Question

1. Michael started a business that makes and sells custom made sweaters for dogs. When he opened up his shop, he paid a one-time licensing fee of $2,500. His only cash costs are the $1,000 he spends per month on rent (including utilities) and $2,500 he spends per month on the materials that he needs to make the sweaters. His total revenue in his first month was $4,500. His sister Carly advises him that he is losing money and should shut down.
   1. (3 points) As an economics guru, what would you advise him to do?
      1. Sunk Cost = $2500
      2. Rent = $1000
      3. Materials = $2500
      4. TR = $4500
      5. $4500 (TR) - $3500 (explicit cost)
         1. Profits = $1000
   2. Are there any other costs that he should take into account? Explain.

Answer 1

Yes, he should take into account the implicit cost. There are opportunity costs that Michael has not taken into consideration. Before opening this shop, he must have been working somewhere. Or, if he were not running this shop for sweaters for dogs, he would have done something else. His salary that he used to get or he would have got is the opportunity cost.

Secondly, the money he has invested in his business must have come from his saving (partly at least). The interest he was earning on that saving deposit is the opportunity cost he must consider.

If he considers these 2 opportunity costs, and incurs loss (most probably he does), then he must shut down and do something more profitable -- where his revenue is more or where his opportunity cost is lower.