Thursday, April 17, 2014

Sriracha Sauces loss is my gain. Nice example to show how a potential change in fixed costs and variable costs affect a firm.

Sriracha sauce maker considers relocation

The makers of the most popular Sriracha sauce (Huy Fong Foods) is facing a dilemma.  A by-product of producing the sauce is an awful smell that permeates the air in the City of Irwindale, California where the manufacturing facility is located.  Area residents don't like it and want something done about it.

The city wants the company to install air-scrubbing technology.  Apparently this is very expensive to do and the company is resisting.

I suppose if the company refuses it can be fined, better yet for our analysis, a "per unit tax" could be levied on each bottle produced.

So, the firm faces the possibility of having to incur a large up front "fixed cost" of installing the equipment or face a small-ish "per unit tax" variable cost on each of the bottles it produces.

Which is better for the firm?

Let's see how this affects the firm in context of how we study it in AP Microeconomics.

I presume Hoy Fung Foods in one of several competitors in the market for Hot Sauce.  As such, I will classify it as operating as a "Monopolistic Competitor".

Here is what the firm graph would look like assuming Hoy Fung Foods is making "Economic Profits" and operating as it has been.

Installing the equipment would be a "fixed cost" for the company.  It is a cost that is incurred regardless of how many bottles of the hot sauce are produced and the cost is spread out over an all the additional bottles produced.  

This affects the AVERAGE TOTAL COST ("ATC*) of producing ONLY and NOT the Marginal Cost ("MC*) of producing each bottle.

This will SHIFT the ATC curve "ATC*" UP to "ATC 1".  The profit maximizing quantity at MR=MC stays the same  at Point "A" (read that again!).   What does change is the firms Economic Profit. 

Where I shifted the "ATC 1" curve, it assumes that it is at "Break Even" (in Economic terms, not Accounting terms) at Point "B".

So, Hoy Fung Foods is breaking even and still producing the same amount of product at Qe and at the same Price consumers are willing and able to pay at "Pe".  Status quo, except for profits!!

What if instead a per unit tax is assessed on each bottle of hot sauce. That would be a small dollar amount for Hoy Fung to absorb, so it MUST be better....right?

A per unit tax affects BOTH the ATC and the Marginal Cost (MC) of producing.  The tax applies to each unit and increases the cost of producing each unit by the amount of the tax. This will shift the ATC curve and the MC curve together.  The MC curve will shift to the LEFT to "MC 1"(or some say "up").

It is kinda hard to see with all the curves, but notice our "Profit Maximizing Quantity" at MR = MC is now at a different spot---Point "A" at "Q1".  Because MC shifted it will intersect Marginal Revenue (MR) at a different spot along the MR curve.  THIS IS KEY!!

Let me clean up the graph above for you.  See below. As a result you can see that the PRICE consumers pay is higher than it was ("P1") and the quantity sold is less too.

BUT is gets worse for the firm.  Notice now that the ATC of producing Q1 bottles of hot sauce is now GREATER than the Price received from consumers (ATC 1 more than P1).  The firm is now incurring Economic LOSSES equal to the area "P1-"C"-"D"- P1".

In this simple analysis holding LOTS of variables constant, we can see that Hoy Fung Foods should probably install the equipment to avoid a per unit tax.  It appears it will be the best outcome for the firm.

While this example might not completely reflect the real time situation, I hope it helps you understand the different way a fixed cost and a variable cost (per unit tax) affects a firm.

This is a must-know concept for the AP Micro test!!

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