Economics
Sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree. These include items such as the construction costs of mines or tunnels, or the development costs of industrial processes. The existence of sunk costs tends to produce hysteresis in the economy, and helps to explain the rarity of contestable markets.
The additional cost incurred as the result of a particular decision or set of circumstances.
That part of cost which varies with the level of output. This is in contrast to fixed costs, which must be incurred for output to be possible at all, and do not depend on its level. It should be noted that this distinction is different from that of variability over time. The price of an input may be stable for years, but it is still a variable cost if the amount used depends on output. The price of another input may be volatile, but it is still a fixed cost if the amount used does not depend on the level of output.
An incremental cost is similar to a marginal cost; it tends to be used when the principal significance is the exclusion of all costs except those that would not have been incurred but for the specific project in view.
Out-of-pocket cost is an item requiring current or future cash expenditure. While, opportunity cost refers to the economic benefit forgone by using a resource for one purpose rather than another
13. Overheard at the water cooler: “I think our company should take advantage of economics of scale by increasing our output, thereby spreading out our overhead costs.” Would you agree with this statement ( assuming this person is not your boss)? Explain.
I agree with the statement. As the economies of scale is defined, it is characterize by a production process in which an increase in the number of units produced causes a decrease in the average cost of each unit. The more the output, the cheaper it is to produce.
Problem 2
Mr. Lee could sell his store and work in a chemical company since working in a chemical company would give him a fixed compensation without the risk of low profit as with the store. In addition, with the 9% interest on an investment of his 0,000, it would be greater than his revenue in store minus the expenses. It is also one reason for Mr. Lee to sell his store so that he would not incur expenses.
Chapter 8 Questions
2. Explain the importance of free entry and exit in the perfectly competitive market. That is, if free entry and exit did not exist, what impact would this have on the allocation of resources and on the ability of firms to earn above-normal profits over time?
“In perfectly competitive markets firms do not face costs to either enter or exit a market. Perfectly competitive firms are free to enter an industry if there is a potential for profit, or to exit the industry in the event of losses. Free entry means that new firms (either those operating in other industries or start-up firms) can easily enter the market, thereby increasing market supply and reducing profit margins. Similarly, free exit means firms can easily exit the industry, thereby reducing market supply and increasing profit margins. Firms do not face barriers-to-exit because of governmental regulation (as in the case of utility companies). Free entry and exit will have important implications for the profit margins of firms operating in a perfectly competitive industry.” ()
“Economic profit” is a theoretical concept used to help explain the behavior of firms in competitive markets. Suggest ways in which this concept can actually be measured.
Economic profit is defined as “the after-tax operating profit less the cost of capital charge for the operating assets” (shareholder executive.gov.uk). Economic Profit can also be expressed as the return on invested capital over the weight adjusted cost of capital, multiplied by the invested capital. EP accounts for the operational flow and then takes into account the business’ cost of capital arising on its operating asset base, or “invested capital”. EP includes financing flows and the impact associated with any particular debt/equity capital structure. The operating profit from which EP is calculated is defined as “earnings before interest, taxes, amortisation (EBITA)”, which equates to revenue less operating expenses”. Operating profit focuses on activities within management’s control and so excludes gains and losses arising from non-operating assets. Invested capital refers to the operating assets on the balance sheet. This is broadly defined as “total assets less current liabilities”. ()
11. Explain why a price-setting firm will always set its revenue-maximizing price below the price that would maximize its profit.
A profit-maximizing number-monopoly will set its price at the level where its marginal cost equals its marginal revenue. Since its demand curve slopes down, its marginal revenue curve slopes down too, and even steeper. This is because each extra unit of output is not only sold at a lower price, but all previous units area also sold at that lower price. So where the two curves intersect, the marginal revenue is less than the demand curve, where the price is, and the difference is an economic profit (since the marginal cost curve also includes all implicit costs). This is not an entrepreneurial profit, but a monopoly profit, since it is not due to the uncertainty of the market, but on the contrary, to assured profits due to the lack of competition.
PROBLEM 2
Indicate whether each of the following statements is true or false and explain why.
A competitive firm that is incurring a loss should immediately cease operations.
False
The firm must first investigate what has caused the loss of the firm. The firm shuts down if the revenue it gets from producing is less than its variable costs. In the long run, if the revenue it gets from producing is lesser than it total costs the firm can decide to exit.
b. A pure monopoly does not have to worry about suffering losses because it has the power to set its prices at any level it desires.
False
Monopoly does not guarantee economic profits even if the firm can dictate its prices. When the price is lower that the average total costs, then the firm suffers losses. If the price is greater than the average variable costs, then the firm can continue its operations in a short run. Being a monopoly can still suffer losses since monopolies face costs and price pressures.
In the long run, firms operating in perfect competition and monopolistic competition will tend to earn normal profits.
False
In a perfect competition, zero profit maximization will occur since in perfect competition, as companies make more profit, others will see opportunity. Competitors has seen no barriers to entry in the market, many firms will enter the market, will raise its production and drives prices down. This will bring profits down. However, when profits go down too much, companies will be forced out of business and the survivors will be better off. So, in the long run, there is competitive equilibrium in a perfectly competitive economy.
On the other hand, monopolistic competition, because there are so many relatively weak firms, there are no barriers to entry. Although not as perfectly easy as in perfect competition, companies can enter the market relatively easily. This makes for a long-term equilibrium competition of no profit. When there is profit to be made, just as in perfect competition, new companies come in and take that profit away through expanded production and dropping prices.
Assuming a linear demand curve, a firm that want to maximize its revenue will charge a lower price than a firm that wants to maximize it profits.
True
When a firm is to maximize its profits it would charge a lower price since with a lower price the company can sell more units of its products.
If P>AVC, a firm’s total fixed cost will be greater than its loss.
False
Since a company can still operate when the price is greater than average fixed cost, it means that the fixed costs are still manageable. It is when the price is less than the AVC that the fixed is greater than its loss that makes firms decide to sell its fixed costs.
When a firm is able to set its price, its price will always be less than its MR.
False
A firm will always sets its price at MR = MC
A monopoly will always earn economic profit because it is able to set any price that it wants to.
False
Although monopolist can dictate its prices, they are not exempted with losses because all firms face costs and prices pressures so there is no guarantee that monopolists always can earn economic profit
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