Question

Suppose that supplying unique plastic parts to Orange Inc. requires an upfront investment of $20,000 to install a modified production line, which allows efficient production of unique plastic parts with a variable cost of $15 per batch. That is, the total cost of producing Q units will be TC(Q)=20000+15Q. At the price of $20 per batch, Orange Inc. agreed to purchase 10,000 batches. However, instead of spending $20,000 on a new production line, you could spend the money on advertising for your camera business, which has much higher per unit profitability. Overall, the average advertising cost per actual customer is $100 (that is, attracting a real customer costs $100 in advertising), and each camera sold brings a profit of $120. What is the economic (not accounting) profit of supplying 10,000 batches of unique parts to Orange Inc., given the money could have also been invested in advertising for the camera business?

Answer 1

Revenue from 10000 batches of unique plastic parts = 10000 * $20 = $200000

Total cost for 10000 batches = 20000 + 15 (10000) = 20000+150000 = $170000

Therefore Accounting profit from supplying 10000 batches of unique parts = 200000 - 170000 = $30000

However $20000 could have been spent on advertising for camera business which would have resulted in $120 profit for per camera sold

$100 advertising cost brings us 1 new customer therefore $20000 advertising cost will result in (20000/100) 200 additional camera customer

Therefore Profit lost in camera business by investing $20000 in unique plastic parts = 200 * $120 = $24000

Therefore Economic profit of supplying 10000 batches of Unique parts = $30000 - $24000 = $6000