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Chapter 6
Cost Analysis
out, other government programs, once begun, seem to have lives of their own.
CHECK STATION 2
A firm spent $10 million to develop a product for market. In the product’s first two years, its profit was $6 million. Recently, there has been an influx of comparable products offered by competitors (imitators in the firm’s view). Now the firm is reassessing the product. If it drops the product, it can recover $2 million of its original investment by selling its production facility. If it continues to produce the product, its estimated revenues for successive two-year periods will be $5 million and $3 million and its costs will be $4 million and $2.5 million. (After four years, the profit potential of the product will be exhausted, and the plant will have zero resale value.) What is the firm’s best course of action?
Profit Maximization with Limited Capacity: Ordering a Best Seller The notion of opportunity cost is essential for optimal decisions when a firm’s multiple activities compete for its limited capacity. Consider the manager of a bookstore who must decide how many copies of a new best seller to order. Based on past experience, the manager believes she can accurately predict potential sales. Suppose the best seller’s estimated price equation is P 24 Q, where P is the price in dollars and Q is quantity in hundreds of copies sold per month. The bookstore buys directly from the publisher, which charges $12 per copy. Let’s consider the following three questions: 1. How many copies should the manager order, and what price should she charge? (There is plenty of unused shelf space to stock the best seller.) 2. Now suppose shelf space is severely limited and stocking the best seller will take shelf space away from other books. The manager estimates that there is a $4 profit on the sale of a book stocked. (The best seller will take up the same shelf space as the typical book.) Now what are the optimal price and order quantity? 3. After receiving the order in Question 2, the manager is disappointed to find that sales of the best seller are considerably lower than predicted. Actual demand is P 18 2Q. The manager is now considering returning some or all of the copies to the publisher, who is obligated to refund $6 for each copy returned. How many copies should be returned (if any), and how many should be sold and at what price? As always, we can apply marginal analysis to determine the manager’s optimal course of action, provided we use the “right” measure of costs. In
