Katja’s Danish Bread: Exercises in Price, Demand, Cost, and Capacity

Through this series of increasingly more sophisticated exercises authored by Aradhna Krishna, students gain a deep understanding of the strong connection between price, demand, variable cost, and capacity. In their efforts to help Katja maximize profit in her bread-making venture, students will learn the concepts of sunk fixed cost, incremental fixed cost, and variable cost. They will discover how a profit-maximizing price depends on all three factors of demand, variable cost and capacity, and how they all interrelate. For example, students learn that fixed cost is important because it affects capacity decisions and hence also entry/exit decisions. However, given a preexisting capacity, fixed cost does not affect the pricing decision. Students also learn how price can be used strategically to avoid increasing capacity. This exercise series is presented in five short parts (Katja’s Danish Bread Exercises A-E). Exercise A is given to students to prepare before class, and Exercises B-E are read in class and done sequentially during class.

• Define incremental fixed cost.
• Describe the strong connection between price, demand, variable cost, and capacity.
• Articulate how a profit-maximizing price depends on all three: demand, variable cost and capacity.