An owner considers adding an elevator to a three-story rental building. Under the principle of increasing and decreasing returns, when is it economically justified?
Correct Answer
A) When the value it adds at least equals its cost
Additional investment is justified as long as marginal benefits equal or exceed marginal costs. For the elevator, that means the value added, measured by the increase in net rental income, should be at least equal to its cost.
Why This Is the Correct Answer
Option A is correct because the elevator is economically justified if the value it adds, measured by an increase in net rental income, is at least equal to its cost. This applies the rule that added investment makes sense while marginal benefits equal or exceed marginal costs.
Why the Other Options Are Wrong
Option B: Whenever the tenants say they would prefer an elevator
Option B, whenever tenants say they would prefer an elevator, is wrong because stated preferences do not show that tenants will pay enough added rent to cover the cost. The test is value added compared with cost.
Option C: When its cost is less than 10% of the building’s value
Option C, when its cost is less than 10% of the building's value, is wrong because no fixed percentage of building value determines feasibility. The cost must be compared with the value the elevator adds, whatever the percentage.
Option D: Whenever competing buildings in the area have elevators
Option D, whenever competing buildings have elevators, is wrong because competitors' features do not prove this elevator would add value at least equal to its cost. Competition may matter, but the test remains marginal benefit versus marginal cost.
Benefit must cover the bill
An improvement pays off only if the value it adds is at least as much as what it costs.
How to use: Use this when a question asks whether an added improvement is economically justified.
Exam Tip
Look for the answer that compares added value or added net income with added cost rather than one based on preference or a fixed percentage.
Common Mistakes to Avoid
- -Relying on tenant preference instead of income evidence
- -Using an arbitrary percentage rule for feasibility
- -Copying competitors' features without testing value added
Concept Deep Dive
Analysis
This question tests the principle of increasing and decreasing returns. Added investment is justified as long as the marginal benefit equals or exceeds the marginal cost. For a rental building, the benefit is measured by the value added through higher net rental income.
Background Knowledge
The principle of increasing and decreasing returns says that added inputs first raise value at an increasing rate, then at a decreasing rate. Investment is justified up to the point where the added value no longer covers the added cost.
Real-World Application
An investor asks an appraiser whether adding an elevator to a three-story walk-up fourplex makes sense. The appraiser estimates the rent increase the elevator would support, converts that net income gain to value and compares it with the installation cost.
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