Question

Laura is a gourmet chef who runs a small catering business in a competitive industry. Laura specializes in making wedding cakes. Laura sells 20 wedding cakes per month. Her monthly total revenue is $500. The marginal cost of making a wedding cake is $20. She has fixed costs of $200 and variable costs of $400.

• Assuming their usual shapes, graph Laura’s average variable cost, marginal cost, average total cost. On your graph, clearly label the following: – The market price. – The quantity Laura is currently producing. – The value of average variable cost, average total cost, and marginal cost at the quantity being produced

. • If Laura is seeking to maximize short-run profit, should Laura shut down, produce more, produce less, or produce the same amount? Explain your logic and use your graph to help with your argument.

Answer 1

Laura sells 20 wedding cakes per month. Her monthly total revenue is $500. Hence market price is TR/Q = 500/20 = $25 per cake. The marginal cost of making a wedding cake is $20.

She has fixed costs of $200 and variable costs of $400. This implies AVC = 400/20 = $20 and TC = 400 + 200 = 600. Thus, ATC = 600/20 = $30. Now see that MC = AVC = 20. Hence AVC is at its minimum.

Currently P > MC and P < ATC. But P > AVC, This shows that she should not shut down because she is covering her variable cost (which is $400 while her revenue is $500).

But she should produce more since P > MC and she can reduce her losses if she produces more. This will increase her MC upto the point where P = MC. She will still face a loss because price is fixed at $25 but her losses can be reduced