HBX- Economics 3

Question 1

Willingness to Sell (WTS)

Answer 1

From the standpoint of a supplier, the minimum price that the firm is willing to accept in return for the input it sells; from the standpoint of a seller, the minimum price that the seller is willing to accept to supply a given quantity of a good or service.

the opportunity cost for suppliers. The LOWEST price at which a supplier is willing to sell you their inputs.
Inputs could be- components for a machine tool, capital that investors are giving you, the effort that employees are exerting on their tasks in your organization, the time & effort it takes an author to write a book & whether they’d want to do so.

Wal-Mart is AMAZING at willingness to sell! Negotiating with suppliers and sharing their data with them gets the suppliers to lower prices!

Why you might be willing to sell your services/aka ‘work for’ facebook/google at a lower pay.

Question 2

total value created

Answer 2

The difference between willingness to sell and willingness to pay

Question 3

Value captured.

Answer 3

The difference between price & cost

Question 4

Consumer Surplus

Answer 4

The value captured by consumers in a market transaction; mathematically, the difference between consumer willingness to pay and price, added up for all consumers who get to transact in the market.

Question 5

A company books $100 million in revenue for fiscal year 2015, the most it has ever earned. However, the company earns a far lower profit than it did the previous year. What could explain this discrepancy?

• The company saw a decline in sales volume from the previous year.
• The company charged a higher price for its product in FY2015.
• The company saw the cost of its inputs increase substantially over the past year.
• The company created less value for its customers during the period.

Answer 5

• The company saw a decline in sales volume from the previous year.
  
  • Even if sales volume did decline, the company still made $100 million in revenue, its most ever. The lower profits must be explained by higher costs.
• The company charged a higher price for its product in FY2015.
  
  • Even if it did charge higher prices, the company still made $100 million in revenue, its most ever. The lower profits must be explained by higher costs.
• The company saw the cost of its inputs increase substantially over the past year.
  
  • With higher revenues, lower profits can only be explained by higher costs.
• The company created less value for its customers during the period.
  
  • This is not necessarily true. With lower profits, the company captured less value itself, but consumers could have captured the same or more value.

Question 6

Which of the following developments will cause an increase in the value created by a firm? Select all that apply.

• Employees at the firm are willing to take a pay cut to work for the company.
• Consumer preferences change and average WTP for the company’s products increases.
• The company is able to increase the price of its main product without a significant decrease in sales.
• The company discovers a new production technology, allowing it to produce its products more efficiently.
• The rate at which the company is taxed is decreased by the government.

Answer 6

• Employees at the firm are willing to take a pay cut to work for the company.
  
  • This would decrease suppliers’ willingness to sell a key input, creating more value overall.
• Consumer preferences change and average WTP for the company’s products increases.
  
  • If customers’ are willing to pay more, but the company leaves prices the same, it is creating more value for its customers without decreasing the value captured by the firm or its suppliers.
• The company is able to increase the price of its main product without a significant decrease in sales.
  
  • While this would lead to more value captured by the company, it would not create more value overall.
• The company discovers a new production technology, allowing it to produce its products more efficiently.
  
  • While this would lead to more value captured by the company, it would not create more value overall.
• The rate at which the company is taxed is decreased by the government.
  
  • While this would lead to more value captured by the company, it would not create more value overall.

Question 7

Which of the following groups is NOT a competitor for Amazon?

• Overstock.com, another online shopping site
• The businesses that sell their products through Amazon.com
• UPS, a delivery service that Amazon uses to ship products to customers
• Amazon Prime customers that use the site to regularly shop
• All of the above are competitors for Amazon.

Answer 7

All of the above are competitors for Amazon.

• A business’ competitors include not only other companies in its industry, but also parties with which the business competes to capture value, such as suppliers and customers.

Question 8

Fixed Cost (FC)

Answer 8

Costs incurred by a business in the production of a product or service that do not vary as the quantity produced rises or falls.

Question 9

Variable Cost (VC)

Answer 9

Costs incurred by a business in the production of a product or service that vary with the level of production.

Question 10

A hotel spends $1 million per year on rent and other fixed costs. The hotel rents out rooms at a rate of $100 per night, and incurs variable costs of $50 per night for each occupied room. In past years, the hotel has rented out 21,000 rooms per year. However, the city has become a less popular tourist destination, causing consumers to travel there less frequently. The hotel anticipates that it will have 10% fewer customers in coming years. What should the hotel do?

• Stay in business without making any changes.
• Decrease prices to $50 per room.
• Exit the industry.

Answer 10

Exit the industry.

• The hotel is now losing money each year. It is making enough money to cover its variable costs, but not enough to cover its total yearly cost. Therefore, it should stop paying rent and other fixed costs, and exit the industry.

Question 11

Opportunity Cost

Answer 11

The value of the best alternative use of a resource.

the indirect costs that occur that you have to take care of- just like the direct costs/The value of the best alternative use of a resource.

The opportunity cost of a choice is the value of the best alternative choice you could have made. That’s the “cost you incur” from making your current choice.

The term economic cost is often used interchangeably with opportunity cost​

Question 12

Accounting Cost

Answer 12

A measure of the direct cost incurred in partaking in a specific business endeavor; costs reported in a company’s financial statements that serve to give an accurate description of where the firm’s money is being spent.

Question 13

But if you’re looking to cost measures to guide you in decision-making, we need to go beyond accounting cost and look at……

Answer 13

opportunity cost

Question 14

Difference between opportunity and account costs

Answer 14

One is better for accurate, objective reporting, (accounting) the other for guiding decision-making (opportunity).

Question 15

Suppose you are a working parent and you currently earn $60,000 per year. You are debating whether you want to leave your job to be a stay-at-home parent. What costs should you consider as you make this decision?

• Cost of hiring a babysitter
• Income foregone while being a stay-home parent
• The foregone pleasure from being at home with your children
• Opportunities foregone of advancing your career
• All of the above

Answer 15

All of the above

• By choosing to go back to work, you need to consider the cost of hiring a babysitter and the foregone experience of being with your children. Alternatively, by choosing to stay home with your children, you are foregoing the income and career opportunity that you could have gained while working.

Question 16

Which of the following statements is true regarding the differences between economic and accounting costs?

• Economic costs include all direct and opportunity costs.
• Accounting costs include all direct and opportunity costs.
• Economic costs include opportunity costs only.
• Accountants consider only opportunity costs when calculating costs.

Answer 16

Economic costs include all direct and opportunity costs.

• Economic costs include all costs of a decision, direct and opportunity costs, whereas accounting costs do not include opportunity costs.

Question 17

Christine is a tax accountant in the United States. Due to the complexity of the U.S. tax code, many Americans often experience difficulties filing their taxes each year. Thus, in the past, Christine has made a large sum of money on the side offering her services during tax season. This year, however, a new computer software is being sold, designed to assist Americans with their taxes for a fraction of the cost that Christine has been charging her customers. At first glance, the software appears to be quite popular. What impact will this new software have on Christine’s profitability?

• The presence of the software will make Christine’s business less profitable.
• The presence of the software will make Christine’s business more profitable.
• The presence of the software will not affect Christine’s profitability.
• The impact on Christine’s profitability is unclear.

Answer 17

The impact on Christine’s profitability is unclear.

• It’s unclear how the presence of the software will affect Christine’s profitability. While the introduction of the software will almost surely force Christine to charge a lower price for her services to compete, Christine’s profitability also depends on her own costs. If Christine is able to use the service to improve her own productivity, her costs may also go down. If costs fall low enough, Christine may be able to maintain the same profitability or even improve her profitability if the software allows her to save time per customer and take on more customers.

Question 18

Al’s Autos, a car rental company, spends $2.1 million per year on car purchases, routine maintenance and other fixed costs. The company rents out cars at an average rate of $100 per day, and incurs variable costs of $70 per day for each rental. In past years, the business has rented out 100,000 cars per year. However, the city in which the company is located has become a less popular tourist destination, causing consumers to travel there less frequently. The rental company anticipates that it will have 25% fewer customers in coming years. What should Al’s do?

• Definitely stay in business
• Decrease prices to $70 per day
• Exit the car rental industry

Answer 18

Definitely stay in business

• Despite the large drop in rentals from 100,000 to 75,000, Al’s is still able to cover both variable and fixed costs. It should remain in business for the time being, unless it continues to lose customers to the point at which it can no longer cover its total yearly costs.

Question 19

A manufacturing company has seen a decline in its physical sales over the past few years, leaving a portion of its fixed infrastructure underutilized. What are some reasonable measures the company could potentially take to maintain its profitability? Select all that apply.

• Try to cut fixed costs in other areas where possible
• Produce more of the product and save the excess supply as inventory until demand picks back up
• Advertise its offerings more to drive sales back up to its original level
• Rent out the underutilized space to other companies for additional revenues
• Recognize some of its revenue from pre-orders early

Answer 19

• Try to cut fixed costs in other areas where possible
  
  • Cutting other fixed costs, such as salaries, could decrease costs enough so that the company is able to capture the same amount of value (profits).
• Produce more of the product and save the excess supply as inventory until demand picks back up
  
  • This is a risky strategy. The decline in sales seems persistent, so there is no guarantee that demand will pick back up. Producing more, even temporarily, will increase total variable costs too—so profitability will decline even further.
• Advertise its offerings more to drive sales back up to its original level
  
  • This is a risky strategy. The decline in sales seems persistent, so there is no guarantee that consumers will want the product despite increased advertising. Advertising will increase total costs too—so profitability will decline even further, even if sales do increase somewhat.
• Rent out the underutilized space to other companies for additional revenues
  
  • This could help improve profitability as the space is not being utilized anyway. If demand does pick back up, the company could take back the space or rent out more space itself.
• Recognize some of its revenue from pre-orders early
  
  • While this tactic could create the illusion of sustained profitability, actual profitability would continue to decline. It may decline even further if the company is fined for accounting fraud.

Question 20

The theme park from the previous question has finished building its fun house. The project cost $240,000 in total and requires two employees to operate it each day costing $50 per employee per day. The park estimates that approximately 400 guests will enter the fun house per day, each paying $1 to enter. After how many years will the theme park break even from operating the fun house?

Answer 20

Between 2 and 3 years

The park makes $400 in revenues each day from guests and must pay $50*2=$100 to its employees each day as costs of operation. Profits per day are thus equal to $400-$100=$300. With these profits, it will take the park 800 days to recover the total amount it spent building the fun house.

Question 21

Suppose that you are the CEO of a national pizza chain. Your business has experienced increases in production costs over the past few years due to a continual increase in the price of cheese. When the price increases first started, your business was able to maintain its profitability by passing the higher costs on to consumers in the form of higher pizza prices. Now, however, your consumers are refusing to pay more for your product. One of your company’s executives suggests acquiring your supplier of cheese in order to control input costs. By doing so, she guarantees that your company will retain your customers and stop losing money. Should you take her advice?

• Yes– you should do anything to retain your customer base.
• No—in doing so, you may retain your customers, but you will still continue to lose money overall.
• No—customers will still continue to leave you even if you control price increases by buying the supplier.

Answer 21

No—in doing so, you may retain your customers, but you will still continue to lose money overall.

• Your colleague is forgetting to include opportunity costs in her reasoning. Even if you acquire the supplier, you will continue to lose money from an economic point of view. This is because you could have sold the cheese to others for a higher price than what you are receiving for it by putting it in your pizzas.

Question 22

Using the information and the Graph below, find out the costs of the other bakery “Hirise”

• HiRise sells its product at $2.05 per loaf. At that price difference, consumers are indifferent between a loaf of HiRise and a loaf of Butterflake.
• HiRise uses more expensive ingredients than Butterflake; you estimate that their cost is 10% higher. HiRise does use the same amount of each ingredient, however, as you do.
• HiRise’s bakery is identical to your own: their total costs for rent, utilities, managers’ salaries, and depreciation are the same as yours. However, their capacity utilization is much higher. That is, they produce and sell 25% more loaves than you do. (For simplicity, assume that both bakeries sell all the bread they make).
• With respect to direct labor, HiRise’s wage rates are the same as yours. Worker productivity is also the same; each HiRise worker can produce just as many loaves per hour as each Butterflake worker can.
• HiRise’s total advertising spend is 50% greater than Butterflake’s.
• Butterflake’s transportation costs are 80% fixed (to cover the metropolitan area) and 20% variable (since more trips are needed for more volume).

Answer 22

One of the important things in figuring out the competitor’s (HiRise’s) costs is to distinguish between fixed versus variable costs, as before. Why is this important? Let’s look at the different cost line items for the two bakeries.

Fixed costs: bakery overhead, advertising, depreciation, and some of the transportation costs.

HiRise pays the same total bakery overhead costs as Butterflake, but this cost is spread out over more loaves. Since HiRise produces 25% more loaves, the per loaf overhead cost is $0.15/1.25 = $0.12. (That is, if fixed costs are spread across 100 loaves at Butterflake, the same fixed costs are spread across 125 loaves at HiRise.) A similar calculation gives us depreciation of $0.08 per loaf.

Similarly, total advertising spend is 50% higher at HiRise, so if the bakeries were producing the same amount of loaves, it would be $0.15 per loaf. Adjusting for the higher volume of loaves at HiRise brings advertising spend down to $0.12 per loaf.

Lastly, let’s look at transportation. HiRise should incur approximately the same variable cost per loaf on transportation. However, 80% of Butterflake’s transportation spending—$0.20 per loaf—is fixed. Adjusting for loaf volume, again, brings this number down to $0.16 at HiRise. If we add back in the $0.05 in variable costs, total transportation cost is $0.21 per loaf.

Question 23

The costs per unit/average costs.

Answer 23

Question 24

A relative cost analysis

Answer 24

An effort to understand how much it costs your company to make a product compared to some other company.

There are three parts to relative cost analysis:

1. Understanding your costs. Look @ your own company and try to understand what costs you incur. This is sometimes complicated because many companies keep their cost accounting for financial statement purposes- not necessarily relating that back to the activities of the company itself. We want to drive down the price delivering the product to a particular customer because THAT’s where competition really occurs.
   
   1. We want to understand not a bakery’s overall cost position. We want to understand it for a particular loaf of bread. That’s where the cost occurs.
      You should do this for PARTICULAR products! Do this for specific products.
   2. Compare UPS & FedEx. You can’t compare generally- (most of their packages don’t compare)On average- you’d be asking, what is the cost that FedEx incurs delivering an overnight letter to the cost UPS incurs delivering a big box. Those 2 products never compete.
      You should ask what’s the cost for the overnight letter for EACH COMPANY.
2. Estimating your competitor’s cost. Companies don’t just give this away- you have to do detective work which typically happens in 2 ways
   
   1. Bottom up- you start w/ your costs broken down (you understand 1st what drives your costs/how you differ) Then ask- what does the competitors cost look like- and build up an estimate of a competitor’s cost structure.
   2. Top down- you look at the aggregate financial statements of the competitor and ask, “What does your estimate that you build from the bottom up match what you see from the top down?”
3. Using the relative cost estimates to explore how decisions are affected. These could be decisions about whether or not to enter a business (are your costs low enough), about whether you can compete in a price war, about where your advantage really comes from, and so on.

It’s challenging, creating, and fun! But you have to do things ethically! You could lie and get data in some hidden ways.

Ex: A company was trying to figure out the wage costs of a certain company. The looked at the CARS outside their own current factory. How many there were and the mix/type of vehicles. They found a strong correlation between what the wage bill was and what they counted in the parking lot.

A common mistake in relative cost analysis is to try to get the point estimate of every cost line item precisely right, rather than understanding what truly drives cost differences between competitors—and therefore where your energies ought to focus.

But even after we’ve identified the most important costs to focus on, how can we get information on these in practice?

Question 25

True or False

The more products you sell, the smaller your fixed price per unit will be.

Answer 25

TRUE

Variable Cost: Cost of producing every extra unit.
Total Cost Per Unit: Fixed Costs + Variable Costs

Question 26

________ shouldn’t affect your current pricing decisions

Answer 26

sunk costs shouldn’t affect your current pricing decisions

Question 27

HiRise’s total costs of $1.61 per loaf were split into $0.48 of fixed costs and $1.13 of variable costs. In a price war, how low do you think HiRise might be willing to go?

What would its profit or loss (per loaf) be at that price?

Answer 27

• 1.13
• -$0.48

Since total costs are $1.61, HiRise will lose 48 cents per loaf at a price of $1.13.

Question 28

What are the two questions to ask to try to predict whether a company is likely to generate profits in its business?

Answer 28

Start by doing a simple analysis of value created relative to competitors.

• Is willingness to pay for your product higher than for your competitor’s?
• Is your cost lower than your competitor’s?

If the answer to these two questions is no, you don’t need to go much further.
It will be hard for you to make much in profits. Conversely, a simple value analysis
will in this case probably tell you as much as or more than a very detailed and complicated analysis of the firm’s customers, its business processes, its technologies or its management skills.

Question 29

Competitive advantage comes from being ______from others

Answer 29

different

Question 30

Answer 30

No because Company B’s cost structure allows it to lower prices further than Company A.

Correct! Good job.

Question 31

At a price of $890 per ton, at what capacity (or capacities) does it make sense for the Ghanaian plant to product? For the Canadian plant to produce? the Chinese plant?

Answer 31

Ghanaian plant

• 100% capacity
  Since the price of aluminum is higher than variable costs, each ton of aluminum will earn more revenue than it will use up in cost. In this case, why not produce at full capacity rather than at partial capacity?

Canadian Plant

• 100% capacity
  Since the price of aluminum is higher than variable costs, each ton of aluminum will earn more revenue than it will use up in cost. In this case, why not produce at full capacity rather than at partial capacity?

Chinese plant

• 0% capacity (shut down)
  Since the price of aluminum is lower than variable costs, each ton of aluminum will cost more to produce than it will earn in revenue. The plant should not produce at all.

Question 32

Supply curves simply capture ____

Answer 32

Supply curves simply capture, graphically, the economic incentives of suppliers to produce at any given price.

Question 33

Things to consider when choosing a factory (other than fixed and variable costs)

Answer 33

• macro country-specific risks that you’d want to consider: exchange rate uncertainty, political risks, or other such factors.
• price uncertainty. For example, plant profits depend not only on costs but on production capacity.
• Everything else equal, the lower are variable costs, the greater is the plant’s profitability. Also, everything else equal, the higher is production capacity, the greater are plant profits.

Question 34

Suppose that worldwide demand for aluminum in a particular year was one ton. Which plant would produce it? At what price?

Answer 34

Sorocaba can charge anywhere between $588 and $599. If the price rises to $599, Zaporozhye will be willing to produce as well. If the price is below $588, Sorocaba will prefer to shut down.

Question 35

Define Supply Curve & Explain the 2 Different Kinds.

Answer 35

Supply Curve, Market

A graphical representation of the willingness to sell of all producers for various quantities of a product or service; the market supply curve is the horizontal sum of each producer’s unique willingness to sell at a given price.

Increase demand further and you rely on less and less efficient plants.

Different types of supply curves.

1. Once a plant is in operation, all that matters (for “short-run” supply curves) are variable costs.
2. Before plants have been built, however, what matters (for “long-run” supply curves) are both fixed and variable costs.

So, which type of supply curve we’re interested in will depend on whether we are interested in:

• Examining production decisions (i.e., the “short-run” decisions). The key question here is: as prices vary, how will production vary for plants that are already in operation?
• Examining entry decisions (i.e., the “longer-run” adjustments). The key question here is: as prices vary, how will production vary for plants, taking into account entry as well?

Question 36

Let’s say buyers demand 3500 tons of aluminum this year. What do you expect the price of aluminum to be?

Answer 36

$1100

Question 37

In the short-run, when considering whether to produce a product, ____ are all that matter.

In the long-run, and when considering whether to enter or exit an industry, _____ matter as well.

Answer 37

In the short-run, when considering whether to produce a product, variable costs are all that matter.

In the long-run, and when considering whether to enter or exit an industry, fixed costs matter as well.

Question 38

Why don’t the seemingly most efficient plants don’t expand capacity and take over the entire market?

Answer 38

1. For one, it might be that their upfront fixed costs in doing so are very high. Remember, the supply curve only captures variable cost (or “marginal cost”)—that’s alright when considering production, but when considering entry or expansion one needs to cover fixed costs too!
2. Maybe their plant variable costs are higher when they expand capacity—so that variable costs are not the same for all production levels. Or it might be that even if they expand capacity, other firms may not exit (for example, if they’re state run).

Question 39

As an incumbent considering whether or not to produce, you’d compare your _____ costs to the ______ costs of the _______.

As an entrant considering whether entry is profitable, you’d compare your ____ costs to the _____ cost of the ______.

Answer 39

As an incumbent considering whether or not to produce, you’d compare your variable costs to the variable costs of the least efficient producer.

As an entrant considering whether entry is profitable, you’d compare your average costs to the variable cost of the least efficient producer.

Question 40

What is the minimum price at which you are willing to supply energy as a coal plant?

• 0
• 50
• 55
• 200

And what does the supply curve look like for this market?

Answer 40

$55

$55 per MWe would be enough to recover the costs of producing each MWe and also the cost of starting up the plant.

Question 41

Why older firms continue to survive and operate even when they are employing apparently inefficient technologies is that ______

Answer 41

why older firms continue to survive and operate even when they are employing apparently inefficient technologies is that they have “sunk” much of their upfront investment cost.

Question 42

Marginal Cost (MC)

Answer 42

The additional cost incurred in producing an extra unit of output.

Question 43

Should you enter an industry if your variable costs are lower than your competitors?

Answer 43

Maybe yes, but maybe no! (To see why look at graphs below)

To see why, just remember that for incumbents, they’re willing to remain in business
and price as low as their marginal cost. But for you as a potential entrant, the right decision is to enter only if you can cover your average cost. In other words, the relevant comparison is not whether your average costs are lower than their average costs,
or indeed whether your marginal costs are lower than theirs, but whether your average costs are lower than their marginal costs- Just make sure you’re considering the right costs when making any decision.

Question 44

Average Total Cost (ATC)

Answer 44

The costs incurred in producing a product per unit of the product sold; mathematically, the total costs for a business, divided by the total volume of units produced.

Question 45

Marginal Revenue

Answer 45

The additional revenue earned by producing extra unit(s) of a product or service.

Question 46

Average Revenue

Answer 46

The revenues received per unit sold; mathematically, the total revenues for a business, divided by the total volume of goods sold; average revenue is equal to price unless there is price discrimination.

Question 47

A tutoring business pays $15,000 per year in rent and utilities, which are all fixed costs. It sells 5,000 hours of tutoring per year, and for each hour of tutoring it incurs variable costs of $30 (to pay the tutor’s wages). What is the average cost per hour of tutoring?

Answer 47

$33

Average cost can be calculated as fixed cost per unit ($15,000/5,000 = $3) plus variable cost per unit ($30). Another way to calculate it is to find total cost ($15,000 + $30*5,000 = $165,000) and divide it by quantity (5,000).

Question 48

An entrepreneur wants to open a new hotel. There is one other hotel operating in the region, and the entrepreneur has estimated that its costs per guest are approximately $50 per guest, of which $30 is variable cost. The entrepreneur forecasts that total costs per guest in the new hotel would be $42, of which $25 would be variable. Assuming consumers will be indifferent between the two hotels, should the entrepreneur open the hotel?

Answer 48

No

The new hotel will have to charge at least $42 per guest to be profitable. However, the incumbent hotel will be willing to cut prices to $30.

Question 49

As an entrepreneur, you should only enter a market if:

Answer 49

Your average cost is less than your competitors’ variable cost per unit.

Incumbents will be willing to sell their product for prices as low as their variable cost, whereas it is not profitable to enter a market if you will not be able to recover your total costs.

Question 50

Which of the following regarding supply curves is NOT true?

• The higher the price, the more firms will be willing to produce.
• In the short run, a steep fall in prices will force the least efficient producers to exit the industry.
• A supply curve can be thought of as a relative cost analysis for all the firms in an industry.
• In the long run, the industry supply curve should take into account both variable costs and fixed costs.

Answer 50

• The higher the price, the more firms will be willing to produce.
  
  • Higher prices provide the incentive for firms to produce more, hence the upward slope of the supply curve.
• In the short run, a steep fall in prices will force the least efficient producers to exit the industry.
  
  • In the short run, a firm is only able to make decisions on its volume of production. Entry/exit decisions are long run considerations. Thus the least efficient producers will stop producing but will not be able to exit the industry in the short term.
• A supply curve can be thought of as a relative cost analysis for all the firms in an industry.
  
  • Moving from left to right, the supply curve depicts the relative efficiency of producers within an industry.
• In the long run, the industry supply curve should take into account both variable costs and fixed costs.
  
  • In the long run, a firm must decide whether to enter/remain in/exit an industry as well as its level of production.

Question 51

• $2.00
• $2.50
• $3.00
• $3.50

Answer 51

• $2.00
  
  • At this price, firms will first start supplying 4000 gallons.
• $2.50
  
  • At this price, firms will continue to supply 4000 gallons, as the price is not high enough for it to be profitable for firms to supply more.
• $3.00
  
  • At this price, firms will first start supplying 6000 gallons.
• $3.50
  
  • At this price, firms will first start supplying 8000 gallons.

Question 52

Profits of a firm can be written as:

Answer 52

Profits = (Price Per Unit − Cost Per Unit) ∗ Quantity Produced

• Your quantity produced depends on what share of the total market size you can grab—which in turn depends on how many competitors you face.
• Power prices are going to be influenced by demand, regulations, and also by the intensity of competition in the market.
• And your costs per unit will be influenced by your production technology, but also by your fixed costs per unit—which in turn depends on the share of the total market you can grab.

In other words, a key factor influencing all three variables is the number of competitors you expect to face in the market.

Question 53

A shop near the ocean sells kites for people to fly on the popular beach nearby. Each kite costs the shop $10, $8 of which is variable costs (for materials and wages for the kite-maker). Another kite-maker wants to enter the market. The potential entrant can make kites for $7 each in variable costs, but adding in the cost of opening a store, the total cost per kite would be $10. Should the new kite-maker open a shop?

• The kite-maker should open a shop as long as customers are not willing to pay $1 more for the existing kites than they will be willing to pay for the new kites.
• The kite-maker should open a shop as long as customers are not willing to pay any more for the existing kites than they will be willing to pay for the new kites.
• The kite-maker should open a shop only if customers will be willing to pay at least $2 more for the new kites than they are willing to pay for the existing kites.
• The kite-maker should definitely not open a shop.

Answer 53

• The kite-maker should open a shop only if customers will be willing to pay at least $2 more for the new kites than they are willing to pay for the existing kites.
  
  • The new kite-maker should compare its total costs ($10 per kite) to the incumbent’s variable costs ($8 per kite). Since the incumbent will be willing to lower its prices to $8, the new kite-maker should only enter the market if customers’ WTP for the new kites is at least $2 higher than their WTP for the existing kites.

Question 54

What does “benefiting from economies of scale” mean

Answer 54

To produce efficiently, firms with high fixed costs need to spread those costs across a much higher output than firms with low fixed costs do.

This is why you often hear entrepreneurs or managers colloquially refer to high fixed cost businesses as “volume businesses.” To recover fixed costs, you need greater volume.

there are few economies of scale to be gained by expanding nationally.

Some companies aren’t meant for economies of scale- Bally’s international gym.
Others have competition in the market that outdoes them- Blockbuster vs. Netflix. (Netflix incurred less fixed costs)

Question 55

Endogenous fixed costs

Answer 55

they are endogenously determined by a firm’s choices, rather than being exogenously determined by industry characteristics.

EXAMPLE: Nike manufactures and sells athletic clothing and equipment. Nike doesn’t face enormous fixed costs just because it operates in the athletic clothing industry. But it has created enormous fixed costs for itself through advertising spending.

This spending serves two purposes.

• It increases consumers’ willingness to pay for Nike products, as we saw in the demand module.
• Just as importantly, it creates a barrier to entry for any competitors trying to break into the industry. A new entrant might realize that in order to compete with Nike, it too would have to launch and maintain a significant advertising campaign. That drastically increases fixed costs, thereby limiting the number of suppliers.

Question 56

Which of the following regarding fixed costs is/are true? Select all that apply.

• The higher the fixed costs it experiences, the lower a firm’s profits will be.
• Companies that incur fixed costs primarily at the level of an individual store are likely to face difficulties scaling their businesses.
• Industries that don’t have high fixed costs will have few barriers to entry.
• Fixed costs do not always imply that the bigger firm will experience cost advantages.
• Companies that experience fixed costs mainly at the local level gain no benefits in scaling up operations to the national level.

Answer 56

• The higher the fixed costs it experiences, the lower a firm’s profits will be.
  
  • While higher fixed costs alone mean lower profits, high fixed costs also create barriers to entry for other firms. This can result in higher market shares for firms already in an industry, meaning high revenues and greater profits. So the effect of high fixed costs on profits can be ambiguous.
• Companies that incur fixed costs primarily at the level of an individual store are likely to face difficulties scaling their businesses.
  
  • True—these companies will necessarily incur fixed costs for every new store, decreasing the benefits of scaling and/or making it more difficult to do so.
• Industries that don’t have high fixed costs will have few barriers to entry.
  
  • This is not necessarily the case. For example, some firms may be barred from entering an industry due to endogenous fixed costs not having to do with industry structure, for example marketing, advertising, incumbent relationships with suppliers, brand name, etc.
• Fixed costs do not always imply that the bigger firm will experience cost advantages.
  
  • True—bigger does not necessarily imply better. Bigger firms may suffer from various inefficiencies related to increased production or scale, potentially driving up costs.
• Companies that experience fixed costs mainly at the local level gain no benefits in scaling up operations to the national level.
  
  • Such companies may experience fewer benefits from scaling than other firms, but could still see some benefits. For example, the benefits from certain fixed costs such as advertising, brand awareness, and others would not be confined to just the local level.