By popular demand, Mike has decided to leave his Coffee shopand open Flower shop
ID: 1231919 • Letter: B
Question
By popular demand, Mike has decided to leave his Coffee shopand open Flower shop. After researching his new greenhouse, Hediscovered he is operating in a perfectly competitive industry andface the following cost schedule. Flats TotalCost 0 15 1 29 2 38 3 45 4 55 5 67 6 83 7 104 8 128 A) Given this cost schedule, how much willMike charge for a flat of flowers? B) If the price of flowers is $11 a flat,should Mike stay in business? Why or Why not? What would he expectto see happen to the flowers industry? C) What should Mike does if the price perflat raises from $11 to $17, will he be able to now live "happilyever after? D) What is the lowest price He will accept and still keepselling flowers? By popular demand, Mike has decided to leave his Coffee shopand open Flower shop. After researching his new greenhouse, Hediscovered he is operating in a perfectly competitive industry andface the following cost schedule. Flats TotalCost 0 15 1 29 2 38 3 45 4 55 5 67 6 83 7 104 8 128 A) Given this cost schedule, how much willMike charge for a flat of flowers? B) If the price of flowers is $11 a flat,should Mike stay in business? Why or Why not? What would he expectto see happen to the flowers industry? C) What should Mike does if the price perflat raises from $11 to $17, will he be able to now live "happilyever after? D) What is the lowest price He will accept and still keepselling flowers?Explanation / Answer
The key is that this is a perfectly competitiveindustry. That means that Mike is a PRICE TAKER. Hecannot set his own price, but can only charge the going rate in hisindustry. I suspect that part a is a trick question.... . . Now, suppose we have some price. How should Mike decidehow much to produce? We usually think of the cost of makingan additional unit as starting out high at Q=0 and then droppingfor a little while, as you get the hang of what you're doing, makeenough units to specialize, etc. Then the costs of makingmore units get more and more expensive, as you start to push thelimits of your shop's capacity. With that in mind, let'ssuppose the price were $9, and decide how much we wanted toproduce. . The typical way economists approach pricing problems is toimagine that we start at 0 and then keep adding additional unitsuntil we want to stop. . If we made one unit, we would earn $9 in revenue and spend $29in costs. This would be a very bad idea. But we canhope that costs are going to get lower, so let's think about makingsome more units anyway. . If we went from one unit to two units, we would earn anADDITIONAL $9 in revenue and incur an ADDITIONAL $9 in costs. So, assuming we had already made that first unit, we would breakeven on the second unit. We would, of course, lose our shirtson the first unit, but let's think about this one unit at atime. . If we went from two units to three units, we would earn anADDITIONAL $9 in revenue and incur an ADDITIONAL $7 in costs. So we'd make a profit on the 3rd unit. . If we went from three units for four units, we would earn anADDITIONAL $9 in revenue and incur an ADDITIONAL $10 in costs, we'dnow be losing money. . . So after the third unit, the additional revenue from sellingone more unit will be less than the additional cost of making thoseunits. Now, in economics we have a fancy-shmancy way oftalking about the properties of the last unit we've made: we callit the MARGINAL UNIT. (Sometimes people call the marginalunit the next unit we would make if we kept going, not the lastunit we made. When we do this with calculus the distinctiondoesn't matter.... Go with what your teacher told you.) TheMARGINAL REVENUE is the amount of extra revenue from the lastsale. In perfect competition, it's always the price. The MARGINAL COST is how much the costs changed from the last sale;you can find that by subtracting Total Cost of Last Unit MinusTotal Cost of Second-to-Last Unit. . Unless we have a very weird cost curve (with "learning bydoing" or the like--stuff not usually found in an intro econcourse!), our costs of adding an additional unit are never going togo down after this, so we know that we'd lose money if we keptadding units. Eyeballing the table tells me that the marginalcost is, indeed, increasing from here on out; you might actuallyneed to do some calculations to see this. . IMPORTANT: Anyway, the point is that IF WE PRODUCE AT ALLwe're going to produce as long as MR > MC, after we've gottenthrough the initial high-cost region where we're setting up theshop, etc. If we have nice equations, we solve for the pointwhere MR = MC, that is, for where P = MC. This is one of themain defining characteristics of perfect competition: P =MC. Memorize it. This is what monopolists will try tomuck around with when you get to monopoly.... . IF WE PRODUCE AT ALL, we maximize profits by producing at thepoint where P=MC (or the point right before it, in problems likethis one where we have "lumpy" decisions to make and haveto produce in integer quantities; we can't just make 3.2units). If we produce less than that, then there are stillprofitable units we could sell if we kept going; if we produce morethan that, we're taking losses. . IMPORTANT: This means that the first step to solving a problemlike this is to calculate the MARGINAL COSTS for eachunit!!!! Then take your price ($11 or $17) and look for thelast unit where the revenue (the price) exceeds the marginalcost. . We still have to decide whether to produce at all,though. What if we don't make enough money to cover thoseinitial costs? . If P=$9, we do NOT make enough money. If we produced atall, we would produce 3 units, for a total revenue of $27, and wewould shell out $45 in costs. Not a good idea! So wecan decide if we want to produce at all by comparing Total Revenue(TR) to Total Costs (TC). Alternatively, we divide byquantity and compare Average Revenue (AR, which is the price) toAverage Costs (AC, calculated as TC/Q). Whether it's easierto compare TR to TC or P to AC will depend on the way theinformation in the problem is given, but either method will givethe same answer. . Your question doesn't seem to distinguish between the"short run" and the "long run," but if your class starts makingthose distinctions it will matter a lot for what costs you look atwhen. I'm assuming that that's a complication you haven't hityet. . One more hint: in part (b), they seem to be assuming that theflower industry has a lot of shops that look like Mike's. Would you expect to see a lot of people exiting the industry orflocking to open new flower shops?Related Questions
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