For the past nine months, Iliana has been producing artisanal ice creams from he
ID: 1111322 • Letter: F
Question
For the past nine months, Iliana has been producing artisanal ice creams from her small shop in Chicago. She’s just been breaking even (earning zero economic profit) that entire time. This morning, the state Board of Health informed her that it is doubling the annual fee for the dairy license under which she (and other ice cream makers) operates, retroactive to the beginning of her operations.
In the short run, how will this fee increase affect Iliana’s output level? Her profit?
In the long run, how will this fee increase affect Iliana’s output level?
Suppose that instead of doubling the annual fee for a license, the state Board of Health required Iliana (and other ice cream makers) to treat every pint of ice cream to prevent the growth of bacteria. How would this regulation affect Iliana’s production decision and profit in both the short and long run?
Explanation / Answer
(a) Profit is maximized by equating Price (Marginal revenue for a small shop that cannot affect market price) with Marginal cost (MC). The annual fee is a fixed cost, and will not impact the MC, therefore profit-maximizing output will remain unchanged. However, since profit is defined as revenue less variable cost less fixed cost, an increase in fixed cost will lead to a loss in short run, since she was breaking even before doubling of fee.
(b) The short run loss will make some shops to exit the market, which will decrease market supply and increase the demand for individual shops, including Iliana's shop. Her output will increase and she will continue to experience lower loss, until a new long run equilibrium is established where she again earns zero loss, zero profit but at a higher output level.
(c) Treatment of every unit of ice cream will increase the unit variable cost, therefore increasing marginal cost (MC) and average total cost (ATC). As MC increases, the MC curve shifts upward and to the left, lowering profit-maximizing output ceteris paribus in short run. This will lead to a short run loss. Iliana may decide to continue operations if price is higher than her average variable cost or shut down otherwise. In the long run, the short run loss will make some shops to exit the market, which will decrease market supply and increase the demand for individual shops, including Iliana's shop. Her output will increase and she will continue to experience lower loss, until a new long run equilibrium is established where she again earns zero loss, zero profit but at a higher output level.