CHAPTER 7

ANALYSIS OF COST

I. CHAPTER OVERVIEW

This chapter continues the discussion of firm production and short-run supply decisions by exploring the nature
of costs. A firm’s production costs are determined by its level of output and are represented along a total cost
schedule. Given the law of diminishing returns, these costs also depend critically upon the particular
combination of inputs used in the production process. As you can imagine there are many ways to build any
product, and it is the firm’s job to choose the most efficient method from among the options available. The
major objective here is for you to obtain a solid understanding of an economist’s perspective of cost accounting
so that subsequent descriptions of market structure will make sense.
The chapter is divided into three sections. First, the short-run cost function is described and then integrated
into the short-run production theory developed in Chapter 6. Second, the nature of business accounting is
outlined. Third, the notion of opportunity cost is explained to differentiate the accountant’s definition of costs
from that used by economists.

II. LEARNING OBJECTIVES

After you have read Chapter 7 in your text and completed the exercises in this Study Guide chapter, you should
be able to:
1. Define and describe total cost, fixed cost, variable cost, marginal cost, and average cost,
understanding what these measures of cost are designed to reflect and how they are related to one another.
2. Derive the associated average and marginal cost statistics from total, fixed, and variable cost.
3. Explain the link between productivity and cost.
4. Demonstrate precisely why marginal cost always intersects average cost at the minimum of any U-
shaped average cost curve.
5. Demonstrate why production costs are minimized when inputs are hired in combinations such that the
ratios of their marginal products to their prices are all equal.
6. Explain carefully the information that a balance sheet is intended to convey. List the major categories
appearing on the two sides of a balance sheet and indicate the meaning (or definition) of each of those
categories.
7. List the major items appearing on an income statement. Indicate the information that an income
statement is intended to convey.
8. Explain the role of depreciation in the correct and accurate construction of an income statement.
9. Define the term opportunity cost and apply it to management decisions made by firms and
individuals.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.
A B
__ Total cost 1. The ratio of the marginal product of an input to its price is equal for all inputs.
function
__ Average cost 2. The extra cost required to produce 1 extra unit of output.
__ Marginal cost 3. A variable that represents change per unit of time.
__ Least-cost rule 4. Total cost divided by the number of units produced.
__ Income 5. Shows the minimum attainable costs of production, given a particular level of
statement technology and set of input prices.
__ Balance sheet 6. Represents the level of a variable.
__ Assets 7. A statement showing revenues, costs, and profits incurred over a given time
period.
__ Liabilities 8. A statement of a firm’s financial position as of a given date, showing assets
equal to the sum of liabilities and net worth.
__ Net worth 9. The value of the next best use for an economic good.
__ Opportunity 10. A physical property or intangible right that has economic value.
cost
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__ Stock 11. Debts or financial obligations owed to other firms or persons.

__ Flow 12. Total assets minus total liabilities.

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Economic Analysis of Costs

1. Total costs include all costs incurred when a firm produces and sells a product; this chapter concentrates on
short-run cost functions so there are two possible categories of costs. Variable costs are those costs whose total
amount varies with the quantity of inputs used and output produced. Fixed costs are those costs that must be
paid by the firm even if its output is zero. Note that in the long run, all costs are variable, since all inputs are
variable.
2. Marginal costs measure the increase in total cost resulting from a l-unit increase in output. Like marginal
product (from Chapter 6), marginal costs focus on the effect of incremental changes.
3. Average costs measure the per unit costs of production at any given level of output. You can find average
variable cost, average fixed cost, or average total cost; all these concepts share the common characteristic of
being per unit measures.
4. The law of diminishing returns, which you learned in Chapter 6, also speaks to the nature of a firm’s costs.
As the firm increases production, additional variable inputs are added to a fixed capital base; as marginal
product begins to fall, marginal costs will begin to rise. Cost curves are U-shaped when short-run returns
increase in the early range of production but eventually start to rise as output increases and more of the variable
inputs are employed.
5. Profit-maximizing firms will attempt to choose the combination of inputs that allows them to produce with
minimum costs. This combination will be such that the marginal productivity of the last dollar spent on each
input is equal for all inputs used in the production process.

B. Economic Costs and Business Accounting

1. The balance sheet is a stock concept, or a snapshot of a firm’s financial health—it reflects the economic
condition of an economic enterprise at some prescribed point in time. The balance sheet begins by listing the
firm’s assets; that is, everything it owns, including cash, buildings, equipment, inventory, and so on.
2. The income statement is a flow concept, or a motion picture—it reflects growth or problems over a given
period of time. Its primary function is to record how much profit (or loss) the company earned from its sales
during some particular period.
3. Depreciation is a way of measuring the annual cost of a capital input that the company owns. Although the
firm does not have to write a check to itself when its own capital equipment is used, it must recognize that
equipment wears out as it is used in the production process. Capital equipment will eventually have to be
replaced, and prudent managers do indeed make allowances for this in their budgets.
4. The firm’s “worth” is not likely to be the same figure as the total monetary value of its assets. Any debts
owed to others—the firm’s liabilities—must be deducted to get an accurate portrait of financial health. The
resulting figure is net worth, the difference between the total value of assets and the total value of liabilities.

C. Opportunity Costs
1. Opportunity costs measure the value of a resource at its next-best alternative use. As long as a resource is
at least as useful as it would be in its next-best alternative use, economists can be sure that no reallocation
would improve the overall efficiency of the firm (or even the economy).
2. If markets are functioning properly the price of the last unit of output sold is just equal to its opportunity
cost. This means that the amount that a buyer is willing and able to pay is exactly equal to the value of the item
at its next-best alternative use; there is no more productive use for the resources used to make that marginal unit
of output.

V. HELPFUL HINTS

1. Marginal product and marginal costs both measure the effect of incremental changes. However, they differ
in an important way. Marginal product measures the addition to total product, or output, when an additional
unit of an input is hired. By contrast, marginal cost measures the addition to total cost when an additional unit
of output is produced. Remember, “margin” means change.
2. Note that marginal cost, even though it is a per unit cost measure, is not the same thing at all as average
cost. To illustrate the difference, consider some baseball or softball statistics. A batter has a batting average
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that indicates the number of hits he or she has gotten out of his or her total number of trips to the plate. Any
average is calculated by dividing some total by the appropriate number of something else. (For example, a
batting average is found by dividing total at-bats by the number of hits. A class average on a test is calculated
by dividing the total of all the test scores by the number of students who took the test.) The marginal
productivity of that batter would indicate how successful that batter was at the very last trip he or she made to
the plate. Remember, “margin” means change.
3. The law of diminishing returns tells us that as we add additional units of a variable input to a fixed capital
base, eventually marginal product will fall. This generates a downward-sloping marginal product curve and
also generates an upward-sloping marginal cost curve. Think of it this way: As a firm attempts to increase
production in the short run, it becomes increasingly more difficult to extend production; hence, it becomes
increasingly more expensive to extend production.
4. Throughout this discussion, we are assuming that the firm is attempting to minimize production costs. This
is consistent with profit maximization but does not necessarily imply that the firm is maximizing profits. There
are things to be considered on the revenue side of the ledger before we can make any claims about profits;
notice that a firm could be producing with minimum costs, but if it gives its product away for free, it will not
earn any profits!

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.

A. Economic Analysis of Costs

1. If AVC rises with output, each increment in cost would have to be ___ the previous average to push the
average higher.
a. greater than
b. equal to
c. less than
d. twice as large as
e. one-half as large as
2. Fixed costs facing any firm in the short run include:
a. any cost whose total is established at the time the input is purchased.
b. the minimum cost of producing any given quantity of output under the most favorable operating
conditions.
c. any cost whose per unit charge has been settled for some future period, such as a long-term wage
contract with a labor union.
d. total expenses which must be covered even if nothing is produced.
e. none of these things.
3. Marginal costs facing any firm considering a change in output represent:
a. extraordinary overtime charges that must sometimes be paid to increase output.
b. the cost incurred even if the firm produces zero output.
c. the difference between the total cost actually incurred to produce any given output and the smallest
possible total cost of producing that output.
d. the increase in total cost that accrues from a 1-unit increase in quantity produced.
e. the increase in total cost that accrues from any increase in quantity produced, whether 1 unit or more.
4. Suppose that the property taxes paid by a firm on its plant are increased; i.e., suppose that its fixed costs
increase. As a result, the marginal cost curve for this firm would move:
a. to the right.
b. to the left.
c. upward.
d. downward.
e. not at all.
5. Total cost in a certain plant, at an output level of 1000 units daily, is $4900. If production is reduced by 1
unit, total cost would be $4890. Within this output range:
a. average cost is greater than marginal cost.
b. average cost and marginal cost are approximately equal.
c. marginal cost is greater than average cost.
d. we cannot compare average and marginal cost, since we cannot derive marginal cost from the given
information.
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e. we cannot compare average and marginal cost, since we cannot derive average cost from the given
information.
Use Figure 7-1 to answer questions 6 through 8.

Figure 7-1

6. At five units of output, the average fixed cost is:

a. $5.
b. $20.
c. $26.
d. $100.
e. $130.
7. The marginal cost of the fifth unit of output is:
a. 0.
b. $2.00.
c. $2.60.
d. $6.00.
e. $30.00.
8. The average variable cost of five units of output is:
a. 0.
b. $2.00.
c. $2.60.
d. $6.00.
e. $30.00.
9. Let average costs be minimized at output X0. Which of the following statements is also true at X0?
a. Average variable cost will be equal to total fixed cost.
b. Profit for the firm must be at its maximum level.
c. Marginal cost will be equal to average variable cost.
d. Marginal cost will be equal to average cost.
e. None of the above is necessarily true at X0.
10. If marginal cost exceeds average cost within a certain range of plant output, then any increase in output
within that range should cause average cost to:
a. rise.
b. fall.
c. rise or fall, depending upon the change in variable cost.
d. remain constant.
e. rise, fall, or remain constant, depending upon market conditions.
11. In a certain plant, marginal cost is $2.00 at 400 units of output weekly and it is $2.50 at 500 units of output.
If output increases within this 400-to-500 range, then average cost:
a. must rise.
b. must fall.
c. must remain constant.
d. may fall, may rise, or both, but cannot remain constant throughout this output range.
e. must fall and then rise.
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12. If a firm has employed all its inputs so that the ratios of marginal product to price are the same for all
inputs, then:
a. the marginal product of each input is equal to its price.
b. the firm is producing the maximum-profit output at minimum cost.
c. the firm is producing the maximum-profit output, but it may or may not be producing that output at
minimum cost.
d. the firm may or may not be producing the maximum-profit output, but it is producing its present output
at minimum cost.
e. the firm may or may not be producing the maximum-profit output, and it may not even be producing
its present output at minimum cost.
13. The production function alone will tell a firm:
a. what it will cost to produce any given quantity of output.
b. the maximum-profit level of output.
c. the various combinations of inputs that should be used in order to produce any given quantity of output
most efficiently, i.e., at the least money cost.
d. the various combinations of inputs that could be used in order to produce any given quantity of output.
e. none of these.
14. A, B, and C are inputs employed to produce good X. If the quantity of A used were increased, then we
would ordinarily expect A’s marginal product to:
a. increase, in all circumstances.
b. increase if the quantities of B and C were left unchanged, but not necessarily to increase if the
quantities of B and C were increased in the same proportion.
c. decrease in all circumstances.
d. decrease if the quantities of B and C were left unchanged, but not necessarily decrease if the quantities
of B and C were increased in the same proportion.
e. decrease if the quantities of B and C were increased in the same proportion, but increase if the
quantities of B and C were left unchanged.
15. A firm employs inputs A and B so that the marginal product of A is 60 and the marginal product of B is 40.
The prices of A and B are $4 and $9, respectively. Assuming that A and B are the only inputs involved, this
firm is:
a. producing its present output at minimum cost but definitely is not earning maximum possible profit.
b. not producing its present output at minimum cost and is not earning maximum possible profit.
c. producing its present output at minimum cost but may or may not be earning maximum possible profit.
d. not producing its present output at minimum cost but nevertheless is earning maximum possible profit.
e. possibly in any of the positions just described—the information furnished is insufficient to tell.
16. In question 15, change the price of input A from $4 to $3. If all the other information still applies, which
alternative in question 15 is now correct?
a. producing its present output at minimum cost but definitely is not earning maximum possible profit.
b. not producing its present output at minimum cost and is not earning maximum possible profit.
c. producing its present output at minimum cost but may or may not be earning maximum possible profit.
d. not producing its present output at minimum cost but nevertheless is earning maximum possible profit.
e. possibly in any of the positions just described—the information furnished is insufficient to tell.
17. Marginal cost reaches its minimum when:
a. average variable cost reaches its minimum.
b. average total cost reaches its minimum.
c. average fixes cost reaches its minimum.
d. marginal product reaches its maximum.

B. Economic Costs and Business Accounting

18. A particular income statement records no depreciation expense for a piece of machinery, even though that
machinery was used for production during the year. This accounting procedure could be justified:
a. if the company did not find it necessary to spend money on the maintenance or repair of the machine
during the year.
b. if depreciation entries totaling the original cost of the machine had already been made on earlier
income statements.
c. if sales for the year were below normal, prompting the company to decid not to charge any
depreciation costs for the year.
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d. if the company responded to an increase in market prices by estimating that the money worth of the
machinery was unchanged even though it underwent some physical depreciation through use during the
year.
e. by recognizing that depreciation entries are properly made on the balance sheet, not the income
statement.
19. A balance sheet must always “balance” because:
a. total assets must equal total liabilities when both are properly specified.
b. net profit is defined as total revenue minus total expenses.
c. the definition of net worth is total assets minus total liabilities.
d. current assets plus fixed assets must equal current liabilities plus long-term liabilities.
e. the definition of net worth is capital stock plus retained earnings.
20. A company’s total assets at the end of 1999 were $100,000, and its total liabilities were $70,000. At the
end of 2000, its total assets were $115,000, and its liabilities totaled $75,000. It paid dividends totaling $15,000
in 2000. Assuming no change in its capital stock, its net profit after taxes for 2000 must have been:
a. $10,000.
b. $15,000.
c. $20,000.
d. $25,000.
e. $30,000.
21. A company’s 2000 income statement shows a net profit earned (after taxes) of $200,000. This means that
on its end-of-2000 balance sheet, as compared with its end-of-1999 balance sheet:
a. the total of assets should be up by $200,000, and so should the total of liabilities plus net worth.
b. retained earnings should be up by $200,000 minus the total of dividends paid.
c. current assets minus current liabilities should be up by $200,000.
d. cash on hand minus expenditures for new fixed assets should be up by $200,000.
e. net worth should be up by $200,000 minus the total of any bond interest paid.
22. A company’s total assets were $600,000, and its total liabilities were $400,000 at the end of 2000. At the
end of 2001, its total assets were $550,000, and its total liabilities were $200,000. During 2001, it (a) paid a
dividend of $50,000 and (b) sold additional shares of its own stock for $100,000. With these figures, its net
profit after taxes for 2001 must have been:
a. zero.
b. $50,000.
c. $100,000.
d. $150,000.
e. $200,000.

C. Opportunity Costs
23. Opportunity costs are defined as:
a. the value of a resource at all its alternative uses.
b. fixed costs of production that must be paid even if output is zero.
c. the addition to total cost when the firm increases output by one unit.
d. the value of a resource at its next-best alternative use.
e. none of the above.
24. The opportunity cost of a new parking lot at your college is:
a. the cost of all the expenses that must be incurred to produce it.
b. determined by the value of the resources at their next-best alternative use.
c. the amount of depreciation on machinery and equipment that must be allowed for the production of the
lot.
d. salary expenses for the laborers who produce it.
e. determined by the fees charged people who park in the new lot.
25. The most important application of opportunity cost arises:
a. for market goods.
b. for nonmarket goods.
c. when planning for national defense.
d. none of the above.
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VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this chapter.

A. Economic Analysis of Costs

1. In the blanks below, put V if you think the item would contribute to variable cost and F if you think it
would be part of fixed cost in the short run.
__ a. The cost of purchasing raw materials.
__ b. Depreciation on machinery when the rate of production is considered to be the primary source of
depreciation.
__ c. The annual fire-insurance premium on plant buildings.
__ d. A tax levied on the firm for each hour of labor employed.
__ e. Depreciation on machinery when time rather than quantity of output produced is considered to be
the factor principally responsible for the depreciation
__ f. Salaries paid to supervisors on an annual basis.
__ g. Local property taxes on buildings.
__ h. The cost of purchasing electric power to run the machines.
__ i. The cost of maintaining an active research-and-development department.
__ j. A royalty paid for the use of certain machines according to number of units produced.
__ k. Extra pay for overtime work by labor.
2. The numbers in Table 7-1 indicate the estimated total cost incurred in producing quantities of output from 0
to 20 units weekly. This firm produces widgets using labor and a fixed capital base.

TABLE 7-1
Total
Total Variable
Output Cost Cost AVC ATC AFC MC
0 50 ___ X X X X
2 70 ___ ___ ___ ___ ___
4 85 ___ ___ ___ ___ ___
6 95 ___ ___ ___ ___ ___
8 100 ___ ___ ___ ___ ___
10 110 ___ ___ ___ ___ ___
12 125 ___ ___ ___ ___ ___
14 145 ___ ___ ___ ___ ___
16 170 ___ ___ ___ ___ ___
18 200 ___ ___ ___ ___ ___
20 235 ___ ___ ___ ___ ___

a. Fill in the missing figures for total variable cost, AVC (average variable cost), ATC (average total
cost), and AFC (average fixed cost).
b. Fill in the missing figures for MC (marginal cost). Hint: Remember that marginal cost is the change
in total cost divided by change in quantity.
c. Plot the total cost, total variable cost, and fixed cost curves in Figure 7-2. Make sure to label your
diagram carefully.
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Figure 7-2

d. Plot the AVC, ATC, AFC, and MC curves in Figure 7-3. Again, make sure to label your diagram
carefully.
3. Suppose the firm described in Chapter 7 of your text is a farm that produces fresh tomatoes in greenhouses.
It can use varying quantities of energy and labor in the short run. Increasing the amount of energy used to run
the greenhouse will improve the yield of the tomato plants; increasing the number of laborers employed to weed
and care for the plants will also increase the yield. The firm finds that the daily marginal productivity of these
inputs is as shown in Table 7-2.

Figure 7-3

TABLE 7-2
Units of Labor Marginal Units of Energy Marginal
Employed Product Employed Product
1 10 1 20
2 12 2 25
3 14 3 22
4 13 4 17
5 11 5 10
6 8 6 1
7 3 7 -10

a. At what level of employment does diminishing returns set in for labor? For energy? Explain.
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b. If workers are paid $4 per unit, and energy costs $11 per unit, and the firm has $57 to spend on inputs,
what is the optimal mix of labor and energy for this firm to employ? Explain.

c. Suppose an oil embargo causes the price of energy to rise. What will happen to the optimal mix of
labor and energy? Explain in general terms.

B. Economic Costs and Business Accounting

4. In December 1999, the Utter Confusion Manufacturing Company was formed, with the sale for cash of
5000 shares of common stock at $10 apiece.
a. In Table 7-3, show this firm’s balance sheet as of December 31, 1999. Assume that the proceeds from
the entire $50,000 stock sale were still held in cash and that no other transactions had taken place yet.

TABLE 7-3
Assets Liabilities and Net Worth
Cash. . . . . . . . . . . . . . . . . . . . . . . . . $___ Liabilities . . . . . . . . . . . . . . . . . . . . . . . $___
Net worth:
Capital . . . . . . . . . . . . . . . . . . . . . . . $___

Now suppose that the firm’s operations during 2000 can be described as follows:
1. Money received (all in cash):
a. Sales of merchandise manufactured, $115,000
b. Bonds sold (100 bonds @ $1000), $100,000
2. Money paid out (all in cash):
a. Machinery purchased, $170,000
b. Raw materials purchased for use, $50,000
c. Wages paid to labor, $24,000
d. Interest paid on bond issue, $10,000
All raw materials purchased were fully used up in manufacturing before the end of the year (i.e., the closing
inventory of raw materials was zero). All goods manufactured during 2000 were sold during 2000 (i.e., zero
finished goods remained in the closing inventory). Depreciation on machinery was estimated at 10 percent, or
$17,000. (The machinery was worth $170,000 when it was purchased on January 1. It was estimated as being
worth only $153,000 on December 31. It was partly “used up” or worn out by use during the year, but that does
not mean a cash outlay of $17,000.) The interest rate paid on the bonds is 10 percent. Note that item 2.d. above
shows interest paid as $10,000, so it must be true that the bonds were floated (i.e., that the $100,000 was
borrowed) on January 1, 2000.
b. How much cash did Utter Confusion have on December 31, 2000? (Hint: Start with the $50,000
raised from the sale of stock. Add the money received from sales of merchandise and bonds, listed above;
then deduct the various cash outlays also listed.)
c. Draw up the firm’s balance sheet for December 31, 2000, in Table 7-4. There are three steps involved:
(1) Run through the information above for assets held at the end of the year; they will have to be listed
at their proper value on that date. (Hint: You have already dealt with cash; you should find only one
other asset.)
(2) Do the same for liabilities. (Hint: You should find only one.)
(3) Repeat the process one more time for net worth. Remember that net worth must be whatever
figure is needed to bring the balance sheet into balance. Follow the convention of dividing net worth
between capital and retained earnings. Leave financial capital at $50,000 (because no more stock was
sold during the year). Let retained earnings be the line within net worth that is manipulated to perform
the balancing act.
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TABLE 7-4
Assets Liabilities and Net Worth
(thousands) (thousands)
Current: Cash. . . . . . . . . . . . . . . . . . . . . . . . $___ Current liabilities: . . . . . . . . . . . . . . . $___
Fixed: Long-term liabilities:
Machinery $___ Bonds . . . . . . . . . . . . . . . . . . . . . $___
Less: dep’n. Net worth:
allowance Capital $___
$___ $___ Retained
$___ earnings $___ $___
$___

5. In this question you will use Table 7-5 to develop the firm’s income statement for 2000 using the
information already furnished in question 4.
Hint: Remember that this income statement should (a) record revenue earned from sales in 2000, (b)
deduct the costs of making and selling the goods in question from this revenue, and (c) show the income (or
profit) remaining after that deduction. It should also indicate the disposition of that profit (paid out as a
dividend, or retained within the business). The sales figure is obviously $115,000. Raw materials purchases
and wages are clearly expense items to be subtracted from sales revenue.

TABLE 7-5
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $___
Less manufacturing cost of goods sold:
Raw materials bought . . . . . . . . . . . . . . . . . . . . . $___
Labor cost (wages). . . . . . . . . . . . . . . . . . . . . . . . $___
Dep’n. on machinery. . . . . . . . . . . . . . . . . . . . . . $___ $___
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $___
Deduct bond interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $___
Net profit and addition to retained earnings . . . . . . . . . . . . . . . $___

C. Opportunity Costs
6. Farmer Jones is trying to decide how to use 10 acres of land in her side yard, and she needs help from you.
She could either rent it out to the local college to use for extra parking (the college is willing to pay $500 per
year for this), or she could plant vegetables on the property. She estimates that direct costs for plants, water,
labor, and fertilizer will total $375; revenues from the sale of the vegetables will total $825. What would you
recommend? What are her opportunity costs in this case? How much profit will she earn? Explain.

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. Suppose that in a given class of students, the average examination grade is always 70. Now we add a few
new students (some extra, or “marginal,” students) to this class. They are weaker students; they always score
between 50 and 55 on examinations. What will happen to the class average? What can you say about the
relationship between the marginal and the average grades in this class?
2. Are the following statements true (T) or false (F)?
a. Average costs are minimized when marginal costs are at their lowest point. T / F
b. Because fixed costs never change, average fixed cost is a constant for each level of output. T / F
c. Average cost is rising whenever marginal cost is rising. T / F
d. A firm minimizes costs when it spends the same amount of money on each input. T / F
3. Explain the difference between a balance sheet and an income statement. Why do accountants need both of
these documents to fully understand a firm’s financial position?
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4. Return to the balance sheet for Hot Dog Ventures, Table 7-6 in your textbook. Suppose that the firm
decides to borrow $45,000 to purchase a new computerized cash register. How would you adjust the balance
sheet to account for this? Explain.
5. Is the following statement true or false: “The opportunity cost of spilling oil in the Atlantic Ocean is zero
because no one pays to sail or swim there.” Please explain.
6. The federal government owns thousands of acres of land in the western United States. It is trying to
determine the appropriate price to charge for use of this land. (Cattle ranchers, mining companies, and others
often rent this space from the government.) How would such a rent be determined? What sorts of costs would
have to be considered by the government? Explain.

IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts

5 Total cost
4 Average cost
2 Marginal cost
1 Least-cost rule
7 Income statement
8 Balance sheet
10 Assets
11 Liabilities
12 Net worth
9 Opportunity cost
6 Stock
3 Flow

VI. Multiple Choice Questions

1. A 2. D 3. D 4. E 5. C 6. B
7. B 8. D 9. D 10. A 22. D 12. D
13. D 14. D 15. B 16. C 17. D 18. B
19. C 20. D 21. B 22. C 23. D 24. B
25. B

VII. Problem Solving

l. a. V
b. V
c. F
d. V
e. F
f. F
g F
h. V
i. F
j. V
k. V
2. a. See table 7-1.
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TABLE 7-1
Total
Total Variable
Output Cost Cost AVC ATC AFC MC
0 50 0 X X X X
2 70 20 10.00 35.00 25.00 20.00
4 85 35 8.75 21.25 12.50 17.50
6 95 45 7.50 15.83 8.33 5.00
8 100 50 6.24 12.50 6.25 2.50
10 110 60 6.00 11.00 5.00 5.00
12 125 75 6.25 10.42 4.17 7.50
14 145 95 6.79 10.36 3.57 10.00
16 170 120 7.50 10.63 3.12 12.50
18 200 150 8.33 11.11 2.78 15.00
20 235 185 9 25 11.75 2.50 17.50

b. See table 7-1.

c. See Figure 7-2.
d. See Figure 7-3.

Figure 7-2 Figure 7-3

3. a. For labor, diminishing returns set in after three units. For energy, diminishing returns set in after two
units.
b. The firm will use six units of labor and three units of energy. At this point, the ratios of the marginal
product of each input to its price are equal.
c. If the price of energy rises, the firm will tend to find an optimal bundle of inputs containing more labor
and less energy.
4. a. See Table 7-3.

TABLE 7-3
Assets Liabilities and Net Worth
Cash. . . . . . . . . . . . . . .$50,000 Liabilities . . . . . . . . . . . . . . $0
Net worth:
Capital. . . . . . . . . . . . . . . . . $50,000
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b. $11,000
c. See Table 7-4.
5. See Table 7-5.

TABLE 7-5
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000
Less manufacturing cost of goods sold:
Raw materials bought. . . . . . . . $ 50,000
Labor cost (wages) . . . . . . . . . $ 24,000
Dep’n. on machinery. . . . . . . . $ 17,000 $ 91,000
Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ 24,000
Deduct bond interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000
Net profit and addition to retained earnings . . . . . . . . . . . . $ 14,000

6. Farmer Jones should rent the land. The opportunity cost of farming it herself is the $500 she could earn if
the resource is used at its next-best alternative. Since she would only earn $450 from her own farming, she
should rent the property

TABLE 7-4
Assets Liabilities and Net Worth
Current: Cash. . . . . . . . . . . . . . . . . . . . . . . . . $11,000 Current liabilities: . . . . . . . . . . . . . . . . . . . . $0
Long-term liabilities:
Bonds. . . . . . . . . . . . . . . . . . . . . $100,000
Fixed: Net worth:
Machinery $170,000 Capital. . . . . . . . . .$50,000
Less: dep'n. Retained
Allowance: $17,000 . . . . . . . . . . . . $153,000 earnings $14,000 . . . . . $64,000
Total Assets. . . . . . . . . . . . . . . . . . . . . . . . . . $164,000 Total Liabilities. . . . . . . . . . . . . . . . . $164,000

VIII. Discussion Questions

1. The average will fall. Since the marginal scores are below the average, they will pull the average down.
2. a. False. Average costs are minimized when average costs equal marginal costs.
b. False. Average fixed costs are total fixed costs divided by quantity of output. Therefore, average fixed
costs fall as output increases.
c. False. As long as marginal costs are below average costs, they are pulling the average cost down.
d. False. A firm minimizes costs when it sets the ratios of marginal product to input price equal for all
inputs.
3. A balance sheet summarizes a company’s financial position at a particular point in time. An income
statement summarizes a flow of financial activity over a period of time. Thus each statement provides a
different type of information to an accountant or financial managers.
4. Fixed assets would increase by $45,000, with the cash register listed as an additional piece of equipment.
Current liabilities would also increase by $45,000, with the loan appearing as an additional accounts payable.
5. This statement is false. The opportunity cost is defined by what the resources would have provided if they
were used in their next-best alternative. The opportunity cost of using the water as a dumping ground might be
enjoyment that people would have gotten from the recreational opportunities that would have been available in
clean water.
6. An appropriate rent would be determined by considering the opportunity cost of using the land at its next
best alternative. The government would have to consider what it is giving up when it rents the land to private
individuals. For example, the government might use the land as a national park.
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