Average Variable Cost Average Fixed Cost †Myassignmenthelp.Com

Question: Discuss About The Average Variable Cost Average Fixed Cost? Answer: Introduction: Based on the case study given to us we examine some issues that Adam and Virginia face when they move over from their regular job to setting up a coffee shop on Sundays. This analysis uses the key concepts of revenue, costs and its types, and lastly the rule to determine expansion when penalty rates dip. We use a variety of costs ranging from fixed, variable, explicit and implicit and sunk cost, and the corresponding average variable cost and average fixed cost. Sunk costs are costs incurred by a firm, but cant be recovered, by definition. These are different from fixed and variable costs as they are not a part of the determination of profit maximising or any other decision making. Sunk costs do not enter any decision making, but they are important as they determine the ease with which a new firm can enter the market. High sunk costs mean more expenditure for the entrant that is irrecoverable. Fixed costs refer to costs that do not vary with output; accordingly they are short run concept. Variable costs vary with output level, and form a crucial part of decision making. As per Tucker (2008) explicit costs refer to payments to nonowners of a firm for their resources, whereas implicit costs refer to opportunity costs of using resources owned by a firm. These also lead to a difference between accounting and economic profits. By logic explicit costs include fixed and variable costs. There is no such distinction of fixed/variable costs for implicit cost. Accounting profits = Total revenues- total explicit costs Economic profits= Total revenues- total explicit costs implicit costs So if any owner of a firm is using his own resources then economic profits will be lower than accounting profits. ANALYTICAL DEVELOPMENT We look at arrange of issues here separately. Profits We start with accounting and economic profits first. We segregate all costs under various headings: Fixed costs include the rent paid for coffee machine and sundries (coffee and cups) = 1000+500=1500 Variable costs = wages = 5 workers *10 hours @40 per hour = 2000 Total revenues = 3*4000 cups = 12000 So accounting profits = 12000-2000-15000= 8500 Now we account for implicit costs, which include wages of Adam and Virginia = 400*2 =800 Rent they could have received for the shop premises if they chose not to operate themselves = 1500 Own money they use after withdrawing from bank = 2*200 = 400 Total implicit costs = 800+400+1500 = 2700 So Economic profits = 8500-2700 = 5800 The average cost under this scenario of a penalty @40 per hour will be total explicit cost / 4000= 3500/4000 = $0.875. This average cost concept only includes accounting profits that use explicit costs. NEXT we move to a scenario where penalty is reduced by 50% to 20 per hour. This will affect our variable costs. So we have new calculations below, where accounting profits are now higher at 9500. The economic profits will also change accordingly, as shown below to 6800. The average costs will be total costs / 4000 = 2500/4000 = 0.625 Sunk Costs: As explained these cost are irrecoverable. Before the cut in penalty there are zero sunk costs. This is because all costs incurred are either implicit or explicit. After the cut we have some sunk costs in terms of what both of them used to earn but cant earn now. They were earning $400 each. If penalty rates were @40, they could have gone back and resumed work, making this cost an implicit cost. However as the penalty rate has dipped they no longer have the option of going back and earning 400 each. At best, they can earn @20 per hour, reducing earnings to 200. Thus, implicit cost is now only 200 per person, while sunk costs are also 200 per person. So total sunk costs = @ 200 for each person = 200*2 =400. Elasticity Of Demand: We are told that any number of coffee cups can be sold at $3 each. This makes demand perfectly elastic, as in a perfectly competitive structure. The demand curve for the firm is horizontal at a price of $3. Optionof Expansion Lastly we consider the possibility and rationality of expansion due to lower variable cost. We already know that they are operating at full capacity in a perfectly competitive setting. The lower variable costs lead to higher profits. The decision to expand must be based on MR-MC rule. Assuming they are in equilibrium MR=MC currently. As costs are lowered it cause lower MC, while MR remains at 3. So we have MR MC. This should lead to an expansion as profits can be made by increasing output. They must opt for expansion. Conclusion: Both Adam and Virginia are rational in deciding to set up a coffee shop. This is because the accounting and economic profits are both positive under both sets of penalty rates. This means that after accounting for the opportunity costs of their labour and their own funds, they still end up with a profit. When penalty rates drop they must opt for an expansion as they are likely to make even more profits. References Courseera.org, n.d. MR=MC rule. [Online] Available at: rules-p-mr-mc-the-shutdown-rule" https://www.coursera.org/learn/principles-of-microeconomics/lecture/zKD8R/pricing-and-production-rules-p-mr-mc-the-shutdown-rule [Accessed 2 Sep 2017]. jodiecongirl, n.d. Accounting vs Economic profits. [Online] Available athttps://socratic.org/microeconomics/profit/accounting-versus-economic-profits [Accessed 5 Sep 2017]. Open.lib.umn.edu, n.d. Perfect Comnpetition in the Long run. [Online] Available at: https://open.lib.umn.edu/principleseconomics/chapter/9-3-perfect-competition-in-the-long-run/ [Accessed 5 Sep 2017]. Oregonstate.edu, n.d. Economic profit and Accounting profit. [Online] Available at: https://oregonstate.edu/instruct/econ201/osman/Lec10/tsld018.htm [Accessed 3 Sep 2017]. Pitt.edu, n.d. Cost concepts. [Online] Available athttps://www.pitt.edu/~upjecon/MCG/MICRO/COST/Costs.html [Accessed 2 Sep 2017]. Rittenburg, L. Tregarthen, T., n.d. Principles of Economics V 1.0. [Online] Available athttps://catalog.flatworldknowledge.com/bookhub/22?e=rittenecon-ch02_s03 [Accessed 4 Sep 2017]. Staffwww.fullcoll.edu, n.d. perfect competition. [Online] Available at: https://staffwww.fullcoll.edu/fchan/Micro/4perfect_competition.htm [Accessed 2 August 2017]. Tucker, I., 2008. Survey of Economics. Cengage books.