Cost Examples: Cost of Production

1. Joe runs a small boat making business: he can make 10 boats per year and sell them for $25,000 each. It costs him $150,000 for the raw materials to build 10 boats. Also, Joe has invested $400,000 in the necessary equipment: $200,000 from his savings on which he was earning 10% interest, and $200,000 borrowed from the bank at 10% interest. Joe can work at a competing boat factory, earning $70,000 per year. What is the total revenue Joe can earn in a year? What are the opportunity costs Joe incurs while producing ten boats?

2. Your aunt is thinking about opening a hardware store. She estimates that it would cost $500,000 per year to rent the location and buy the stock. In addition, she would have to quit her $50,000 a year job as a stockbroker. What is your aunt’s opportunity cost of running the hardware store for a year? If your aunt thought she could sell $510,000 worth of merchandise in a year, should she open the store?

3. The information below is for Lukas’ teddy bear manufacturing plant, where L = number of workers; Q = output; MPL = marginal product of labor; FC = fixed cost; VC = variable cost; TC = total cost; AC = average cost; MC= marginal cost. It costs $100 to set up the plant, and Lukas pays $25 per hour. Complete the table. Plot the marginal cost and average cost curves. According to your graph, what is the efficient scale of the firm?

L Q (per hour) MPL FC VC TC AC MC 0 0 1 20 2 50 3 90 4 120 5 140 6 150 7 155 8 158

4. Suppose a chair manufacturer finds that the MRTS of K for L in his production process is substantially greater than the ratio of the rental rate on machinery to the wage rate. How should he alter his use of K and L to minimize the cost of production?

5. If MC is increasing, do you know whether AVC is increasing or decreasing? Explain.

6. What is the difference between economies of scale and economies of scope? Why can one be present without the other?

7. Assume a computer firm’s marginal costs of production are constant at $1000 per computer. However, the fixed costs of production are equal to $10,000. Calculate the firm’s average variable cost and average total cost curves. If the firm wanted to minimize the average total cost of production, would it choose to be very large or very small? Explain.