ECO10004: ECONOMIC PRINCIPLES

WEEK 5_TUTORIAL SOLUTIONS

Key concepts: Explicit Cost, Implicit Cost, Economic Profit, Accounting Profit, Fixed Cost,
Variable Cost, Marginal Cost, Average Total Cost, Law of Diminishing Return
Question 1)
a. Explicit costs are monetary costs that Sarah has to pay in order to operate her business
on a regular basis. Sarah’s explicit costs include rent ($30,000), staff wages ($20,000)
and food ($15,000).
Total explicit costs: $65,000.
Implicit costs are non-monetary costs. They represent the benefits Sarah has to give
up in order to pursue her goal of running her own restaurant. Sarah’s implicit costs
include (i) the full-time salary she is willing to give up ($50,000) (ii) the forgone
interest receipt as she commits her savings to opening the restaurant ($1,000).
Total implicit costs: $51,000
b. Accounting profit takes into account only explicit costs (costs that must be paid and
result in an outflow of resources).
Accounting Profit = Revenue – Explicit Costs = $100,000 - $65,000 = $35,000.
Economic Profit takes into account both explicit costs and implicit costs.
Economic Profit = Revenue – Explicit Costs – Implicit Costs = $100,000 - $65,000 -
$51,000 = -$16,000 (Negative $16,000).
The accounting profit suggests that Sarah’s restaurant business is profitable. It appears
that she should continue with it.
The economic profit, however, tells a different story. Sarah is making an economic
loss (-$16,000). This suggests that running her own restaurant is the not the best
option available to Sarah. From a purely economic point of view, Sarah will be better
off staying at her full-time job.
It should be noted that the economic profit calculated above may not tell the full story
here. It is possible that Sarah is keen to run her own restaurant because it is her
passion and she receives a significant amount of mental value out of doing it. Also,
there are values out of Sarah being her own boss instead of having to work for
someone else. These are difficult to measure and are beyond the scope of this unit.
c. The $30,000 Sarah spends on buying equipment is NOT a cost. The equipment
represents the restaurant’s capital. Suppose that she decides to discontinue the
business after a year.
The equipment will still be there for her to sell and recoup the majority of her initial
spending. However, it is true that the value of those equipment will decline over time
due to wear and tear or better equipment becoming available in the market. The loss
in value of Sarah’s equipment is called depreciation. It is in itself a cost, more
specifically, an implicit cost.
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 It is interesting to note that albeit an implicit cost, depreciation is counted when
calculating accounting profit as per common accounting practices (Those of you who
are doing ACC10007 will know this). It is a rare instance of accounting profit
covering an implicit cost.
Question 2)
a. Fixed cost. As the insurance amount will stay the same regardless of the number of
pizzas Simon produces
b. Variable cost. As the more pizzas Simon makes, the more pizza dough he has to buy.
The cost will increase when output rises
c. Variable Cost. If Simon wants to make more pizza, he likely has to hire more workers
and ends up paying more wages.
d. Fixed cost. As the lease payment will stay the same regardless of the number of pizzas
Simon produces
e. Fixed cost. As Simon will keep paying $300 every month for advertisement
regardless of the number of pizzas he produces.
Question 3)
a & b.
Quantity Quantity Fixed Variable Total Average Marginal
of staff of coffees Cost Cost Cost Total Cost Cost
made (Rent) (Wage)
0 0 $70 0 $70 - -
1 30 $70 $200 $270 $9.00 $6.67
2 70 $70 $400 $470 $6.71 $5.00
3 130 $70 $600 $670 $5.15 $3.33
4 170 $70 $800 $870 $5.12 $5.00
5 200 $70 $1,000 $1,070 $5.35 $6.67

c. For the first three employees, marginal cost keeps decreasing and the production gets
more efficient. This suggests an increase in the marginal productivity of labour. This
is the result of division of labour and specialisation. When output is low (30 coffees
per day), only one employee is hired and he has to take care of everything e.g. take the
order, make the coffee, bring the coffee to customers, etc. As output keeps increasing,
more staff are hired, and they start to divide the work among each other. For example,
one makes the coffee and one takes order and brings coffee to customers and the other
takes care of the cashier. As long as marginal productivity of labour increases,
marginal costs will fall.

From employee number 4, the law of diminishing return kicks in. The coffee shop
proves too small with not enough machine & equipment and employees start to step
on the feet of each other. The law of diminishing return causes the marginal
productivity of labour to fall. Thus, marginal cost begins to rise.

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 If Oscar continues to have a high number of customers every day, he will have to
think of upgrading his coffee shop with additional equipment (one more coffee
machine, for example). He might even think of relocating to a bigger space. However,
these moves are not possible in the short run. Only in the long run can they be carried
out.
Question 4)
a.

$10.00
ATC & MC
$9.00
Oscar's coff ee shop
$8.00

$7.00

$6.00 ATC
MC
Costs

$5.00

$4.00

$3.00

$2.00

$1.00

$-
0 50 100 150 200 250
Output

b. Based on the graph above, the following observations can be made:

i. ATC and MC intersect at ATC’s lowest
ii. When MC < ATC, ATC will keep falling
iii. When MC > ATC, ATC will keep rising
Question 5) There are three main mistakes in the graph the student has drawn
i. The student’s graph does not show Marginal Cost (MC)
ii. The Average Fixed Cost curve (AFC) cannot be in a U-shape, as shown on
the student’s graph. Total fixed cost always remains constant. Therefore, as
output rises, average fixed cost keeps decreasing. This means the AFC curve
will keep going down. There cannot be any point on the AFC curve where
average fixed cost starts to rise
iii. Average Total Cost is the sum of Average Variable Cost and Average Fixed
Cost (ATC = AVC + AFC). Therefore, Average Total Cost must always be
greater than Average Variable Cost. It is impossible for the ATC curve to stay
below the AVC curve, as shown on student’s graph.
A correct cost graph is shown below.
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Question 6)
a. If Suzanne expects to produce 700 pizzas per week, she should go with a smaller
pizza house, represented by ATC1. If she is to build a larger pizza house (ATC2), the
average total cost at 700 pizzas per week is higher than the smaller pizza house.
b. Operating a larger pizza house like Jill does is a different story. A large pizza house
incurs a substantially greater amount of fixed costs. For example, Jill must rent a
bigger space (more rent) and have more machines & equipment installed (more
depreciation). For all of the spending on fixed costs to be worth it, Jill must produce a
large amount of outputs. As fixed costs are spread across a large amount of outputs,
Average Fixed Cost will be low, which helps reduce Average Total Cost.

At 500 pizzas per week, the amount of output is simply not high enough. AFC
remains high which leads to high ATC.
Jill needs to reach 1,100 pizzas per week to achieve economies of scale at which the
ATC is minimised.
If time allows, there should also be a discussion in class on the difference in Average
Variable Cost (AVC) between a small pizza house and a large pizza house.
Hint: The key difference lies in the marginal productivity of labour and the point at
which the law of diminishing return kicks in

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Multiple Choice Questions
1. D
2. A
3. B
4. D
5. C
6. C
7. B
8. D
9. D
10. B

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