Question

Q2: Frank is thinking about quitting his teaching job, which pays $75,000 per year, to own and operate his own food truck business. If he starts the business, he will spend $90,000 to purchase a truck and appliances (which he feels is a better option than renting the physical capital). This amount of money would come from two sources: $35,000 would be borrowed from a bank at an interest rate of 4% per year and $55,000 would come from Frank’s savings, which are currently earning interest of 0.6% per year in a no-risk savings account but could earn 11% if invested in an alternative such as corporate bonds that were equally risky as his intended food truck business. Frank expects his food truck business will spend $70,000 per year on assistants, $17,000 per year on food and beverages, and $5,000 per year on other costs such as gasoline, propane, and food containers. The truck and appliances are expected to have a useful life of 8 years and a scrap value of $2,000 and Frank expects to use straight-line depreciation. Frank expects to pay himself a salary of $15,000 per year while operating his food truck business. Finally, he expects the food truck business to generate total revenues of $170,000 per year after it has been operating for several years and has matured.

a) What are the expected annual explicit costs of Frank’s intended food truck business AND what do they add up to?

b) What are the expected annual implicit costs of Frank’s intended food truck business AND what do they add up to?

Hint: There are only two implicit costs.

c) What is the expected annual accounting profit of Frank’s intended food truck business?

d) What is the expected annual economic profit of Frank’s intended food truck business?

e) What amount of income would Frank earn annually if he operated his food truck business?

Hint: Follow the actual money that flows to Frank.

f) What amount of income would Frank earn annually if he chose the best alternative to operating his food truck business?

g) Would an economist recommend that Frank start the food truck business? Explain.

Q1: True or false: A business making a positive accounting profit should always operate?

Answer 1

a) expected annual explicit costs are:

Depreciation on truck and equipment = 88000 / 8 = 11000

Salary to assistants = 70000

Food and beverages = 17000

Other costs = 5000

Frank's salary = 15000

Interest on bank loan (4% on 35000) = 1400

Total = 119400

b) Annual implicit costs

Salary foregone by Frank = 75000

Return on corporate bonds on 55000 @ 11% = 6050

Total 81050

c) expected accounting profits = revenue - accounting cost = 170000 - 119400 = 50600

d) expected economic profits = account profits - implicit costs = 50600 - 81050 = -30450

e) Frank would earn (accounting wise) = salary from food truck business + profits from food truck business = 15000 + 50600 = 65600

f) Frank's best alternative is to continue his job and invest the 55000 he has in corporate bonds and earn 81050

g) No, since his best alternative is better than running his food truck business (income of 81050 versus 65600)

Q1 - Not true. A business earning accounting profits doesn't consider implicit costs and these may be higher than the accounting profits earned by the business implying that the business is actually making losses.