Economic Analysis - Questions and Answer

Economic Analysis – Questions and Answer

1. Which of the following is included in the opportunity cost of taking this exam, and why; Tuition fee? Study time? Sleep?

Since the requirement is to know the opportunity cost of taking an exam; first we must identify the meaning of the word opportunity cost. Opportunity cost is the cost of choosing a certain alternative over the sets of choices of alternative courses. Since taking exam will incur time therefore all possible opportunity cost must have been related to spending time. In the choices the opportunity cost are Study time and sleep because in taking an exam the time to spend on studying was foregone as well as well as the opportunity and benefit of sleeping. Both the time of studying and the benefit of sleeping was trade-off the time in taking the final exam. In economics opportunity cost is very important aspect in analysis because economics involves decision making in taking the best alternative courses of action and by this way every decision maker can maximize the use of its resources.

2. Suppose that Bamboo Craft Production, Inc, ( BCPI ) develops a revolutionary new process lowering the cost producing their signature product, bamboo chandelier. Use the short run and the long run cost/revenue diagram to show how BCPI’s output would be affected in the short run and the long run, assuming that rivals do not learn about the new process. (You should assume that the bamboo chandelier industry is perfectly competitive.) What will happen to the market price, quantity sold, and BPCI’s profits? How will this change when rivals find out about and adopt the new process?

- The Short Run and Long run cost diagram of BCPI

The graph shows that Bamboo Craft Production, Inc the average cost in the short run and in the long run. Assuming that BCPI had develop a revolutionary new process that lowers the production cost in the short run, the shape of the average total cost curve (ATC) is U-shaped. The, short run average cost curve falls in the beginning, reaches a minimum and then begins to rise. The reasons for the average cost to fall in the beginning of production are that the fixed factors of a firm remain the same. The change only takes place in the variable factors such as raw material, labor, etc. As the fixed cost gets distributed over the output as production is expanded, the average cost, therefore, begins to fall. When a firm fully utilizes its scale of operation or so called the economies of scale this is due to development of the new process , the average cost is then at its minimum and the firm is then operating to its optimum capacity. If a firm in the short-run increases its level of output with the same fixed plant; the economies of that scale of production change into diseconomies and the average cost then begins to rise sharply.

However as illustrated in BCPI diagram the long run shows that all costs of a firm are variable. The factors of production can be used in varying proportions to deal with an increased output. The firm having time-period long enough can build larger scale or type of plant to produce the anticipated output. The shape of the long run average cost curve is also U-shaped but is flatter that the short run curve.

- BCPI Revenue Curve

BCPI revenue diagram shows that total revenue (TR), is the total flow of income to a firm from selling a given quantity of output at a given price, less tax going to the government. The value of TR is found by multiplying price of the product by the quantity sold. Initially, upon development of the company’s new revolutionary process there is less competition in a given market and is likely to lead to higher market prices and the possibility of higher super-normal profits by then the output increases and total revenue (TR) also increases, but at a decreasing rate. If It eventually reaches a maximum and then decreases with further output at the moment when the rivals has discover the same process development. However, as output increases the average revenue (AR) curve slopes downwards. The AR curve is also the firm’s demand curve. Average revenue is revenue per unit, and is found by dividing TR by the quantity sold, Q. AR is equivalent to the price of the product, where P x Q/Q = P, hence AR is also price. The marginal revenue on the other hand (MR) curve also slopes downwards, but at twice the rate of AR. This means that when MR is 0, TR will be at its maximum. Increases in output beyond the point where MR = 0 will lead to a negative MR. Marginal revenue (MR) is the revenue generated from selling one extra unit of a good or service. It can be found by finding the change in TR following an increase in output of one unit. MR can be both positive and negative.

3. How will and increase in consumer’s income affect budget constraint? How will it affect optimal consumption of the two goods, say car and gasoline?

As consumers Income increases consumer’s purchasing power also increases and with regards to the budget constraint since it is the limit on the consumption bundles that a consumer can afford. The consumer would like to end up on the highest possible indifference curve, but he must also stay within his budget. The highest indifference curve that the consumer can reach is the one that is tangent to the budget constraint. The point where they touch is called the optimum. At this point, the marginal rate of substitution is equal to the relative price of the two goods. A change in income shifts the budget constraint. Since that Normal Good is a good for which an increase in income raises the quantity demanded and Inferior Good is a good for which an increase in income reduces the quantity demanded. In the case of car and gasoline since the gasoline is a complementary goods of car then we can say that the effect of an increase in consumers income on the consumption of both car and gasoline is an increasing rate. Because the consumer can now afford to buy car so as the consumption of the gasoline will increase however if the question is the effect on the substitute goods then the answer will be a different.

4. What is the difference between a fixed and a variable factor of production? Is a labor always a variable factor? Is capital always a fixed factor? Explain.

The difference between fixed and variable factor of production is made in the short run production time period. The short run is a time period where at least one factor of production is in fixed supply. We usually assume that the quantity of capital inputs is fixed and