Question

Overheard at the water cooler: "The demand and cost estimates that were provided at the meeting are very useful [Q =400 - 8P and TC = 600 + 2Q]. Unfortunately, what we did not realize at the time was that our fixed costs were underestimated by at least 40 percent. This means that we'll have to adjust our price upward by at least 40 percent to cover the added fixed cost. In any case there is no way in the world we can survive by charging less than $28.00 for our product."

a. Comment on this statement. Do you agree with the speaker? Explain.

b. What price and quantity do you think this firm should charge and produce if it wants to maximize its short-run profit? Explain.

Answer 1

A. I disagree with the speaker.

This is because even though the fixed costs were underestimated by 40%, they are only part of the total cost as the total cost also includes variable costs. So the total cost would only increase by a fraction of 40% and hence it doesnt make sense to increase the total price by 40%.

Any business survives till it at least recovers its variable costs. When the speaker says at least 28 dollars is required, it means the variable cost is 28. This is wrong as it is clear from the given Total Cost curve is that variable cost is 2.

B. The profit will be maximized when Marginal Revenue=Marginal Cost. Marginal Cost is given at 2.

Marginal Revenue is just price, so at P=2 profit will be maximized.

Putting this in Q,

Q=400-8*2

Q=384