BADM 560 – FIRM AND INDUSTRY ANALYSIS

PROBLEM SET TWO SOLUTIONS

1. a. $2.5MM per year in rent and other operating expenses.

b. 3 X $1.0MM = $3.0MM in foregone salary.
c. $2.5MM or more for positive accounting profits. $5.5MM or more for positive economic profits.
2. a. The total lease cost of $5,000 is a fixed cost. The $5,000 less the recoverable portion of $1,000
specified in the lease yields an unrecoverable (i.e., sunk) cost of $4,000 immediately upon signing
the lease.
b. No. You should not accept the offer. Under the terms of the lease, you can still return the electric
bicycle and receive $1,000 instead of the $500 that your friend has offered.
3. This problem requires accurately distinguishing between sunk costs and avoidable costs. As JMR has
already paid for market research ($5,000) and cost analysis research ($10,000), these costs are sunk
and do not factor into the decision to open the restaurant. The remaining costs are those that JMR
can avoid or would need to cover if they proceed with opening the restaurant. A good way to approach
this problem is to look at the cash outflows and inflows required to set up (and eventually sell) the
restaurant.
Cash outflows: $100,000 (building purchase) + $30,000 (improvements) + $10,000 (RE agent) =
$140,000.
Cash inflows: $123,000 (building sale).
For this endeavor to be worthwhile, JMR must make positive economic profit. In other words, the
cash inflows must exceed the cash outflows, or $140,000 - $123,000 = $17,000. JMR must therefore
earn a minimum total profit of at least $17,000 in its one year of operation. “But what about
opportunity costs?” It is normally important and correct to consider the associated opportunity costs
in any problem such as this. However, the problem as stated does not give you ANY information
regarding what JMR is currently doing (i.e., what the potential opportunity costs would be) nor does
it indicate what JMR would have to give up if it proceeded to open up the restaurant. For these
reasons, it is appropriate to mention opportunity costs but further analysis regarding them is not
possible.
4. For this problem, the revenues received must at least cover the sum of the explicit costs (EC) and
opportunity costs (OC) incurred.
Explicit Costs (EC) include the maintenance expense, raw materials, labor and utilities. Note that the
explicit costs do not include the $200,000 spent on the equipment, as it maintains its market value of
$200,000. EC = 4,000 + 50,000 + 40,000 + 14,000 = 108,000.
Opportunity Costs (OC) include foregone salary, foregone interest on the savings account, and
foregone rent on the building. OC = 46,000 + .05(200,000) + 12(2,500) = 46,000 + 10,000 + 30,000 =
86,000.
EC + OC = 108,000 + 86,000 = 194,000.
The minimum level of revenues required in the first year in order for economic profit to be positive is
just greater than $194,000.
5. a.
Q FC VC(Q) TC(Q) ATC(Q) MC(Q)
0 1,000 0 1,000 NA NA
1 1,000 1,000 2,000 2000 1,000
2 1,000 1,500 2,500 1250 500
3 1,000 3,000 4,000 1333 1,500
4 1,000 5,000 6,000 1500 2,000
5 1,000 9,000 10,000 2000 4,000
6 1,000 14,000 15,000 2500 5,000

b. Economies of scale occur in the range of declining average costs: 1–2 amplifiers.
c. Diseconomies of scale occur in the range of increasing average costs: 2–6 amplifiers.
6. a. For economies of scale:
150 320
X: AC (=
5) = 3; AC (10
= ) = 3.2.
5 10
100 210
Y: AC ( 50
= ) = 2; AC (100
= ) = 2.1.
50 100
Both X and Y exhibit diseconomies of scale over their respective output ranges.
b. For economies of scope:
AT (5,50) : TC(5,0) + TC(0,50) = 150 + 100 = 250 > TC(5,50) = 240.
AT (10,100) : TC(10,0) + TC(0,100) = 320 + 210 = 530 > TC(10,100) = 500.
The manufacturing facility exhibits economies of scope.
7. Recall that economies of scope are present when the total cost of manufacturing two outputs jointly
is less than the cost of manufacturing them separately. In this case, the new and joint production
process produces jelly as a byproduct of peanut butter, so that the total cost of manufacturing P oz.
of peanut butter with an equivalent J oz. of jelly (i.e., P = J) is 𝑇𝑇𝑇𝑇𝑃𝑃𝑃𝑃 = 1000 + 10𝑃𝑃 (this can also be
expressed as: 𝑇𝑇𝑇𝑇𝑃𝑃𝑃𝑃 = 1000 + 10𝐽𝐽).
Under the old and separate processes, the total cost of producing arbitrary amounts of peanut butter
(P) and jelly (J) is: 𝑇𝑇𝑇𝑇𝑃𝑃 + 𝑇𝑇𝑇𝑇𝐽𝐽 = 150 + 80𝑃𝑃 + 50 + 30𝐽𝐽. Recognize that peanut butter and jelly are
always sold in a ratio of 1:1. If more peanut butter than jelly is produced using the separate processes,
the additional peanut butter is wasted. If more jelly than peanut butter is produced using the separate
processes, the additional jelly is wasted. In order to assess whether the new and joint process provides
economies of scope, compare the costs using this process (which “automatically” produces peanut
butter and jelly in a 1:1 ratio) to the sum of the costs under the old and separate processes when each
is producing the same amount (i.e., when P = J). The total production costs with the old and separate
processes are: 150 + 80𝑃𝑃 + 50 + 30𝐽𝐽 = 150 + 80𝑃𝑃 + 50 + 30𝑃𝑃 = 200 + 110𝑃𝑃. Economies of
scope exist if there are values of P over some range where 200 + 110𝑃𝑃 > 1000 + 10P. Solving for
P indicates: 200 + 110𝑃𝑃 > 1000 + 10P → 100P > 800 → P ≥ 8. Economies of scope therefore
exist when eight or more PB&J kits are produced using the new and joint process; otherwise, it is less
expensive to produce PB&J kits using the old and separate processes.