You are the chief financial officer for a firm that sells digital music players.

Question

You are the chief financial officer for a firm that sells digital music players. Your firm has the following average-total-cost schedule: Your current level of production is 600 devices, all of which have been sold. Someone calls, desperate to buy one of your music players. The caller offers you $550 for it. Should you accept the offer? Why or why not?

Explanation / Answer

This question is all about the difference between average total cost and marginal cost. Your firm is Profit seeking. Thus, if the caller is willing to pay more fora a music player than the MARGINAL cost of producing an additional music player, you should accept the offer. The caller is willing to pay $550 for it, but how much does it cost to produce? We see that to produce 600 players it costs your firm $180,000. ( 600 players at an average total cost of $300 dollars)- (600)x(300)=180,000 However, to produce 601 players it costs your firm $180,901. ( 601 players at an average total cost of $301 dollars)- (601)x(301)=180,901 Therefore, the marginal cost of producing one extra player is $901. (180,901-180,000)=901 Since $901>$550 you should reject the offer. (I know it can be tricky, $550 is still far greater than the average cost of $301, but that is irrelevant. Since it is less than the marginal cost of 901 you must reject the offer)

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