BA533: Economics for Managers THE PENNSYLVANIA STATE UNIVERISTY

Fall 2017 Smeal College of Business

ANSWERS TO PRACTICE PROBLEMS
Module 1

1. (b) By the sunk-cost principle, the price that you paid for the car is irrelevant to the decision you are
considering. All the other factors described here affect the current or potential value of the car to you,
which is relevant to the decision to sell it or not. The key idea in this and the next question is that all
economic decisions should be forward looking. The price you paid for the car changes nothing in the
future.

2. (c) By the opportunity cost principle, and the sunk-cost principle, what matters in determining the cost of
something is not how much you paid for it, but how much it will cost to replace. The opportunity cost of
gasoline here is the same for both cars as it will cost you the same amount (the new, higher gas price) to
replace the gasoline you use from either car. Therefore the cost of traveling is the same regardless of
which car you use.

3. (c) The sunk-cost principle says that individuals should only consider costs and benefits they can still
influence with their decisions. The 20 minutes already spent in line should not matter to Stephen. It is a
sunk cost. Similarly, he has already paid for the lift ticket and presumably the cost of the ticket cannot be
recovered if Stephen decides not to ski. Hence, the $30 expense is sunk as well. The decision should be
based on costs he can still influence (standing in line for another 5 minutes) and the benefits associated
with it (20 minutes of skiing).

4. (i) Any small business that uses mostly labor and standard equipment would be an example. In particular,
consulting businesses, real estate brokerages and small trucking companies can all expand capacity
relatively quickly. Other service industries take longer to expand (e.g., restaurants) because expansion
requires custom-built physical space.

(ii) Any high fixed-cost operation (any heavy manufacturing business) can take from 1 to 3 (or more)
years to expand capacity. Steel manufacturing plants for example take several years to build.

5. The franchise fee will raise the firm's total fixed costs. Therefore, it will increase total cost and average
total cost. Marginal cost, total variable cost, and average variable cost will be unaffected in the short run.

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