Chapter 8 The Quest For Profit And The Invisible Hand

1. Chapter 8The Quest For Profit And The Invisible Hand

2. Problem #3, Chapter 8 • John Jones owns and manages a café in Collegetown whose annual revenue is $5,000. Annual expenses are as above

3. Solution to Problem #3 (1) • A) Calculate John’s annual accounting profit • Recall the difference between accounting profit and economic profit • Accounting profit = Total revenue – Total explicit cost • Economic profit = Total revenue – Total explicit and implicit costs • Economic profit is always less than accounting profit • In this question, the total annual revenue is $5,000 • The total explicit cost is the sum of the annual expenses • Total explicit cost = Labour + Food and drink + Electricity + Vehicle lease + Rent + Interest on loan for equipment • Total explicit cost = $4250

4. Solution to Problem #3 (2) • Annual accounting profit = $5000 - $4250 = $750 • B) John could earn $1000 per year as a recycler of aluminum cans. However, he prefers to run the café. In fact, he would be willing to pay up to $275 per year to run the café rather than to recycle. Is the café making an economic profit? Should John stay in the café business? Explain. • Considers the two options for John: Running a café or Being a recycler • If he runs the café, he will forgone the annual income ($1000) that he can potentially earn from being a recycler

5. Solution to Problem #3 (3) • In addition, if he runs the café, he will receive benefit which is equivalent to $275 per year • Therefore, if he runs the café, he will forgo the potential income earned from recycling minus the benefits he receives from the café • His true opportunity cost is $1000 - $275 = $725 • Economic profit = Accounting profit – Implicit cost (OC) • Economic profit = $750 - $725 = $25 • Since John’s annual economic profit is greater than 0, he should run the business

6. Solution to Problem #3 (4) • C) Suppose the café revenues and expenses remain the same, but the recyclers’ earnings rise to $1,100 per year. Is the café still making an economic profit? Explain. • If the earnings from recycling increases to $1,100, that means the true opportunity cost becomes $1100 - $275 = $825 • Again, economic profit = accounting profit – opportunity cost • New economic profit = $750 - $825 = -$75 • Since the new economic profit is less than zero, John will suffer from an annual economic loss of $75 from running the cafe

7. Solution to Problem #3 (5) • D) Suppose John had not had to get a $10,000 loan at an annual interest rate of 10 percent to buy equipment, but instead had invested $10,000 of his own money in equipment. How would your answer to parts a and b change? • If John did not borrow a loan to finance the equipment, he could save the interest on loan for equipment • As a result, the total explicit cost would be decreased by $1000 to $3250 • Therefore, the new annual accounting profit = $5000 - $3250 = $1750

8. Solution to Problem #3 (6) • However, the economic profit in part b would not change (assuming that the interest rate one has to pay on bank loan is the same as that one gets from bank deposits.) • There would be a new opportunity cost for the interest income of $1000 that John would forgo by investing his money in the equipment • The increase in the accounting profit in part a would be offset by the new opportunity cost when we calculate the new economic profit for part b • New economic profit = new accounting profit – new opportunity cost • New economic profit = $1750 – ($1000 - $275 +$1000) • New economic profit = $1750 - $1725 = $25 (No change!)

9. Solution to Problem #3 (7) • E) If John can earn $1000 a year as a recycler, and he likes recycling just as well as running the café, how much additional revenue would the café have to collect each year to earn a normal profit? • Normal profit refers to the opportunity cost of the resources owned by the firm • To earn a normal profit, the café would have to cover all its implicit and explicit costs • After all explicit costs are taken into account, the opportunity cost of running the café is $1000 • The accounting profit of running the café is $750 • Therefore, the café would have to earn an additional annual revenue of $250 to earn a normal profit of zero

10. Problem #9, Chapter 8 • You have an opportunity to buy an apple orchard that produces $25,000 per year in total revenue. To run the orchard, you would have to give up your current job, which pays $10,000 per year. If you would find both jobs equally satisfying, and the annual interest rate is 10 percent, what is the highest price you would be willing to pay for the orchard?

11. Solution to Problem #9 (1) • If you buy the apple orchard, you will incur an opportunity cost of forgoing the alternative use of money like investment • Given in the question, the annual interest rate is 10% • That means if you buy the apple orchard, you will incur an opportunity cost that is equivalent to 10% of the price of the apple orchard • In addition, you will have to forgo the potential income you earn from your current job, which is $10,000 per year • Recall economic profit = total revenue – total explicit and implicit costs

12. Solution to Problem #9 (2) • Total revenue = $25,000 per year • Total cost = $10,000 forgone income + (Priceappleorchard * 10% annual interest rate) • You are willing to pay for the apple orchard up to a value that makes a zero economic profit • $25,000 = $10,000 + (0.10*Priceappleorchard) • Priceappleorchard = $150,000