27 March, 2006

Reading: Ch 5. pp. 184-186

Problem #11: Due Friday (note: Correct HW11 ‘Variable Average Costs’ should be Average Total Costs’)

Lecture 25

REVIEW______:

IV. Chapter 5. The Production Process and Costs

C. Costs

1. Short Run Costs.

b. The supply curve for the firm

c. Algebraic Forms of the Cost Function.

Preview______

c. Algebraic Forms of the cost function (continued)

d. Sunk costs vs. Variable Costs

Lecture______

C. Costs and the Theory of the Firm

2. Short Run Costs: Observations (continued)

Example: Suppose C(Q) = 200 + 2Q2

What are marginal costs, average fixed costs, average variable costs and average total costs when Q=10? When are average total costs minimized? (To be worked in class).

C(10) = 200 +2(10)2 this is total cost

ATC = 400/10 = 40

ATC = 200/Q + 4Q

ATC min =100 -2Q2

100/3 = Q2

The firm earns 0 profits at the ATC min, or when MC=ATC

At what price would the firm earn 0 profits? At what price would the firm shut down?

e. Sunk vs. Variable Costs. A final distinction (and one we’ve made before). Fixed costs may be divided into two components: Sunk costs and recoverable costs. Sunk costs are costs forever lost after they are paid. This is an important distinction, for the opportunity costs of recoverable assets and sunk cost assets is remarkably different.

Example: Suppose you are choosing between the purchase of a Toyota Corolla (for $12,500) and a GEO Probe (for $11,000). After a year the book value on the cars will be $11,000 and $7,000. What are the sunk cost components associated with the purchase of each car? How does this difference affect your decision to undertake a 5 year loan to pay for the cars?

Example: Suppose you are the Ford Motor Company, and you purchase vast quantities of titanium dioxide for use in catalytic converters. You purchase so much that the price of the metal skyrockets to $50 per ounce. Then a new catalytic converter technology is developed that no longer uses titanium dioxide. The market price of the compound falls to $2 per ounce. You have 100,000 tons of titanium dioxide. What should you do with it?

Notice a firm whose fixed costs are sunk will behave differently that one whose fixed costs are resalable. Consider, for example the decision to stay in the airline industry when you can resell your fleet of planes, and when you cannot. You would stay in business longer when you cannot resell your fleet, because those costs are sunk.