Check Your Understanding

1. Question

   The accompanying table shows three possible combinations of fixed cost and average variable cost. For each choice, average variable cost is constant (it does not vary with the quantity of output produced).

   Choice	Fixed cost	Average variable cost
   1	$8,000	$1.00
   2	12,000	0.75
   3	24,000	0.25

   1. For each of the three choices, calculate the average total cost of producing 12,000, 22,000, and 30,000 units. For each of these quantities, which choice results in the lowest average total cost?

      The accompanying table shows the average total cost of producing 12,000, 22,000, and 30,000 units for each of the three choices of fixed cost. For example, if the firm makes Choice 1, the total cost of producing 12,000 units of output is $8,000 + 12,000 × $1.00 = $20,000. The average total cost of producing 12,000 units of output is therefore $20,000/12,000 = $1.67. The other average total costs are calculated similarly.

      	12,000 units	22,000 units	30,000 units
      Average total cost from Choice 1	$1.67	$1.36	$1.27
      Average total cost from Choice 2	1.75	1.30	1.15
      Average total cost from Choice 3	2.25	1.34	1.05

      Thus, if the firm wanted to produce 12,000 units, it would make Choice 1 because this gives the firm the lowest average total cost. If it wanted to produce 22,000 units, it would make Choice 2. If it wanted to produce 30,000 units, it would make Choice 3.

   2. Suppose that the firm, which has historically produced 12,000 units, experiences a sharp, permanent increase in demand that leads it to produce 22,000 units. Explain how its average total cost will change in the short run and in the long run.

      Having historically produced 12,000 units, the firm would have adopted Choice 1. When producing 12,000 units, the firm would have had an average total cost of $1.67. When output jumps to 22,000 units, the firm cannot alter its choice of fixed cost in the short run, so its average total cost in the short run will be $1.36. In the long run, however, it will adopt Choice 2, making its average total cost fall to $1.30.

   3. Explain what the firm should do instead if it believes the change in demand is temporary.

      If the firm believes that the increase in demand is temporary, it should not alter its fixed cost from Choice 1 because Choice 2 generates higher average total cost as soon as output falls back to its original quantity of 12,000 units: $1.75 versus $1.67.

2. Question

   In each of the following cases, explain whether the firm is likely to experience economies of scale or diseconomies of scale and why.

   1. an interior design firm in which design projects are based on the expertise of the firm’s owner

      This firm is likely to experience diseconomies of scale. As the firm takes on more projects, the costs of communication and coordination required to implement the expertise of the firm’s owner are likely to increase.

   2. a diamond-mining company

      This firm is likely to experience economies of scale. Because diamond mining requires a large initial setup cost for excavation equipment, long-run average total cost will fall as output increases.