Question

1.Let’s say at our current level of production, producing one more unit of output would increase total revenue by $20 and increase total cost by $30. Should the firm increase or decrease its production? What does this have to do with the MR = MC condition?

2.The neoclassical theory of consumption can be summarized as individuals having “Champagne tastes on beer budget”. Explain what this quote means in terms of preferences and budget constraints. How does this quote help us understand the neoclassical theory of how individuals make consumption choices?

3. Say we have an indifference curve that shows us all the combinations of two goods (face masks and hand sanitizer) that make us equally happy. If the amount of face masks I consume is on the y-axis and the amount of hand sanitizer I consume is on the x-axis, my marginal rate of substitution (MRS) will tell me how many face masks I am willing to give up to get one additional hand sanitizer. Why does the MRS diminish (get smaller) as we go further down this indifference curve (as I get more and more hand sanitizer)?

Answer 1

1)

The firm should DECREASE it's Production.

Producing one more unit of output will increase total revenue by $20 i.e., marginal revenue MR of one additional unit of output is $20. Producing one more unit of output will increase total cost by $30 i.e., marginal cost MC of one more additional unit of output is $30. As MC > MR, this additional unit of output produced will reduce the profits of the firm and hence the firm should DECREASE it's Production so as to increase it's profits by producing less.

A firm produces that level of output where marginal cost is equal to marginal revenue ( MC= MR). If MC > MR , then the cost of producing one additional unit of output is more than the revenue earned from the sale of that additional unit of output. As such, this would Decrease the profits of the firm and the firm will reduce it's Production to increase it's profits by producing less. If MR > MC , then the cost of producing an additional unit of output is less than the Revenue earned from the sale of that additional unit of output. As such, this would increase the profits of the firm and the firm would increase it's Production. When MC = MR, then the cost of producing an additional unit of output is equal to the revenue earned from the sale of that additional unit of output and hence the firm would maximise profits and there would be no incentive to increase or decrease the production. Here, as MR is $20 which is less than MC of $30, the firm should DECREASE it's Production and produce where MC= MR.