Question

Sara is a dot.com entrepreneur who has established a Web site at which people can design and buy sweatshirts. Sara pays \(\$ 1,000\) a week for her Web server and Internet connection. The sweatshirts that her customers design are made to order by another firm, and Sara pays this firm \(\$ 20\) a sweatshirt. Sara has no other costs. The table sets out the demand schedule for Sara's sweatshirts. $$\begin{array}{cc} \begin{array}{c} \text { Price } \\ \text { [dollars per sweatshirt/ } \end{array} & \begin{array}{c} \text { Quantity demanded } \\ \text { (sweatshirts per week) } \end{array} \\ \hline 0 & 100 \\ 20 & 80 \\ 40 & 60 \\ 60 & 40 \\ 80 & 20 \\ 100 & 0 \end{array}$$ a. Do you expect other firms to enter the Web sweatshirt business and compete with Sara? b. What happens to the demand for Sara's sweatshirts in the long run? What happens to Sara's economic profit in the long run?

Short answer

No other firms will enter the market, and Sara will make no economic profit in the long run.

Step-by-step solution

Understand the Cost Structure

Sara has a fixed cost of \( \$ 1,000 \) per week for her Web server and Internet connection. Additionally, she pays \( \$ 20 \) per sweatshirt to another firm for making the sweatshirts.

Identify the Revenue and Profit at Different Prices

Calculate the total revenue and total cost at different prices and quantities. For example, at a price of \( \$ 20 \): - Quantity demanded = 80 sweatshirts- Total revenue = Price \( \times \) Quantity = \( 20 \times 80 = \$ 1,600 \)- Total cost = Fixed Cost + Variable Cost = \( 1,000 + (20 \times 80) = \$ 2,600 \)- Profit = Total revenue - Total cost = \( 1,600 - 2,600 = -\$ 1,000 \)Repeat similar calculations for other price points.

Analyze Market Entry

Since at all price points Sara is either making a loss or breaking even, other firms are unlikely to enter the market because there is no economic profit to be gained.

Long-Run Demand and Profit

In the long run, if no other firm enters the market, the demand for Sara's sweatshirts will remain stable. Her economic profit will remain zero, as she's only able to cover her costs.

Key concepts

fixed costs

In economics, fixed costs are expenses that do not change with the level of production or sales. For instance, Sara pays \(\$1,000\) each week for her Web server and Internet connection. This cost stays the same regardless of how many sweatshirts she sells.
This means whether she sells zero or 100 sweatshirts in a week, the amount she spends on her server and Internet connection remains \(\$1,000\). Fixed costs are essential because they represent a base level of spending that the business cannot avoid.
Understanding fixed costs is crucial for calculating overall expenses and setting prices to cover these costs, along with other variable costs and profit.
Examples of fixed costs include:

• Rent
• Salaries of permanent employees
• Insurance
• Depreciation of physical assets

variable costs

Variable costs are expenses that change directly with the level of production or sales volume. For Sara, the variable cost is \(\$20\) per sweatshirt she needs to pay to another firm that makes the sweatshirts.
This means if Sara sells more sweatshirts, her total variable costs increase linearly. Conversely, if she sells fewer sweatshirts, her variable costs decrease. Knowing variable costs is crucial for businesses since it helps in planning and analyzing how changes in sales affect total costs and profitability.
Formula for calculating total variable costs: Variable Cost per unit \times\ Number of units produced. In Sara's case, if she sells 80 sweatshirts, her total variable cost would be:
\(\$20 \times\ 80 = \$1,600\).
These costs include items like:

• Raw materials
• Commissions
• Utilities (portion used in production)
• Shipping and packaging

economic profit

Economic profit considers both explicit costs and implicit costs. Explicit costs are direct, out-of-pocket payments, while implicit costs represent the opportunity costs of using resources in their next-best alternative use.
For Sara, calculating economic profit involves subtracting both her fixed and variable costs from her total revenue. For example, at a price of \(\$20\), the quantity demanded is 80, and her total revenue would be \(20 \times\ 80 = \$1,600\).
To find her profit:
\(\text{Total cost} = \text{Fixed Cost} + \text{Variable Cost} = \$1,000 + (20 \times\ 80) = \$2,600\)
\(\text{Profit} = \text{Total revenue} - \text{Total cost} = \$1,600 - \$2,600 = -\$1,000\)
In this case, Sara is facing a loss. Understanding economic profit is essential because it reflects the real profitability by considering all costs involved.

demand schedule

The demand schedule is a table that shows the quantity demanded of a good at various price levels. For Sara, the demand schedule helps in understanding how many sweatshirts will be sold at different price points.
A typical demand schedule looks like this:

• \(\$0\) per sweatshirt – Quantity demanded: 100
• \(\$20\) per sweatshirt – Quantity demanded: 80
• \(\$40\) per sweatshirt – Quantity demanded: 60
• \(\$60\) per sweatshirt – Quantity demanded: 40
• \(\$80\) per sweatshirt – Quantity demanded: 20
• \(\$100\) per sweatshirt – Quantity demanded: 0

Understanding the demand schedule is critical because it helps Sara predict how changes in price will affect sales volume.
This, in turn, allows her to set prices that maximize profit or achieve other business objectives. For example, she might decide to lower the price to \(\$20\) if she wants to increase sales, knowing she can expect to sell about 80 sweatshirts at that price.