Chapter 8
The Quest For Profit And The
Invisible Hand
Problem #3, Chapter 8
Labour
Food and drink
$2000
$500
Electricity
Vehicle lease
Rent
Interest on loan for equipment
$100
$150
$500
$1,000
• John Jones owns and manages a café in Collegetown whose
annual revenue is $5,000. Annual expenses are as above
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
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
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
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
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
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!)
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
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?
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
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