In-Class Review Problems

Problem #1 Hiro owns and operates a small business that provides economic consulting services. During the year he spends $55,000 on traveling to clients and other expenses, and the computer that he owns depreciates by $2,000. If he didn’t use the computer, he could sell it and earn yearly interest of $100 on the money created through this sale. Hiro’s total revenue for the year is $100,000. Instead of working as a consultant for the year, he could teach economics at a small local college and make a salary of $50,000.

Questions to Answer What is Hiro’s accounting profit? What is Hiro’s economic profit? Should Hiro continue working as a consultant, or should he teach economics instead?

Answer to Question #1-1 55,000 (Travel/other expenses) $ 100,000 (Total Revenue) 55,000 (Travel/other expenses) 2,000 (depreciation) ______________ $ 43,000 (Accounting Profit)

Answer to Question #1 Pts2 & 3 $ 43,000 (Accounting Profit) 50,000 (Salary as Econ Prof foregone) 100 (interest foregone) ______________ $ -7,100 (Economic Profit) ******************************************************** Economically speaking, Hiro would be better off not being in business for himself and taking the Econ teaching job!!

Problem #2 Suppose you have just paid a nonrefundable fee of $1,000 for your meal plan for your first semester at college. This allows you to eat dinner in the cafeteria every evening.

Question to Answer You are offered a part-time job in a restaurant where you can eat for free each evening. Your parents say that you should eat dinner in the cafeteria anyway, since you have already paid for those meals. Are your parents right? Explain why or why not.

Answer to Question #1 Your parents are wrong. The $1000 is a SUNK COST, which should not be considered in the present decision. Since both the school cafeteria and the restaurant meals are free, you should be deciding where you eat based on other perceived benefits (taste, convenience, etc.) rather than price.

Question to Answer You are offered a part-time job in a different restaurant where, rather than being able to eat for free, you receive only a large discount on your meals. Each meal there will cost you $2; if you eat there each evening this semester, it will add up to $200. Your roommate says that you should eat in the restaurant since it costs less than the $1,000 that you paid for the meal plan. Is your roommate right? Explain why or why not.

Answer to Question #2 Your roommate is wrong. The SUNK COST of the meal plan is immaterial now. You should decide where to eat based on the benefit and cost of the restaurant meal vs. the benefit of the cafeteria meal. If you decide to eat the restaurant meal, it would be because the benefit of it (however you are measuring that benefit) is greater than the $2 you would pay for it.

Problem #4 Marty’s Frozen Yogurt is a small shop that sells cups of frozen yogurt in a university town. Marty owns three frozenyogurt machines. His other inputs are refrigerators, frozenyogurt mix, cups, sprinkle toppings, and, of course, workers. He estimates that his daily production function when he varies the number of workers employed (and at the same time, of course, yogurt mix, cups, and so on) is as shown in the accompanying table.

Marty’s Production Table

Questions to Answer What are the fixed inputs and variable inputs in the production of cups of frozen yogurt?

Draw the total product curve Draw the total product curve. Put the quantity of labor on the horizontal axis and the quantity of frozen yogurt on the vertical axis. What is the marginal product of the first worker? The second worker? The third worker? Why does marginal product decline as the number of workers increases?

Answer to Question #4—1 The fixed inputs are those whose quantities do not change as the quantity of output changes: frozen-yogurt machines, refrigerators, and the shop. The variable inputs are those whose quantities do change as the quantity of output changes: frozen-yogurt mix, cups, sprinkle toppings, and workers.

Answer to Question #4—2

Answer to Question #4—3 The marginal product, MPL, of the first worker is 110 cups. The MPL of the second worker is 90 cups. The MPL of the third worker is 70 cups. The MPL declines as more and more workers are added due to the principle of diminishing returns to labor. Since the number of frozen-yogurt machines is fixed, as workers are added there are fewer and fewer machines for each worker to work with, making each additional worker less and less productive.

Problem #5 You have the information shown in the accompanying table about a firm’s costs. Complete the missing data.

Answer to Question #5

Problem #6 You produce widgets. Currently you produce 4 widgets at a total cost of $40.

Questions to Answer What is your average total cost? Suppose you could produce one more (the fifth) widget at a marginal cost of $5. If you do produce that fifth widget, what will your average total cost be? Has your average total cost increased or decreased? Why? Suppose instead that you could produce one more (the fifth) widget at a marginal cost of $20. If you do produce that fifth widget, what will your average total cost be? Has your average total cost increased or decreased? Why?

Answer to Question #6—1 Your average total cost is $40/4 = $10 per widget.

Answer to Question #6—2 If you produce one more widget, you are producing five widgets at a total cost of $40 + $5 = $45. Your average total cost is therefore $45/5 = $9. Your average total cost has decreased because the marginal cost of the additional widget is below the average total cost before you produced the additional widget.

Answer to Question #6—3 If you produce one more widget, you are producing five widgets at a total cost of $40 + $20 = $60. Your average total cost is therefore $60/5 = $12. Your average total cost has increased because the marginal cost of the additional widget is above the average total cost before you produced the additional widget.