Chapter 17 — Exercises

Section A — Computing costs

A1. A firm has fixed costs of $500/day and variable costs given by the following table:

Compute: (a) Total cost for each output level. (b) Average total cost. (c) Average fixed cost. (d) Average variable cost. (e) Marginal cost (for each 10-unit increment).

A2. Plot ATC, AVC, AFC, and MC from A1 on the same graph. Verify that MC crosses ATC and AVC at their respective minimums.

A3. At what output level is ATC minimized? Is this the same output level where MC = ATC?

A4. Suppose the firm can sell each unit for $20. At what output level should it produce? (Hint: produce where MR = MC, as long as P ≥ AVC.)

A5. Now suppose the price falls to $12. Should the firm shut down? Why or why not? (Check the shutdown rule: P vs. min AVC.)

Section B — Diminishing returns

B1. Explain diminishing returns in your own words. Why does adding the 100th worker to a production line add less output than the 10th worker?

B2. Give a real-world example of diminishing returns from outside of manufacturing. (Hint: studying, cooking, farming, or any activity where adding more of one input eventually produces less additional output.)

B3. Diminishing returns explain why the MC curve eventually slopes upward. Walk through the logic: how does falling marginal product translate into rising marginal cost?

B4. Does diminishing returns mean that total output eventually falls? Or just that it rises at a decreasing rate? Be precise.

Section C — Short run vs. long run

C1. Identify three costs that are fixed in the short run but variable in the long run for a restaurant.

C2. Why are there no fixed costs in the long run?

C3. A firm has a lease on a building for 5 more years. In the short run (within the lease), the building cost is fixed. In the long run (after the lease expires), it becomes variable. Explain why this matters for the firm's decision-making.

C4. A firm is earning enough revenue to cover variable costs but not total costs. Should it: (a) shut down immediately, (b) continue operating in the short run but exit when the lease expires, or (c) continue operating indefinitely? Justify.

Section D — Economies of scale

D1. Name three sources of economies of scale and give an example of each.

D2. Name two sources of diseconomies of scale and give an example of each.

D3. Why do many industries have firms of many different sizes? (Hint: the LRATC curve is often relatively flat over a wide range.)

D4. Why is semiconductor manufacturing a natural monopoly (or near-monopoly)? Apply the economies-of-scale framework.

D5. A small bakery and a large bakery both make bread. The small bakery has higher ATC. Does this mean the small bakery should close? What other factors might let it survive?

Section E — The Riverside Foods example

E1. Riverside's optimal output is about 1.5–1.6M lbs/month. What would happen if the wholesale price rose from $1.10 to $1.30? Would Riverside want to expand output? Why?

E2. What would happen if the price of raw vegetables (an input) rose by 20%? Which cost curves would shift? What happens to the optimal output?

E3. Riverside is considering buying a second production line (capital investment of $5M). This would increase capacity but also increase fixed costs. Under what conditions would the investment be worthwhile?

E4. A new competitor opens a frozen-food plant 50 miles from Millbrook. Apply the cost framework: how does new competition affect Riverside's pricing and output decisions?

Section F — Sunk costs

F1. A firm spent $2M developing a product that flopped. It can spend another $500K to salvage the product for a niche market, expected to generate $400K in revenue. Should it spend the $500K? Apply the sunk cost principle.

F2. "We've already invested $10 million in this project. We can't stop now." Is this good reasoning or bad reasoning? Explain.

F3. Give a personal example of sunk-cost thinking from your own life. How would you have decided differently if you had ignored the sunk cost?

Section G — Data lookup

G1. Look up the U.S. Producer Price Index (PPI) for processed foods on FRED (series PCUOMFG or similar). How have producer costs for food manufacturing changed over the last 10 years?

G2. Look up average hourly earnings in manufacturing (FRED series CES3000000008 or similar). How have manufacturing wages changed over the last 20 years? How does this affect firm cost structures?

Section H — Reflection

• Before this chapter, did you think about the costs behind the products you buy? Has this chapter changed your perspective?
• Which concept was most surprising: diminishing returns, the MC-ATC relationship, or sunk costs?
• How thin do you think profit margins are for typical firms? Does the Riverside example (12.5% margin) surprise you?

Selected answers in appendices/answers-to-selected.md.