Question

American Widget Corporation, which has a rising short run Marginal Cost curve is currently operating at a loss. \(\mathrm{AWC}^{\prime} \mathrm{s}\) chief economist says that if P rises a little, output should not be increased because, if it were, Marginal Costs would rise and the company would end up with a bigger loss on a higher volume. Should AWC's president listen to the chief economist? Why or why not?

Short answer

In summary, AWC's president should consider the chief economist's advice by comparing the change in price (P) with the change in Marginal Cost (MC). If MC increases more than the slight increase in price, it would not be profitable to increase the output. However, if the rise in price brings it equal to or more than the rise in MC, the president may want to consider increasing the output.

Step-by-step solution

Understanding Marginal Cost

Marginal Cost (MC) can be defined as the change in the total cost that arises when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. In the provided scenario, AWC's Marginal Cost curve is rising, implying that the cost of producing additional units is increasing.

Understanding Price and Output relationship

Basic economic theory suggests that a firm should increase production up to the point where MC equals the price (P), thereby maximizing total profits or in this case, minimizing losses. This is because when the price one can charge for a good is higher than the MC of producing it, there is an opportunity for a profit.

Evaluating the chief economist’s claim

The chief economist of AWC advises against increasing output if price rises slightly. This implies that the economist believes the MC will increase more than the price, leading to a bigger loss. This could only be true if the increase in price is less than the MC of producing the additional units.

Making the final decision

AWC's president should consider the chief economist's advice by comparing the change in price with the change in MC. This requires a detailed understanding of the company's cost structure and the market conditions for their product. If the MC increases more than the slight increase in the price, then it would not be profitable to increase the output, hence, AWC's president should consider the economist's advice. But, if the rise in P brings it equal to or more than the rise in MC, AWC’s president may want to consider increasing the output.

Key concepts

Cost-Output Relationship

In economics, understanding the **cost-output relationship** is crucial for businesses to make informed decisions. The cost-output relationship details how the costs of a firm change when it alters its level of output. It's important to note that, in most cases, producing more units tends to increase the total production cost. However, the relationship is not always linear.
When we talk about marginal cost (MC), we refer to the additional cost incurred by producing one more unit. A rising MC curve indicates that each additional unit costs more to produce. This scenario could be due to various factors like limited capacity, resource scarcity, or inefficiencies at higher production levels. Businesses must evaluate whether increasing output leads to proportionally higher sales revenues.

• Increases in output should ideally match or surpass costs to benefit the firm monetarily.
• A mismatch can result in greater financial losses, especially if additional costs are not covered by additional revenues.

For the American Widget Corporation, if their marginal cost continues to rise, the output increase might not justify the cost, potentially validating the chief economist's concern.

Profit Maximization

Profit maximization is the core objective for most businesses and is achieved by adjusting production levels to gain the highest possible profits. A classic principle is that firms should continue to produce until the marginal cost (MC) of production equals the price (P) at which they can sell their goods. In a profitable scenario, the selling price should be higher than the MC attributable to the last unit produced. Hence, the difference between the price and the MC measures profit per additional unit. However, this may not always be straightforward.

• If MC is rising sharply, as suggested in the case of AWC, the room for profit diminishes every time output is increased.
• If increased output results in a higher MC than the price, the additional units become unprofitable.

The advice from AWC's economist revolves around this principle. It implies careful monitoring of both price changes and MC adjustments to ensure they align for optimal profitability or, at the very least, minimize potential losses.

Economic Decision Making

When it comes to **economic decision making**, particularly in production and cost management, firms weigh multiple factors to arrive at decisions that align with their financial objectives. The underlying objective is to enhance profits or minimize losses. For American Widget Corporation, the decision involves understanding market dynamics, production capabilities, and cost structures.

• Analyzing cost behavior is vital. This includes knowing when costs increase unreasonably when output is expanded.
• Market conditions, such as demand and price changes, significantly affect decision-making processes. An accurate assessment can avoid costly misjudgments.
• Another crucial factor is resource allocation – making sure resources are optimally used to prevent wastage and unnecessary expenses.

AWC’s president must make a decision based on comprehensive data analysis: if a small price increase does not offset rising marginal costs, maintaining current output levels might be wiser. However, if the industry conditions change favorably, resulting in greater demand or price hikes that match cost increases, the company may capitalize on those changes.