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Example: Rate of Return . Suppose you invested $50,000 to get your new start-up company up and running. After one year your company produces a profit of $2,500. Your rate of return on your initial investment is the profit divided by the initial investment. In this example:
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Example: Rate of Return • Suppose you invested $50,000 to get your new start-up company up and running. After one year your company produces a profit of $2,500. • Your rate of return on your initial investment is the profit divided by the initial investment. • In this example: rate of return = $2500/$50000 = 5%
Rate of Return Example: Continued • You earned 5% rate of return on your initial $50,000 investment in your start-up. Is this a good or bad return on your investment? • To answer we need to know what was your opportunity cost of capital.
Normal Rate of Return • Normal Rate of Return takes into account the opportunity cost of capital. • Normal Rate of Return = rate of return – opportunity cost of captial. • If you earn at least the normal rate of return on your initial capital investment you’ll be happy.
Negative Normal Rate of Return • Suppose you could have earned 10% interest on a risk-free government bond. In other words the opportunity cost of the $50,000 was the 10% return you could have earned if you invested in a government bond. • Normal Rate of Return = 5% - 10% = -5% • You are earning a negative normal rate of return. It does not mean you are losing money. It just means you are earning less return than you could have been.
Normal Rate of Return • Suppose you could have earned 5% interest on a risk-free government bond. In this case the rate of return you received from your initial investment is exactly equal to the rate of return you could have earned from investing the money in bonds. • Normal rate of return = 5% - 5% = 0% • You are earning a normal rate of return. Earning a normal rate of return just means your investment earned exactly what you would have gotten if you invested in a bond.
Positive Normal Rate of Return • Suppose you could have earned 2% interest on a risk-free government bond. • Normal Rate of Return = 5% - 2% = 3% • You are earning a positive normal rate of return.
Calculating Total Costs and Total Economic Costs: An Example • Suppose you are starting up a small business selling belts at a kiosk at the mall. You estimate that you will be able to sell 3000 belts at $10 each. You will hire one worker and pay that worker $14,000 a year. You will need to purchase the belts annually from a supplier for $5 each. Additionally, to start your business you will need a small push cart kiosk that costs $20,000 (you will dip into your savings to pay this). Assume that your savings account could have yielded a 10% return. What is the profit for your firm? What is the economic profit for your firm?
Marginal Product of Labor • Marginal Product of Labor (MPL) is the additional output that is produced when one more worker is hired.
Law of Diminishing Returns • The law of diminishing returns state that adding additional units of one input, while holding other inputs fixed, will result in output growing, but at a decreasing rate. The marginal product of labor will be decreasing.
Choice of Technology: Example Consider a firm that produces 150 widgets and has to choose among three technologies. Suppose the firm is facing the following input prices: The price of capital = $100 per unit of capital The price of labor = $80 per worker Which technology should the firm employ? What if the price of labor is $40 per worker?
