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?

Estimating a Cubic Cost Function

Using the Production and Total Cost Data from Question 6, use regression analysis in Excel to estimate a Cubic Cost function for this firm. The dependent variable will be Total Cost (TC) and the independent variables will be Q, Q^2, and Q^3. You will have to generate/calculate the Q^2 and Q^3 variables in separate columns, and then use them as part of your independent variables in the regression.

1. Estimate the equation for a cubic cost function and report the results:

Total Cost (TC) = F + aQ + bQ² + cQ³

2. Are all of the coefficient estimates “significant”? Explain the importance of whether the coefficients are significant or not.

3. What is the R-Square value of the cost function estimate, and how do you interpret that?

4. Compare the intercept of your regression to what you know about the actual fixed costs in the table. How close are they? What does this tell you about estimating cost equations?

Answer 1

a)

Fixed costs are incurred even when output is zero and does not change with output. Examples of fixed cost is insurance, Salary to executives.

Sunk costs

A sunk cost refers to money that has already been spent and which cannot be recovered. Sunk costs are not relevant to future decisions.

Examples are funds spent on research and development.

Variable costs vary with production. Examples of variable costs are material, labor,

Marginal costs are additional costs incurred due to the production of one more unit.

b)

Accounting Profit= Revenue- explicit costs. Explicit costs require monetary payments like rent, wages, utilities.

Economic profit= Accounting profit-implicit costs Implicit or opportunity costs do not require actual monetary payments. Implicit costs are opportunity costs. Opportunity cost is the value of the next best alternative.

The main difference between accounting profit and economic profit is that economic profit includes both explicit and implicit costs, whereas, accounting profit includes only explicit costs.

c) MC= MR. The profit maximization rule for most market structures is MC= MR.

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