A developer can build one to six stories on a site. Each added story costs $500,000. Market analysis shows the value each added story contributes: 2nd story $700,000; 3rd story $800,000; 4th story $540,000; 5th story $430,000; 6th story $330,000. Under the principle of increasing and decreasing returns, what height is economically justified?
Correct Answer
B) 4 stories
Added investment is justified as long as marginal benefit equals or exceeds marginal cost. The 4th story adds $540,000 for $500,000; the 5th adds only $430,000 for $500,000, so building stops at four stories. Stopping at three confuses the onset of decreasing returns with the point where returns fall below cost; five includes the first unjustified story; six maximizes total value while ignoring cost.
Why This Is the Correct Answer
Option B is correct because each story through the 4th adds at least its $500,000 cost: the 4th adds $540,000, a net gain of $40,000. The 5th adds only $430,000, $70,000 less than its cost, so building beyond four stories lowers the net return.
Why the Other Options Are Wrong
Option A: 3 stories
Option A, 3 stories, stops where the marginal gain peaks at $800,000. Returns do begin to decrease after that, but the 4th story still adds $540,000 for a $500,000 cost, so it is justified.
Option C: 5 stories
Option C, 5 stories, includes the 5th story, which adds $430,000 but costs $500,000, a loss of $70,000. The last justified story is the 4th.
Option D: 6 stories
Option D, 6 stories, builds every story that adds any value, which maximizes total value but ignores cost. The 5th and 6th stories add $430,000 and $330,000 against $500,000 each, losing $70,000 and $170,000.
Stop when gain dips below cost
Decreasing returns are a warning, not a stop sign. Keep adding until the next unit's added value falls below its added cost.
How to use: Use this on any table of added costs and added values, whether stories, units or remodeling items.
Exam Tip
Write the net gain of each increment beside the table; the answer is the last increment with a gain of zero or more.
Common Mistakes to Avoid
- -Stopping as soon as marginal returns begin to decline
- -Maximizing total value instead of value net of cost
- -Including the first increment whose added value is below cost
Concept Deep Dive
Analysis
This is a marginal analysis problem. Compare each story's added value with its added cost, and keep building while the added value is at least the added cost. The trap is that returns start to decrease after the 3rd story, but decreasing returns do not mean the next story is unjustified until its added value drops below cost.
Background Knowledge
The principle of increasing and decreasing returns holds that adding agents of production raises net income up to a point, after which each further increment adds less. Investment is justified while marginal benefits equal or exceed marginal costs, which is how owners judge additions, remodeling and building height.
Real-World Application
An appraiser doing a feasibility study for a mid-rise project tests several building heights. She recommends the height at which the last added floor still returns at least its cost.
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