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 $160,000 for labor, $50,000 for rent, and $30,000 for equipment. There is a one-half probability that revenues will be $210,000 and a one-half probability that revenues will be $400,000.

Instructions: For all parts, enter a loss as a negative number. If you are entering any negative numbers be sure to include a negative sign (-) in front of those numbers.

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

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

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

Your accounting profit?

Your economic profit?

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

   (Click to select)  No  Yes

c. 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?

In the high-revenue case?

What will your average after-tax accounting profit be?

What about your average after-tax economic profit?

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

Answer 1

Particulars	Calculation	Low revenue situation	High revenue situation	Expected Value
		P	Q	R=0.5*P+0.5*Q
Probability		0.5	0.5
Revenue	A	2,10,000	4,00,000	3,05,000
Labour	B	1,60,000	1,60,000
Rent	C	50,000	50,000
Equipment	D	30,000	30,000
Opportunity cost	E	60,000	60,000		Quit job
Economic Profits	F=A-B-C-D-E	-90,000	1,00,000	5,000	Yes
Accounting Profits	G=A-B-C-D	-30,000	1,60,000	65,000	Yes
After tax of 25%
Tax	H=G*25% (if positive)	-	40,000		Quit job
Profit after tax	I=G-H	-30,000	1,20,000	45,000	Yes
Economic Profit after tax	J=F-H	-90,000	60,000	-15,000	No

1. a. In low revenue situation accounting losses will be -30,000.

b. In high revenue situation accounting profit will be 160,000.

2. a. expected revenue = 0.5*210000 + 0.5*400000 => 305,000

b. Average accounting profit (0.5*160000+ 0.5*(-30000)) => 65,000.

c. Average economic profit (0.5*100000 + 0.5*(-90000)) => 5,000

d. As both average accounting profits and economic profits are positive, I will quit my job.

3. After government levied tax of 25% on profits:

a. Accounting profits after tax in low revenue case = -30,000 (No tax as no profits is there).

b. Accounting profits after tax in high revenue case = 120,000 (160,000 * (1-25%))

c. Average after tax accounting profits = (-30000*0.5 + 120000*0.5) => 45,000.

d. Average after tax economic profits = (-90,000*0.5 + 60,000*0.5) => -15,000.

As economic profit after tax is negative, i will not quit job.

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