Question

Two university graduates, Bill and Steve, worked for an advertising agency at an annual salary of $40,000 each for 3 years after they graduated. Then, they decided to quit their jobs and start a partnership that designs and builds Web sites. They rented an office for $12,000 a year and bought capital for $30,000. To pay for the equipment, Bill and Steve borrowed money from a bank at an annual interest rate of 6 percent. During their first year of operation, the partners' total revenue was $100,000. The market value of their capital at the end of the year was $20,000. If Bill and Steve do not design Web pages, their best alternatives are to return to their previous job.

a)​What is the firm's economic depreciation?

b)​What are the partnership's costs?

c)​What is the firm's economic profit in the first year of operation?

Answer 1

a) Economic depreciation of the firm

This is the decrease in the value of the firm during the year

Economic depreciation = Cost of investment - Market value at the end of the year

= 30000 - 20000 = 10000 $

b) Costs of Partnership

Actual costs = Expenses incurred = Rent + Interest on loan = 12000+ 30000*6%

= 13800 $

Opportunity costs = Salary lost = 40000*2 = 80000 $ ( These are to be included in costs because this amount is lost to the partners as they choose to run the partnership. Had they continued the jobs, they could have gained this. Otherwise, the partners are not drawing anything from the partnership firm. Their remuneration should be actually borne by the firm, which is included as opportunity costs, even if actually unpaid.)

Total costs including opportunity costs = 93800 $

c) Economic profits of partnership

Revenue earned - Economic costs = 100000 -93800 = 6200 $

Note: Depreciation on machinery is ignored as it is not given in the question.