Question

Frederick opened a small organic grocery store last year and is considering the profits he made. His store took in $120,000 in total revenue. To rent his storefront for the year, he had to invest $40,000. To supply it with the shelves, refrigerators, registers, and other miscellaneous equipment necessary, he had to invest another $10,000. Over the course of the year, he paid his employees a total of $35,000. To run his new business, he had to give up his old yearly salary of $30,000. Instead of investing his money in the business, he could have invested it in the stock market and earned 10% interest. Assume that the stock market is Frederick’s next best alternative for investing his money and that he did not pay himself a wage.

1. What were Frederick’s implicit costs?

2. What was Frederick’s accounting profit?

3.

If Frederick’s goal was to make as much profit as possible, how does opening the grocery store compare with his next best alternative? (Hint: think about Frederick's economic profit)

Answer 1

Question 1

Implicit cost refers to the cost of resources provided the owner.

In the given case, owner has provided capital to pay rent and to purchase equipment.

$40,000 was provided for rent and $10,000 was provided for purchase of equipment.

So, a total capital of $50,000 was provided by the owner.

This money can be invested in the stock market and would have earned 10% interest.

Calculate the interest foregone -

Interest foregone = $50,000 * 0.10 = $5,000

Fredrick also have to give up yearly salary of $30,000 to work at his own business.

Foregone salary = $30,000

Calculate the implicit cost -

Implicit cost = Foregone salary + Foregone interest = $30,000 + $5,000 = $35,000

Thus,

The implicit cost is $35,000.

Question 2

Accounting profit is the difference between the total revenue and the explicit cost.

Following are the explicit cost of Fredrick -

Rent = $40,000

Equipment purchased = $10,000

Salaries paid = $35,000

Explicit cost = Rent + Equipment purchased + Salaries paid = $40,000 + $10,000 + $35,000 = $85,000

Calculate the accounting profit -

Accounting profit = Total revenue - Explicit cost = $120,000 - $85,000 = $35,000

Thus,

The accounting profit is $35,000.

Question 3

Fredrick earns an accounting profit of $35,000.

His implicit costs are $35,000.

Economic profit = Accounting profit - Implicit cost = $35,000 - $35,000 = $0

Thus, Fredrick earns an economic profit of $0.

If he invests his $50,000 in the stock market (next best alternative) then he can earn $5,000 as interest.

So,

Opening the grocery store would be less profitable than his next best alternative.