Your aunt is thinking about opening a hardware store.

She estimates that it would cost $500,000 per

year to rent the location and buy the stock. In addition, she would have to quit her $50,000 per year
job as an accountant.

a. Define opportunity cost.

b. What is your aunt’s opportunity cost of running a hardware store for a year? If your aunt thought
she could sell $510,000 worth of merchandise in a year, should she open the store? Explain.

A. The opportunity cost of something is what must be given up to acquire it as in this case aunt would
have to quit her job if she goes for store. So, job quitting can be considered as an opportunity cost.

B. The opportunity cost of running the hardware store is $550,000, consisting of $500,000 to rent the
store and buy the stock and a $50,000 opportunity cost, because your aunt would quit her job as an
accountant to run the store. Because the total opportunity cost of $550,000 exceeds revenue of
$510,000, your aunt should not open the store, as her profit would be negative.

Q.2.
Your cousin Vinnie owns a painting company with fixed costs of $200 and the following schedule for
variable costs:

Houses Painted/month 1 2 3 4 5 6 7
Variable Costs $10 20 40 80 160 320 640
Calculate average fixed cost, average variable cost, and average total cost for each quantity. What is
the efficient scale of the painting company?

The calculation of Average FC, Average VC, and Average TC are shown in the table below considering
the known values of fixed cost and the variable costs at different levels of output.

The values are given below:

Quantity TFC TVC AFC AVC TC ATC

1 200 10 200 10 210 210

2 200 20 100 10 220 110

3 200 40 66.67 13.33 240 80

4 200 80 50 20 280 70

5 200 160 40 32 360 72

6 200 320 33.33 53.33 520 86.67

7 200 640 28.55 91.43 840 120

Formulas used:

TC = TVC + TFC ATC = TC/Q

AFC = TFC/Q

AVC = TVC/Q

From the table, observe that the ATC is minimum at 4 Units of output with ATC =$70

Q.1.
Suppose there are 1,000 hot pretzel stands operating in New York City. Each stand has the
usual U-shaped average-total-cost curve. The market demand curve for pretzels slopes
downward, and the market for pretzels is in long-run competitive equilibrium.

a. Draw the current equilibrium, using graphs for the entire market and for an individual
pretzel stands.
b. The city decides to restrict the number of pretzel-stand licenses, reducing the number
of stands to only 800. What effect will this action have on the market and on an
individual stand that is still operating? Draw graphs to illustrate your answer.
c. Suppose that the city decides to charge a fee for the 800 licenses, all of which are quickly
sold. How will the size of the fee affect the number of pretzels sold by an individual stand? How will
it affect the price of pretzels in the city?
d. The city wants to raise as much revenue as possible, while ensuring that all 800 licenses
are sold. How high should the city set the license fee? Show the answer on your graph.