Frank Murphy is considering how many snowmobiles to purchase for his snowmobile rental business. Below are his estimates of the number of snowmobile rentals per year, depending on the number of snowmobiles available. After paying all non-interest expenses, expenses Frank expects to net $10 per rental. Each snowmobile costs $15,000. How many snowmobiles should Frank purchase if the real interest rate is 5.5%?

Question

Frank Murphy is considering how many snowmobiles to purchase for his snowmobile rental business. Below are his estimates of the number of snowmobile rentals per year, depending on the number of snowmobiles available.  After paying all non-interest expenses, expenses Frank expects to net $10 per rental. Each snowmobile costs $15,000. How many snowmobiles should Frank purchase if the real interest rate is 5.5%?

Quizplus · Accepted Answer

Since the additional number of rentals (marginal product), is diminishing when more snowmobiles are purchased, the value of the marginal product is also diminishing. While the first snowmobile adds 90 rentals per year (90 - 0), the second snowmobile adds only 80 rentals per year (170 - 90) and so forth. The marginal value of marginal product is therefore: $900 for the first snowmobile (90 × $10), $800 for the second snowmobile (80 × $10), $700 for the third snowmobile (70 × $10), $600 for the fourth snowmobile (60 × $10), and $500 for the fifth and final snowmobile (50 × $10). Since the annual interest cost of each snowmobile is $825 (5.5% × $15,000), the value of marginal product exceeds $825 for only the first snowmobile but not for the second one, so only 1 snowmobile should be purchased.

Frank Murphy Is Considering How Many Snowmobiles to Purchase for His