Question

Q4. A manufacturer of electronics products is considering entering the telephone equipment business. It estimates that if it were to begin making wireless telephones, its short run cost function would be as follows:

Q (thousands) AVC                 AC                   MC

9                                  41.10               52.21               30.70

10                                40.0                 50.0                 30.10

11                                39.1                 48.19               30.10

12                                38.40               46.73               30.70

13                                37.90               45.59               31.90

14                                37.60               44.74               33.70

15                                37.50               44.17               36.10

16                                37.60               43.85               39.10

17                                37.90               43.85               39.10

18                                38.40               43.96               46.90

19                                39.10               44.36               51.70

20                                40.0                 45.0                 57.10

1. Suppose the average wholesale price of a wireless phone is $50. Do you think this company should enter the market? Explain.
2. How much is the profit (loss) earned by this firm at the optimal level of production.
3. Suppose the firm does enter the market and that over time increasing competition causes the prices of phones to fall to $35. How would that affect the firm’s production levels and profit? Explain.

Answer 1

a. In order to maximize profits, the company would produce at a level where MC = MR. That level is somewhere between 18,000 and 19,000 units. At 19,000 units, the AC (average cost) is 44.36, which is higher than the price of 50. Yes, the company should enter the market as it would make profits

b. At this level of production (let's assume it is 19,000) units, its revenue would be 19,000 x 50 = 950,000 and cost would be 19,000 x 44.36 = 842,840. Hence the profit will be 950,000 - 842,840 = 107,160

c. If the price falls to $35, the firm would make losses at every level of production, since its AC is higher than $35 at every level of production. To maximize profit (or minimize loss) it would produce at a level somewhere between 14,000 and 15,000 units because that is where MC = MR. The loss at this level (let's assume it is 15,000 units) would be:

15000 x (35 - 44.17) = -137550 (loss of 137,550)