Chapter 8 The Quest For Profit And The Invisible Hand 3 Additional Questions

In Accountant’s point of view, “Profit” means the difference between total revenue and the actual payment incurs for a firm’s factor of production. Accounting Profit = Total Revenue – Explicit costs In Economist’s point of view, “Profit” means the difference between total revenue and the total cost. Recall, in Economics, “Total cost” means the sum of explicit costs and implicit costs (or opportunity cost) Economic profit = Total Revenue – Explicit costs – Implicit costs

Thus, Accounting Profit and Economic Profit is differ by the value of Implicit cost (or Opportunity cost). This is called “Normal Profit” – the opportunity cost of the resources supplied by a firm’s owners. It is the differences between accounting profit and economic profit. Normal Profit = Accounting Profit – Economic Profit

Accounting Profit = Total Revenue – Explicit costs Economic Profit = Total Revenue – Explicit costs – Implicit costs Economic Profit = Accounting Profit – Implicit costs A firm’s decision: It should remain in the business if the firm is, - Earning positive economic profit : Accounting profit > Implicit costs It is indifference to stay or leave if the firm is, - Earning zero economic profit. Accounting profit = Implicit costs

Smith is a corn farmer earning economic profits and Wesson is a wheat farmer receiving a normal profit. Wesson has an incentive to become a corn farmer because A)His accounting profits are negative. B)He is not currently covering his opportunity costs. C)He could earn more than his next best alternative. D)His accounting profits are zero. E)He dislikes Smith and wants to undermine Smith’s profit. Ans:C Additional Question #1

Economic Profit = Total Revenue – Explicit costs – Implicit costs Economic Profit = Accounting Profit – Implicit costs (Normal profit) Normal Profit = Accounting Profit – Economic Profit Smith is earning economic profit, he is able to cover the explicit cost and as well as the implicit cost. Wesson is receiving a normal profit, he is only able to cover the implicit cost. Wesson has an incentive to become a corn farmer only if he could earn more than the normal profit. All rational farmers of course will choose the alternative that yields the highest economic profit. Thus, Wesson will be attracted to corn farming. (C)

Assume you have an idea for a new fruit picking machine that will cost the same as current fruit picking methods but will yield 10% more revenue because it will pick more fruit and damage less. To develop the new machine you would have to take two years off from your $25,000/year job managing the fruit company. Should you take the time off to develop the new machine if the current fruit revenue is $500,000? Explain. Should take the time off if it earns a positive Economic profit: Economic Profit = Accounting Profit – Implicit costs (Normal profit) Accounting Profit on the development of new machine > Implicit cost Additional Question #2

To take 2 years time off to develop the new machine, need to forgo: - 2 years current job salary, 2($25,000) = $50,000 This is the opportunity cost to develop the new machine Revenue from the new machine, $500,000 (0.1) = $50,000 Accounting profit = $50,000 Economic profit = $50,000 - $50,000 = $0 Therefore, you are indifference to take 2 years time off to develop the new machine or to stay in the current job.

Assume you own, manage and are the only employee for a T- shirt concession at a college sports arena. The financial information for the business is given below. Additional Question #3 Retail price of shirt$15 Number of shirts sold per day100 Cost of plain T-shirt$5each Cost of T-shirt design$5each Equipment rental fee (per day)$100 Stand rental fee (per day)$200

A) What is your accounting profit? Total revenue = $15 x 100 = $1500 Total explicit cost = $5(100) + $5(100) + $100 +$200 = $1300 Accounting profit = $ $1300 = $200 Retail price of shirt$15 Number of shirts sold per day100 Cost of plain T-shirt$5each Cost of T-shirt design$5each Equipment rental fee (per day)$100 Stand rental fee (per day)$200

B) Your next best alternative job is to work as a manager for another local retail business. If your economic profit is zero, how much could you earn as a manager for another business? It is equivalent to ask, What is the cost of your next best alternative (or opportunity cost)? Economic profit = Total revenue – Explicit cost - Implicit Or Economic profit = Accounting profit – Implicit cost If economic profit is zero, then your next best alternative (opportunity cost) must equal to the Accounting profit, $200/day.

C) Assume you enjoy owning and operating the T-shirt stand (you value it at $100 per day). If your total costs increased to $1600, and if you shut down total cost would be zero, should you continue selling t-shirts? Explain. If continue to sell T-shirt: The new Accounting Profit is $ $1600 = -$100 The new Economic Profit is $ $ $200 = -$300 Even though you value the work at $100, you should shut down the stand. The $100 value of working at the stand covers the accounting loss, but you can not cover your opportunity cost, $200. Since you are making negative Economic Profit, you should not continue selling T-shirts.

~ End of Chapter 8 ~