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Bus 640 - Managerial Economics - Applied Problems

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Week 5 Applied Problems

Kenneth L. Mowery

BUS640: Managerial Economics

Magdalena Cutler

October 1, 2012

Week 5 Applied Problems

Chapter 11, Applied Problem #8:

Suppose you own a home remodeling company. You are currently earning short-run profits. The home remodeling industry is an increasing-cost industry. In the long run, what do you expect will happen to

a. Your firm's costs of production? Explain

"In the short run, the manager's production decisions are limited because some of the inputs used by the firm are fixed for the short-run period of production" (Thomas & Maurice, 2011, p. 418). Now, in the long, since the inputs are variable, the company can use any size building and any amount of capital to increase or maximize the profits. In the long run the company can decide the size of the production facility. The firm's costs of production will probably rise due to the fact that it is trying to maximize its profits. The company is entering a competitive market and needs to make a profit, so we will look at our long run average and marginal costs, along with the elasticity of demand.

b. The price you can charge for your remodeling services? Why?

Since the remodeling company is in a competitive market, it must be careful on the price that it charges for its services. The company does not want to go too low on the price as this will not maximize their profits and it does not want to go too high because there are other remodeling companies that are able to do the same work and the company's profits would drop.

"For a competitive firm, the marginal revenue from the additional production of an input is equal to the price of the product [or service in this case], which is marginal revenue for a perfectly competitive firm, times the marginal product of the input" (Thomas & Maurice, 2011, p.430). So, let's say the remodeling company has a marginal product of 50 and the price at which the product or service can be sold is $25, the marginal revenue product for that unit is $1,250 (= P X MP = $25 X 50). So, if the remodeling company hires another unit of labor it will add 50 extra units of output that can be sold for $25 and will add to the total revenue that is attributable to hiring this extra unit of labor, $1,250. In this way we can determine how much to charge for our services.

c. Profits in home remodeling? Why?

Our remodeling company's capital, since we are in the long-run, is not fixed. The entry of new firms is possible and the "industry's response to an increase in price takes on a new dimension" (Thomas & Maurice, 2011, p. 421). The supply adjustment to this change in price is not, as Thomas and Maurice put it, "complete until entry or exit results in zero economic profit" (2011, p.421). Since we are expanding in an increasing-cost industry, our prices for inputs may rise. As the company increases or expands the output, resource prices rise, causing the long-run average cost to shift upward (Thomas & Maurice, 2011, p. 425). I believe that the remodeling company's profits will rise in the long-run.

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