ECON10004: INTRODUCTORY MICROECONOMICS

SOLUTIONS TO PRE-TUTORIAL TASKS FOR TUTORIAL 2

(Week beginning March 6)
1. The objective of models is to provide a simplified representation of an aspect of
economic activity which we are seeking to understand. All models start with
simplifying assumptions. Such simplification is necessary to improve our
understanding of reality because it allows us to focus on the key features of the
phenomena we analyse. The assumptions should not ignore crucial aspects of the
phenomena. Often, it is reasonable to make different assumptions and models.

2. The publisher Murdoch Cengage is thinking of publishing a book on ‘The Life and
Times of Julia Gillard’. Murdoch will incur three types of costs in publishing such a
book. An up-front royalty payment of $100 would need to be made to Ms Gillard
prior to her writing the book. The cost of typesetting and printing the book would be
$1000. And the cost of advertising would be $250. Murdoch decides that each copy
of the book should be sold for $25. Suppose that after Ms Gillard has written the
book, but before it has been sent to typesetting, Murdoch has to decide whether to
proceed with publication. To proceed with publication, Murdoch must think that
revenue from book sales will be at least as great as the opportunity cost of production.
What is the minimum number of copies he would need to expect to sell in order to
want to publish?

This question is asking you to use the concepts of opportunity cost and sunk cost.
Murdoch will only publish the book if the revenue from publishing is greater than the
opportunity cost (and opportunity cost does not include any sunk costs). In this
example Murdoch makes the decision on whether to publish the book after it is
written; that is, after the $100 royalty payment to Gillard. Hence the $100 royalty
payment is a sunk cost. No matter whether Murdoch decides to publish the book, he
will still incur that $100 cost. The opportunity cost of publishing – the extra costs that
he would not otherwise incur – are the typesetting/printing and advertising.
Together these equal $1250. Given that Murdoch will sell each book for $25, this
implies that it would be necessary to sell 50 copies to obtain revenue equal to the
opportunity cost.

3. Wally is considering starting his own website development business. To start the
business he will have to reduce to half-time in his current job, from which he earns
$50,000 per year. As well, he has already paid $5,000 to study (suck cost) a web
developer’s course, and would have to use $10,000 from his savings to pay for extra
computer equipment he would need in the business. The computer equipment could
be resold for $5,000 at the end of one year if Wally decided to discontinue his
business. There is currently an interest rate of 10% per annum. What will be Wally’s
opportunity cost from operating the business for one year?

Wally’s opportunity cost is:

i) Cost of reducing his time spent working in his current job to half-time: Equals ½ of
$50,000 = $25,000;
ii) Cost of interest foregone on savings invested: Cost for 1 year is 10% of $10,000
equals $1,000; and
iii) Amount of savings invested that is not recouped at end of the year: Equals
difference between amount of savings invested ($10,000) and resale price of
equipment ($5,000) equals $5,000.
Hence, opportunity cost is $31,000. Note that the cost of the web developer’s course
is a sunk cost since Wally has already incurred this cost prior to making the decision
about whether to start his business.

4. You are the manager of a gym, and you have to decide how many customers to
admit each hour. Assume that each customer stays exactly one hour. Customers are
costly to admit because they inflict wear and tear on the exercise equipment.
Moreover, each additional customer generates more wear and tear than the customer
before. As a result, the gym now faces increasing marginal cost:

Qty of customers per hour MC per customer

0
1 $14
2 $14.50
3 $15
4 $15.50
5 $16
6 $16.50
7 $17

a) Suppose that each additional customer pays $15.25 for a one-hour work-out. Use
the marginal benefit/marginal cost rule to find the optimal number of customers.

b) The price of a one-hour work-out increases to $16.25. What is the optimal number
of customers per hour that you should admit now?

The marginal benefit (MB)/marginal cost (MC) rule says that the optimal level of an
activity occurs where any unit that has MB > MC is chosen, but any unit with MB <
MC is not chosen. Applying this rule will maximize total benefit minus total cost.
a) When the price per work-out is $15.25 per hour, then the optimal number of
customers per hour is 3. This is because the third customer has a MC of $15 (so that
MB > MC), but the fourth customer has a MC of $15.50 (so that MB < MC).
b) When the price per work-out increases to $16.25, then the optimal number of
customers increases to 5 per hour.

5. Georgia and Lauren go to a karate class. Both have to choose how many classes
per week to attend. Each class costs $20. The following table shows Georgia’s and
Lauren’s estimates of the marginal benefit that each of them gets from each class per
week.

Qty of classes Lauren’s MB Georgia’s MB

of each class of each class
0
1 $23 $28
 2 $19 $22
3 $14 $15
4 $8 $7

Use the marginal benefit/marginal cost rule to find the optimal number of classes for
Lauren and for Georgia.

Once again using the marginal benefit/marginal cost rule, the optimal number of
classes per week for Lauren is 1 (MB of first class is $23 against MC of $20; but MB
of second class is $19 against MC of $20); and the optimal number of classes per
week for Georgia is 2.

6. To earn extra money in the summer, you grow tomatoes and sell them at a farmers’
market for 30 cents per kilo. By adding compost to your garden you can increase your
yield as shown in the table below. If compost costs 50 cents per kilos, and your goal is
to maximize your earnings from tomato sales minus costs, how many kilos of
compost should you add?

Kilos of compost Kilos of tomatoes

0 100
1 120
2 125
3 128
4 130
5 131
6 131.5

The underlying principle to use in answering this question is that you will want to add
an extra kilo of compost provided that the marginal benefit (extra revenue earned)
exceeds the marginal cost (cost of compost). This is because if MB > MC, then your
total net earnings (profits) will increase. On the other hand, if, by adding an extra kilo
of compost, MB < MC, then you should not add that kilo since it will reduce your
total net earnings.

Note that the marginal cost of each kilo of compost is $0.50. The marginal benefit of
each kilo of compost is equal to the extra kilos of tomatoes produced if that kilo of
compost is applied multiplied by the amount earned per kilo of tomatoes. For
example, applying 1 kilo of compost increases tomato production by 20 (from 100 to
120). Hence the marginal benefit is 20x$0.30 = $6.00.

From the table below it can be seen that the optimal amount of compost to apply is 4
kilos.

Kilos of Kilos of Marginal cost Marginal Marginal

compost tomatoes of compost effect of benefit of
kilo of compost
compost on
tomatoes
 0 100
1 120 $0.50 20 $6.00
2 125 $0.50 5 $1.50
3 128 $0.50 3 $0.90
4 130 $0.50 2 $0.60
5 131 $0.50 1 $0.30
6 131.5 $0.50 0.5 $0.15

7. Economists often attempt to measure the value of time by using wage rates or
average salary levels. According to these measures, the value of time in growing
economies is always rising. How does the growing value of time affect the types of
services and products introduced into the economy? How might this increase in the
value of time be related to increasing consumption of take-away food, and greater
incidence of households contracting out services such as gardening and cleaning?

An increasing value of time raises the opportunity cost of time spent in leisure
activities or other activities outside the paid workforce. In other words, the wage
income you forego by having an hour of leisure or in activities outside the paid
workforce rather than in paid work is increased. This means that the opportunity cost
for households of doing their own gardening, cleaning, and cooking (to mention just a
few examples) is higher because these are activities that are done outside paid work
time. For a rational decision-maker an increase in the cost of an activity makes it less
likely that the activity will be undertaken. So for example the higher cost of doing
one’s own garden increases the likelihood that individuals will choose to contract out
this activity rather than doing it themselves. Or the higher cost of time spent preparing
meals increases the likelihood that individual will choose to switch to consuming fast-
food.

8. Suppose for a new electric car model the total benefit function, TB, is given by TB
= f(Q) = 9 Q – 0.5 Q 2 , and the total cost function, TC, is given by TC = f(Q) = 2 + Q
+ 0.5 Q2, where Q is a measure quantity.
a) Derive functions for marginal benefit and marginal cost, namely the first derivative
b) Use the MB = MC rule to determine the Q that maximises net benefit
c) Calculate TB, TC and net benefit

This question asks you to apply calculus to find the decision quantity to maximise net
benefits. Often, you have the options of logic, a diagram, numerical examples, or a
combination to solve decision problems. This example requires choosing Q to
maximise net benefit.
a) Taking the first derivative MC = dTC/dQ = 1 + Q, and MB = dTB/dQ = 9 – Q
b) Equating MB = MC gives Q* = 4 to maximise net benefit
c) Substituting Q = 4 gives TB = 28, TC = 14 and TB – TC = net benefit= 14.