The video game industry has significant returns to scale because it costs a lot to make a game but relatively little to copy it onto a disk and distribute it. Suppose that the cost of creating a game is $1,000,000 while the cost of copying and distributing is only $10 per unit.
a) If the price is $60 per unit, what is the break even level of output?
b) Suppose that there are 25,000 potential consumers of this product, each of whom is forecast to buy 1 game. If the company were to spend $1m on advertising and this spending were to increase sales by 50 percent, forecast the company’s profit.
a) Break Even Quantity = Fixed cost / Price - average variable cost
= 1000,000 / 60 - 10 = 1000,000 / 50 = 25000.
b) Before advertisement consumers = 25000
After advertisement consumer increase by 50% = 25000*50/100 =12500
After advertisement total consumers = 25000+12500 = 37500.
Total variable cost of 37500 games = 37500 * 10 = 375,000
Total cost = Fixed + advertisement cost + variable cost
= 1000,000 + 1000,000 + 375,000
= $23,75,000
Total revenue from 37500 games = 37500 * 60 = 22,50,000.
Profit = 22,50,000 - 23,75,000 = - $125,000
Negative sign shows there will be loss after advertisement.
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