CH11-solution-9e

CH11 1.

Which of the following news items involves a short-run decision and which involves a long-run decision? Explain January, 31, 2008: Starbucks will open 75 more stores abroad than originally predicted, for a total of 975. This decision is a long-run decision. It increases the quantity of all of Starbucks’ factors of production, labor and the size of Starbucks’ plant.

February, 25, 2008: For three hours on Tuesday, Starbucks will shut down every single one of its 7,100 stores so that baristas can receive a refresher course. This decision is a short-run decision. It involves increasing the quality of Starbucks’ labor and so only one factor of production—labor—changes and all the other factors remain fixed.

June, 2, 2008: Starbucks replaces baristas with vending machines. This decision is a short-run decision. It involves changing two of Starbucks’ factors of production, labor and one type of capital. But other factors of production, such as Starbucks’ land and other capital inputs such as the store itself, remain fixed.

July, 18, 2008: Starbucks is closing 616 stores by the end of March. This decision is a long-run decision. It decreases the quantity of all of Starbucks’ factors of production, labor and the size of Starbucks’ plant.

2.

The table sets out Sue’s Surfboards’ total product schedule. a. Draw the total product curve. To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping and is illustrated in Figure 11.1.

b. Calculate the average product of labor and draw the average product curve.

Labor

Output

(workers

(surfboards

per week)

per week)

1

30

2

70

3

120

4

160

5

190

6

210

7

220

The average product of labor is equal to total product divided by the quantity of labor employed. For example, when 3 workers are employed, they produce 120 surfboards a week, so average product is 40 surfboards per worker. As Figure 11.2 (on the next page) shows, the average product curve is upward sloping when up to 3 workers are hired and then is downward sloping when more than 4 workers are hired.

c. Calculate the marginal product of labor and draw the marginal product curve. The marginal product of labor is equal to the increase in total product that results from a one-unit increase in the quantity of labor employed. For example, when 3 workers are employed, total product is 120 surfboards a week. When a fourth worker is employed, total product increases to 160 surfboards a week. The marginal product of increasing the number of workers from 3 to 4 is 40 surfboards. We plot the marginal product at the halfway point, so at a quantity of 3.5 workers, the marginal product is 40 surfboards per worker per week. As Figure 11.2 (on the next page) shows, the marginal product curve is upward sloping when up to 2.5 workers a week are employed and it is downward sloping when more than 2.5 workers a week are employed.

d. Over what output range does the firm enjoy the benefits of increased specialization and division of labor? The firm enjoys the benefits of increased specialization and division of labor over the range of output for which the marginal cost decreases. This range of output is the same range over which the marginal product of labor rises. For Sue’s Surfboards, the benefits of increased specialization and division of labor occur until 2.5 workers are employed.

e. Over what output range does the firm experience diminishing marginal product of labor? The marginal product of labor decreases after 2.5 workers are employed.

f. Over what output range does this firm experience an increasing average product of labor but a diminishing marginal product of labor? The marginal product of labor decreases and the average product of labor increases between 2.5 and 3.5 workers.

g. Explain how it is possible for a firm to experience simultaneously an increasing average product but a diminishing marginal product. As long as the marginal product of labor exceeds the average product of labor, the average product of labor rises. For a range of output the marginal product of labor, while decreasing, remains greater than the average product of labor, so the average product of labor rises. Each additional worker, while producing less than the previous worker hired is still producing more than the average worker.

3.

Sue’s Surfboards, in problem 2, hires workers at $500 a week and its total fixed cost is $1,000 a week. a. Calculate total cost, total variable cost, and total fixed cost of each output in the table. Plot these points and sketch the short-run total cost curves passing through them. Total cost is the sum of the costs of all the factors of

production that Sue’s Surfboards uses. Total variable cost is the total cost of the variable factors. Total fixed cost is the total cost of the fixed factors. For example, the total variable cost of producing 120 surfboards a week is the total cost of the workers employed, which is 3 workers at $500 a week, which equals $1,500. Total fixed cost is $1,000, so the total cost of producing 120 surfboards a week is $2,500. Figure 11.3 shows these total cost curves.

b. Calculate average total cost, average fixed cost, average variable cost, and marginal cost of each output in the table. Plot these points and sketch the short-run average and marginal cost curves passing through them.

AFC

AVC

ATC

MC

Output

(dollars

(dollars

(dollars

(dollars

(surfboards)

per

per

per

per

surfboard)

surfboard)

surfboard)

surfboard)

33.33

16.67

50.00

30

12.50 70

14.29

14.29

28.58 10.00

120

8.33

12.50

20.83 12.50

160

6.25

12.50

18.75 16.67

190

5.26

13.16

18.42 25.00

210

4.76

14.29

19.05 50.00

220

4.55

15.91

20.46

Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output. For example, take the case in which the firm makes 160 surfboards a week. Total fixed cost is $1,000, so average fixed cost is $6.25 per surfboard; total variable cost is $2,000, so average variable cost is $12.50 per surfboard; and, total cost is $3,000, so average total cost is $18.75 per surfboard. Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 120 to 160 surfboards a week, total cost increases from $2,500 to $3,000, an increase of $500. This $500 increase in total cost means that the increase in output of 40 surfboards increases total cost by $500. Marginal cost is equal to $500 divided by 40 surfboards, which is $12.50 a surfboard. The table shows these data schedules and the curves are plotted in Figure 11.4.

c. Illustrate the connection between Sue’s AP, MP, AVC, and MC curves in graphs like those in Fig. 11.6. AP Labor

Output

MP

(surfboards (surfboards

(workers) (surfboards) per worker) per worker)

AVC

MC

(dollars

(dollars

per

per

surfboard) surfboard) 1

30

30.0

16.67 40.0

2

70

35.0

12.50 14.29

50.0 3

120

40.0

10.00 12.50

40.0 4

160

40.0

12.50 12.50

30.0 5

190

38.0

16.67 13.16

20.0 6

210

35.0

25.00 14.29

10.0 7

220

31.4

The table sets out the AP and MP data used to draw the curves. Figure 11.5 shows the curves and the relationships. When the AP curve rises the AVC curve falls and vice versa. When the MP curve rises the MC curve falls and vice versa.

4.

Sue’s Surfboards, in problems 2 and 3, rents the factory building and the rent is increased by $200 a week. If other things remain the same, how do Sue’s Surfboards’ short-run average cost curves and marginal cost curve change. The rent is a fixed cost, so total fixed cost increases. The

50.00 15.91

increase in total fixed cost increases total cost but does not change total variable cost. Average fixed cost is total fixed cost per unit of output. The average fixed cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve and average variable cost curve do not change.

5.

Workers at Sue’s Surfboards, in problems 2 and 3, negotiate a wage increase of $100 a week for each worker. If other things remain the same, explain how Sue’s Surfboards’ short-run average cost curve and marginal cost curve change. The increase in the wage rate is a variable cost, so total variable cost increases. The increase in total variable cost increases total cost but total fixed cost does not change. Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward. The average fixed cost curve does not change.

6.

Sue’s Surfboards, in problem 2, buys a second plant and the output produced by each worker increases by 50 percent. The total fixed cost of operating each plant is $1,000 a week. Each worker is paid $500 a week. a. Calculate the average total cost of producing 180 and 240 surfboards a week when Sue’s Surfboards operates two plants. Graph these points and sketch the ATC curve. To calculate the average total cost when two plants are operated, recall that total cost is the cost of all the factors of production. For example, when 4 workers are employed they now produce 240 surfboards a week. With 4 workers, the total variable cost is $2,000 a week and the total fixed cost is (coincidentally also) $2,000 a week. Hence the total cost is $4,000 a week. The average total cost of producing 240 surfboards is $16.67 a surfboard. Similarly the average total cost of producing 180 surfboards is $19.44. To graph the ATC curve the average total costs at all the quantities are required. Figure 11.6 shows the average total cost curve, ATC2 when Sue’s operates two plants. (It also shows Sue’s average total cost curve, ATC1, when Sue operates one plant.)

b. To produce 180 surfboards a week, is it efficient to operate

one or two plants? The long-run average cost curve is made up of the lowest parts of the firm's short-run average total cost curves when the firm operates one plant and two plants. The long-run average cost curve is illustrated in Figure 11.6 as the darker part of the two ATC curves. At lower levels of output the LRAC curve is derived from operating one plant while at higher levels it is derived from operating two plants. The LRAC curve shows that to produce 180 surfboards it is efficient to operate 1 plant.

c. To produce 160 surfboards a week, is it efficient for Sue’s to operate one or two plants? The LRAC curve shows that to produce 160 surfboards it is efficient to operate 1 plant.

7.

Airlines Seek Out New Ways to Save on Fuel as Costs Soar The financial pain of higher fuel prices is particularly acute for airlines because it is their single biggest expense. … [Airlines] pump about 7,000 gallons into a Boeing 737 and as much as 60,000 gallons into the bigger 747 jet. … Each generation of aircraft is more efficient. At Northwest, the Airbus A330 long-range jets use 38 percent less fuel than the DC-10s they replaced, while the Airbus A319 medium-range planes are 27 percent more efficient than DC-9s. … The New York Times, June 11, 2008 a. Is the price of fuel a fixed cost or a variable cost for an airline? The price of fuel is a variable cost for an airline.

b. Explain how an increase in the price of fuel changes an airline’s total costs, average costs, and marginal cost. An increase in the price of fuel raises an airline’s total cost, its average total cost, its average variable cost, and its marginal cost. It does not change the airline’s average fixed cost or total fixed cost.

c. Draw a graph to show the effects of an increase in the price of fuel on an airline’s TFC, TVC, AFC, AVC, and MC curves.

Figure 11.7 shows an airline’s TFC and TVC curves; Figure 11.8 shows an airline’s AFC, AVC, and MC curves. The increase in the price of fuel has no effect on the airlines fixed cost, so the TFC and AFC curves do not change. The increase in the price of fuel raises the firm’s variable costs and its total costs. As a result the firm’s TVC, AVC and MC curves shift upward as illustrated in the figures from the curves labeled “0”to the curves labeled “1”.

d. Explain how a technological advance that makes an airplane’s engines more fuel efficient changes an airline’s total product, marginal product, and average product. This situation is an example of technological change that is embodied in capital. This change will allow the airline to produce more output—passenger miles—using fewer resources. Hence the airline’s total product, marginal product, and average product all increase.

e. Draw a graph to illustrate the effects of more fuel efficient aircraft on an airline’s TP, MP, and AP curves.

Figure 11.9 shows the airline’s TP curves. The new engines shift the TP curve upward from TP0 to TP1. Figure 11.10 shows the airline’s MP and AP curves. These curves also shift upward as a result of the new fuel efficient engines.

f. Explain how a technological advance that makes an airplane’s engines more fuel efficient changes an airline’s average variable cost, marginal cost and average total cost. The airline’s average variable cost and marginal cost both decrease. The new engines that use the new technology are presumably more expensive than the older, less fuel efficient engines. The engines are a fixed cost. So at lower levels of output the new average total cost is higher than the old average total cost while at larger levels of output the new average total cost is lower than the old average total cost.

g. Draw a graph to illustrate how a technological advance that makes an airplane engine more fuel efficient changes an airline’s AVC, MC, and ATC curves. Figure 11.11 illustrates these changes. The airline’s AVC and MC curves shift downward as indicated by the shift from the grey curves

labeled “0” to the black curves labeled “1”. At lower levels of output the ATC curve shifts upward and at larger levels of output the ATC curve shifts downward.

8.

The table shows the production function of

Labor

Output

(workers

(rides per day)

per day)

Plant 1

Plant 2

10

20

40

55

65

20

40

60

75

85

30

65

75

90

100

40

75

85

100

110

10

20

30

40

Jackie’s Canoe Rides. Jackie’s pays $100 a day for each canoe it rents and $50 a day for each canoe

Canoes

Plant 3

Plant 4

operator it hires. a. Graph the ATC curve for Plant 1 and Plant 2. To find the average total cost for each plant, at the different levels of output add the cost of the workers, $50 per worker, and the fixed cost, the cost of the canoes, $100 per canoe. So for plant 1, the total cost for 20 rides is $1,500; for 40 rides is $2,000; and, for 65 rides is $2,500. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.12. (The average total cost curve for one plant, ATC1, is the same as the thicker curve through the first 4 points.)

b. On your graph in a, plot the ATC curve for Plant 3 and Plant 4. These are drawn in Figure 11.12.

c. On Jackie’s LRAC curve, what is the average cost of producing 40, 75, and 85 rides a week? The long-run average total cost curve is illustrated in Figure 11.12 as the thicker curve. It is comprised of the parts of the short-run average total cost curves that are the minimum average total cost for the different levels of output. From this curve,

the average cost of producing 40 rides is $50; of producing 75 rides is $40; and the average cost of producing 85 rides is $47.06.

d. What is Jackie’s minimum efficient scale? Jackie’s minimum efficient scale is the smallest quantity at which the long-run average cost is the lowest. Jackie’s minimum efficient scale is 65 canoe rides where, with one plant, the average total cost is $38.46.

e. Explain how Jackie’s uses its LRAC cost curve to decide how many canoe to rent. Jackie’s will use its long-run average total cost curve by building the size of the plant that minimizes its long-run average cost at the level of output that Jackie’s expects to produce.

f. Does Jackie’s production function feature economies of scale or diseconomies of scale? Jackie’s has both economies of scale for up to 65 canoe rides and then diseconomies of scale for more than 65 canoe rides.

9.

Business Boot Camp At a footwear company called Caboots, sales rose from $160,000 in 2000 to $2.3 million in 2006. But in 2007 sales dipped to $1.5 million. Joey and Priscilla Sanchez, who run Caboots, blame the decline partly on a flood that damaged the firm’s office and sapped morale. Based on a Fortune article, CNN, April 23, 2008 If the Sanchezes are correct in their assumptions and the prices of footwear didn’t change a. Explain the effect of the flood on the total product curve and marginal product curve at Caboots. The total product curve shifted downward as a result of the flood and sapped morale. That is, the factors of production produced less footwear in 2007 than in 2006. The downward shift in the total product curve decreased the marginal product so the marginal product curve also shifted downward.

b. Draw a graph to show the effect of the flood on the total product curve and marginal product curve at Caboots.

Figure 11.13 shows the downward shift in the total product curve and Figure 11.14 shows the downward shift in the marginal product curve. The flood and lack of morale shift the TP and MP curves downward from TP1 to TP2 and from MP1 to MP2.

10. No Need for Economies of Scale Illinois Tool Works Inc. might not seem like an incubator for innovation. The 93-year-old company manufactures a hodgepodge of mundane products, from automotive components and industrial fasteners to zip-strip closures for plastic bags … and dedicates production lines and resources to high-volume products. A line will run only those three or four products. … Runs are much longer and more efficient. By physically linking machines … they are able to eliminate work in process and storage areas … All the material handling and indirect costs are reduced. Business Week, October 31, 2005 a. How would you expect “physically linking machines” to affect the firm’s short-run product curves and short-run average cost curves? By “physically linking machines,” for any amount of labor the firm can produce more than before. The plant’s total product increases so the short-run total product curve shifts upward. The marginal product and average product curves also shift upward. As a result of the increase in the average product, the firm’s short-run average variable cost and average total cost both decrease so that

the average variable cost curve and average total cost curve shift downward.

b. Draw a graph to show your predicted effects of “physically linking machines” on the firm’s short-run product curves and cost curves.

Figure 11.15 shows the effect of physically linking machines on Illinois Tool’s total product curve. The total product curve shifts upward from TP1 to TP2. Figure 11.16 shows the effects on Illinois Tool’s marginal product and average product curves. These curves shift upward from AP1 to AP2 for the average product of labor and from MP1 to MP2 for the marginal product of labor. Figure 11.17 shows the effect of physically linking machines on Illinois Tool’s cost curves. The costs fall so that all the cost curves shift downwards: The average variable cost curve shifts downward from AVC1 to AVC2, the average total cost curve shifts downward from ATC1 to ATC2, and the marginal cost curve shifts downward from MC1 to MC2.

c. Explain how concentrating “production lines and resources to high-volume products” can influence long-run average cost as the output rate increases. By specializing in “high-volume products” the firm will be able to enjoy economies of scale. In other words, with this specialization, as the firm increases its production its long-run average costs will decline.

11. Grain Prices Go the Way of the Oil Price Every morning millions of Americans confront the latest trend in commodities markets at their kitchen table. … Rising prices for crops … have begun to drive up the cost of breakfast. The Economist, July 21, 2007 Explain how the rising price of crops affects the average total cost and marginal cost of producing breakfast cereals. When producing cereal, the cereal crops used are a variable factor of production. An increase in the price of these crops boosts the firms’ average total cost and the firms’ marginal cost of producing cereal.

12. Coffee King Starbucks Raises Its Prices Blame the sour news at Starbucks this week on soaring milk costs. … The wholesale price [of ] milk is up nearly 70% in the 12 months. …“There’s a lot of milk in those (Starbucks) lattes,” notes John Glass, CIBC World Markets restaurant analyst. USA Today, July 24, 2007 a. Is milk a fixed factor of production or a variable factor of production? Milk is a variable factor of production.

b. Describe how the increase in the price of milk changes Starbucks’ short-run cost curves. The increase in the price of milk shifts Starbucks’ short-run AVC, ATC, and MC curves upward.

13. Bill’s Bakery has a fire and TP

AFC

AVC

ATC

10

120

100

220

MC

Bill loses some of his cost data. The bits of paper that he 80 recovers after the fire 20

A

B

150

provide the information in the 90 table (all the cost numbers are 30

40

90

130

dollars). Bill asks you to come 130 to his rescue and provide the 40

30

C

D

missing data in the five spaces E identified as A, B, C, D, and 50

24

108

132

E. A is the average fixed cost, AFC, when the output is 20. Average fixed cost equals total fixed cost divided by output, or AFC = TFC ÷ Q. Rearranging gives TFC = AFC × Q. So the total fixed cost for the problem equals $120 × 10, which is $1,200. A equals $1,200, TFC, divided by 20, Q, which is $60. B is the average variable cost, AVC, when output is 20. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC − AFC, so average variable cost equals $150 − $60, which is $90. D is the average total cost, ATC, when output, Q, equals 40. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So the total cost when 30 units are produced is $130 × 30, which is $3,900. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = ∆TC ÷ ∆Q. Rearranging gives ∆TC = MC × ∆Q, so the change in total cost between Q = 30 and Q = 40 is $130 × 10, or $1,300. Therefore the total cost when Q equals 40 is $3,900 + $1,300, or $5,200. The average total cost when Q is 40 is $5,200 ÷ 40, or $130. C is the average variable cost, AVC, when output, Q, equals 40. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC − AFC. As a result, average variable cost equals $130 − $30, which is $100. E is the marginal cost, MC, when output increases from 40 units to 50 units. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = ∆TC ÷ ∆Q. To calculate marginal cost, the total cost when output is 40 and the total cost when output is 50 are needed. Average total cost equals total cost

divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So the total cost when 40 units are produced is $130 × 40, which is $5,200 and total cost when 50 units are produced is $132 × 50, which is $6,600. So the marginal cost equals ($6,600 − $5,200) ÷ 10, which equals $140.

14. ProPainters hires students at $250 a week to paint houses. It leases equipment at $500 a week. The table

Output Labor

(houses

(students)

painted

sets out its total product schedule. a. What is total cost, average total

per week) 1

2

cost, and marginal cost if

2

5

ProPainters paints 12 houses a week?

3

9

To paint 12 houses, ProPainters hires

4

12

4 students. The total variable cost is

5

14

$1,000 (paid to the students) and the

6

15

total fixed cost is $500 (the leased equipment). Therefore the total cost is $1,500. The average total cost equals $1,500/12, which is $125 per house. The marginal cost of 10½ houses is $83.33 and the marginal cost of 13 houses is $125.00. These mean that the marginal cost of 12 houses is $108.33.

b. At what output is average total cost a minimum? Using the data in the table, the average total cost is at its minimum of $125 per house when 13 houses are painted.

c. Explain why the gap between total cost and total variable cost is the same at all outputs. The gap between total cost and total variable cost is total fixed cost. Because the fixed cost is the same at all levels of output, the difference between the total cost and total variable cost is constant.

15. ProPainters hire students at $250 a week to paint houses. It leases equipment at $500 a week. Suppose that ProPainters doubles the number of students it hires and doubles the amount of equipment that it leases. ProPainters experiences diseconomies of scale. a. Explain how the ATC curve with one unit of equipment differs from that when ProPainters uses double the amount of equipment. Because ProPainters experiences diseconomies of scale, when ProPainters doubles its inputs the minimum average cost is higher than when it uses the lesser quantities of inputs. Even so, at high levels of output the average total cost of producing the large level of output with the greater quantities of inputs is lower than the average total cost of producing this large level of output with the smaller quantities of inputs.

b. Explain what might be the source of the diseconomies of scale that ProPainters experience. ProPainters might experience diseconomies of scale because when it gets larger the complexity of operating the business increases, which increases the costs of running the business and making decisions.

16. The table shows the production function of Bonnie’s Balloon

Labor

Output

(workers

(rides per day)

per day)

Plant 1

Plant 2

Plant 3

Plant 4

10

13

15

Rides. Bonnie’s pays 10

4

$500 a day for each 20

10

15

18

20

30

13

18

22

24

40

15

20

24

26

50

16

21

25

27

Balloons

1

2

3

4

balloon it rents and $25 a day for each balloon operator it hires. a. Graph the ATC curve for Plant 1 and Plant 2.

To find the average total cost for each plant, at the different levels of output add the variable cost, which is the cost of the workers or $25 per worker, to the fixed cost, which is the cost of the balloons or $500 per balloon. For Plant 1, the total cost for 4 rides is $750; for 10 rides is $1,000; for 13 rides is $1,250; for 15 rides is $1,500; and, for 16 rides is $1,750. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.18.

b. On your graph in a, plot the ATC curve for Plant 3 and Plant 4. Figure 11.18 shows these ATC curves.

c. On Bonnie’s LRAC curve, what is the average cost of producing 18 rides and 15 rides a day? The long-run average total cost curve is illustrated in Figure 11.18 as the darker line. The long-run average cost curve is comprised of the segments of the different short-run average total cost curves that have the minimum average total cost for the different levels of output. For 15 rides a day the average cost is $100 and for 18 rides a day the average cost is $97.22.

d. Explain how Bonnie’s uses its long-run average cost curve to decide how many balloons to rent. Bonnie’s will use its long-run average total cost curve by building the size of the plant that minimizes its long-run average cost at the number of balloon rides that Bonnie’s expects to produce.

17. A firm is producing at minimum average total cost with its current plant. Sketch the firm’s short-run average total cost curve and long-run average cost curve for each of the following situations and explain, using the concepts of economies of scale and diseconomies of scale, the circumstances in which the firm a. Can lower its average total cost by increasing its plant.

Figure 11.19 illustrates this case at the point labeled A. Here the firm experiences economies of scale, so if it increases the size of its plant and also all its other inputs by the same proportion, its average total cost can be lowered.

b. Can lower its average total cost by decreasing its plant. Figure 11.19 illustrates this case at the point labeled B. Here the firm experiences diseconomies of scale, so if it decreases the size of its plant and also all its other inputs by the same proportion, its average total cost can be lowered.

c. Cannot lower its average total cost. Figure 11.19 illustrates this case at the point labeled C. Here the firm is already producing at the minimum of its long-run average cost. In this case, the firm’s average cost increases no matter if the firm increases or decreases the size of its plant and all its other inputs.

18. Starbucks Unit Brews Up Self-Serve Espresso Bars … automated, self-serve espresso kiosks are in grocery stores. … The machines, which grind their own beans, crank out lattes, … and drip coffees … take credit and debit cards, [and] cash. … Concordia Coffee, a small Bellevue coffee equipment maker, builds the self-serve kiosks and sells them to Coinstar for just under $40,000 per unit. Coinstar installs them … and provides maintenance. The kiosks use [Starbuck’s] Seattle’s Best Coffee. … The self-serve kiosks remove the labor costs of having a barista. … Store personnel handle refills of coffee beans and milk. … MSNBC, June 1, 2008 a. What is Coinstar’s total fixed cost of operating one self-serve kiosk? The fixed costs are the cost of the machine itself, $40,000.

b. What are Coinstar’s variable costs of providing coffee at a self-serve kiosk? The variable costs include the cost of the coffee beans and other ingredients and, presuming that the kiosks need more maintenance the heavier their use, the cost of maintaining the kiosks.

c. Assume that a coffee machine operated by a barista costs less than $40,000. Explain how the fixed costs, variable costs, and total costs of barista-served and self-served coffee differ. The fixed cost of the Coinstar machine exceeds that of the barista-operated machine. The variable cost of the barista-operated machine exceeds that of the Coinstar machine. The total cost of the Coinstar machine is probably higher than that of the barista-operated machine at lower levels of output and is probably lower at higher level of outputs.

d. Sketch the marginal cost and average cost curves implied by your answer to c. Figure 11.20 shows the different marginal costs and average total cost curves. The costs with the barista-operated machine are labeled “1” and the costs with the Coinstar are labeled “2”. The average total cost of the Coinstar machine is higher than that of the barista-operated machine at low levels of output and is lower than the average total cost of the barista-operated machine at high levels of output. The marginal cost of the Coinstar machine is lower than the marginal cost of the barista-operated machine.

19. A Bakery on the Rise Some 500 customers a day line up to buy Avalon’s breads, scones, muffins, and coffee. … Staffing and management are worries. Avalon now employs 35 … [and] it will hire 15 more. … Payroll will climb by 30% to 40%. … As new CEO, Victor has quickly executed an ambitious agenda that includes the move to a larger

space. … Avalon’s costs will soar. … Its monthly rent, for example, will leap to $10,000, from $3,500. CNN, March 24, 2008 a. Which of Avalon’s decisions described in the news clip is a short-run decision and which is a long run decision. Hiring the additional 15 workers is a short-run decision; increasing the size of its space, that is, the size of its plant, is a long-run decision.

b. Why is Avalon’s long-run decision riskier than its short run decision? Avalon’s long-run decision is riskier than its short-run decision because it is more difficult to change the long-run decision. In particular if Avalon decides to reverse its short-run decision to hire more workers, it is straightforward to fire the workers. However to reverse the long-run decision of increasing the size of its plant is more difficult and takes much longer to do.

c. By how much will Avalon’s short-run decision increase its total variable cost? Avalon’s short-run decision to increase its workforce increases its total variable cost (its payroll) by 30 percent to 40 percent. The increase in workers boosts Avalon’s output and leads to a movement along its total variable cost curve.

d. By how much will Avalon’s long-run decision increase monthly total fixed cost? Avalon’s long-run decision to increase the size of its plant (its space) increases its total fixed cost by $6,500. Avalon’s TFC curve shifts upward.

e. Draw a graph to illustrate Avalon’s short-run cost curves before and after the events described in the news clip. Figure 11.21 shows Avalon’s short-run AVC and ATC curves before and after. The old cost curves are labeled with a “1” and the new cost curves, after the expansion, are labeled with a “2”, At lower levels of output Avalon’s new average cost curves lie above its old average cost curves and at higher levels of output

Avalon’s new average cost curves lie below its old average cost curves. (In the figure the new minimum average total cost equals the old minimum, so Avalon has constant returns to scale.)

20. Gap Will Focus on Smaller Scale Stores Gap has too many stores that are 12,500 square feet … deemed too large. … “Stores are larger than we need.” … The target size of stores should be 6,000 square feet to 10,000 square feet. In addition, the company plans to combine previously separate concept stores. Some Gap body, adult, maternity, baby and kids stores will be combined in one, rather than in separate spaces as they have been previously. CNN, June 10, 2008 a. Thinking of a Gap store as a production plant, explain why Gap is making a decision to reduce the size of their stores. Gap believes that its stores are too large and that it is operating where it has diseconomies of scale. By reducing the size of its plant (its stores) Gap can slide down its LRAC curve and decrease its average cost.

b. Is Gap’s decision a long-run decision or a short-run decision? Explain. Gap’s decision is a long-run decision because it involves the size of the firm’s plant.

c. How might combining Gap’s concept stores into one store help better take advantage of economies of scale? At 12,500 square feet Gap’s stores were too large and Gap was incurring diseconomies of scale. When Gap combines its separate Gap concept stores into a smaller space, Gap will use fewer resources, particularly less capital and less labor. Gap’s costs will be less as a result. Additionally Gap’s sales will be less but the proportionate decrease in cost will exceed the decrease in Gap’s production. In this case Gap’s average costs will decrease so that Gap can reap economies of scale it currently is not enjoying.

21. The Sunk-Cost Fallacy You have good tickets to a basketball game an hour’s drive away. There’s a blizzard raging outside, and the game is being televised. You can sit warm and safe at home by a roaring fire and watch it on TV, or you can bundle up, dig out your car,

and go to the game. What do you do? Slate, September 9, 2005 a. What type of cost is your expenditure on tickets? At the time of the game, the cost of the ticket is a sunk cost.

b. Why is the cost of the ticket irrelevant to your current decision about whether to stay at home or go to the game? The cost of the ticket is a sunk cost; that is, the cost of the ticket has already been incurred. Because the cost of the ticket is the same regardless if you attend the game or stay at home, the cost of the ticket is irrelevant to your decision whether to attend or stay at home.

22. Study Reading Between the Lines on pp. 266-267 and then answer the following questions. a. Sketch the AFC, AVC, and ATC curves for electricity production using seven technologies: (i) nuclear, (ii) coal, (iii) gas, (iv) hydro (v) wind, (vi) SUNRGI’s new solar system, and (vii) today’s solar technology.

C:\Users\user\A ppData\Local\Temp\Temp1_Park in_GE_9e_SM.zip\Micro\Figures\microCH11sm22iiiiii.tif

The figures above show the average cost curves. In Figure 11.27 the higher cost curves are for solar power; the lower cost curves are for SUNRGI’s new solar system.

b. Sketch the marginal cost curves for electricity production using seven technologies: (i) nuclear, (ii) coal, (iii) gas, (iv) hydro (v) wind, (vi) SUNRGI’s new solar system, and (vii) today’s solar technology. The figures above show the marginal cost curves.

c. Given the cost differences among the different methods of generating electricity, why do you think we use more than one method? If we could use only one method, which would it be? The different methods have minimum average total costs at different amounts of output. Hence depending on the level of output, in different locales different methods of producing electricity have the lowest cost. Additionally in one locale a coal plant, for example, might provide ¾ of the electricity demanded when it is producing at its minimum average total cost. But to produce the remaining ¼ of the electricity with another coal plant might have higher average total cost than if the quantity was produced with a gas plant. Hence one locale might have several different plants depending on the quantity of electricity demanded and the plants’ minimum average total costs. Finally, the price of natural gas, coal, oil, and nuclear fuel can vary tremendously over time. By having different types of plants some protection is gained against having a concentration in a type of plant whose costs happened to soar. If we could use only one method, setting aside the costs of storing used nuclear fuel, it appears that nuclear plants generate electricity at the lowest average total cost.