3. Mr. Johnson would like to open a new business for which he needs a license fr

Question

3. Mr. Johnson would like to open a new business for which he needs a license from the city of Atlanta for $25,000. The license is refundable, but only $5,000 is refundable in the event that the firm does not use the license within 3 days. (10 points) a) What is the firm's fixed cost? b) What are the firm's sunk cost? c) suppose Mr. Johnson obtains the license but does not use it. Two days after signing the lease, Mr. James, another business tycoon offers Mr. Johnson $4,000 for the license. Should Mr. Johnson accept the offer? Why?

Explanation / Answer

Q3.

(a) License fee for operating business in the City of Atlanta is $25,000.

It has been provided that license fee is refundable but not in full. Only $5,000 are refundable and that also in the event, the firm does not use the license with in 3 days.

Fixed cost is the cost that does not change with level of output. If Mr. Johnson obtains the license and open business and produce whatever level of output, license fee will remain same. As license fee remains same whatever be the level of output, therefore, license fee is the fixed cost for the firm.

License fee is $25,000.

Hence, the firm's fixed cost is $25,000.

(b) Sunk cost refers to the cost that has already been incurred and could not be recovered.

In the given case, firm obtains license to start business by paying $25,000. Even if firm decides not to start business then also only $5,000 are refundable and that also within 3 days. Remaining $20,000 are non-refundable.

So,after obtaining license, whatever the firm decides - to operate or not, $20,000 has already been incurred and could not be recovered.

Thus, firm's sunk costs are $20,000.

(c) It has been provided that if firm does not use license within 3 days and revert it back, it can get $5,000 as refund.

It's only been two days since Mr. Johnson has obtained license. If he does not intend to use it, he has one more day to surrender it to authorities and get refund of $5,000.

Mr. James is offering only $4,000 which is less than the amount Mr. Johnson can get as refund.

With one day's time still with Mr. Johnson, he should not accept the offer of Mr. James as he can get higher payout as refund if he surrenders the license in next one day.

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