Question

John Jones owns and manages a café whose annual revenue is $50 000. Annual expenses are as follows:

Labour	$20 000
Food and drink	$5 000
Electricity	$1 000
Vehicle lease	$1 050
Rent	$5 000

                Interest on loan for equipment            $10 000

1. Calculate John's annual accounting profit.                                        
2. John could earn $10 000 per year as a recycler of aluminium cans. However, he prefers to run the café. In fact, he would be willing to pay up to $2750 per year to run the café rather than to recycle. Calculate his opportunity cost of running the café. Is the café making an economic profit (calculate the profits)? Should John

                stay in the café business? Explain.                                                    

3. Suppose the café's revenues and expenses remain the same, but recyclers' earnings rise to $11 000 per year. Calculate his new opportunity cost. Is the café still making an economic profit (calculate the profits)? Explain.
4. Suppose John had not had to get a $100 000 loan at an annual interest rate of 10 per cent to buy equipment, but instead had invested $100 000 of his own money in equipment. HOW would your answer to parts (a) and (b) change  

  

With reference to your answer in Question 3(a) above, if John can earn $10 000 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?

[Hint: To earn a normal profit, Accounting profit = Implicit Cost]

Answer 1

Accounting profit is total revenue minus explicit costs. Explicit costs are those that require monetary payments like rent, salary, repairs etc.

a)

Revenue= $50,000

Annual expenses=

Labour	$20,000
Food and drink	$5 000
Electricity	$1 000
Vehicle lease	$1 050
Rent	$5 000

         Interest on loan for equipment        $10 000

Total                                                =        $42,050.

Accounting profit= Revenue- annual expenses

                           = $50,000 - $42,050=$7,950.

Accounting profit = $7,950.

b)

Economic profit is total revenue minus (explicit costs + implicit costs). Implicit costs do not require actual monetary payments. Implicit costs are opportunity costs. Opportunity cost is the value of the next best alternative.

Opportunity cost for John is $10,000 - $2,750= $7,250.

Economic profit = Total revenue – (explicit costs + implicit costs)

= $50,000 – ($42,050 + $7,250)=$50,000 - $49,300= $700.

Since John is making an economic profit, he should stay in business.

c)

Opportunity cost for John is $11,000 - $2,750= $8,250.

Economic profit = Total revenue – (explicit costs + implicit costs)

= $50,000 – ($42,050 + $8,250)=$50,000 - $50,250= -$250..

Since John is making an economic loss, he should leave business.

d)

a) Accounting profit will rise by $10,000. It would be $17, 950. So in part (a), accounting profit will rise by $10,000.

b) $1,000 is the interest foregone when he invests his own money. The implicit cost will not be$10,000 + $8250=$18,250

Economic profit will be $50,000 ($17,950 + $18,250)=$50,000 - $36,200 = $13,800.

Answer will not change as John is making an economic profit.

e) Normal profit means when

Accounting profit = Implicit costs

Implicit cost is $10,000.

Accounting profit is $7,950, so he has to earn 2,050 to make normal profit.