Presentation on theme: "Chapter 8 The Quest For Profit And The Invisible Hand"— Presentation transcript:
1 Chapter 8 The Quest For Profit And The Invisible Hand
2 Problem #3, Chapter 8 Labour $2000 Food and drink $500 Electricity $100Vehicle lease$150RentInterest on loan for equipment$1,000John Jones owns and manages a café in Collegetown whose annual revenue is $5,000. Annual expenses are as above
3 Solution to Problem #3 (1) A) Calculate John’s annual accounting profitRecall the difference between accounting profit and economic profitAccounting profit = Total revenue – Total explicit costEconomic profit = Total revenue – Total explicit and implicit costsEconomic profit is always less than accounting profitIn this question, the total annual revenue is $5,000The total explicit cost is the sum of the annual expensesTotal explicit cost = Labour + Food and drink + Electricity + Vehicle lease + Rent + Interest on loan for equipmentTotal explicit cost = $4250
4 Solution to Problem #3 (2) Annual accounting profit = $ $4250 = $750B) John could earn $1000 per year as a recycler of aluminum cans. However, he prefers to run the café. In fact, he would be willing to pay up to $275 per year to run the café rather than to recycle. Is the café making an economic profit? Should John stay in the café business? Explain.Considers the two options for John: Running a café or Being a recyclerIf he runs the café, he will forgone the annual income ($1000) that he can potentially earn from being a recycler
5 Solution to Problem #3 (3) In addition, if he runs the café, he will receive benefit which is equivalent to $275 per yearTherefore, if he runs the café, he will forgo the potential income earned from recycling minus the benefits he receives from the caféHis true opportunity cost is $ $275 = $725Economic profit = Accounting profit – Implicit cost (OC)Economic profit = $750 - $725 = $25Since John’s annual economic profit is greater than 0, he should run the business
6 Solution to Problem #3 (4) C) Suppose the café revenues and expenses remain the same, but the recyclers’ earnings rise to $1,100 per year. Is the café still making an economic profit? Explain.If the earnings from recycling increases to $1,100, that means the true opportunity cost becomes $ $275 = $825Again, economic profit = accounting profit – opportunity costNew economic profit = $750 - $825 = -$75Since the new economic profit is less than zero, John will suffer from an annual economic loss of $75 from running the cafe
7 Solution to Problem #3 (5) D) Suppose John had not had to get a $10,000 loan at an annual interest rate of 10 percent to buy equipment, but instead had invested $10,000 of his own money in equipment. How would your answer to parts a and b change?If John did not borrow a loan to finance the equipment, he could save the interest on loan for equipmentAs a result, the total explicit cost would be decreased by $1000 to $3250Therefore, the new annual accounting profit = $ $3250 = $1750
8 Solution to Problem #3 (6) However, the economic profit in part b would not change (assuming that the interest rate one has to pay on bank loan is the same as that one gets from bank deposits.)There would be a new opportunity cost for the interest income of $1000 that John would forgo by investing his money in the equipmentThe increase in the accounting profit in part a would be offset by the new opportunity cost when we calculate the new economic profit for part bNew economic profit = new accounting profit – new opportunity costNew economic profit = $1750 – ($ $275 +$1000)New economic profit = $ $1725 = $25 (No change!)
9 Solution to Problem #3 (7) E) If John can earn $1000 a year as a recycler, and he likes recycling just as well as running the café, how much additional revenue would the café have to collect each year to earn a normal profit?Normal profit refers to the opportunity cost of the resources owned by the firmTo earn a normal profit, the café would have to cover all its implicit and explicit costsAfter all explicit costs are taken into account, the opportunity cost of running the café is $1000The accounting profit of running the café is $750Therefore, the café would have to earn an additional annual revenue of $250 to earn a normal profit of zero
10 Problem #9, Chapter 8You have an opportunity to buy an apple orchard that produces $25,000 per year in total revenue. To run the orchard, you would have to give up your current job, which pays $10,000 per year. If you would find both jobs equally satisfying, and the annual interest rate is 10 percent, what is the highest price you would be willing to pay for the orchard?
11 Solution to Problem #9 (1) If you buy the apple orchard, you will incur an opportunity cost of forgoing the alternative use of money like investmentGiven in the question, the annual interest rate is 10%That means if you buy the apple orchard, you will incur an opportunity cost that is equivalent to 10% of the price of the apple orchardIn addition, you will have to forgo the potential income you earn from your current job, which is $10,000 per yearRecall economic profit = total revenue – total explicit and implicit costs
12 Solution to Problem #9 (2) Total revenue = $25,000 per yearTotal cost = $10,000 forgone income + (Priceappleorchard * 10% annual interest rate)You are willing to pay for the apple orchard up to a value that makes a zero economic profit$25,000 = $10, (0.10*Priceappleorchard)Priceappleorchard = $150,000
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