory until demand picks back up
• Advertise its offerings more to drive sales back up to its original level
• Rent out the underutilized space to other companies for additional revenues
• Recognize some of its revenue from pre-orders early

Answer 4

Try to cut fixed costs in other areas where possible

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).

Produce more of the product and save the excess supply as inventory until demand picks back up

This is a risky strategy. The decline in sales seems persistent, so there is no guarantee that demand will pick back up. Producing more, even temporarily, will increase total variable costs too—so profitability will decline even further.

Advertise its offerings more to drive sales back up to its original level

This is a risky strategy. The decline in sales seems persistent, so there is no guarantee that consumers will want the product despite increased advertising. Advertising will increase total costs too—so profitability will decline even further, even if sales do increase somewhat.

Rent out the underutilized space to other companies for additional revenues

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.

Recognize some of its revenue from pre-orders early

While this tactic could create the illusion of sustained profitability, actual profitability would continue to decline. It may decline even further if the company is fined for accounting fraud.

Question 5

Is COST TO CONSTRUCT PARKING LOT a fixed or variable cost?

Answer 5

FIXED

Question 6

Is CASHIER SALARIES a fixed or variable cost?

Answer 6

FIXED

Question 7

Is BUILDING INSURACE a fixed or variable cost?

Answer 7

FIXED

Question 8

Is COST OF PHYSICAL CHECKOUT COUNTERS a fixed or variable cost?

Answer 8

FIXED

Question 9

Is HOURLY WAGES FOR BUTCHES AND BAKERS a fixed or variable cost?

Answer 9

VARIABLE

Question 10

Is DELIVERY COSTS FOR ONLINE ORDERS a fixed or variable cost?

Answer 10

VARIABLE

Question 11

Is ADVERTISING COSTS a fixed or variable cost?

Answer 11

FIXED

Question 12

Is MAINTENANCE OF RISES AND ATTRACTIONS a fixed or variable cost?

Answer 12

FIXED

Question 13

Is COST TO BUILD A FUN NEW HOUSE a fixed or variable cost?

Answer 13

FIXED

Question 14

Is SALARIES OF LAWYERS a fixed or variable cost?

Answer 14

FIXED

Question 15

Is COSTS OF FOOD AND DRINK a fixed or variable cost?

Answer 15

VARIABLE

Question 16

Is HOURLY WAGES FOR CLOWNS AND CARTOON CHARACTERS a fixed or variable cost?

Answer 16

VARIABLE

Question 17

The theme park from the previous question has finished building its fun house. The project cost $240,000 in total and requires two employees to operate it each day costing $50 per employee per day. The park estimates that approximately 400 guests will enter the fun house per day, each paying $1 to enter. After how many years will the theme park break even from operating the fun house?

• Within 1 year
• Between 1 and 2 years
• Between 2 and 3 years
• After 3 years

Answer 17

Within 1 year

See correct answer for explanation.

Between 1 and 2 years

See correct answer for explanation.

Between 2 and 3 years

The park makes $400 in revenues each day from guests and must pay $50*2=$100 to its employees each day as costs of operation. Profits per day are thus equal to $400-$100=$300. With these profits, it will take the park 800 days to recover the total amount it spent building the fun house.

After 3 years

See correct answer for explanation.

Question 18

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?

• Yes– you should do anything to retain your customer base.
• No—in doing so, you may retain your customers, but you will still continue to lose money overall.
• No—customers will still continue to leave you even if you control price increases by buying the supplier.

Answer 18

Yes– you should do anything to retain your customer base.

This is not always true, especially if it is not profitable to operate anymore. See correct answer for explanation.

No—in doing so, you may retain your customers, but you will still continue to lose money overall.

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.

No—customers will still continue to leave you even if you control price increases by buying the supplier.

If your customers don’t experience further price increases, they will likely continue to buy your pizza, especially if competitors are forced to raise their own pizza prices. However, you will be losing money as a company, because you could have sold the cheese for more money.

Question 19

Consider the following table:

The owner of Company B is considering starting a price war with Company A to eliminate a smaller competitor in its industry. Would it be a wise decision for Company B to enter a price war with Company A?

• No, because Company A has more flexibility to increase output and lower costs.
• Yes, because Company B’s cost structure allows it to lower prices further than Company A.
• No, because Company B cannot price low enough to force Company A to exit the industry.
• Yes, because Company B has greater market share than Company A.

Answer 19

No, because Company A has more flexibility to increase output and lower costs.

Variable cost-per-unit would remain the same even if Company A produced more, so this could not be the reason.

Yes, because Company B’s cost structure allows it to lower prices further than Company A.

This is not true.

No, because Company B cannot price low enough to force Company A to exit the industry.

It costs both firms $0.75 per unit. Thus, Company B cannot force A to leave the market by pricing lower than its variable cost-per-unit.

Yes, because Company B has greater market share than Company A.

In this case, market share should not matter in winning the price war.

Question 20

A company books $100 million in revenue for fiscal year 2015, the most it has ever earned. However, the company earns a far lower profit than it did the previous year. What could explain this discrepancy?

• The company saw a decline in sales volume from the previous year.
• The company charged a higher price for its product in FY2015.
• The company saw the cost of its inputs increase substantially over the past year.
• The company created less value for its customers during the period.

Answer 20

The company saw a decline in sales volume from the previous year.

Even if sales volume did decline, the company still made $100 million in revenue, its most ever. The lower profits must be explained by higher costs.

The company charged a higher price for its product in FY2015.

Even if it did charge higher prices, the company still made $100 million in revenue, its most ever. The lower profits must be explained by higher costs.

The company saw the cost of its inputs increase substantially over the past year.

With higher revenues, lower profits can only be explained by higher costs.

The company created less value for its customers during the period.

This is not necessarily true. With lower profits, the company captured less value itself, but consumers could have captured the same or more value.

Question 21

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.
• Consumer preferences change and average WTP for the company’s products increases.
• The company is able to increase the price of its main product without a significant decrease in sales.
• The company discovers a new production technology, allowing it to produce its products more efficiently.
• The rate at which the company is taxed is decreased by the government.

Answer 21

Employees at the firm are willing to take a pay cut to work for the company.

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.

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.

While this would lead to more value captured by the company, it would not create more value overall.

Question 22

Which of the following groups is NOT a competitor for Amazon?

• Overstock.com, another online shopping site
• The businesses that sell their products through Amazon.com
• UPS, a delivery service that Amazon uses to ship products to customers
• Amazon Prime customers that use the site to regularly shop
• All of the above are competitors for Amazon.

Answer 22

Overstock.com, another online shopping site

See correct answer for explanation.

The businesses that sell their products through Amazon.com

See correct answer for explanation.

UPS, a delivery service that Amazon uses to ship products to customers

See correct answer for explanation.

Amazon Prime customers that use the site to regularly shop

See correct answer for explanation.

All of the above are competitors for Amazon.

A business’ competitors include not only other companies in its industry, but also parties with which the business competes to capture value, such as suppliers and customers.

Question 23

An IT entrepreneur is considering entering the PC support industry. She estimates that the annual costs associated with renting an office, computers, and phones are $45,000. Utilities, such as electricity, water and heat, will run her $600/month. To be competitive, she would need to pay her potential employees’ wages of $20/hour. The total number of support hours these employees would cover for a year would be 5,742. What is the lowest price per hour at which the entrepreneur should consider entering the industry?

• $9.10/hour
• $20.00/hour
• $27.84/hour
• $29.10/hour

Answer 23

$9.10/hour

This bill rate does not include the hourly wages of employees. See the correct answer for a list of all fixed and variable costs.

$20.00/hour

This figure does not include the total of all fixed and variable costs. See the correct answer for a list of all fixed and variable costs.

$27.84/hour

This bill rate does not include the cost of monthly utilities. See the correct answer for a list of all fixed and variable costs.

$29.10/hour

Fixed costs are equal to ($45,000) + ($600 * 12 months) = $52,200 for rent, computers, phones and utilities. Variable costs are equal to ($20/hour * 5742 hours) = $114,840 for wages. Total costs are thus equal to $52,200 + $114,840 = $167,040. Divide these costs of $167,040 by 5,742 hours for an hourly minimum bill rate of about $29.

Question 24

Which of the following is true about “volume businesses?”

• Such businesses typically exist in markets with many other competitors.
• Such businesses typically have very high minimum efficient scales of operation.
• Such businesses can typically handle big drops in prices for their product or service.
• Such businesses can typically recover their fixed costs quickly.

Answer 24

Such businesses typically exist in markets with many other competitors.

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.

Such businesses typically have very high minimum efficient scales of operation.

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.

Such businesses can typically handle big drops in prices for their product or service.

Even small drops in prices can ruin a firm’s profitability and make it not worthwhile to remain in an industry.

Such businesses can typically recover their fixed costs quickly.

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.

Question 25

Patrick is considering opening a bowling alley in his town. The total costs to build the alley would be $2 million, which would include 24 lanes, machinery, the front desk, a snack bar, pins, bowling balls and shoes.

Patrick estimates that customers would bowl roughly 5000 games per year on each of the lanes. In order to operate the alley, Patrick must have 6 employees working at all times. He anticipates keeping his business open 12 hours per day, 365 days per year and paying each employee $15/hour. How much would Patrick have to charge for each game bowled to turn a profit within a year?

• $2.00
• $5.00
• $16.67
• $19.96

Answer 25

$2.00

See correct answer for explanation.

$5.00

See correct answer for explanation.

$16.67

This price does not include the variable costs of running the bowling alley.

$19.96

To recover his fixed costs in a single year, Patrick must charge almost $20 per game! This is far too much for a game of bowling. He will have to charge lower prices and recover his fixed costs over a longer period of time.

Question 26

Patrick recognizes that customers will not likely pay more than $5.00 per game to bowl at his alley. If Patrick charges this amount, how many years will it take him to turn a profit? (Assume that customers will still demand to bowl 5,000 games each year on each lane at the alley)

Recap of costs:

The total costs to build the alley would be $2 million, which would include 24 lanes, machinery, the front desk, a snack bar, pins, bowling balls and shoes. Patrick estimates that customers would bowl roughly 5000 games per year on each of the lanes. In order to operate the alley, Patrick must have 6 employees working at all times. He anticipates keeping his business open 12 hours per day, 365 days per year and paying each employee $15/hour.

• Just over 3 years
• Just over 5 years
• Just under 7 years
• -Just under 10 years

Answer 26

Just over 3 years

It would take Patrick ($2,000,000) / ($600,000 in revenues per year) = 3.33 years to recover his fixed costs if there were no variable costs to running the alley.

Just over 5 years

See correct answer for explanation.

Just under 7 years

See correct answer for explanation.

-Just under 10 years

If Patrick were to charge $5 per game, he would make ($5.00 per game)*(5,000 games per lane per year)*(24 lanes) = $600,000 per year in revenues. His costs would be equal to (6 employees)*($15 per hour)*(12 hours per day)*(365 days per years) = $394,200 per year. Thus, each year he would make $205,800 in profits. At this rate, it would take him $2,000,000/$205,800 per year = 9.72 years to recover his initial investment to build the alley.

Question 27

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

• The higher the fixed costs it experiences, the lower a firm’s profits will be.
• Companies that incur fixed costs primarily at the level of an individual store are likely to face difficulties scaling their businesses.
• Industries that don’t have high fixed costs will have few barriers to entry.
• Fixed costs do not always imply that the bigger firm will experience cost advantages.
• Companies that experience fixed costs mainly at the local level gain no benefits in scaling up operations to the national level.

Answer 27

The higher the fixed costs it experiences, the lower a firm’s profits will be.

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 incur fixed costs primarily at the level of an individual store are likely to face difficulties scaling their businesses.

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.

Industries that don’t have high fixed costs will have few barriers to entry.

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.

Fixed costs do not always imply that the bigger firm will experience cost advantages.

True—bigger does not necessarily imply better. Bigger firms may suffer from various inefficiencies related to increased production or scale, potentially driving up costs.

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.

Question 28

Which of the following regarding economies of scale is true?

• Firms that benefit from economies of scale in production will continue to do so as they increase output.
• Economies of scale can operate at the level of the individual firm or industry, but not on the local level.
• Scale economies can be either positive or negative, or both, based on a firm’s size.
• Firm size is the sole determinant of whether a business is able to decrease costs from scaling production.

Answer 28

Firms that benefit from economies of scale in production will continue to do so as they increase output.

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.

Economies of scale can operate at the level of the individual firm or industry, but not on the local level.

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.

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.

Firm size is the sole determinant of whether a business is able to decrease costs from scaling production.

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.

Question 29

The graph below depicts the supply curve for gasoline on a small island nation. Each producer has a maximum capacity of 2000 gallons.

At what prices will a maximum of 4000 gallons of gasoline be produced? Select all that apply.

• $2.00
• $2.50
• $3.00
• $3.50

Answer 29

$2.00

At this price, firms will first start supplying 4000 gallons.

$2.50

At this price, firms will continue to supply 4000 gallons, as the price is not high enough for it to be profitable for firms to supply more.

$3.00

At this price, firms will first start supplying 6000 gallons.

$3.50

At this price, firms will first start supplying 8000 gallons.

Question 30

The graph below depicts the supply curve for gasoline in another island nation.

Which of the following statements is true? Select all that apply.

• Some producers in this nation have a lower average variable cost than that of all of the producers on the other island.
• There are likely fewer producers of gasoline on this island.
• There are likely more producers of gasoline on this island.
• At a price of $3.50 per gallon, more gasoline is produced on this island nation than on the first.
• At a price of $3.25 per gallon, firms have a higher combined gross revenue on this island nation than on the first.

Answer 30

Some producers in this nation have a lower average variable cost than that of all of the producers on the other island.

On this island gasoline is produced at a price below $1.50 per gallon, implying that at least some firms find it profitable to produce and sell gasoline. This implies that the average variable cost of some firms is below $1.50, which cannot be said about any of the firms on the other island. On the first island, no firms produced until the price reached $1.50.

There are likely fewer producers of gasoline on this island.

Since the supply curve is smoother in this case, there are at least five, and likely more, producers on this island.

There are likely more producers of gasoline on this island.

This would be reasonable to assume. A smoother supply curve implies that there are a larger number of firms willing to produce smaller volumes of gasoline than in the first.

At a price of $3.50 per gallon, more gasoline is produced on this island nation than on the first.

At this price, each island produces 8000 gallons.

At a price of $3.25 per gallon, firms have a higher combined gross revenue on this island nation than on the first.

At this price, more gasoline is produced on this island than on the other one. Firms are willing to produce at this price point, meaning they must be earning some revenues from the new sales.

Question 31

Which of the following regarding supply curves is NOT true?

• The higher the price, the more firms will be willing to produce.
• In the short run, a steep fall in prices will force the least efficient producers to exit the industry.
• A supply curve can be thought of as a relative cost analysis for all the firms in an industry.
• In the long run, the industry supply curve should take into account both variable costs and fixed costs.

Answer 31

The higher the price, the more firms will be willing to produce.

Higher prices provide the incentive for firms to produce more, hence the upward slope of the supply curve.

In the short run, a steep fall in prices will force the least efficient producers to exit the industry.

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.

A supply curve can be thought of as a relative cost analysis for all the firms in an industry.

Moving from left to right, the supply curve depicts the relative efficiency of producers within an industry.

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.

Question 32

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?

• Yes, since the new plant will have double the capacity, the entrant will be able to sell double the amount and gain more profit than the other plant.
• Yes, since the average costs of the new plant will be lower than the incumbent plant.
• Yes, since the variable costs the new plant will be lower than the incumbent plant.
• He should not build the plant.

Answer 32

Yes, since the new plant will have double the capacity, the entrant will be able to sell double the amount and gain more profit than the other plant.

Despite the higher production capacity, he should not enter because his average costs are higher than the incumbent company’s variable costs.

Yes, since the average costs of the new plant will be lower than the incumbent plant.

He should not enter because his average costs are higher than the incumbent company’s variable costs.

Yes, since the variable costs the new plant will be lower than the incumbent plant.

He should not enter because his average costs are higher than the incumbent company’s variable costs.

He should not build the plant.

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.

Question 33

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 will not cover total costs.
• The owners decided to go on a vacation to Florida.
• Other mountains nearby have shut down for the season.
• Owners expect that revenue earned won’t cover variable costs.

Answer 33

Owners expect that revenue will not cover total costs.

If revenue were not enough to cover total costs, but were covering variable costs, the ski resort would stay open.

The owners decided to go on a vacation to Florida.

The owners could probably find someone to run the ski resort in their absence.

Other mountains nearby have shut down for the season.

If anything, this would make the ski resort less likely to shut down, since its revenues might increase as new customers come to the resort instead of going to other mountains.

Owners expect that revenue earned won’t cover variable costs.

If the revenue is not enough to cover operating costs, the ski resort would have no reason to stay open.

Question 34

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 fall to $3,200 per boat and fixed costs fall to $800 per boat
• Variable costs are unchanged at $4,000 per boat and fixed costs fall to $800 per boat
• Variable costs are unchanged at $4,000 per boat and fixed costs are unchanged at $1,000 per boat
• Variable costs rise to $5,000 per boat and fixed costs are unchanged at $1,000 per boat

Answer 34

Variable costs fall to $3,200 per boat and fixed costs fall to $800 per boat

See correct answer for explanation.

Variable costs are unchanged at $4,000 per boat and fixed costs fall to $800 per boat

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.

Variable costs are unchanged at $4,000 per boat and fixed costs are unchanged at $1,000 per boat

See correct answer for explanation.

Variable costs rise to $5,000 per boat and fixed costs are unchanged at $1,000 per boat

See correct answer for explanation.

Question 35

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
• Profit + consumer surplus

Answer 35

Profit

The profit is the difference between the price ($75) and the cost ($40)

Consumer surplus

Consumer surplus is the difference between WTP ($90) and the price ($75)

Profit + consumer surplus

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

Question 36

A farm equipment manufacturer has already spent $3 million in research and development to design a new model of tractor. To produce the tractors, the company will have to contract to rent a factory for a year at a cost of $20 million, and will then spend an additional $10,000 per tractor in materials and wages.

The company estimates that it can sell 2,000 tractors per year at a certain price, and concludes that it should produce the tractors. What is the lowest price the company could be using in this calculation?

• $10,000
• $11,500
• $20,000
• $21,500

Answer 36

$10,000

Since the company is deciding whether to start producing tractors, it needs to cover the $20 million in fixed costs as well as the $10,000 in variable costs.

$11,500

$11,500 would be enough to cover the variable costs of the tractors, plus the $3 million spent on research and development. However, the $3 million is sunk, and should not be included in calculations. Moreover, the $20 million in yearly fixed costs is not sunk, and should be taken into account.

$20,000

The company needs to earn enough on each tractor to cover the fixed costs of operating for a year. $20 million spread over 2,000 tractors is $10,000 per tractor, so adding in the variable costs, the company needs to sell each tractor for $20,000

$21,500

$21,500 per tractor would be enough to cover even the sunk costs of research and development. However, since these costs have already been incurred, they should not factor into forward-looking decisions.

Question 37

Suppose the farm equipment manufacturer from the previous question was able to charge $30,000 per tractor, and produces and sells 2,000 tractors per year at that price. As a reminder, the company originally spent $3 million in research and development costs. The company now spends $20 million at the beginning of each year to rent a factory, and $10,000 per tractor in materials and wages.

If another manufacturer enters the market in the middle of a year and engages the company in a price war, what is the lowest price the company would be willing to charge for each tractor?

• $10,000
• $11,500
• $20,000
• $21,500

Answer 37

$10,000

The company should be willing to produce tractors as long as the price they sell for covers the variable costs of production.

$11,500

Since the research and development costs are already sunk, they should not factor into forward-looking decisions.

$20,000

Since the company has already paid the rent for the year, that $20 million is sunk, and should not factor into the decision of whether or not to produce.

$21,500

Since the research and development costs are already sunk, they should not factor into forward-looking decisions.

Question 38

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

• A chain of bookstores that incurs fixed costs every time it opens a new store.
• A law firm that faces large labor costs.
• A fast food restaurant that incurs fixed costs to set up new locations, but low variable costs per customer.
• 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.

Answer 38

A chain of bookstores that incurs fixed costs every time it opens a new store.

Since the costs increase with each additional store, spreading across the country will not lead to very significant economies of scale.

A law firm that faces large labor costs.

As the law firm takes on more clients, it will need to hire more lawyers, so this cost does not scale well.

A fast food restaurant that incurs fixed costs to set up new locations, but low variable costs per customer.

This company’s fixed costs are mostly local.

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.

This company’s fixed costs scale well as it expands nationally.

Question 39

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

• Low variable costs
• Network effects
• High customer willingness to pay
• Low opportunity costs of entering the industry
• High fixed costs

Answer 39

Low variable costs

See correct answers for explanation.

Network effects

If a product exhibits network effects, the dominant suppliers in the industry grow more and more successful as existing customers draw in new customers. This leads to industries with a few large competitors rather than many small ones.

High customer willingness to pay

See correct answers for explanation.

Low opportunity costs of entering the industry

See correct answers for explanation.

High fixed costs

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.

Question 40

An entrepreneur has developed a method of manufacturing light bulbs that significantly reduces the costs of production. The entrepreneur should enter the industry if:

• Its average cost per light bulb is less than existing manufacturers’ variable cost per light bulb.
• Its average cost per light bulb is less than existing manufacturers’ average cost per light bulb.
• Its variable cost per light bulb is less than existing manufacturers’ variable cost per light bulb.
• Its fixed cost per light bulb is less than existing manufacturers’ fixed cost per light bulb.

Answer 40

Its average cost per light bulb is less than existing manufacturers’ variable cost per light bulb.

Existing firms will be able to lower prices to the level of their variable costs. The entrepreneur will only want to enter if prices will be high enough to cover total costs.

Its average cost per light bulb is less than existing manufacturers’ average cost per light bulb.

See correct answer for explanation.

Its variable cost per light bulb is less than existing manufacturers’ variable cost per light bulb.

See correct answer for explanation.

Its fixed cost per light bulb is less than existing manufacturers’ fixed cost per light bulb.

See correct answer for explanation.

Question 41

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?

• Employees at Amazon do not value salary as much as employees at other companies.
• Employees at Amazon are less qualified than ones at other companies.
• Amazon has been able to lower some of its employees’ WTS for their labor.
• Amazon has a lower WTP for employees.

Answer 41

Employees at Amazon do not value salary as much as employees at other companies.

Even if this is true, students who have received two job offers should prefer the one with a higher salary unless there is some other reason to prefer the lower offer.

Employees at Amazon are less qualified than ones at other companies.

Since the employees received offers from other companies, they are probably not less qualified.

Amazon has been able to lower some of its employees’ WTS for their labor.

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.

Amazon has a lower WTP for employees.

Amazon’s WTP will determine what salary it offers to the students, but cannot be the explanation of why the students would choose Amazon over another employer.

Question 42

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 remains unchanged because the cost of room, board, and tuition has not changed.
• It decreases because you now have more resources to afford college education.
• It increases because you are foregoing more money for college.
• It remains unchanged because the benefits of attending college have not changed.

Answer 42

It remains unchanged because the cost of room, board, and tuition has not changed.

See correct answer for explanation.

It decreases because you now have more resources to afford college education.

See correct answer for explanation.

It increases because you are foregoing more money for college.

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.

It remains unchanged because the benefits of attending college have not changed.

See correct answer for explanation.

Question 43

Two children living in a neighborhood have decided to go into business running lemonade stands.

Annie has spent $10 on a pitcher to make the lemonade in, and can produce up to 70 cups of lemonade per day. She spends $0.15 per cup of lemonade on lemons, sugar, and plastic cups.

Bobby has spent $1 on a pitcher, and can produce only 20 cups of lemonade per day. He spends $0.25 per cup of lemonade on lemons, sugar, and plastic cups.

Which of the following graphs represents the supply curve for lemonade in this neighborhood?

Answer 43

Supply curve 4

The first 70 cups will be produced by Annie, who is willing to produce them as long as price covers her $0.15 variable costs. If more than 70 cups are produced, they will have to be sold at a price of $0.25 to cover Bobby’s variable costs. A maximum of 90 cups can be supplied by this market.

Question 44

The table below shows fixed and variable costs per unit for an ice cream shop, “Company A,” and its local competitor, “Company B.”

Costs for rent and utilities are fixed by contract, and the two shops produce the same flavor of ice cream. The owner of Company A is considering lowering the price of its ice cream, starting a price war with Company B in an effort to grab market share from its competitor. Would it be a wise decision for Company A to enter a price war with Company B?

• No, because Company B’s cost structure allows it to lower prices further than Company A.
• No, a price war will be ineffective when the two companies have the same total costs per unit.
• Yes because Company A’s cost structure allows it to lower prices further than Company B.
• Yes, because Company A has greater market share than Company B.

Answer 44

No, because Company B’s cost structure allows it to lower prices further than Company A.

A price war would be won by the company that can lower its prices the most. The ability to lower prices is based off of the variable costs per unit.

No, a price war will be ineffective when the two companies have the same total costs per unit.

See correct answer for explanation.

Yes because Company A’s cost structure allows it to lower prices further than Company B.

See correct answer for explanation.

Yes, because Company A has greater market share than Company B.

See correct answer for explanation.

Question 45

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.
• Higher fixed costs incurred in order to meet demand end up increasing the cost of production.
• Corn ethanol’s relative inefficiency as a fuel raises production costs for corn producers.
• The opportunity cost for supplying corn is higher than before.

Answer 45

To meet higher demand, the industry relies more on less cost efficient producers of corn.

As more corn is demanded, the additional corn will be produced by less efficient suppliers, and prices will increase to cover their costs.

Higher fixed costs incurred in order to meet demand end up increasing the cost of production.

The price charged by producers is based on their variable, rather than fixed, costs of production.

Corn ethanol’s relative inefficiency as a fuel raises production costs for corn producers.

The corn producers do not have to use corn ethanol themselves, so its relative inefficiency will probably not impact their costs.

The opportunity cost for supplying corn is higher than before.

We have no reason to believe that the opportunity cost of supply corn has increased in general.

Question 46

Although labor is typically viewed as a variable cost in the very short run, some labor costs may be fixed. Which of the following items represents an example of a fixed labor cost?

• A salaried clerk who has a two-year employment contract
• A cashier who is paid on an hourly basis
• A cashier who is paid on an hourly basis
• All of the above

Answer 46

A salaried clerk who has a two-year employment contract

Regardless of the change of outputs in the company, the clerk is still being paid at a fixed salary for two years.

A cashier who is paid on an hourly basis

If output decreased significantly, the company could cut back on the cashier’s hours, thereby decreasing the cost. If output increased, the company might want the cashier to work more.

A part-time student who works at a fashion boutique twice a week

The boutique could increase or decrease the student’s hours to adjust costs to changing output levels.

All of the above

See explanations above.

Question 47

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?

• No, the company should shut down to avoid further losses.
• Yes, if the additional customers would lower the average cost enough to make the firm profitable.
• No, since the company is losing money on each unit sold, a greater quantity would lower profits further.
• Yes, because more customers now will result in more profit in the future.

Answer 47

No, the company should shut down to avoid further losses.

Expanding the customer base might decrease per-unit costs sufficiently to make the company profitable.

Yes, if the additional customers would lower the average cost enough to make the firm profitable.

As output increases, fixed costs per unit will decrease. This may lead to low enough average costs that the firm will be profitable.

No, since the company is losing money on each unit sold, a greater quantity would lower profits further.

Price might be higher than the variable costs, in which case producing a greater quantity of the good will actually decrease losses.

Yes, because more customers now will result in more profit in the future.

We do not know whether the price is higher than the variable cost. If it is not, additional customers will simply result in greater losses.

Question 48

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?

• 2/9
• 1/4
• 5/9
• 5/8

Answer 48

2/9

See correct answer for explanation.

1/4

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

5/9

See correct answer for explanation.

5/8

See correct answer for explanation.

Question 49

The average total cost to bake 100 cookies is $0.17 per cookie. The marginal cost is constant at $0.10 for each cookie produced. The total cost to bake 100 cookies is:

• $7.00
• $10.00
• $17.00
• $27.00

Answer 49

$7.00

See correct answer for explanation.

$10.00

See correct answer for explanation.

$17.00

The average total cost of $0.17 per cookie includes both marginal cost ($0.10 per cookie) and fixed cost per unit ($0.07 per cookie). The total cost of baking 100 cookies is the average total cost multiplied by the number of cookies.

$27.00

See correct answer for explanation.

Question 50

Consider the following cost structures for three oil producers:

If the price for a barrel of oil is currently $42, what is the amount of barrels produced by these suppliers?

• 140,000 barrels
• Between 140,000 and 220,000 barrels
• 220,000 barrels
• Between 220,000 and 320,000 barrels

Answer 50

140,000 barrels

See correct answer for explanation.

Between 140,000 and 220,000 barrels

See correct answer for explanation.

220,000 barrels

Both Green House Oils and Shale Ale will produce at full capacity at a price of $42. Fossils R Us will not produce any oil.

Between 220,000 and 320,000 barrels

See correct answer for explanation.

Question 51

An entrepreneur is considering starting a new business to produce and sell gourmet cookie dough. The entrepreneur estimates that average total costs per pack of dough would be $7, of which variable costs per pack would be $5.

An incumbent bakery in the neighborhood sells cookie dough for $10 per pack. The entrepreneur estimates that this bakery spends $8 in total costs on each pack of dough, $7 of which is variable costs.

Should the entrepreneur start the new business?

• The entrepreneur should start the new business ONLY if customers are willing to pay at least $1 more for the new dough than for the incumbent’s dough, so the entrepreneur can make some profit and grow the business.
• The entrepreneur should start the new business as long as customers are willing to pay at least as much for his cookie dough as for the incumbent’s product.
• The entrepreneur should definitely start the new business because his variable cost per pack of dough is already lower than that of the incumbent bakery.
• The entrepreneur must be indifferent to starting the business because his average cost per pack is equal to his established rival’s variable cost per pack.

Answer 51

The entrepreneur should start the new business ONLY if customers are willing to pay at least $1 more for the new dough than for the incumbent’s dough, so the entrepreneur can make some profit and grow the business.

See correct answer for explanation.

The entrepreneur should start the new business as long as customers are willing to pay at least as much for his cookie dough as for the incumbent’s product.

Since the entrepreneur’s average cost per unit is equal to the established competitor’s variable cost per unit, the entrepreneur should pursue the venture if customers’ are willing to pay at least $10 for the entrepreneur’s dough.

The entrepreneur should definitely start the new business because his variable cost per pack of dough is already lower than that of the incumbent bakery.

The business should consider whether or not it can recover its fixed costs as well, since it has not yet entered the dough market.

The entrepreneur must be indifferent to starting the business because his average cost per pack is equal to his established rival’s variable cost per pack.

This is only true if consumer WTP for the entrepreneur’s cookie dough is equal to consumer WTP for the incumbent’s cookie dough.

Question 52

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 paid to the workers hired to run the resort and tend to its guests.
• The wages lost by the owner in pursuing his own venture, instead of working for an already established resort.
• The cost of materials to build the main hotel, pools and guesthouses.
• The money foregone by using the land on which the resort will stand, instead of selling it or using it for another venture.
• The cost of hiring accountants to keep track of the company’s books.

Answer 52

The wages paid to the workers hired to run the resort and tend to its guests.

Labor costs are a direct cost of doing business that would show in the firm’s financial statements.

The wages lost by the owner in pursuing his own venture, instead of working for an already established resort.

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 cost of materials to build the main hotel, pools and guesthouses.

These are direct costs.

The money foregone by using the land on which the resort will stand, instead of selling it or using it for another venture.

This is an opportunity cost and should be included in the economic cost.

The cost of hiring accountants to keep track of the company’s books.

Believe it or not, this is a direct accounting cost.