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Production Costs for a Typical Firm

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1) Your boss, the mayor of a city, thought that she'd come up with a great way to raise city revenue: increase the tax on gasoline in the city! However, she discovered that the city was actually receiving less tax revenue after the gas tax increase than before. Incensed, she declared that the economic policy prescription of taxing goods with inelastic demand must be flawed. Comment

Inelastic products are products whose demand is not usually affected by any changes in price. Essential products like gas, food and others usually have inelastic demand schedules.

However, given the fact that gasoline has to some extent gotten some substitutes in the form of electric cars and hybrids, any increase may be offset with demand increasing for the substitutes. The demand may still be high but consumers now have a greater range of choices in electric cars, hybrids, public transport etc, which may help reduce demand.

2) Complete the table below, which represents the production costs for a typical firm. (Round numbers to the nearest tenth)

NOTE: Double-click the table to see the formulas used.

At what level of output do diminishing returns set in? How do you know?

Diminishing returns is the principle whereby an additional unit produced does not bring any extra benefit. The principle can be measured with the marginal cost curve. From the graph below, you will observe that the marginal cost curve breaks its spiral immediate to an output of 3 units. It is at this point that marginal cost is $16.3. After this point any other unit just increases the marginal cost. This is undesirable because the objective, of the firm, is to maximize profit (Marginal revenue - Marginal cost).

3) Hotdogs are very cheap at the grocery store about $2 for a package of 8, or 25 cents each. At a baseball game they cost $3 each. Use the concept of price elasticity of demand to explain why.

Demand, for a product, is greatly influenced by the need and desire of the consumer. During a game, the demand for hotdogs would usually be higher due to the large crowds in the stadium. The seller can increase prices given the idea that people would still buy it in order to possibly assuage their hunger during a game. In other words, the hotdog's elasticity during a game would usually be slight inelastic.

4) The initial price of a cup of coffee is $1, and at that price, 400 cups are demanded. If the price falls to $0.90, the quantity demanded will increase to 500.
a. Calculate the (arc) price elasticity of demand for coffee.
Old New
Price $1.0 $0.9
Quantity 400 500
Arc elasticity 2.11 =-(((500 - 400)/(500 + 400)) * ((0.9 + 1)/(0.9 - 1)))

b. Based on your answer, is the demand for coffee elastic or inelastic?

Elasticity measures the way demand changes as price changes. The price elasticity values can range from negative values to positive. The value, of 2.11, shows that coffee is very elastic.

c. Based on your answer to a., if the price of coffee is increased by 10%, what will happen to the revenues from coffee? Carefully explain how you know.

From the above table, you will observe that as price increases the revenue would decrease.

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This solution analyzes production costs for a typical firm.

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1). Your boss, the mayor of a city, thought that she'd come up with a great way to raise city revenue: increase the tax on gasoline in the city! However, she discovered that the city was actually receiving less tax revenue after the gas tax increase than before. Incensed, she declared that the economic policy prescription of taxing goods with inelastic demand must be flawed. Comment

Inelastic products are products whose demand is not usually affected by any changes in price. Essential products like gas, food and others usually have inelastic demand schedules.

However, given the fact that gasoline has to some extent gotten some substitutes in the form of electric cars and hybrids, any increase may be offset with demand increasing for ...

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  • M. Sc., London South Bank University
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