Question

Ruth Ginsburg is evaluating two options. The first option is to open her own legal practice. Based on her business plan, she computed the following annual estimates using very conservative assumptions:

• Total revenue = $220,000
• Purchases = $80,000
• Utility costs = $27,000
• Parttime Administrative Assistant = $25,000

Ruth will operate the business by herself. She will operate the business from a building that she owns. The building has been paid in full.

The second option is to work for a law firm as a legal associate. Her annual salary would be $64,000. She could also rent her building for $24,000 per year.

Using the concepts of accounting profit and economic profit, compare and contrast the two options. Which option is the most profitable for Ruth Ginsburg?

Answer 1

First Option

Own legal practice (Business Plan)

Total revenue = $220,000

Purchases = $80,000

Utility costs = $27,000

Part time Administrative Assistant = $25,000

Total Explicit or accounting cost = $80,000 + $27,000 + $25,000 = $132,000

Accounting Profit = TR – Accounting Cost

Accounting Profit = $220,000 – $132,000 = 88,000

Second Option

Working for legal firm

Annual salary = $64,000

Rent of the building = $24,000

Total Implicit cost = $64,000 + $24,000 = $88,000

Economic Profit = Accounting Profit – Implicit Cost

Economic Profit = 88,000 – 88,000 = 0

Economic profit is zero.

The concept of economic profit can be negative, positive or zero. If the economic profit is negative, then the market or option is not attractive and the firm should exit from the market (or not to invest money). If the economic profit is positive, then the firm should invest the money. There will be incentives to enter into the market.

If the economic profit is zero, then there is no reason to enter or exit from the market. In the above question the economic profit is zero and the person will be indifferent to enter or to leave the market. It otherwise means he will be in an indifferent state of mind to select either the business plan or to work for a legal firm. When economic profit is zero, a firm is earning the same as it would if its resources were employed in the next best alternative.