Chapter 8
The Quest For Profit And The
Invisible Hand
3 Additional Questions
• In Accountant’s point of view, “Profit” means the difference
between total revenue and the actual payment incurs for a
firm’s factor of production.
• Accounting Profit = Total Revenue – Explicit costs
• In Economist’s point of view, “Profit” means the difference
between total revenue and the total cost.
• Recall, in Economics, “Total cost” means the sum of explicit
costs and implicit costs (or opportunity cost)
• Economic profit = Total Revenue – Explicit costs – Implicit costs
• Thus, Accounting Profit and Economic Profit is differ by the
value of Implicit cost (or Opportunity cost).
• This is called “Normal Profit” – the opportunity cost of the
resources supplied by a firm’s owners. It is the differences
between accounting profit and economic profit.
• Normal Profit = Accounting Profit – Economic Profit
• Accounting Profit = Total Revenue – Explicit costs
• Economic Profit = Total Revenue – Explicit costs – Implicit costs
• Economic Profit = Accounting Profit – Implicit costs
• A firm’s decision:
• It should remain in the business if the firm is,
- Earning positive economic profit :
Accounting profit > Implicit costs
• It is indifference to stay or leave if the firm is,
- Earning zero economic profit.
Accounting profit = Implicit costs
Additional Question #1
Smith is a corn farmer earning economic profits and
Wesson is a wheat farmer receiving a normal profit.
Wesson has an incentive to become a corn farmer because
A)
B)
C)
D)
E)
His accounting profits are negative.
He is not currently covering his opportunity costs.
He could earn more than his next best alternative.
His accounting profits are zero.
He dislikes Smith and wants to undermine Smith’s profit.
Ans: C
• Economic Profit = Total Revenue – Explicit costs – Implicit costs
• Economic Profit = Accounting Profit – Implicit costs (Normal profit)
• Normal Profit = Accounting Profit – Economic Profit
• Smith is earning economic profit, he is able to cover the
explicit cost and as well as the implicit cost.
• Wesson is receiving a normal profit, he is only able to cover
the implicit cost.
• Wesson has an incentive to become a corn farmer only if he
could earn more than the normal profit.
• All rational farmers of course will choose the alternative that
yields the highest economic profit.
• Thus, Wesson will be attracted to corn farming. (C)
Additional Question #2
• Assume you have an idea for a new fruit picking machine that
will cost the same as current fruit picking methods but will
yield 10% more revenue because it will pick more fruit and
damage less. To develop the new machine you would have to
take two years off from your $25,000/year job managing the
fruit company. Should you take the time off to develop the
new machine if the current fruit revenue is $500,000? Explain.
• Should take the time off if it earns a positive Economic profit:
• Economic Profit = Accounting Profit – Implicit costs (Normal profit)
• Accounting Profit on the development of new machine > Implicit cost
• To take 2 years time off to develop the new machine, need to
forgo:
- 2 years current job salary, 2($25,000) = $50,000
• This is the opportunity cost to develop the new machine
• Revenue from the new machine, $500,000 (0.1) = $50,000
• Accounting profit = $50,000
• Economic profit = $50,000 - $50,000 = $0
• Therefore, you are indifference to take 2 years time off to
develop the new machine or to stay in the current job.
Additional Question #3
• Assume you own, manage and are the only employee for a Tshirt concession at a college sports arena. The financial
information for the business is given below.
Retail price of shirt
$15
Number of shirts sold per day
100
Cost of plain T-shirt
$5each
Cost of T-shirt design
$5each
Equipment rental fee (per day) $100
Stand rental fee (per day)
$200
Retail price of shirt
$15
Number of shirts sold per day
100
Cost of plain T-shirt
$5each
Cost of T-shirt design
$5each
Equipment rental fee (per day) $100
Stand rental fee (per day)
$200
• A) What is your accounting profit?
• Total revenue = $15 x 100 = $1500
• Total explicit cost = $5(100) + $5(100) + $100 +$200 = $1300
• Accounting profit = $1500 - $1300 = $200
• B) Your next best alternative job is to work as a manager for
another local retail business. If your economic profit is zero,
how much could you earn as a manager for another business?
• It is equivalent to ask, What is the cost of your next best
alternative (or opportunity cost)?
• Economic profit = Total revenue – Explicit cost - Implicit
• Or Economic profit = Accounting profit – Implicit cost
• If economic profit is zero, then your next best alternative
(opportunity cost) must equal to the Accounting profit,
$200/day.
• C) Assume you enjoy owning and operating the T-shirt stand
(you value it at $100 per day). If your total costs increased to
$1600, and if you shut down total cost would be zero, should
you continue selling t-shirts? Explain.
•
•
•
•
If continue to sell T-shirt:
The new Accounting Profit is $1500 - $1600 = -$100
The new Economic Profit is $1500 - $1600 - $200 = -$300
Even though you value the work at $100, you should shut
down the stand.
• The $100 value of working at the stand covers the accounting
loss, but you can not cover your opportunity cost, $200.
• Since you are making negative Economic Profit, you should
not continue selling T-shirts.
~ End of Chapter 8 ~