Tutorial 1 Solutions

UNIVERSITY OF MELBOURNE
DEPARTMENT OF ECONOMICS
ECON90015 Managerial Economics
Semester 2, 2018
Solution sheet
Tutorial Exercise 1: Introduction to key concepts
Task 1
These questions are about opportunity cost (and sunk cost).
An approach to defining opportunity cost is to say:
‘When a decision-maker chooses an action that will involve use of resources that
are then not available for alternative uses, the opportunity cost of the action is the
value to the decision-maker of those resources in their next best alternative
uses’.
To calculate opportunity cost you need to:
1. List all the resources that are not available for alternative use when a decision-
maker chooses some action; and
2. Calculate the value of each of those resources in their next best alternative
use.
For sunk cost, an approach is to say that these are costs which are incurred prior
to making a decision about whether to take an action, and hence will not vary
with or depend on whether the decision-maker chooses the action
a) When Linda chooses to operate her own business, there are two types of
resources she gives up – her time and her money. The value of her time for
one year is $100,000 – her salary at McKinsey’s which we are told is the best
alternative use of her time. Linda must purchase an office for $500,000. But
note that she can sell it for the same price at any time. So, this is not an
opportunity cost. However, she could have saved the money she used to buy
the office and earn interest for a year of $50,000. Hence the opportunity cost
is $150,000.
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To calculate the opportunity cost of hiring a research assistant Linda needs to
take into account the resources that would be used by hiring this employee.
One type of resource will be the time it takes Linda to manage the employee
– this could be measured as her lost sales revenue [the value of the next best
use of her time]. For example, suppose it takes 10 per cent of Linda’s time to
manage the employee – then the opportunity cost would be $20,000 if her
sales revenue was $200,000 (That is, 10 per cent of her revenue). Another
type of resource will be monetary expenses. For example, if it is necessary to
buy equipment for the research assistant, then there will be an opportunity
cost equal to cost of equipment that cannot be recouped through resale plus
the interest cost of spending on equipment rather than saving the money.
b) The books are already printed so in this case the costs of printing represent a
sunk cost. However, the cost of distributing the book and the royalty payment
to the professor will only be incurred if the publisher decides to distribute the
book to bookstores. (The royalty payment is only made for copies of the book
that are sold, but we are told to assume that all copies distributed to
bookstores will be sold.) Hence the distribution cost and royalty payment
constitute the opportunity cost of distributing the book. This is $6000 (1000
copies times ($1 distribution + $5 royalty)).
c) The minimum amount that the manager should be willing to charge to rent the
plane to travel from Cairns to Melbourne is the opportunity cost of renting the
plane for that trip. Begin by noting that the costs of fuel, wages to pilots, and
$500 of wages for flight attendants are sunk costs. This is because the plane
must be returned to Melbourne regardless of whether there are passengers,
and these costs would be incurred on such a trip. Hence it follows that the
opportunity costs – extra costs associated with having passengers on the
flight from Melbourne to Cairns – are equal to the extra ($500) wages for flight
attendants, and the $100 cleaning costs. That is, the manager would need to
receive at least $600 to be willing to rent the plane for the trip from Cairns to
Melbourne.
Task 2
a) This question asks students to revise the concepts of marginal cost, marginal
benefit, and sunk cost. First, the $10 million is a sunk cost as it has already
been spent, and there is no portion of this cost that is avoided (or incurred)
depending on whether the project is completed. Second, to work out whether
2
to complete the project it is necessary to compare marginal cost and marginal
benefit. Marginal cost is the $5M required to complete the project. Marginal
benefit can be assumed to equal (1/2)x($2M) + (1/2)x($10M) = $6M. (This
assumes that the decision-maker cares about the expected monetary payoff –
or in other words, is risk-neutral.) Since MB > MC, therefore a rational
decision-maker will complete the project.
b) The expected rate of return on these projects can be thought of as the

marginal return (or marginal benefit) available to the firm as it undertakes
each additional investment project. Similarly, the cost of capital schedule may
be thought of as the marginal cost of acquiring the needed funds to finance
the projects. Following the marginal analysis rule you should invest in
additional projects so long as the expected rate of return on the project
exceeds the marginal cost of capital funds needed to finance the projects.
Project A, which offers an expected rate of return of 27% and requires an

outlay of $25 million, is acceptable because the marginal return exceeds the
marginal cost of capital (10.0% for the first $50 million of funds raised). In fact,
projects A through to F all meet the marginal test because the marginal return
on each of these projects exceeds the marginal cost of capital funds needed
to finance these projects. In contrast, projects G, H and I should not be
undertaken because they offer returns of 13%, 11% and 8% respectively,
compared with the marginal cost of capital of 14.5% and 15.5 % for the $40
million needed to finance these projects. See the table below.
Project Investment Expected Cumulative Cost of

required ($ rate of return investment finance (%)
millions) (%) ($ millions)
A 25.0 27.0% 25.0 10.0%
B 25.0 24.0 50.0 10.0
C 25.0 21.0 75.0 10.5
D 40.0 18.0 115.0 11.0
E 20.0 15.0 135.0 12.2
F 30.0 14.0 165.0 12.2
G 20.0 13.0 185.0 14.5
H 13.0 11.0 198.0 15.5
I 7.0 8.0 200.0 15.5
c) The marginal cost of each extra 100 brochures is $10. The marginal benefit
is the extra newspapers sold due to 100 brochures being distributed
3
multiplied by 10 cents. For the third 100 brochures this is $12.50. So, you
would certainly want to distribute 300 brochures. Then consider the marginal
benefit of the fourth 100 brochures. This is only $7.50. Hence it is optimal for
you to distribute 300 brochures. This maximizes the economic profit.
Number of Total sales of Marginal benefit Marginal Eco. Profit

brochures newspapers [= additional sales x cost [= total
distributed price] revenue -
total cost]
100 200 200 x 0.10 = $20 $10 $10
200 350 150 x 0.10 = $15 $10 $15
300 475 125 x 0.10 = $12.50 $10 $17.50
400 550 75 x 0.10 = $7.50 $10 $15
500 600 50 x 0.10 = $5 $10 $10
So, in this example, the marginal benefit is the additional revenue obtained from
distributing additional brochures.
Notice that the far-right hand column of the table shows that the economic profit,
calculated as total revenue from selling newspapers less total cost of the
brochures, is at a maximum when 300 brochures are distributed.

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UNIVERSITY OF MELBOURNE

ECON90015 Managerial Economics

Tutorial Exercise 1: Introduction to key concepts

These questions are about opportunity cost (and sunk cost).

An approach to defining opportunity cost is to say:

To calculate opportunity cost you need to:

b) The expected rate of return on these projects can be thought of as the

Project A, which offers an expected rate of return of 27% and requires an

Project Investment Expected Cumulative Cost of

Number of Total sales of Marginal benefit Marginal Eco. Profit

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