Tag: Variable cost

Solved Problem: When to Close a Sandwich Shop

Supports: Microeconomics and Economics, Chapter 12, and Essentials of Economics, Chapter 9.

Photo from the Wall Street Journal.

A recent article in the Los Angeles Times discussed the problems faced by the owners of a sandwich shop in the Chinatown neighborhood of Los Angeles.  The owners had closed the shop and then decided to reopen it. The article quoted one of the owners as saying: “After closing [the shop] we realized we still have our lease, we still have our loans from the [federal government’s Small Business Association], from COVID, the bills are still coming in. We can’t even afford to close. We can’t afford to be open, we can’t afford to be closed.”

a. What does the owner of the sandwich shop mean by saying they can’t afford to be open but they also can’t afford to be closed? Answer by explaining what the likely relationship is between the revenue the owners were earning from the shop and the shop’s fixed, variable, and total costs . 

b. Are the owners likely to keep the sandwich shop open in the long run? Briefly explain.

Solving the Problem

Step 1: Review the chapter material. This problem is about when a firm should decide to shut down in the short run, so you may want to review the section “Deciding Whether to Produce or to Shut Down in the Shortrun” in Microeconomics (and Economics), Chapter 12, Section 12.4, (Essentials of Economics, Chapter 9, Section 9.4).

Step 2: Answer part a. by explaining what the sandwich shop’s owner meant by her statement, using the likely relationship between the shop’s revenue and its fixed, variable, and total cost in your explanation. That the owner states that “we can’t afford to be open” indicates that the firm is incurring a loss, so the revenue from the shop is less than the toal cost of operating it. But after closing the shop, the owners reopened it because “we can’t afford to be closed.” That statement indicates that the owners will incur a smaller loss by operating the shop than by keeping it closed. If the shop is closed, the owners still have to pay the shop’s fixed costs, such as the rent on the shop and the payments the owners must make on loans. We can infer that the loss from remaining open is less than the loss from being closed. In that situation, the shop’s revenue must be enough to cover the variable cost of operating it, although not enough to cover the total cost.

Step 3: Answer part b. by explaining whether the owners are likely to keep the sandwich shop open in the long run. By definition, in the long run, the owners will no longer have any fixed costs because the period of its lease will have ended and it will have paid off its loans—or possibly defaulted on them. If the revenue from operating the shop remains less than the total cost of operating it in the long run, the owners will permanenly close the shop.

The Effect on a Firm’s Costs of Using a Generative AI Program

Supports: Microeconomics, Chapter 11, Section 11.5; Economics, Chapter 11, Section 11.5; and Essentials of Economics, Chapter 8, Section 8.5

Photo from the Wall Street Journal.

Imani owns a firm that sells payroll services to companies in the Atlanta area. Her largest cost is for labor. She employs workers who use software to prepare payroll reports and to handle texts and calls from client firms. She decides to begin using a generative AI program, like ChatGPT, which is capable of quickly composing thorough answers to many questions and write computer code. She will use the program to write the additional computer code needed to adapt the payroll software to individual client’s needs and to respond to clients seeking advice on payroll questions. Once the AI program is in place, she will need only half as many workers. The number of additional workers she needs to hire for every 20 additional firms that buy her service will fall from 5 to 1. She will have to pay a flat monthly licensing fee for the AI program; the fee will not change with the number of firms she sells her services to. Imani determines that making these changes will reduce her total cost of providing services to her current 2,000 clients from $2,000,000 per month to $1,600,000 per month

In answering the following questions, assume that, apart from the number of workers, none of the other inputs—such as the size of her firm’s office, the number of computers, or other software—change as a result of her leasing the AI program.

a. Briefly explain whether each of the following statements about the cost situation at Imani’s firm after she begins using the AI program is correct or incorrect.

  1. Her firm’s average total cost, average variable cost, and average fixed cost curves will shift down, while her firm’s marginal cost curve will shift up.
  2. Her firm’s average total cost, average variable cost, average fixed cost and marginal cost curves will all shift up.
  3. Her firm’s average total cost, average variable cost, and marginal cost curves will shift down, while her average fixed cost curve will shift up.
  4. Her firm’s average total cost, average variable cost, average fixed cost, and marginal cost curves will all shift down.
  5. Her firm’s average fixed cost curve will shift up, but her other cost curves will be unchanged.

b. Draw a graph illustrating your answer to part a. Be sure to show the original average total cost, average variable cost, average fixed cost, and marginal cost curves. Also show the shifts—if any—in the curves after Imani begins using the AI program.

Solving the Problem

Step 1:  Review the chapter material. This problem requires you to understand definitions of costs, so you may want to review the sections “The Difference between Fixed Costs and Variable Costs,” “Marginal Costs,” and “Graphing Cost Curves”

Step 2:  Answer part (a) by explaining whether each of the five listed statements is correct or incorrect. The cost of the AI program is fixed because it doesn’t change with the quantity of her services that Imani sells. Her firm will have greater fixed costs after licensing the AI program but she will have lower variable costs because she is able to produce the same level of output with fewer workers. Her marginal cost will also decline because she needs to hire fewer workers as the quantity of services she sells increases. We know that the average total cost per month of providing her service to 2,000 clients has decreased because we are given the information that it changed from ($2,000,000/2,000) = $1,000 to ($1,600,000/2,000) = $800.

  1. This statement is incorrect because her average fixed cost curve will shift up as a result of her total fixed cost having increased by the amount of the AI program license and because her marginal cost curve will shift down, not up.
  2. This statement is incorrect because all of her cost curves, except for average fixed cost, will shift down, not up.
  3. This statement is correct because it describes the actual shifts in her cost curves. 
  4. This statement is incorrect because her average fixed cost curve will shift up, not down.
  5. This statement is incorrect because her rather than being unaffected, her average total cost, average variable cost, and marginal cost curves will shift down.

Step 3:  Answer part (b) by drawing the cost curves for Imani’s firm before and after she begins using the AI program. Your graph should look like the following, where the curves representing the firm’s costs before Imani begins leasing the AI program are in blue and the costs after leasing the program are in red.