6. An outside firm can make components according to the cost function TC=1m + 10
ID: 1191704 • Letter: 6
Question
6. An outside firm can make components according to the cost function TC=1m + 10Q. Suppose it typically produces 10m units.
(a) What is this firm’s cost per unit? Suppose that your firm is able to buy components at this cost per unit. If you order 1m units from this outside firm, what is your total cost of components?
(b) Suppose you can produce the component yourself with the same total cost function; TC=1m + 10Q. How much do the 1m components cost?
(c) If the transactions cost of dealing with an independent firm is .8m and the internal cost of managing your own component division is .2m, is it more profitable to outsource?
7. (a) Answer the same questions as in the previous problem if TC = .5m + 10Q.
(b) In which problem are economies of scale more important? Explain how this affects your outsourcing decision.
Explanation / Answer
a) TC/unit = (1m + 10Q)/Q = (1m + 10* 10 m) /10m = 10.10 /unit
If the firm 1m unit from outside at 1.1 and rest (i.e. 9 m ) it produces so the total cost will be = ( 1m +10*9) +1.10
= 91 +10.10 = 101.10
b) TC = 1+ (10 * 10 )= 101
TC/unit = 101/10 = 10.10/unit
c) If the transaction cost of dealing is .8 and internal cost is .2
TC if manufactures = 1 (.8+.2) +(10*10) = 101
TC if outsource = TC of manufacting + Internal cost of managing = 101 + .2 = 101.2
It is profitable to produce rather than outsourcing as TC is less while producing.
TC/unit = (1m + 10Q)/Q = (1m + 10* 10 m) /10m = 10.10 /unit
If the firm 1m unit from outside at 1.1 and rest (i.e. 9 m ) it produces so the total cost will be = ( 1m +10*9) +1.10
= 91 +10.10 = 101.10
b) TC = 1+ (10 * 10 )= 101
TC/unit = 101/10 = 10.10/unit
c) If the transaction cost of dealing is .8 and internal cost is .2
TC if manufactures = 1 (.8+.2) +(10*10) = 101
TC if outsource = TC of manufacting + Internal cost of managing = 101 + .2 = 101.2
It is profitable to produce rather than outsourcing as TC is less while producing.
7 ) A)
TC/unit = (.5+ 10Q)/Q = (.5m + 10* 10 m) /10m = 10.05 /unit
If the firm gets 1m unit from outside at 10.05 and rest (i.e. 9 m ) it produces so the total cost will be = ( .5m +10*9) +10.05
= 90.5 +10.05 = 100.55
TC = .5+ (10 * 10 )= 100.5
TC/unit = 100.5/10 = 10.05/unit
7 ) Economies of scale is there when the cost reduces if you produce more. If the firm outsource partly then the cost will be more as Fixed cost will be more per unit and therefore the cost will be increased. And if it fully outsources then still it'll have to .2 fixed cost. So it is better to produce rather than outsourcing
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