Answer to Question #155189 in Microeconomics for Mar

Question

Andris has started his own business.

He has invested in his business - 40 000.

Bank interest rate 10%.

Revenue:

72 000.

Expenses:

rent 5 000,

labor 12 000

equip. 20 000.

Determine:economic profit and accounting profit

Will Andris continue to run his business?

Answer 1

$\bold {Answers}$

Accounting profit $= \$55,000$

Economic profit $=\$53,400$

Decision: He should continue running the business because it yields positive profits and higher returns than investing in the bank.

$\bold {Solutions}$

Profit = Total revenue - total expenses

Accounting profit

= Total revenue - total explicit costs

= Revenue - (rent + labour)

= $72,000 - (5,000 + 12,000)

= $72,000 - $17,000

= $55,000

Economic profit

= Total revenue - explicit costs - implicit costs

= Accounting profit - implicit costs

In this case, the only implicit cost is the interest forgone by not investing the money in a savings account in the bank.

Opportunit cost = $40,000 × 4%

= $40,000 × 0.04

= $1,600

Therefore,

Economic profit = $55,000 - $1,600

= $53,400

Note: the equipment cost of $20,000 is a capital expenditure, not a renenue expenditure. Hence, it is not included in profit computations.

The $40,000 investment cost is a sunk cost.

Decision: Andris should continue running his business since he realize positive profits. Both accounting and economic profits are positive. Also, running the business yields higher annual returns as compared to the bank annual interest of $1,600.