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Elasticity and Cost Concepts

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1. You've been hired by an unprofitable firm to determine whether it should shut down its unprofitable operation. The firm currently uses 50,000 workers to produce 200,000 units of output per day. The daily wage (per worker) is $80, and the price of the firm's output is $25. The cost of other variable inputs is $400,000 per day. Although you don't know the firm's fixed cost, you know that it is high enough that the firm's total costs exceed its total revenue. Provide a report to management of the firm as to whether or not it should continue to operate at a loss? Be sure to show your work to support the decision you outlined in your report.

2. Suppose the price of apples rises from $3 a pound to $3.50 and your consumption of apples drops from 35 pounds of apples a month to 20 pounds of apples. Calculate your price elasticity of demand of apples. What can you say about your price elasticity of demand of apples? Is it Elastic, Inelastic, or Unitary Elastic? Be sure to show the work you used to support your answer.

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Solution Summary

The solution to the first problem discusses whether an unprofitable firm should continue to produce or shutdown at current levels of output and costs. The solution to the second problem discusses the price elasticity of demand. It calculates price elasticity of demand in the given scenario and provides a suitable interpretation of the value obtained.

Solution Preview

Please refer to the attached file for the complete solution. Formulas typed with the help of equation writer are missing here.

Solution:

In the theory of firms, every firm tries to maximize its profits and to minimize its losses in case it is making losses.
Number of workers employed=L=50000
Wage Rate=w=$80 per worker per day
Daily Labor costs=L*w=50000*80=$4000,000
Other Variable Input costs per day=$400,000
Total Variable Costs per day (TVC)=Daily Labor Costs+ Other Variable input costs per day
=$4000000+$400000
=$4,400,000
Total output=Q=200000 units
Average Variable Cost=AVC=TVC/Q= 4,400,000/200000
=$22 per unit
Price of firm's output (P)=$25 per unit
Contribution margin per unit=P-AVC=$25-$22=$3

We know that shut down point is ...

Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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