Question

1. A key part of understanding a market is to understand something about the supply of products and services produced by profit-maximizing firms; firms that try to maximize the value of revenues minus costs. The core profit equation is thus:

Profit = Price x Quantity – Variable Costs – Fixed Costs

1. What are the distinctions between fixed costs, sunk costs, variable costs and marginal costs?

2. What is the difference between economic profit and accounting profit? Why should managers focus mainly on economic profits?

3. What is the basic profit maximization rule in relation to MC for businesses when trying to choose production levels for most market structures?

4. Complete the following table:

Q Output	FC Fixed Cost	VC Variable Cost	TC Total Cost	AFC Average Fixed Cost	AVC Average Variable Cost	ATC Average Total Cost	MC Marginal Cost
0	$2,000	$ 0
76	2,000	400
248	2,000	800
492	2,000	1,200
784	2,000	1,600
1,100	2,000	2,000
1,416	2,000	2,400
1,708	2,000	2,800
1,952	2,000	3,200
2,124	2,000	3,600
2,200	2,000	4,000

5. Referring to the cost table you calculated above:

• If the product being produced is currently priced at $2.00 comment on the short-term and long-term operating choices faced by the firm.

• If the product is currently selling for $10.00 what would you anticipate happening in the long-run for this firm?

• If the ATC represents the long-term average total costs for the industry, and the market is perfectly competitive, what would you predict as the long-run price of the product?

Answer 1

a1)

• Fixed costs refer to the permanent costs that a company has to pay irrespective of its production level, i.e even paid at output level of 0 units.
• Sunk costs refers to the costs which have already been incurred and cannot be recovered.
• Variable costs are the costs which change as different levels of output are produced.
• Marginal cost is the change in total cost which is incurred when producing an additional unit of the product.

a2)

Accounting profit refers to the net income that a company generates that is what we get after subtracting various expenses and costs from the total revenue. It only takes into consideration the explicit costs.

Economic profit is calculated by looking at the cash flow of a company that is the actual amount of cash generated by businesses after which the opportunity cost for taking one alternative instead of the other by a business is also considered. In economic profit, we subtract only explicit costs and implicit costs both.

The managers should focus mainly on economic profits because it also takes into concern the opportunity costs and it accounts for a longer span of time than accounting profits. These can be used by managers to decide if they want to enter or exit a market.

a3)

The basic profit maximisation rule states that if a firm is willing to maximise it's profits, then it shall"

1. Operate at a level where MR=MC

2. After MR=MC, MC curve should be rising.

here, MR= marginal revenue and MC= marginal cost

If MR>MC, then for each additional unit produced, revenue will be higher than cost and you will be willing to produce more till profit maximising level.

If MR<MC, for each unit produced, costs will be higher than revenue and so you will want to produce less.

For more clarity, refer to the figure below:

a4)

Using the following formulas, we can complete the table

1. Total Cost = Fixed Cost + Variable Cost

2. Average Fixed Cost = Total Fixed Cost / Output Level

3. Average Variable Cost = Total Variable Cost / Output Level

4. Average Total Cost = Total Cost / Output Level

Output	Fixed Cost	Variable Cost	Total Cost	Average Fixed Cost	Average Variable Cost	Average Total Cost
0	2000	0	2000	-	-	-
76	2000	400	2400	26.31	5.26	31.57
248	2000	800	2800	8.06	3.22	11.29
492	2000	1200	3200	4.06	2.43	6.50
784	2000	1600	3600	2.55	2.04	4.59
1100	2000	2000	4000	1.81	1.81	3.63
1416	2000	2400	4400	1.41	1.69	3.10
1708	2000	2800	4800	1.17	1.63	2.81
1952	2000	3200	5200	1.02	1.63	2.66
2124	2000	3600	5600	0.94	1.69	2.63
2200	2000	4000	6000	0.90	1.81	2.72