Exam Costs

1) In 1985, Alice paid $20,000 for an option to purchase ten acres of land. By paying the $20,000, she bought the
right to buy the land for $100,000 in 1992. When she acquired the option in 1985, the land was worth $120,000.
In 1992, it is worth $110,000. Should Alice exercise the option and pay $100,000 for the land?
A) No
B) Yes
C) It depends on what the rate of inflation was between 1985 and 1992.
D) It depends on what the rate of interest was.

2) Farmer Jones bought his farm for $75,000 in 1975. Today the farm is worth $500,000, and the interest rate is 10
percent. ABC Corporation has offered to buy the farm today for $500,000 and XYZ Corporation has offered to
buy the farm for $530,000 one year from now. Farmer Jones could earn net profit of $15,000 (over and above all
of his expenses) if he farms the land this year. What should he do?
A) Farm the land for another year and sell to XYZ Corporation.
B) Reject both offers.
C) Sell to ABC Corporation.
D) Accept either offer as they are equivalent.

3) Which of the following statements demonstrates an understanding of the importance of sunk costs for decision
making?
I. "Even though I hate my MBA classes, I can't quit because I've spent so much money on tuition."
II. "To break into the market for soap our firm needs to spend $10M on creating an image that is unique to our
new product. When deciding whether to develop the new soap, we need to take this marketing cost into
account."
A) I only B) II only C) Both I and II D) Neither I nor II

4) Consider the following statements when answering this question.

I. Increases in the rate of income tax decrease the opportunity cost of attending college.
II. The introduction of distance learning, which enables students to watch lectures at home, decreases the
opportunity cost of attending college.
A) I is true, and II is false. B) I and II are both true.
C) I and II are both false. D) I is false, and II is true.

5) Complete the following table:

Total Variable Fixed Marginal

Output Cost Cost Cost Cost
0 50
1 60
2 75
3 100
4 150
5 225
6 400

1
6) Complete the following table:

Total Variable Fixed Marginal

Output Cost Cost Cost Cost
0 60
1 10
2 90
3 100
4 80
5 180
6 50

7) A firm's total cost function is given by the equation:

TC = 4000 + 5Q + 10Q 2 .
(1) Write an expression for each of the following cost concepts:

a. Total Fixed Cost

b. Average Fixed Cost
c. Total Variable Cost
d. Average Variable Cost
e. Average Total Cost
f. Marginal Cost

(2) Determine the quantity that minimizes average total cost. Demonstrate that the predicted relationship
between marginal cost and average cost holds.

2
Answer Key
Testname: UNTITLED1

1) B
2) C
3) B
4) B
5) Total Variable Fixed Marginal
Output Cost Cost Cost Cost
0 50 0 50 -
1 60 10 50 10
2 75 25 50 15
3 100 50 50 25
4 150 100 50 50
5 225 175 50 75
6 400 350 50 175

6) Total Variable Fixed Marginal

Output Cost Cost Cost Cost
0 60 0 60 -
1 70 10 60 10
2 90 30 60 20
3 110 50 60 20
4 140 80 60 30
5 180 120 60 40
6 230 170 60 50
7) PART (1)
a.
TFC = 4000

b.
4000
AFC =
Q
c.
TVC = TC - TFC
TVC = 5Q + 10Q2

d.
TVC 5Q + 10Q2
AVC = = = 5 + 10Q
Q Q

e.
TC 4000 + 5Q + 10Q2
ATC = =
Q Q

f.
MC = 5 + 20Q

PART (2)
ATC is minimized where MC is equal to ATC.

3
Answer Key
Testname: UNTITLED1

Equating MC to ATC
4000 + 5Q + 10Q2
= 5 + 20Q
Q
4000 +5Q + 102 = 5Q + 20Q2
4000 = 10Q2
Q2 = 400
Q = 20

ATC is minimized at 20 units of output. Up to 20, ATC falls, while beyond 20 ATC rises.
MC should be less than ATC for any quantity less than 20.
For example, let Q = 10:
MC = 5 + 20(10) = 205
4000 + 5(10) + 10(10)2
ATC = = 505
10
MC is indeed less than ATC for quantities smaller than 20.
MC should exceed ATC for any quantity greater than 20.
For example, let Q = 25:
MC = 5 + 20(25) = 505
4000 + 5(25) + 10(25)2
ATC = = 415
25
MC is indeed greater than ATC for quantities greater than 20.