Questions for Critical Thinking

Questions for Critical Thinking 4

Chapter 7:

a. Discussion Questions: 2, 8, and 9.

b. Problems: 2(a), 3*, 4**, and 11***

2. What is the distinction between marginal cost and incremental cost, and how are sunk costs treated in managerial decision making and why?

Incremental cost is closely related to the economist's marginal cost. Marginal cost may be defined as the addition to the total cost resulting from producing one more unit. On the other hand, Incremental cost may be defined as the addition to total cost resulting from a particular decision. Both are concerned with changes in total cost, say increase or decrease in total costs that result from producing and distributing additional or fewer units of a product, or from a change in the method of production or distribution such as the use of improved machinery etc.

Sunk costs are not considered in managerial decision making, only incremental or marginal cost are considered for any decision making. Sunk costs are not relevant because it is that cost which has already occurred and which cannot be recovered. Therefore basing decision on this cost is not fundamentally incorrect.

8. What shape of LAC curve has been found in many empirical studies and what does this mean for the survival of small firms in the industry? The LAC curve has been found to have a U Shape in many of the empirical studies that have been done. This means that for the survival of small firms could face hardships as larger firms tend to have a cost advantage, and the industry tends naturally to become a monopoly, and hence is called a natural monopoly. Natural monopolies tend to exist in industries with high capital costs in relation to variable costs.

9. What is the meaning of economies of scope?

The reduction in the firm's unit cost by producing two or more goods or services jointly rather than separately. For example, a company dealing in processed food items can have economies of scope by entering into soft drinks industry as the company already has knowledge, skills and experience in related type of products, which can be used to reduce the cost of production for the soft drinks.

How do they differ from economies of scale?

The economies of scale are closely related to economies of scope. While economies of scale says that the firm can reduce the unit cost by increase the number of units produced, the economies of scope means that the firm can reduce the unit cost by producing more than one product. Engaging in more than one lone of business may require a firm to have a certain minimum scale of production. Also a firm's expansion into different lines of business naturally increases its scale of operations.

What do learning curves show? How do they differ from economies of scale?

A learning curve is a function that shows how labor hours per unit decline as units of production increase due to workers learning and becoming better at their jobs. The learning curve is used to predict how labor hours will change as more units are produced.

While economies of scale arise due to spreading of fixed costs over a large volume, the learning curve benefits arises due to better management of process through leaning and experience.

What is the usefulness of learning curves as a managerial tool? What is the reason for rising international trade in inputs and the use of foreign trade in inputs and the use of foreign labor?

The more units a firm produces, the lower will be the incremental cost. Thus firm, which are using cost leadership as a strategy, can take advantage of lower cost if they are able to ride faster on their learning curve. To do that the firm should focus on increasing their market share rapidly.

To ride faster on learning curve firms need to produce very high volumes and focus on what they knows best (core competencies). Thus, companies across the world produce only those items in which they have core competencies. This requires expanding business by firms across the world and more trade in inputs and labor. Firms take the entire world as a single market and trade in inputs from wherever they can source the best value for money supplies and employ best people who are best in their work irrespective of country of origin.

Problems

2(a). Given the following total cost schedule of a firm, derive the total fixed cost and total variable cost schedules of the firm, and from them derive the average fixed cost, average variable cost, average total cost and marginal cost schedules of the firm.

Q 0 1 2 3 4 5

TC $30 50 60 81 118 180

Q Total Fixed Cost Total Variable Cost Total Cost

0 30 0 30

1 30 20 50

2 30 30 60

3 30 51 81

4 30 88 118

5 30 150 180

Q Avg. Fixed Cost Avg. Variable Cost Avg. Total Cost

0 0 0 0

1 30 20 50

2 15 15 30

3 10 17 27

4 7.5 22 29.5

5 6 30 36

Q Total Cost Marginal Cost

0 30

1 50 20

2 60 10

3 81 21

4 118 37

5 180 62

3. (a) Should the airline replace its night flight from Los Angeles with a morning flight? (Please calculate and compare the profit under each flight)

Current Revenues = $200*(80+50)=$26,000

Operating cost = $11000*2=$22,000

Cost of overnight stay = $1200

Fixed costs = $3000

Total cost=26,200

Current profits = 26000-26200=-200

Replacing night flight with morning flight:

Revenues

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