Deck 11: Managerial Decisions in Competitive Markets

Question 1

The MidNight Hour, a local nightclub, earned $100,000 in accounting profit last year. This year the owner, who had invested $1 million in the club, decided to close the club. What can you say about economic profit (and the rate of return) in the nightclub business?

Answer 1

The accounting profit of Midnight hour was $ 100,000. On the other hand while calculating economic profits one not only takes into consideration accounting profits but also the opportunity cost associated with the amount invested.
- In this example, the amount of 1 million earns 10% return of $100,000. This the accounting profit.
- If the same investment would have earned Midnight hour 20% , then economic profits would show a decrease of $200,000 from accounting profit.

Question 2

Redstone Clayworks, Inc., a small firm located in Sedona, manufactures clay fire pits that homeowners place on their patios for decoration and light-duty heating. Redstone is one of 53 firms worldwide supplying clay fire pits to retailers such as Home Depot, Lowe's, Front Gate, and other upscale home product chains. Despite the best marketing efforts of these retailers to differentiate their individual brands of fire pits, consumers don't care much about brands: A clay fire pit is a clay fire pit, regardless of who sells it. The following spreadsheet below provides data on Redstone's costs of production.

a. Create a spreadsheet using Microsoft Excel (or any other spreadsheet software) that matches the one above by entering the output and cost data given above. Then use the appropriate formulas to create four new columns in your spreadsheet for average fixed cost ( AFC ), average variable cost ( AVC ), average total cost ( ATC ), and short-run marginal cost ( SMC ). [Computation check: At Q = 400, SMC = $110]. The world demand and supply curves for clay fire pits intersect at $190 per unit.
b. Use the appropriate formulas to create two more columns in your spreadsheet for total revenue ( TR ) and marginal revenue ( MR ). [Computation check: At Q = 400: MR = $190].
c. Use the appropriate formulas to create three more columns in your spreadsheet for profit ( PROF ), average profit ( AVGPROF ), and profit margin ( PROFMARG ). [Computation check: At Q = 400: AVGPROF = $95].
d. If Redstone's manager wishes to minimize average total cost, how many clay fire pits should be produced? How many to maximize profit margin?
e. Redstone's manager is fired, and you are now the manager of Redstone Clayworks. How many fire pits would you choose to produce? Why?
f. Now triple the total fixed costs to $15,000 in your spreadsheet. How does this change your production decision in part e ? Explain briefly.
g. Suppose a congressional environmental panel announces that greenhouse gases from clay fire pits are contributing significantly to global warming. The announcement causes worldwide demand for fire pits to shrink substantially, and clay fire pit prices fall to $65 per unit. How does this change your production decision in part e ?
Explain briefly. [Note: Return total fixed cost to the original level of $5,000.]

Answer 2

The following is the cost table of R.Clay works:
(A) All average costs are derived by dividing quantity and marginal cost by finding the difference between consecutive outputs:
(B) Total revenue is the product of price (190) and quantity. Marginal revenue is the difference between consecutive total revenue divided by difference in consecutive quantity (100):
(C) Profit is the difference between total revenue and total cost. Average profit is profits divided by respective quantity. Profit margin is profit divided by respective total revenue:
(D) Average total cost is minimum at quantity 300. In this quantity the average total cost is $90.
(E) The profit is maximized when marginal revenue is equal to marginal cost. This happens at quantity 750 (average of 700 and 800 quantity).
(F) The answer remains the same, 750 units yields highest profits. This is because the marginal cost and revenue is not affected by fixed cost. Marginal cost is a function of variable cost.
(G) The production should be carried when
Price = marginal revenue = marginal cost = $65.
This happens at quantity 100.

Question 3

The manager of All City Realtors wants to hire some real estate agents to specialize in selling housing units acquired by the Resolution Trust Corporation (RTC) in its attempt to bail out the savings and loan industry. The commission paid by the RTC to the company to sell these homes is a flat rate of $2,000 per unit sold, rather than the customary commission that is based on the sale price of a home. The manager estimates the following marginal product schedule for real estate agents dealing in government-owned housing:

a. Construct the marginal revenue product schedule by filling in the blanks in the table.
b. If the manager of All City Realtors must pay a wage rate of $32,000 per year to get agents who will specialize in selling RTC housing, how many agents should the manager hire? Why?
c. If the wage rate falls to $18,000 per year, how many agents should the manager hire?
d. Suppose the RTC raises its commission to $3,000 per unit sold. Now what is the marginal revenue product for each real estate agent employed?
e. Now that the RTC is paying $3,000 per unit sold, how many agents should the manager hire if the wage rate is $30,000?

Answer 3

Given the information,
(A) The following shows the table containing marginal revenue and no of units sold by respective agents:
(B) If wage rate is $32000 per year, then firm should hire 2 agents. This is because the marginal revenue should be equated with marginal cost. If more than 2 agents are hired, the marginal cost will exceed the marginal revenue.
(C) If wage rate is $18000 per year, then firm should hire 4 agents. This is because the marginal revenue should be equated with marginal cost to attain the maximizing point. If more than 4 agents are hired, the marginal cost will exceed the marginal revenue.
(D) If commission is $3000 , then marginal revenue product would be:
(E) If the wage rate is $30000, then firms should hire 4 agents. Here the marginal revenue taken is the nearest to $30000. This is because firms cannot hire 4.5 agents.

Question 4

HoneyBee Farms, a medium-size producer of honey, operates in a market that fits the competitive market definition relatively well. However, honey farmers are assisted by support prices above the price that would prevail in the absence of controls. The owner of HoneyBee Farms, as well as some other honey producers, complain that they can't make a profit even with these support prices. Explain why. Explain why even higher support prices would not help honey farmers in the long run.

Question 5

Insurance agents receive a commission on the policies they sell. Many states regulate the rates that can be charged for insurance. Would higher or lower rates increase the incomes of agents? Explain, distinguishing between the short run and the long run.

Question 6

If all the assumptions of perfect competition hold, why would firms in such an industry have little incentive to carry out technological change or much research and development? What conditions would encourage research and development in competitive industries?

Question 7

At a recent board meeting, the president and CEO got into a heated argument about whether to shut down the firm's plant in Miami. The Miami plant currently loses $60,000 monthly. The president of the firm argued that the Miami plant should continue to operate, at least until a buyer is found for the production facility. The president's argument was based on the fact that the Miami plant's fixed costs are $68,000 per month. The CEO exploded over this point, castigating the president for considering fixed costs in making the shutdown decision. According to the CEO, "Everyone knows fixed costs don't matter!"
a. Should the Miami plant be closed or continue to operate at a loss in the short run?
b. How would you explain to the incorrect party that he or she is wrong?

Question 8

Suppose you own a home remodeling company. You are currently earning short-run profits. The home remodeling industry is an increasing-cost industry. In the long run, what do you expect will happen to
a. Your firm's costs of production? Explain.
b. The price you can charge for your remodeling services? Why?
c. Profits in home remodeling? Why?

Question 9

The New York City Parks Department doubled the annual fee for the hot-dog pushcart that had the exclusive license for the spot just south of the Metropolitan Museum of Art to $288,000. Why would anyone pay almost $300,000 for a pushcart license? Who is obtaining the economic rent for the obviously lucrative pushcart location? How much economic profit is the pushcart owner probably earning?

Question 10

Grocery stores and gasoline stations in a large city would appear to be examples of competitive markets: There are numerous relatively small sellers, each seller is a pricetaker, and the products are quite similar.
a. How could we argue that these markets are not competitive?
b. Could each firm face a demand curve that is not perfectly elastic?
c. How profitable do you expect grocery stores and gasoline stations to be in the long run?

Question 11

During a coffee-room debate among several young M.B.A.s who had recently graduated, one of the young executives flatly stated, "The most this company can lose on its Brazilian division is the amount it has invested (its fixed costs)." Not everyone agreed with this statement. In what sense is this statement correct? Under what circumstances could it be false? Explain.

Question 12

During the summer of 2009 at the European Union's headquarters in Brussels, dairy farmers across Europe protested low milk prices caused by the EU's move away from farm crop subsidy programs toward more heavy reliance on market-determined prices for agricultural products. The Wall Street Journal reported that the dairy farmers demanded "a fair price for (their) milk, which covers at least (their) production cost and some profit margin." The EU Farm Commissioner responded, "what farmers need to do is produce less."
a. Although in economics there is no such thing as a "fair" price, how might marketdetermined prices be considered "fair" in an economic sense?
b. Why don't dairy farmers take the Commissioner's advice and just produce less milk?

Question 13

EverKleen Pool Services provides weekly swimming pool maintenance in Atlanta. Dozens of firms provide this service. The service is standardized; each company cleans the pool and maintains the proper levels of chemicals in the water. The service is typically sold as a four-month summer contract. The market price for the four-month service contract is $115. EverKleen Pool Services has fixed costs of $3,500. The manager of EverKleen has estimated the following marginal cost function for EverKleen, using data for the last two years:
SMC = 125 - 0.42 Q + 0.0021 Q 2
where SMC is measured in dollars and Q is the number of pools serviced each summer. Each of the estimated coefficients is statistically significant at the 5 percent level.
a. Given the estimated marginal cost function, what is the average variable cost function for EverKleen?
b. At what output level does AVC reach its minimum value? What is the value of AVC at its minimum point?
c. Should the manager of EverKleen continue to operate, or should the firm shut down? Explain.
d. The manager of EverKleen finds two output levels that appear to be optimal. What are these levels of output and which one is actually optimal?
e. How much profit (or loss) can the manager of EverKleen Pool Services expect to earn?
f. Suppose EverKleen's fixed costs rise to $4,000. How does this affect the optimal level of output? Explain.

Question 14

Airline industry experts generally believe that because of the "highly competitive" nature of U.S. airline markets, it is usually impossible to pass on higher jet fuel prices to passengers by raising ticket prices.
a. What factors do you suppose contribute to making U.S. airline markets "highly competitive"?
b. Accepting the premise that U.S. airline markets are indeed highly competitive, analyze in both the short run and long run the difficulty of raising ticket prices when jet fuel prices rise.

Question 15

Legendary for his business and investment acumen, Warren Buffett is frequently called the "Oracle of Omaha" after his birthplace in Omaha, Nebraska. As one of the world's wealthiest business owner-investors, business executives are always interested in any insight or opinion Mr. Buffett might wish to share. Explain each one of the following statements made by Warren Buffett. (Quotations from The Wall Street Journal , September 23, 2002.)
a. "You cannot be the high-cost producer in a commodity business."
b. "Sometimes it's not even any good to be the low-cost producer."