Chapter 8 The Quest For Profit And The Invisible Hand

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Chapter 8The Quest For Profit And The Invisible
Hand
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Problem 3, Chapter 8

• John Jones owns and manages a café in Collegetown
  whose annual revenue is 5,000. Annual expenses
  are as above

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Solution to Problem 3 (1)

• A) Calculate Johns annual accounting profit
• Recall the difference between accounting profit
  and economic profit
• Accounting profit Total revenue Total
  explicit cost
• Economic profit Total revenue Total explicit
  and implicit costs
• Economic profit is always less than accounting
  profit
• In this question, the total annual revenue is
  5,000
• The total explicit cost is the sum of the annual
  expenses
• Total explicit cost Labour Food and drink
  Electricity Vehicle lease Rent Interest on
  loan for equipment
• Total explicit cost 4250

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Solution to Problem 3 (2)

• Annual accounting profit 5000 - 4250 750
• B) 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 recycler
• If he runs the café, he will forgone the annual
  income (1000) that he can potentially earn from
  being a recycler

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Solution to Problem 3 (3)

• In addition, if he runs the café, he will receive
  benefit which is equivalent to 275 per year
• Therefore, if he runs the café, he will forgo the
  potential income earned from recycling minus the
  benefits he receives from the café
• His true opportunity cost is 1000 - 275 725
• Economic profit Accounting profit Implicit
  cost (OC)
• Economic profit 750 - 725 25
• Since Johns annual economic profit is greater
  than 0, he should run the business

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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 1100 - 275 825
• Again, economic profit accounting profit
  opportunity cost
• New economic profit 750 - 825 -75
• Since the new economic profit is less than zero,
  John will suffer from an annual economic loss of
  75 from running the cafe

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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
  equipment
• As a result, the total explicit cost would be
  decreased by 1000 to 3250
• Therefore, the new annual accounting profit
  5000 - 3250 1750

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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 equipment
• The 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 b
• New economic profit new accounting profit new
  opportunity cost
• New economic profit 1750 (1000 - 275
  1000)
• New economic profit 1750 - 1725 25 (No
  change!)

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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 firm
• To earn a normal profit, the café would have to
  cover all its implicit and explicit costs
• After all explicit costs are taken into account,
  the opportunity cost of running the café is 1000
• The accounting profit of running the café is 750
• Therefore, the café would have to earn an
  additional annual revenue of 250 to earn a
  normal profit of zero

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Problem 9, Chapter 8

• You 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?

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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 investment
• Given 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 orchard
• In addition, you will have to forgo the potential
  income you earn from your current job, which is
  10,000 per year
• Recall economic profit total revenue total
  explicit and implicit costs

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Solution to Problem 9 (2)

• Total revenue 25,000 per year
• Total 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 10,000 (0.10Priceappleorchard)
• Priceappleorchard 150,000