Question

You are currently a worker earning $60,000 per year but are considering becoming an entrepreneur. You will not switch unless you earn an accounting profit that is on average at least as great as your current salary. You look into opening a small grocery store. Suppose that the store has annual costs of $150,000 for labor, $60,000 for rent, and $40,000 for equipment. There is a one-half probability that revenues will be $210,000 and one-half probability will be $420,000.

A. In the low-revenue situation, what will your accounting profit or loss be?

B. In the high-revenue situation, what will your accounting profit or loss be?

C. On average, how much do you expect your revenue to be?

D. Your accounting profit?

E. Your economic profit?

F. Will you quit your job and try your hand at being an entrepreneur?

G. Suppose the government imposes a 25 percent tax on accounting profits. This tax is only levied if a firm is earning positive accounting profits. What will your after-tax accounting profit be in the low-revenue case?

H. In the high-revenue case?

I. What will your average after-tax accounting profit be?

J. What about your average after-tax economic profit?

K. Will you now want to quit your job and try your hand at being an entrepreneur?

L. Other things equal, does the imposition of the 25 percent profit tax increase or decrease the supply of entrepreneurship in the economy?

Answer 1

(A)

Explicit costs of business are as follows -

Labor = $150,000

Rent = $60,000

Equipment = $40,000

In low-revenue situation,

Total revenue = $210,000

Total explicit cost = Labor + Rent + Equipment

Total explicit cost = $150,000 + $60,000 + $40,000 = $250,000

Calculate the accounting profit -

Accounting profit = Total revenue - Total explicit cost = $210,000 - $250,000 = -$40,000

The accounting profit is -$40,000.

Negative profit implies loss.

So,

In the low-revenue situation, the accounting loss will be $40,000.

(B)

Explicit costs of business are as follows -

Labor = $150,000

Rent = $60,000

Equipment = $40,000

In high-revenue situation,

Total revenue = $420,000

Total explicit cost = Labor + Rent + Equipment

Total explicit cost = $150,000 + $60,000 + $40,000 = $250,000

Calculate the accounting profit -

Accounting profit = Total revenue - Total explicit cost = $420,000 - $250,000 = $170,000

The accounting profit is $170,000.

So,

In the high-revenue situation, the accounting profit will be $170,000.

(c)

There is a one-half probability that revenues will be $210,000 and one-half probability will be $420,000

Calculate the average revenue -

Average revenue = (0.50 * $210,000) + (0.50 * $420,000)

Average revenue = $105,000 + $210,000 = $315,000

On average, the revenue is expected to be $315,000.

(d)

Average revenue = $315,000

Total explicit cost = $250,000

Calculate the accounting profit -

Accounting profit = Average revenue - Total explicit cost = $315,000 - $250,000 = $65,000

The accounting profit would be $65,000 .

(e)

Accounting profit = $65,000

The person has to quit his job to start the business.

His current salary is $60,000.

So, he has to foregone the salary of $60,000.

Implicit cost = $60,000

Calculate the economic profit -

Economic profit = Accounting profit - Implicit cost

Economic profit = $65,000 - $60,000 = $5,000

The economic profit would be $5,000.

(f)

A positive economic profit indicate the viability of business in long run.

In given case, the economic profit is positive.

So,

The person must quit his job and try his hand at entrepreneurship.