Question

Two former Northwestern University students worked in an

investment bank at a salary of $60,000 each for 2 years after

they graduated. Together they saved $50,000. After 2 years,

they decided to quit their jobs and start a business designing

Web sites. They used the $50,000 to buy computer equipment,

desks, and chairs. For the next 2 years, they took in $40,000 in

revenue each year, paid themselves $10,000 annually each,

and rented an office for $18,000 per year. Prior to the investment,

their $50,000 was in bonds earning interest at a rate of

10 percent. Are they now earning economic profits? Explain

your answer.

Answer 1

Economic profit is that profit which is in excess of the opportunity cost of the money they spend to produce their product

The opportunity cost of their time each per year = $60000/2

= $30000

The opportunity cost of their capital in bond = 10% *50000

=$5000

total opportunity cost =$60000+$5000 =$65000

Their gross revenue =$40000

Rent=$18000

Total net profit=$40000-18000 =$22000

Economic profit=Net profit-opportunity cost

=$22000-$65000

Economic loss =$43000