Chapter 14 - Rent, Interest, and Profit
Chapter 14 Rent, Interest, and Profit
QUESTIONS
1. How does the economist’s use of the term “rent” differ from everyday usage? Explain:
“Though rent need not be paid by society to make land available, rental payments are very useful
in guiding land into the most productive uses.” LO1
Answer: In everyday usage, “rent” is the term used to describe the payment that must be
paid for the legal borrowing of some good or service. One pays rent for the use of a
house or apartment; or one rents a tool from the equipment rental company. When
paying this rent one is paying for part of the capital cost of the commodity, plus its
maintenance, plus a share of the taxes on it, plus profit to the owner.
An economist defines rent much more restrictively: Economic rent is the price paid for
the use of land and other natural resources which are completely fixed in total supply.
Land is completely fixed in total supply. No matter how high the rent, no more can be
brought into use. Thus rent serves no incentive function; the same amount of land will be
available no matter how high the rent. But the resulting argument that rent is a surplus
that could be eliminated without reducing the supply is to look at it from the viewpoint of
society only.
2. Explain why economic rent is a surplus payment when viewed by the economy as a whole but
a cost of production from the standpoint of individual firms and industries. Explain: “Land rent
performs no ‘incentive function’ for the overall economy.” LO1
Answer: Land is completely fixed in total supply. As population expands and the
demand for land increases, rent first appears and then grows. From society’s perspective
this rent is a surplus payment unnecessary for ensuring that the land is available to the
economy as a whole. If rent declined or disappeared, the same amount of land would be
available. If it increased, no more land would be forthcoming. Thus, rent does not
function as an incentive for adding land to the economy.
But land does have alternative uses. To get it to its most productive use, individuals and
firms compete and the winners are those who pay the highest rent. To the high bidders,
rent is a cost of production that must be covered by the revenue gained through the sale
of the commodities produced on that land.
3. In the 1980s land prices in Japan surged upward in a “speculative bubble.” Land prices then
fell for 11 straight years between 1990 and 2001. What can we safely assume happened to land
rent in Japan over those 11 years? Use graphical analysis to illustrate your answer. LO1
Answer: Given that the supply of land is perfectly inelastic, the drop in prices must have
resulted from decreased demand for land. The demand for land would fall if there were
less of a return on the land (i.e. rent), so we can safely assume that land rent fell in Japan
between 1990 and 2001. The shifts from D1 to D2 to D3 in Figure 14.1 demonstrate
graphically what happened in Japan.
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Chapter 14 - Rent, Interest, and Profit
4. How does Henry George’s proposal for a single tax on land relate to the elasticity of the supply
of land? Why are there so few remaining advocates of George’s proposal? LO3
Answer: The supply of land is perfectly inelastic. Therefore, taxing returns on land (thus
changing its price) will not affect how much is available. Taxing other inputs would
discourage their use, so George reasoned that the government could earn sufficient
revenue without diminishing the productive potential of the economy by taxing land only.
There are a number of reasons why few support George’s proposal today. They include:
1) Taxing land only would not provide sufficient revenue for the government; 2) It is
difficult to separate the rent from other resource payments for many income payments; 3)
There are many forms of unearned income, such as those inheriting large sums and living
off the interest; and 4) It would unfairly burden current land owners who paid the
increased land values to former owners.
5. If money is not an economic resource, why is interest paid and received for its use? What
considerations account for the fact that interest rates differ greatly on various types of loans? Use
those considerations to explain the relative sizes of the interest rates on the following: LO2
a. A 10‐year $1000 government bond.
b. A $20 pawnshop loan.
c. A 30‐year mortgage loan on a $175,000 house.
d. A 24‐month $12,000 commercial bank loan to finance the purchase of an automobile.
e. A 60‐day $100 loan from a personal finance company.
Answer: Though money is not in itself productive, it is useful for acquiring resources
that are productive. In borrowing money, businesses get the use of it to buy factories,
machines, and equipment that are productive and with which the businesses hope to make
a profit. Thus, it makes economic sense to pay for the use of money. It would make no
economic sense to lend money without charging interest, for the lender has the alternative
of buying productive real capital or consumer goods with it.
There are many considerations involved in the fact that interest rates differ greatly on
various types of loans. (1) Risk: The greater the chance the borrower will not repay, the
higher the interest rate. (2) Maturity: The longer the term of the loan, the higher the
interest rate to compensate the lender for the risk of being without the use of the money
for an extended period of time. (3) Loan size: The smaller the loan, the higher the
interest rate because the administrative costs of large and small loans are about the same
absolute amounts. (4) Taxability: The interest payments on certain state and municipal
bonds being nontaxable, the interest that lenders require as payment is lower.
(a) A 10-year $1000 government bond will have a relatively low rate of interest because
it is risk-free: The Federal government cannot default (since its promise to repay is in
currency that the government can have printed). However, the term to maturity
normally would lead to a higher interest rate than a shorter-term government bond.
The loan size is irrelevant here because the government pays the same interest
regardless of the bond’s denomination.
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Chapter 14 - Rent, Interest, and Profit
(b) A $20 pawnshop loan will have a high rate of interest. There’s good chance the good
pawned will not be redeemed but, in this case, the pawnbroker is not really at risk.
The pawned article undoubtedly has a resale value greater than $20. The high
interest rate in fact helps ensure that the good will not be redeemed—to the
pawnbroker’s benefit. The high interest rate also compensates for the small size of
the loan.
(c) Mortgages are generally large loans at a relatively low interest rate. The loan is for a
very long term and the house is pledged as collateral. Under certain circumstances,
the loan may qualify for a government-subsidized mortgage insurance program,
which insures the lender against default. Additionally, the borrower may deduct the
interest from his/her taxable income. These contrasting considerations result in a
lower interest rate than most types of long-term loans.
(d) A 24-month $12,000 commercial bank loan to finance the purchase of an automobile
will certainly have a higher interest rate than a government bond, but its risk is
reduced by the fact that the automobile serves as collateral for the loan. However,
the bank would rather get its money back than a used car, so the bank certainly does
not consider the loan risk-free. The loan is of a relatively large size; this will tend to
lower the interest rate. The outcome of these conflicting considerations is an interest
rate lower than for a straight, unsecured, consumer loan but higher than for a loan to
a well-established business.
(e) A 60-day $100 loan from a personal finance company will have the highest
rate of all, except possibly for the pawnshop loan. Though it is very short
term, it is considered relatively high risk, because otherwise the borrower
would have gotten the loan from a bank; and the loan size is very small,
making the administrative costs high in relation to the loan size. Also, the fact
that it is a personal loan implies there is no collateral like a car or home to
back it up.
6. Why is the supply of loanable funds upsloping? Why is the demand for loanable funds
downsloping? Explain the equilibrium interest rate. List some factors that might cause it to
change. LO2
Answer:
(a) The supply of loanable funds is upsloping because savers will make more funds
available at higher interest rates than lower interest.
(b) The demand for loanable funds is downsloping because there are few investment and
R&D projects that yield a high rate of return and many more that will yield a lower
rate of return.
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Chapter 14 - Rent, Interest, and Profit
(c) The equilibrium interest rate is determined where the interest rate (cost of borrowing
the funds) is equal to the expected rate of return (the expected benefit from
borrowing the funds and engaging in the investment or R&D project). The supply of
loanable funds may change because of a change in households’ attitudes about saving
(tax policies, macroeconomic conditions) or changes in Federal Reserve policies
relative to the money supply. The demand for loanable funds could change as a
result a change in technology or a change in the demand for the final product. If
there is either a change in supply of or demand for loanable funds, the interest rate
will change.
7. Here is the deal: You can pay your college tuition at the beginning of the academic year or the
same amount at the end of the academic year. You either already have the money in an
interest‐bearing account or will have to borrow it. Deal, or no deal? Explain your financial
reasoning. Relate your answer to the time-value of money, present value, and future value. LO4
Answer: The answer is you pay at the end of the academic year in both cases. For
demonstrative purposes consider the following values: Tuition is $10,000 and the interest
rate over the academic year is 10% (not an annual rate). If you already have the $10000
and you put it in an interest bearing account you will have $11000 (=1.10*$10000) at the
end of the academic year. You pay the $10000 in tuition and pocket $1000. If you paid at
the $10000 tuition at the beginning of the year you would lose this $1000 (The future
value of the $10000 is $11000).
On the other hand, if you had to borrow the $10000 to pay your tuition you would still
pay at the end of the academic year. Using the values as above, you borrow the $10000
today and put in an interest bearing account, which give you $11000 at the end of the
academic year. You pay your tuition of $10000, which leaves you $1000 additional
dollars. If you paid at the beginning of the academic year you would once again lose this
$1000. This implies you could reduce your remaining debt burden to $9000 (assuming a
government financed interest free student loan) by using the $1000 in interest to pay
down the principal on the original loan.
8. What are the major economic functions of the interest rate? How might the fact that many
businesses finance their investment activities internally affect the efficiency with which the
interest rate performs its functions? LO3
Answer: There are two major economic functions of the interest rate. (1) Interest rates
affect the level of domestic output as the monetary authorities deliberately vary them by
changing the money supply. Low interest rates encourage investment, and this tends to
expand the economy. High interest rates discourage investment and this tends to restrain
inflation or contract the economy. (2) Interest rates allocate capital to its most productive
uses. When interest rates are, say, at 10 percent, a project that expects to earn 8 percent
after the payment of all costs will not be undertaken, because the cost of the borrowed
money is greater than the return expected on it. This is true even if the firm is using its
own money. Why make 8 percent on the project with the firm’s money when lending it
will earn 10 percent? On the other hand, all projects that are expected to return more than
the interest rate will be undertaken. The interest rate thus allocates money capital to
those investments that are most productive, that is, which have the highest rate of return.
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Chapter 14 - Rent, Interest, and Profit
To the extent that firms truly are profit maximizers, the internal financing of investment
should make no difference to the investment decision. One invests if the expected rate of
return is greater than the rate of interest; one does not if the rate of interest is greater.
However, firms are probably somewhat less anxious about what happens to money that
they do not have to pay back. In other words, the efficiency with which the interest rate
performs its functions is probably lessened the more firms finance their investments
internally.
9. Distinguish between nominal and real interest rates. Which is more relevant in making
investment and R&D decisions? If the nominal interest rate is 12 percent and the inflation rate is
8 percent, what is the real rate of interest? LO3
Answer: The nominal interest rate is the interest rate stated in dollars of current value
(unadjusted for inflation). The real interest rate is the nominal interest rate adjusted for
inflation (or deflation). The real interest rate is more relevant for making investment
decisions—it reflects the true cost of borrowing money. It is compared to the expected
return on the investment in the decision process. Real interest rate = 4 percent (= 12
percent - 8 percent).
10. Historically, usury laws that put below‐equilibrium ceilings on interest rates have been used
by some states to make credit available to poor people who could not otherwise afford to borrow.
Critics contend that poor people are those most likely to be hurt by such laws. Which view is
correct? LO3
Answer: The critics are probably closer to the truth than the legislators. The relatively
high interest rates charged in a free market to those with little or no collateral to put up as
security on a loan is demanded by banks and other legitimate lending institutions because
of the additional risk of nonrepayment involved. No doubt, banks are sometimes a little
more hardhearted with the poor than is necessary to keep the banks viable; they may well
charge a little more than the risks really require. However, when laws are passed
preventing banks and other legitimate lending institutions from charging the rate they
think is justified, these institutions simply stop lending to the poor entirely.
So, the poor, who were supposed to be helped, end up going to loan sharks and others
outside the law, who charge truly usurious interest rates running into the hundreds of
percent a year and who demand an arm and a leg as security. Sometimes literally!
11. How do the concepts of accounting profit and economic profit differ? Why is economic profit
smaller than accounting profit? What are the three basic sources of economic profit? Classify
each of the following according to those sources: LO4
a. A firm’s profit from developing and patenting a new medication that greatly reduces
cholesterol and thus diminishes the likelihood of heart disease and stroke.
b. A restaurant’s profit that results from the completion of a new highway past its door.
c. The profit received by a firm due to an unanticipated change in consumer tastes.
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Chapter 14 - Rent, Interest, and Profit
Answer: Accounting profit is what remains of a firm’s total revenues after it has paid for
all the factors of production employed by the firm (its explicit costs) but not for the use of
the resources owned by the business itself. Economists also take into consideration
implicit costs—the payment the owners could have received by using the resources they
own in some other way. The economist adds these implicit costs to the accountant’s
explicit costs to arrive at total cost. Subtracting the total cost from total revenue results in
a smaller profit (the economic profit) than the accountant’s profit.
Sources of economic profit: (1) creating popular new products; (2) reduce production
costs below rivals' costs; and (3) create and maintain a profitable monopoly.
(a) Profit from creating a popular new product, as well as monopoly profit from the
patent.
(b) Creating and maintaining a monopoly as a result of its locational advantage.
(c) Profit from creating a popular 'new' product. Note here that the change in consumer
preferences has made the good 'popular'. The term 'new' is relative, it may have been
around for awhile but people just did not want to buy it in the quantities they now do.
12. Why is the distinction between insurable and uninsurable risks significant for the theory of
profit? Carefully evaluate: “All economic profit can be traced to either uncertainty or the desire to
avoid it.” What are the major functions of economic profit? LO4
Answer: An insurable risk does not fatally affect the profit and loss of a firm. The firm
insures against fire and theft and so on and then goes about its business, secure in the
knowledge that it cannot suffer an irreparable loss if one of the insured-against events
occurs.
Economic profit (and serious loss) occurs when the firm takes uninsurable risks. Such
risks relate to uncontrollable and unpredictable changes in demand and supply conditions.
An insurance company is most unlikely to insure against a serious recession occurring in
the next year or so or against the price of oil skyrocketing—or, if one did, the premium
the insurance company would demand would be greater than the profit a firm could
expect to make by forecasting these events correctly. Thus, firms must risk that the
demand for their products in the future will give them adequate revenue to cover their
future costs that, too, they must take the risk of estimating. If the firms are successful,
they have earned their economic profits.
“All economic profits can be traced to either uncertainty or the desire to avoid it.” A
considerable amount of economic profits can be traced to either uncertainty or the desire
to avoid it, but not all. There is clearly uncertainty in trying to estimate future demand
and supply conditions. A firm cannot be sure what it will get for its output, what the
input will cost, and the consequent economic profit or loss. There is also much
uncertainty with regard to innovation. Will it fly, literally, or figuratively in the sense of
being able to convince people to buy the new or redesigned product? Or will all of the
revenue needed to pay back the development costs be gained before freeloading copiers
come on the market with their versions?
However, though monopoly economic profits may be the product of the same types of
uncertainty just discussed, they are by no means entirely so. It is De Beers’ tight control
of the supply of diamonds that has ensured its continuing economic profits, not favorable
changes in the public’s demand for diamonds.
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Chapter 14 - Rent, Interest, and Profit
The major functions of profits include providing an incentive for entrepreneurial
initiative in combining resources to produce a good or service; for innovation in the form
of new products or production processes; and for taking the risks which the entrepreneur
bears by operating in a dynamic and uncertain environment. Profits also allocate
resources among alternative lines of production. Entrepreneurs seek profits and shun
losses, which means industries will expand as long as they experience economic profits
and contract when they experience losses.
13. What is the combined rent, interest, and profit share of the income earned by Americans in a
typical year if proprietors’ income is included within the labor (wage) share? LO5
Answer: If proprietors’ income is included within the labor share of income, wages
would be almost 80 percent of national income. That leaves about 20 percent of the
national income in the form of rent, interest and profit—a relatively small share and a
share that has been remarkably stable in the United States since 1900.
14. LAST WORD Assume that you borrow $5000, and you pay back the $5000 plus $250 in
interest at the end of the year. Assuming no inflation, what is the real interest rate? What would
the interest rate be if the $250 of interest had been discounted at the time the loan was made?
What would the interest rate be if you were required to repay the loan in 12 equal monthly
installments?
Answer: Simple interest in the first case is 5 percent. $250 / $5000  100 
In the second case the amount received at the time of borrowing would be $4750, so the
interest rate is slightly higher at 5.26%. $250 / $4750  100 
If you repaid the loan in twelve monthly installments and the interest payments still were
equal to $250, then you have repaid $5250 total, but you have repaid part of the principal
each month. Therefore, you did not borrow the entire $5000 for the whole year. Without
having the exact equation to solve this problem, you could estimate that you borrowed on
average $2500 for the whole year, since you would have paid back about half by the sixth
month and reduced the principal by about 1/12 for every month thereafter. This means
that the $250 is about 10 percent of the average amount borrowed.
PROBLEMS
1. Suppose that you own a 10‐acre plot of land that you would like to rent out to wheat farmers.
For them, bringing in a harvest involves $30 per acre for seed, $80 per acre for fertilizer, and $70
per acre for equipment rentals and labor. With these inputs, the land will yield 40 bushels of
wheat per acre. If the price at which wheat can be sold is $5 per bushel and if farmers want to
earn a normal profit of $10 per acre, what is the most that any farmer would pay to rent your 10
acres? What if the price of wheat rose to $6 per bushel? LO1
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Chapter 14 - Rent, Interest, and Profit
Answers: At a wheat price of $5 per acre, the revenue from the land would be $200 per acre
(= 40 bushels per acre times $5 per bushel) or $2000 for all 10 acres. The cost including a
normal profit would be $190 per acre (= $30 + $80 + $70 + $10) or $1,900 for all 10 acres.
Thus the most anyone would pay to rent the land would be $10 per acre (= $200 per acre $190 per acre) or $100 for all 10 acres. At a wheat price of $6 per acre, the revenue from the
land would be $240 per acre (= 40 bushels per acre times $6 per bushel) or $2400 for all 10
acres. Since the costs will remain unchanged at $190 per acre, the most anyone would pay to
rent the land would be $50 per acre (= $240 per acre - $190 per acre) or $500 for all 10
acres.
Feedback: Consider the following example. You own a 10‐acre plot of land that you
would like to rent out to wheat farmers. For them, bringing in a harvest involves $30 per
acre for seed, $80 per acre for fertilizer, and $70 per acre for equipment rentals and labor.
With these inputs, the land will yield 40 bushels of wheat per acre. If the price at which
wheat can be sold is $5 per bushel and if farmers want to earn a normal profit of $10 per
acre, what is the most that any farmer would pay to rent your 10 acres?
To answer this question we begin by calculating the revenue generated per acre. A bushel
of wheat sells for $5 and each acre produces 40 bushels of wheat. Thus, revenue per acre
equals $200 (=$5 x 40). Since there are 10 acres of land on the farm total revenue equals
$2000 (=10 x $200).
The total cost per acre equals $190 (=$30+$80+$70+$10), which is the sum of the seed
cost, fertilizer cost, equipment rental, and normal profit respectively. Thus, the total cost
for 10 acre farm is $1900 (=10 x $190).
To find the most any farmer would pay to rent the 10 acre farm (land) we subtract the
total cost from total revenue. This equals $100 (=$2000 (revenue) - $1900 (cost)). So, the
most the farmer would be willing to pay to rent the land is $100 since anything more
would result in a loss (negative economic profit). Finally, since there are 10 acres of land,
the most the farmer would be willing to pay per acre in rent is $10 (=$100/100).
If the price of wheat increased to $6 a bushel then total revenue per acre would equal
$240 (=$6 x 40). Total revenue for the farm would equal $2400 (=10 x $240). The total
cost remains the same, $1900. This implies $500 remains for potential land payment
(=$2400-$1900), which is the most any farmer would be willing to pay to rent the land.
Again, since there are 10 acres of land the most any farmer would pay per acre is $50
(=$500/10).
2. Suppose that the demand for loanable funds for car loans in the Milwaukee area is $10 million
per month at an interest rate of 10 percent per year, $11 million at an interest rate of 9 percent per
year, $12 million at an interest rate of 8 percent per year, and so on. If the supply of loanable
funds is fixed at $15 million, what will be the equilibrium interest rate? If the government
imposes a usury law and says that car loans cannot exceed 3 percent per year, how big will the
monthly shortage (or excess demand) for car loans be? What if the usury limit is raised to 7
percent per year? LO2
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Chapter 14 - Rent, Interest, and Profit
Answers: The equilibrium interest rate is 5 percent per year. Under the usury law’s 3
percent per year cap on interest, the excess demand will be $2 million dollars worth of car
loans per month. When the usury law is changed to raise the maximum interest rate to 7
percent per year, it is no longer a binding constraint since the equilibrium interest rate is 5
percent per year; thus, there is $0 of excess demand at that usury limit.
Feedback: Consider the following example. Suppose that the demand for loanable funds
for car loans in the Milwaukee area is $10 million per month at an interest rate of 10
percent per year, $11 million at an interest rate of 9 percent per year, $12 million at an
interest rate of 8 percent per year, and so on. Also assume the supply of loanable funds is
fixed at $15 million.
Interest rate on
Loan
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
Demand for
Loanable Funds
$10 million
$11 million
$12 million
$13 million
$14 million
$15 million
$16 million
$17 million
$18 million
$19 million
Supply of
Loanable Funds
$15 million
$15 million
$15 million
$15 million
$15 million
$15 million
$15 million
$15 million
$15 million
$15 million
The table above demonstrates that the demand for loanable funds increases by $1 million
for every 1% reduction in the interest rate.
The equilibrium interest rate occurs where the demand for loanable funds equals the
supply of loanable funds. This occurs at the interest rate of 5%.
Now, if the government imposes a usury law and says that car loans cannot exceed 3
percent per year, how big will the monthly shortage (or excess demand) for car loans be?
What if the usury limit is raised to 7 percent per year?
Under a usury law’s 3 percent per year cap on interest, the excess demand will be $2
million dollars worth of car loans per month. When the usury law is changed to raise the
maximum interest rate to 7 percent per year, it is no longer a binding constraint since the
equilibrium interest rate is 5 percent per year; thus, there is $0 of excess demand at that
usury limit.
3. To fund its wars against Napoleon, the British government sold consol bonds. They were
referred to as “perpetuities” because they would pay £3 every year in perpetuity (forever). If a
citizen could purchase a consol for £25, what would its annual interest rate be? What if the price
were £50? £100? Bonds are known as “fixed income” securities because the future payments that
they will make to investors are fixed by the bond agreement in advance. Do the interest rates of
bonds and other investments that offer fixed future payments vary positively or inversely with
their current prices? LO3
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Chapter 14 - Rent, Interest, and Profit
Answers: 12 percent; 6 percent; 3 percent; inversely.
Feedback: To calculate the price of a perpetuity we use the formula, price =
(payment/interest rate), or to calculate the interest rate we use the formula, interest rate =
(payment/price).
Given the following payments (example): If a citizen could purchase a consol for £25,
what would its annual interest rate be? What if the price were £50? £100? Assume a
payment of £3 every year in perpetuity (forever).
Consol for £25: interest rate = (£3/£25) = 0.12 (12%)
consol for £50: interest rate = (£3/£50) = 0.06 (6%)
consol for £100: interest rate = (£3/£100) = 0.03 (3%)
The interest rates vary inversely with current prices (see formulas above).
4. Suppose that the interest rate is 4 percent. What is the future value of $100 four years from
now? How much of the future value is total interest? By how much would total interest be greater
at a 6 percent interest rate than at a 4 percent interest rate? LO3
Answers: $116.99; $16.99; $9.26
Feedback: Consider the following example. Assume that the interest rate is 4 percent.
What is the future value of $100 four years from now? How much of the future value is
total interest? By how much would total interest be greater at a 6 percent interest rate than
at a 4 percent interest rate?
To calculate the future value of $100 four years from we compound the interest for the
four years. The future value for each successive year is:
Year 1: $100 x (1.04) = $104 (carry this amount forward to year two)
Year 2: $104 x (1.04) = $108.16 (carry this amount forward to year three)
Year 3: $108.16 x (1.04) = $112.49 (carry this amount forward to year four)
Year 4: $112.49 x (1.04) = $116.99 (future value in four years)
Note that this answer could also be found via substitution back to Year 1, which gives us
the formula:
Future value = initial amount x (1+interest rate)T, where T is the number of years of
compounding.
For the values above we have Future value = $100 x (1.04)4 = $100 x 1.1699 = $116.99.
To calculate the future value of total interest, subtract the principal (the initial amount)
from total future value. This is $16.99 (=$116.99 - $100).
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Chapter 14 - Rent, Interest, and Profit
To find out how much greater total interest would be at a 6 percent interest rate than at a
4 percent interest rate, first find the future value at the 6% interest rate. Using the formula
above, future value = $100 x (1.06)4 = $100 x 1.2635 = $126.25.
Second, find the future value of total interest. This is $26.25 (=$126.25 - $100).
Finally, subtract the total interest at the 4% rate from the total interest at the 6% rate. This
equals $9.26 (= $26.25 - $16.99).
5. You are currently a worker earning $60,000 per year but are considering becoming an
entrepreneur. You will not switch unless you earn an accounting profit that is on average at least
as great as your current salary. You look into opening a small grocery store. Suppose that the
store has annual costs of $150,000 for labor, $40,000 for rent, and $30,000 for equipment. There
is a one‐half probability that revenues will be $200,000 and a one‐half probability that revenues
will be $400,000. LO4
a. In the low‐revenue situation, what will your accounting profit or loss be? In the high‐revenue
situation?
b. On average, how much do you expect your revenue to be? Your accounting profit? Your
economic profit? Will you quit your job and try your hand at being an entrepreneur?
c. Suppose the government imposes a 25‐percent tax on accounting profits. This tax is only levied
if a firm is earning positive accounting profits. What will your after-tax accounting profit be in
the low‐revenue case? In the high‐revenue case? What will your average after‐tax accounting
profit be? What about your average after‐tax economic profit? Will you now want to quit your
job and try your hand at being an entrepreneur?
d. Other things equal, does the imposition of the 25‐percent profit tax increase or decrease the
supply of entrepreneurship in the economy?
Answers: (a) Explicit costs are $220,000 (= $150,000 + $40,000 + $30,000). Thus accounting
profits in the lower-revenue case are -$20,000 (= $200,000 - $220,000) while accounting
profits in the higher-revenue case are $180,000 (= $300,000 - $220,000).
(b) On average, revenues will be $300,000 per year (= 0.5*$400,000 + 0.5*$200,000). Thus,
on average, accounting profits will be $80,000 per year (= $300,000 in average revenue $220,000 in explicit costs). This means that on average economic profits will be $20,000 per
year (= $80,000 of average accounting profits - $60,000 opportunity costs of foregone
wages). You WILL want to quit your job to become an entrepreneur.
(c) In the low-revenue case, the after-tax accounting profit will be the same since the firm is
making a loss of - $20,000 and the tax is only applied if the firm is making a profit. In the
high-revenue case, the after-tax accounting profit will be $135,000 (= 0.75* $180,000).
Given those numbers, the average after-tax accounting profit will be $57,500 (= 0.5*[$20,000] + 0.5*$135,000). The average after-tax economic profit will be - $2,500 (= $57,500
in average after-tax accounting profit - $60,000 in foregone wages). You will NOT want to
quit your job and become an entrepreneur.
(d) The profit tax decreases the supply of entrepreneurship in the economy.
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Chapter 14 - Rent, Interest, and Profit
Feedback: Consider the following example: You are currently a worker earning $60,000
per year but are considering becoming an entrepreneur. You will not switch unless you
can expect to earn a profit that is on average at least as great as your current salary. You
look into opening a small grocery store. Suppose that the store has annual costs of
$150,000 for labor, $40,000 for rent, and $30,000 for equipment. There is a one‐half
probability that revenues will be $200,000 and a one‐half probability that revenues will
be $400,000.
Part a: The accounting profit in each scenario equals revenue minus explicit costs. The
explicit costs in both cases (independent of state) equal $220,000 (= $150,000 (labor) +
$40,000 (rent) + $30,000 (equipment)).
Scenario 1 (low revenue case, Revenue equals $200,000): Here the accounting profit is $20,000 (= $200,000 - $220,000).
Scenario 2 (high revenue case, Revenue equals $400,000): Here the accounting profit is
$180,000 (= $400,000 - $220,000).
Part b: The average revenue will be a weighted average of the two cases above, where
the weights are the probabilities of each case. Here we assume that each case, or scenario,
is equally likely (probability of 0.5 for each).
Average revenue equals $300,000 (= 0.5x$200,000 + 0.5x$400,000).
Average profit will equals $80,000 (= $300,000 (average revenue) - $220,000 (explicit
cost)). Note that the explicit cost is the same in both scenarios.
You will quit your job because the average profit of $80,000 exceeds your current
income of $60,000. (NOTE, we ignore risk here.)
Part c: If the government were to impose a 25% tax on all accounting profits this would
only affect scenario 2. The government does not subsidize losses.
Scenario 1 (low revenue case, Revenue equals $200,000): Here the accounting profit is $20,000 (= $200,000 - $220,000).
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Chapter 14 - Rent, Interest, and Profit
Scenario 2 (high revenue case, Revenue equals $400,000): Here the accounting profit is
$180,000 (= $400,000 - $220,000). With the 25% tax the net revenue equals $135,000 (=
0.75x$180,000). This is the percentage of the accounting profit the firm receives after
paying taxes.
Here, we calculate the firm's average profit by taking a weighted average of the 'after-tax'
profits for the two scenarios. average after-tax profits equal $57,500 (= 0.5x(-$20,000) +
0.5x$135,000).
You will not quit your job because the average profit of $57,500 is less than your current
income of $60,000. (NOTE, we ignore risk here.)
Part d: Yes, the reduction in after-tax profits induces some individuals not to undertake
investments or decisions that are pre-tax profitable.
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