Question

1. Collins is currently teaching computer age philosophy at MIT, making $85,000 per year. He is considering leaving his job to open up a restaurant in Santa Fe. He estimates that he will need to spend $200,000 per year on space and supplies and $100,000 per year on wages for his staff. The restaurant will earn $340,000 per year in revenue.

1. Assuming his estimates are accurate, what will Collins’ accounting profit be each year?

2. Assuming his estimates are accurate, what will Collins’ economic profit be each year?

3. Explain, beyond just reciting how it is calculated, what economic profit means, and why economists might believe it is a better estimate for the profitability of an economic decision.

Answer 1

A) Accounting profit refer to the profits earned by deducting the explicit costs from revenue.

Accounting profit of Collins when he opens the restaurant is $340,000-100,000-200,000=$40,000.

So his accounting profit is $40,000

B) Economic profits refer to the calculation of profits by not just explicit costs but implicit costs as well. So Collins opportunity cost ie the salary he gave up is also included as a part of implicit costs

Total economic profit= revenue- explicit costs - implicit costs

=$340,000-100,000-200,000-85000

=(-) $45,000

So the economic profit are (-)$45000

c) Economic profits are much better estimates for the probability of economic decision because it takes into account the implicit or opportunity costs ie the costs one has to give up for using the first best alternative by foregoing the second best alternative. Given that we have scarce resources and unlimited needs, it is important to have the implicit costs into account to put the resource in the best use.

In Collin'' case, it isn't advisable to take on the restaurant because one year of Colin could be utilised in a better way, giving him higher returns in being professor than an owner of restaurant.

(You can comment for doubts)