Example 1: You start a consulting firm after college.
• Your total revenues are $250K per year
• Your cost for office supplies, office space, employees, and travel is
$200K per year
In accounting terms your profit would be $50K per year.
How much is your economic profit?
The answer depends on the opportunity cost of your time. Suppose
you could get a job and McKinsey and Company making $75,000 per
year. The opportunity cost of your time is $75K per year and your
economic profits would be negative $25K
Example 2: You start a landscaping business.
To get the business going you initially must invest $10,000 to purchase a
truck, a trailer, some mowers, weed whackers, shovels, and a Bobcat.
You also have to purchase gas and pay your workers. The expenditures cost
you $20K per year.
If the opportunity cost of your time is $20K per year capital depreciates at a
rate of 10% per year and the interest rate is 5%, what is your economic cost?
• Implicit Costs
o Opportunity cost of the $10K invested
o Depreciation on your capital
o Your time
• Explicit Costs
o Gas and Labor
0.05*10K
0.10*10K
$30K
$20K
Total Cost=$51,500
A firm can rent or buy capital. If it rents capital the price of capital is going
to be the price they pay to rent expressed as a fraction of the total value of
the capital.
Implicit Rental Rate if Captal (r) – the rental income forgone when you a
firm uses its own capital expressed as a total percentage of the value of the
capital – Two components
o interest cost (implicit or explicit)
o depreciation
Example 3: You start a landscaping business.
To get the business going you initially must invest $10,000 to purchase a
truck, a trailer, some mowers, weed whackers, shovels, and a Bobcat. You
do not have the money on hand so you borrow it from a bank at a interest
rate of 0.10.
You also have to purchase gas and pay your workers. The expenditures cost
you $20K per year.
If the opportunity cost of your time is $30K per year capital depreciates at a
rate of 10% per year and the interest rate is 5%, what is your economic cost?
• Implicit Costs
o Depreciation on your capital
o Your time
• Explicit Costs
o Bank Interest on your Loan
o Gas and Labor
Total Cost=$52,000
0.10*10K
$30K
0.10*10,000
$20K