Question

1. After viewing the film Back to the Future, Matt takes a nap but has a disturbing dream. He sees himself 50 years into the future, and his town has become a large city. Dozens of computer businesses exist in the city. However, he is still selling only 1200 computers a year at his store. He observes that computer prices are now $900 and his ATC is still $1000. His AVC is $750 and his AFC is $250. In a panic, Matt closes his store immediately rather than continue to lose money. Did he do the right thing? Why, or why not? Illustrate numerically why your answer is right.

2. In desperation, Matt considers raising his price back to the $1,300 that he charged in the “good old days.” Without any more information than the fact that computers now sell in a perfectly competitive market, can you tell Matt what the outcome of his price change will be?

3. Perplexed about whether his proposed action is the right approach and uncertain about your advice, Matt calls in a consultant who tells him that he is much smaller than other vendors who are making a profit at the going price. The consultant sketches out a U-shaped long-run average total cost curve and inserts two short-run cost curves on the graph. One is Matt's and the other is one like the successful competitors operate. The graph incorporates the information presented so far and, according to the consultant, is Matt's blueprint for success. Unfortunately, Matt has lost the graph and asks you to help him reproduce it. Sketch out the long-run average cost, two short-run average cost curves and their marginal cost curves, the demand curve facing each firm in the industry, and Matt's average variable cost curve. Explain to Matt the point the consultant was trying to make by identifying the profit Matt will have if he expands.

Answer 1

1-ans Matt didn't do the right thing as he was able to recover his variable cost of production. If he shut down he is to loose his fixed costs which he has already spent.

Matt's shut down losses =Fixed Costs =AFC×Q=250×1200=$300000

If he continues, his losses =TC—TR=1200000—1080000=1200000

So he should close because his losses will be higher than if he would have continued his business.

2:ans It will be a wrong step taken by him, now market is of perfect competition, so he has to adopt market price (p=900) else he can't sell any quantity and he will bear more losses than before.

3:ans graph is drawn below in picture ;