Question

(a) Magnus, a lawyer working for a large firm and earning $60,000 per year is contemplating setting up his own law practice. He estimates that renting an office would cost $10,000 per year, hiring a legal secretary would cost $20,000 per year, renting the required office equipment would cost $15,000 per year and purchasing the required supplies, paying for electricity, telephone and so forth would cost another $5,000. Magnus estimated that his total revenues for the year would be $100,000 and he is indifferent between keeping his present occupation with the large law firm and opening his own law office.

(i) How much would be the explicit cost of Magnus for running his own law office?

(ii) How much would the accounting costs be?

(iii) How much would the implicit cost be?

(iv) How much would the economic costs be?

(v) Should Magnus (the lawyer) go ahead and start his own practice?

(b) A profit maximizing firm in a competitive market is currently producing 50 units of output. It has average revenue of $2, total variable cost of $80 and a total fixed cost of $60. As the manager, you are required to advise management on what to do.

(i) Use a graph to demonstrate the circumstances that would prevail in a competitive market.

(ii) Identify costs, revenue, and the economic losses or profits on your graph.

(iii)Determine whether this firm will shut down, exit or choose to remain in the market.

(iv)Explain your answer.

Answer 1

Question 1

(i)

Calculate the explicit cost of Magnus -

Explicit cost = Rent of office + Salary of legal secretary + Rent of office equipment + Miscellaneous expenses

Explicit cost = $10,000 + $20,000 + $15,000 + $5,000

Explicit cost = $50,000

The explicit cost of Magnus for running his own law office is $50,000.

(ii)

Accounting costs are the sum total of all explicit costs.

The sum total of all explicit costs is $50,000.

So,

The accounting costs would be $50,000.

(iii)

Calculate the implicit cost -

Implicit cost = Salary foregone

Implicit cost = $60,000

So,

The implicit cost would be $60,000.

(iv)

Calculate the economic costs -

Economic costs = Explicit costs + Implicit costs

Economic costs = $50,000 + $60,000 = $110,000

So,

The economic costs would be $110,000.

(v)

Magnus expects to earn a total revenue of $100,000.

However, total economic costs would be $110,000.

This implies that Magnus would not be able to recover all its costs and would incur an economic loss of $10,000.

So,

Magnus should not go ahead and start his own practice.