Question

Suppose Nicholas owns a business making Christmas tree ornaments. Currently, he makes 300 ornaments a month. At this level of production, each additional ornament takes him 30 minutes to make and costs him $5 in materials. Nicholas makes his ornaments in a small studio that he rents for $300 a month. Nicholas can easily increase or decrease the amount of time he spends making ornaments, and he can easily go to the store to buy additional materials to make the ornaments, but he has a year-long lease on his studio, so he has to pay his monthly rent no matter how many ornaments he produces each month. Nicholas values his time at $10 per hour. Other than his time, the cost of the materials and the rent on his studio, Nicholas has no additional production costs.
a At Nicholas's current level of production, what is the marginal cost of making an additional ornament each month?
b. At Nicholas's current level of production, what is the monthly average fixed cost of each ornament?
c. Assuming that it is not Nicholas's interest to shut down, should he change his current monthly level of production if he can sell each ornament for $15? If so, how should his production change?

1. He should not make any changes.
2. He should decrease the number of ornaments he makes each month.
3. He should increase the number of ornaments he makes each month.

d. How would Nicholas’s profit-maximizing level of output each month differ if his monthly rent were $350 instead of $300?

1. His profit-maximizing level of output would be higher.
2. His profit-maximizing level of output would be lower.
3. His profit-maximizing level of output would not change.

e. How would Nicholas’s profit-maximizing level of output each month differ if the materials to make each ornament cost $4 instead of $5?

1. His profit-maximizing level of output would not change.
2. His profit-maximizing level of output would be lower.
3. His profit-maximizing level of output would be higher.

Answer 1

Solution and Explanation:

1. MC = Cost of raw material + Cost of time

MC = 5 plus (10 divide by 2)

MC = $10

2.  TFC = $300

Q = 300 ,  AFC = TFC/Q = 300 divide by 300 = $1

3.  His profit maximizing output would be higher

Reason: P = MR = $15 ,  MC = $10

Since MR > MC, and at the profit maximizing point MR = MC, it is better for Nicholas to increase his output.

4.  His profit maximizing output would be higher

Reason: P = MR = $15 ,  MC = $4 + $5 = $9

Since MR > MC, and at the profit maximizing point MR = MC, it is better for Nicholas to increase his output.