Stanley Ford makes mountains out of molehills. He can do this with almost no eff

Question

Stanley Ford makes mountains out of molehills. He can do this

with almost no effort, so for the purposes of this problem, let us assume

that molehills are the only input used in the production of mountains.

Suppose mountains are produced at constant returns to scale and that

it takes 100 molehills to make 1 mountain. The current market price of

molehills is $20 each. A few years ago, Stan bought an “option” that

permits him to buy up to 2,000 molehills at $10 each. His option contract

explicitly says that he can buy fewer than 2,000 molehills if he wishes, but

he can not resell the molehills that he buys under this contract. In order

to get governmental permission to produce mountains from molehills,

Stanley would have to pay $10,000 for a molehill-masher’s license.

(a) The marginal cost of producing a mountain for Stanley is $1,000

if he produces fewer than 20 mountains. The marginal cost of producing

a mountain is $2,000 if he produces more than 20 mountains.

(c) If the price of mountains is $1,600, how many mountains will Stanley

produce? 20 mountains.

(d) The government is considering raising the price of a molehill-masher’s

license to $11,000. Stanley claims that if it does so he will have to go out

of business. Is Stanley telling the truth? No. What is the highest

fee for a license that the government could charge without driving him

out of business? The maximum they could charge

is the amount of his profits excluding the

license fee, $12,000.

(e) Stanley’s lawyer, Eliot Sleaze, has discovered a clause in Stanley’s

option contract that allows him to resell the molehills that he purchased

under the option contract at the market price. On the graph above,

use a pencil to draw Stanley’s new marginal cost curve. If the price of

mountains remains $1,600, how many mountains will Stanley produce

now? He will sell all of his molehills and

produce zero mountains.

The answers are in bold letters. Please give the explanation of each part.

Explanation / Answer

(a) The marginal cost of producing a mountain for Stanley is $1,000

if he produces fewer than 20 mountains. The marginal cost of producing

a mountain is $2,000 if he produces more than 20 mountains.

Marginal Cost = Change in Total Cost /Change in Output

Cost incurred in producing additional mountain = $10 * 100 Mole hills (Cost of one Molehill * Number of molehills required to produce 1 Mountain)

= $1000

So, Marginal Cost upto 20 Mountain = 1000 / 1= $1000

If he produces more than 20 Mountains, he needs more than 2000 Mole hills, which is not in his contract. Applicable price for 1 Mole hill = $20

Total Price = 20 * 100

= $2000

So Marginal cost would be = $2000 / 1

= $2000

So, Marginal Cost would be $2000 if he produces more than 20 Mountains

c) If the price of mountains is $1,600, how many mountains will Stanley

produce?

Decision for producing number of mountains can be taken where Marginal Revenue > Marginal Cost

At 20 Mountains,

Marginal Revenue = $1600

Marginal Cost = $1000

More Than 20 Mountains

Marginal Revenue = $1600

Marginal Cost = $2000

So, for 20 Mountains MR is higher than Marginal Cost, whereas if it is more than 20 mountains, MR is less than MC.

So, it will produce 20 Mountains.

d) Total Revenue earned if Stanley produces 20 mountains = 1600 * 20

= $32000

Total Cost incurred in producing 20 Mountains = 20 * 1000

= $20000

So, Profit earned = 32000 - 20000 = 12000

If the government is considering raising the price of a molehill-masher’s license to $11,000,

Net Profit earned = 12000 - 11000 = $1000

So Stanley will not go out of business as he is still earning a profit of $1000.

Highest fee for a license that the government could charge without driving him out of business

= Amount of his profit - Licence fee

= $12000

e) New Marginal Cost = $1000

As he can resell all the Molehills at a Market price of $20, which he has purchased at a price of $10, so Stanley will sell all of his molehills and produce zero mountains.

This is because, he will earn a profit of $10 on each molehill resold by him in the market.

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