Question

John Smith previously earned £ 10,000 a year in employment and had £ 100,000 invested in government securities, yielding 10% per annum. He sold his securities for £ 100,000 and started his own business. Initially, he rented a factory for £ 5000 per annum, but subsequently purchased it for £ 20,000, leaving £ 80,000 as the financial capital within the firm. John Smith’s accountants estimate that total revenue of the firm in the past year was £ 100,000 and total costs were £ 80,000, including a salary of £ 5000 paid to John Smith.

Estimate the profit of this firm from the viewpoint of (i) The accountant (ii) The economist, explaining clearly the reason for any difference. [15 marks]

Answer 1

1) Assuming that the profit is being calculated from the point of view of an accountant, profits would be total revenue less explicit costs. This means that any implicit costs in terms of opportunity costs would not be taken into account while arriving at the final profits. Now, the revenues of the business were GBP 100000 and total explicit costs were GBP 80000, which means that total accounting profit is GBP 20000.

2) When we are calculating economic profits, we shall subtract any implicit costs in terms of opportunity cost from the accounting profit. We see, first, that John Smith would've earned GBP 10000 in employment, but the business has only paid him GBP 5000 in salary, which means there is an opportunity cost of GBP 5000 that John Smith faces as the owner of this business. Secondly, the capital invested yielded John Smith 10%, or an amount of GBP 10000 per annum, which is another opportunity cost of running the business. However, he later only left $80000 as financial capital in the firm, so the opportunity cost now is GBP 8000. Finally, the land that is owned and is used for business could've been rented in the market for GBP 5000, which is another implicit cost of doing business on it. So, the total implicit/opportunity costs are (5000+8000+5000)= GBP 18000. We subtract this from accounting profit of GBP 20000 to arrive at an economic profit of GBP 2000.