Question

1. Assume that a competitive firm has short-run costs as follows:

Q	TFC	TVC	TC	MC	AFC	AVC	ATC
1	100	50	150	50	100	50	150
2	100	80	180	30	50	40	90
3	100	120	220	40	33	40	73
4	100	170	270	50	25	42.5	67.5
5	100	250	350	80	20	50	70

If the P = $55, what is the firm’s profit maximizing Q and how large is the profit? What about if P = $26?

1. “Firms should never sell its product for less than it costs to produce.” Indicate if this statement is TRUE or FALSE and briefly explain if “costs to produce” is interpreted as:

• ATC
• AVC
• MC

3. Managers sometimes feel a commitment to recovering historical costs/ costs incurred long ago and make pricing & output decisions with an eye towards recovering them. Is this a good idea? Briefly explain why/ why not.

Answer 1

When Price = $55, total revenue is as shown in the table below:

Q	TFC	TVC	TC	MC	AFC	AVC	ATC	Price	TR	MR
1	100	50	150	50	100	50	150	55	55	55
2	100	80	180	30	50	40	90	55	110	55
3	100	120	220	40	33.33	40	73	55	165	55
4	100	170	270	50	25	42.5	67.5	55	220	55
5	100	250	350	80	20	50	70	55	275	55

Here we see that TR > TVC only for the first unit. From second unit onwards, TR< TC. So the firm will make operational profits only by producing 1 unit.

So, profit maximizing quantity is 1.

Profit = TR - TVC = 55 - 50 =5 (this is operational profit, that is considering only variable cost, not fixed cost).

Profit = $5

“Firms should never sell its product for less than it costs to produce.” Indicate if this statement is TRUE or FALSE

Ans : TRUE

“costs to produce” is interpreted as AVC (avaerage varible cost) or costs of inputs.

b) when price is $26:

Q	TFC	TVC	TC	MC	AFC	AVC	ATC	Price	TR	MR
1	100	50	150	50	100	50	150	26	26	26
2	100	80	180	30	50	40	90	26	52	26
3	100	120	220	40	33.33	40	73	26	78	26
4	100	170	270	50	25	42.5	67.5	26	104	26
5	100	250	350	80	20	50	70	26	130	26

When price is at $26, TR = 26, which is less than AVC = 50. The firm is not making even operating costs. Such price is called 'shutdown price'. Even it produces 1 unit of putput, its profit will be 26 - 50 = -24

Profit = - 24

The firm should shut down.

Managers sometimes feel a commitment to recovering historical costs/ costs incurred long ago and make pricing & output decisions with an eye towards recovering them.

This is not a good idea. Reason: A firm's income statement based on historical cost will indicate that its earnings are zero every year. It is not a realistic indication of its financial position as it would mean that the firm is shrinking in size. For making output and price decision, the firm would need the current value of its asset and depreciation amount, not historical. That is, historical costs are irrelevant to decisions of current period unless they are continued unchanged into the future.Moreover, hostorical cost is written off while acquiring a replacement. But bringing them into the current year to make production decisions regarding the current year output and pricing leads to inappropriate and incorrect decisions.