Out of Class - Theory of the Firm Problems
Accounting vs. Economic Profit and Loss
In
2012, Sid was a law professor and earned $80,000 per year. But he got
tired of teaching law students and decided to start his own law firm.
He started his firm at the beginning of 2013.
Sid’s revenue from his law business in 2013 was $240,000.
He cashed in a $70,000 savings bond that was paying him 6% interest per
year in order to start his business. He
used the entire $70,000 to buy machines, paper, etc. to start up his law
business. Sid
also hired Donna to work for him part time and paid her a total of $30,000
during 2013. Sid’s other business
expenses for 2013 were equal to $22,000. Sid
also had to give up renting out a building he started using for his business.
He earned $13,800 per year renting out his building before he started his
business.
At the end of 2013 Sid was trying to decide if he should stay in business
or go back to teaching law. His
only concern at this point is money and he is only considering this one year (he is not forecasting future earnings, etc.).
Determine Sid’s: (NO
WORK, NO POINTS)
Total Revenue for his Law Business ($)
- Explicit costs ($)
= Accounting Profit or Loss ($)
- Implicit costs ($)
= Economic profit or loss ($)
Would you recommend Sid continue in his business or go back to teaching? Explain you answer.
Out of Class - Theory of the Firm Problems
Accounting vs. Economic Profit and Loss
Answers
Total Revenue for his Law Business ($) = $240,000 (given)
- Explicit costs ($) = $70,000 + $30,000 + $22,000 = $122,000
= Accounting Profit or Loss ($) = Profit of $118,000 ($240,000 - $122,000)
- Implicit costs ($) = $80,000 + $4,200 ($70,000 x .06) + $13,800 = $98,000
= Economic profit or loss ($) = $118,000 - $98,000 = $20,000 Economic Profit
Would you recommend Sid continue in his business or go back to teaching? Explain you answer. Sid should stay in his law business. He is making $20,000 more in that business than he would in his next best opportunity (being a law professor).