TASC Economics Level 3: The Bakery's Second Oven

The Bakery's Second Oven

A small bakery currently produces 400 loaves a day with one oven and four bakers. Fixed costs (rent, oven lease, insurance) are $600 per day; each baker costs $150 per day; ingredients run $0.80 per loaf. Adding a second oven would raise fixed costs to $900 per day but let the bakery produce up to 900 loaves with the same four bakers. The owner estimates that at $3.00 per loaf, the local market will absorb 700 loaves daily; beyond that, price would have to fall to $2.40 to sell 900. A supermarket chain has offered a standing contract for 300 loaves daily at $2.10, which would use spare capacity but is priced below the current average total cost at 400 loaves.

1. Compute average total cost at 400 and at 700 loaves with the second oven, and decide whether the second oven is justified on cost grounds alone.

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Current operation (400 loaves, one oven):

Fixed: $600
Labor: 4 × $150 = $600
Ingredients: 400 × $0.80 = $320
Total: $1,520 → ATC = $1,520 / 400 = $3.80 per loaf

With second oven at 700 loaves:

Fixed: $900
Labor: $600
Ingredients: 700 × $0.80 = $560
Total: $2,060 → ATC = $2,060 / 700 = $2.94 per loaf

So the second oven lowers ATC by about $0.86 per loaf, mainly by spreading the larger fixed cost over far more output. That is the spreading effect of fixed costs - the classic source of economies of scale here.

But lower ATC alone does not justify the investment. At $3.00, 700 loaves yield revenue of $2,100 against cost of $2,060 - a thin margin of $40/day. The oven is justified only if the owner is confident demand holds near 700 at $3.00. If demand is weaker, the higher fixed cost becomes a burden: at 400 loaves with the second oven, ATC would be ($900 + $600 + $320)/400 = $4.55, worse than today. The decision is a bet on volume, not on cost per se.

2. Should the bakery accept the supermarket contract at $2.10? Analyze using marginal reasoning and identify the conditions under which your answer changes.

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The relevant comparison is price versus marginal cost, not price versus ATC. Once fixed costs are sunk, they do not change with the contract.

Marginal cost per loaf is ingredients only ($0.80) plus any incremental labor. With spare capacity and the same four bakers, incremental labor is zero, so MC ≈ $0.80. At $2.10, each contract loaf contributes $1.30 toward fixed costs. For 300 loaves that is $390 per day of contribution - substantial.

So on marginal reasoning the contract should be accepted if the capacity is genuinely spare and does not displace higher-priced retail sales. The condition matters: if filling the contract forces the bakery to turn away $3.00 customers, the relevant comparison becomes the forgone margin ($3.00 − $0.80 = $2.20) against the contract margin ($1.30), and the contract loses.