4. Lucy S Lasagna

4. Lucy’s Lasagna

TC

MC

1. If the price of lasagna is $7.50 a plate, Lucy’s best option is to shut down. If she shuts down, she will lose $5, the total fixed costs. If she were to operate the least she would lose is $11.00 (at 2 plates of lasagna). The problem is that $7.50 does not even cover the cost of labour, cheese and pasta at the lowest cost per unit. That is, the minimum average variable costs are more than $7.50.
2. Her shutdown point is $10.00. If the price is lower than that, she is not covering the costs she can avoid by shutting down. If the price is more than $10.00, she can cover the variable costs of production. That is, the price of the lasagna will cover the labour and raw material costs incurred in producing each meal.
3. Lucy will only make a profit if the price is at least $11.50 a plate. In the long run, she will leave the industry if the price is less than $11.50, because it does not cover all her costs. She could do better in some other line of business.
4. If the price is more than $11.50, other firms will enter the industry, and Lucy will be pleased to stay in business. A price of $11.50 covers all the expenses of producing lasagna, so a price higher than that yields profits greater than could be obtained in the next best opportunity.
5. In the long run the price of lasagna will be $11.50. If the price is lower, firms will leave the industry, so that the supply decreases and price rises. If the price is higher, firms will enter the industry, so that the supply increases and price falls. At $11.50, firms will neither enter nor leave the industry. Profits are zero. But remember, these are economic profits. An accountant would calculate a positive profit. An economist includes the forgone income from the next best opportunity in the costs of production, so at $11.50 Lucy is receiving enough per plate of lasagna to provide as high a return as she could get in any other opportunity available to her.

6.

1. The market price is $8.40
2. The industry’s output is 350,000 cassettes.
3. Each firm produces 350.
4. Each firm is taking a loss of $1561 (new ATC)
5. Firms exit the industry
6. In the long run there will be 500 firms in the industry.

Explanations:

In question 6 the costs of the firm are the same as in question 5 except that the fixed costs have increased by $980. Fixed costs play no part in variable costs, so the AVC do not change. Fixed costs also play no part in marginal costs, so they don’t change. Marginal costs are the increase in costs that result from producing one more unit of output – so they are the cost of the additional raw materials, fuel and labour required to increase output by one unit. Since by definition, the quantity of the fixed factors of production do not increase as output increases, the cost of the fixed factors have no impact on marginal costs. As a result the change in fixed costs only alters the ATC. All other costs remain the same.

Since $980 is the addition to total fixed costs the change in ATC can be made by calculating AFC at each output, as shown above. AFC = 980/output. The additional AFC is then added to the old ATC to give the new ATC.

The market price must equate the quantity demanded to the quantity supplied in the short run, when firms are neither entering nor leaving the industry. The demand schedule in question 5 indicates that at a price such as $11.60 people will wish to buy 250,000 cassettes. Profit maximising firms will expand production so long as the added revenue from one more unit (the price of $11.60) exceeds the added costs from one more unit, or the marginal cost. So each firm will produce more than 400 cassettes and less than 450 cassettes. Since there are 1000 identical firms, output would exceed 400,000 and be much greater than the quantity demanded of 250,000 at $11.60. Price would fall, so $11.60 can’t be the market price.

If price were to equal $7.50, people would be willing to buy about 375,000 cassettes, but each firm would only be willing to produce a little less than 300 or 300,000 in total. Quantity demanded would exceed quantity supplied and price would rise.

If the price were $8.40, people would be willing to buy 350,000 cassettes, and each firm would be willing to produce 350 each or 350,000 cassettes. Quantity demanded would equal quantity supplied and price would remain at $8.40. Therefore, $8.40 is the market price in the short run.

The economic profit per unit is the difference between the ATC and the price received. The total profit is the profit per unit times the number of units or quantity. When the output is 350, the ATC is $12.86. Since the price is only $8.40, less than the ATC, the firm is making a loss of $4.46 per unit. $4.46 times the output of 350 gives a total loss of $1561. Although the firm is making a loss it is better to operate than to shut down in the short run. You know this because the price is greater than the variable costs of $7.20 at an output of 350, so that the price covers all the costs which could be avoided by reducing output to zero.

In the long run, firms will only stay in an industry if the price covers the average total costs. If price is less than minimum ATC, the firm must take a loss and the owners would be better off if they sold the business and invested their capital and energy elsewhere. If the price is greater than ATC however, firms can make a profit. Since costs as defined by economists include next best opportunity, making a profit means that a firm is doing better in this industry than in its next best opportunity. As a result, firms will enter the industry whenever price is above minimum ATC so that a profit can be made.

As firms leave the industry, the supply curve shifts in and the market price for the product will rise. So if price is below the minimum ATC, firms will be making a loss and will exit the industry. As they leave, the supply in the industry shifts in and the price rises. If the price were above the minimum ATC, firms would enter the industry. As they enter, the supply shifts out and the price falls.

In the long run, the price will equal minimum ATC at that level all firms are just breaking even. None will enter and none will leave. So in the long run the price will equal minimum ATC. In this example the minimum ATC is $12.40, so the price will be $12.40. Each firm will produce an output of 450.

For the price to have stabilized at $12.40, people must be willing to buy the quantity produced when price is $12.40. Each firm is producing 450, the quantity where ATC and MC equal $12.40. The demand schedule shows that the quantity demanded at $12.40 is between 250,000 and 200,000 cassettes, say 225,000 cassettes. In order for the quantity supplied to just equal the quantity demanded, the number of firms must have fallen until 450 (the output of each firm) times the number of firms equals 225,000. Now 225,000 divided by 450 equals 500. When there are 500 firms, each producing 450 cassettes, the quantity supplied will be 225,000 and the industry will be in long run equilibrium.

Note that at this equilibrium the cost of one more unit, MC is $12.40 and just equals what one more unit is worth to people. Cassettes are being produced at the lowest possible cost per unit. Firms are making no excess profits. They are just getting the return on their investment equal to the next best opportunity.

8. Demand has decreased in the cassette industry.

1. Market price is $7.65
2. Output is 300,000
3. Each firm produces 300
4. Each firm loses $1815
5. About 222 (new fixed costs) (500 firms with the original ATC and fixed costs)

Explanation:

The reduction in demand means that in the short-term the quantity demanded at the price of $8.40 falls below the quantity supplied. Price must fall. At the price of $7.65 each of the original 1000 firms will produce 300 cassettes and total industry supply of 300,000 will equal the 300,000 demanded at the price of $7.65.

Each firm is making a loss. The loss per unit is the difference between the price of $7.65 and the ATC at an output of 300, $13.70 or $6.05 per cassette. (Business really stinks.) The total loss is $6.05 times output of 300 or $1815. Production is greater than zero because the price is still higher than the minimum AVC of $7.00. (If the firm shut down it would lose $1980, the added fixed costs of 980 plus $1000, the original fixed costs.)

In the long run firms will exit the industry until the price rises to equal the minimum ATC. Using the new ATC calculated in question 6, the price must rise to $12.40 for firms to stop leaving the industry. As firms exit, supply decreases and prices rise. Extending the demand curve in question 8 (the text hasn’t done a great job on these problems), we see that when the price is about $12.40, quantity demanded will be about 100,000. In order to produce at the minimum ATC of $12.40, each firm will produce an output of 450. The quantity demanded of 100,000 can be produced by about 222 firms, each producing 450 units. That is, 100,000 divided by 450 equals 222.22.

Perhaps the text intended this question to be answered with the original ATC, that is without the increase in fixed costs introduced in question 6. In that case, the price must rise to the old minimum ATC of $10.00. Each firm will produce 400 cassettes when the price is $10.00. At $10.00 the quantity demanded is 200,000. The output of 200,000 could be produced by 500 firms, each producing 400 cassettes. (200,000 divided by 400 equals 500). So, with the original table, 500 firms would remain in the industry.