Log out Go to App
Go to App

Learning Materials

Features

Discover

Chapter 12: Problem 9

Suppose you decide to open a copy store. You rent store space (signing a 1-year lease to do so), and you take out a loan at a local bank and use the money to purchase 10 copiers. Six months later, a large chain opens a copy store two blocks away from yours. As a result, the revenue you receive from your copy store, while sufficient to cover the wages of your employees and the costs of paper and utilities, doesn't cover all your rent and the interest and repayment costs on the loan you took out to purchase the copiers. Briefly explain whether you should continue operating your business.

Short Answer

Expert verified
Whether to continue running the business depends on the current revenue and costs, not on the sunk costs. If the costs that are not being covered by the current revenue are less than the potential earnings that could be gained by using the resources elsewhere (opportunity cost), then it would be better to continue running the business. However, the sunk costs (money spent on lease and copiers) should not influence this decision as they are costs already incurred and cannot be recovered.

Step by step solution

01

Identify the Sunk Costs

The first step is to identify the sunk costs in this problem. Sunk costs are costs that have already been incurred and cannot be recovered. In this case, the sunk costs are the rent for the store lease for a year and the money used to purchase the ten copiers.
02

Evaluate Current Revenue and Costs

The next step is to evaluate the current financial situation of the business. Look at how much revenue the business is currently generating and what are the current costs that this revenue is able to cover. In this scenario, the revenue is sufficient to cover the wages of the employees and the costs of paper and utilities but not the rent and the interest and repayment of the loan.
03

Making the Decision

Based on these pieces of information, the decision about whether to continue running the business can be made. If the costs that are not covered by the current revenue (in this case, the rent and the interest and repayment of the loan) are less than the potential income that one could earn by utilizing the resources elsewhere (called 'opportunity cost'), then it would be better to keep the business running and just try to minimize these extra costs.
04

Consider the Sunk Cost Fallacy

The final step is to remember not to fall into the sunk cost fallacy. Just because money has already been spent on the lease and the copiers (sunk costs) does not mean it is necessary to keep the business running in an attempt to 'recoup' these costs. These are costs that have already been spent and cannot be recovered. The decision needs to be made based on current and future costs and revenues, not past costs.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

Why are consumers so powerful in a market system?

An article in the Wall Street Journal discussing the financial results for General Electric Co. (GE) for the first quarter of 2017 reported that, compared with the same quarter in the previous year, the firm's revenue had fallen from \(\$ 27.94\) billion to \(\$ 27.66\) billion, while its profit had increased from \(\$ 228\) million to \(\$ 653\) million. How is it possible for GE's revenue to decrease but its profit to increase? Doesn't GE have to maximize its revenue to maximize its profit? Briefly explain.

What is the relationship between a perfectly competitive firm's marginal cost curve and its supply curve?

A columnist for the Wall Street Journal discussed the fact that some firms were buying existing drilling operations in Canadian oil sands regions. These operations would not have been profitable to build from scratch but were profitable to operate given that they were already built because, as the columnist said, "The key is the distinction between fixed and variable costs. While the fixed investment in new oil sands projects is prohibitive, variable costs can be in the low \(\$ 20\) range per barrel." The columnist estimated that the fixed cost of a new oil sands drilling operation could be \(\$ 95\) per barrel. At the time the column was written, the price of oil was about \(\$ 50\) per barrel. a. Assuming that variable cost of an existing oil sands operation is \(\$ 20\) per barrel and the price of oil is \(\$ 50\) per barrel, how much were the companies selling these drilling operations losing per barrel? b. At a price of \(\$ 50\) per barrel, were the companies buying the existing drilling operations earning a profit of \(\$ 30\) per barrel? If not, explain what information we would need to calculate their profit.

According to an article in the Wall Street Journal, in 2007 the insurance company AXA Equitable signed a long-term lease on 2 million square feet of office space in a skyscraper on Sixth Avenue in Manhattan in New York City. In \(2013,\) AXA decided that it needed only 1.7 million square feet of office space, so it subleased 300,000 square feet of space to several other firms. Although AXA is paying a rent of \(\$ 88\) per square foot on all 2 million square feet it is leasing, it is only receiving \(\$ 40\) per square foot from the firms to which it is subleasing the 300,000 square feet. Briefly explain why AXA's actions might make economic sense in the short run. Would these actions make sense in the long run? Briefly explain.
See all solutions

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free