Practice problems -- Answer Key

1. The sole proprietor of the "Books and More" bookstore receives all accounting profits earned by her firm and a $28,000-a-year salary she pays herself. She has a standing salary offer of $35,000 a year if she agrees to work for a large corporation. If she had invested her capital outside her own company, she estimates that would have returned $22,000 a year. Last year, her accounting profit was $50,000. What was her economic profit?

In order to calculate her economic profit, we need to subtract her implicit costs from the accounting profit. By not taking an alternative job, she loses $7,000 ($35,000 - $28,000). This is the opportunity cost of her time. The opportunity cost of keeping her capital tied up in her company is $22,000. The economic profit is therefore $50,000 - $7,000 - $22,000 = $21,000.

2. In his spare time, Shelby Williams makes chain mail using metal rings he buys from a hardware store, a C-clamp, and a pair of pliers. He sells the final product at local crafts fairs and at bikers' annual convention in Sturgis, SD. Being interviewed once by a local newspaper, he said literally the following: "The materials cost me $30, and the rest is just my labor, which is free. One vest sells for about $150, which gives me net profit of $120 for three nights of work."

a. Is he talking about economic profit or accounting profit? Explain the difference between the two.

He takes only his explicit costs into account, therefore he refers to the accounting concept of profit. In order to estimate his economic profit, he needs to subtract his opportunity costs as well.

b. Discuss Shelby's statement from economic perspective (taking the opportunity cost into account, that is).

He refers to his labor as free, which is wrong from an economist's perspective. His time has value determined by other optional ways to spend his time. If, for instance, his next best alternative use of this time is to get a part-time job, then his value is equal to the money he would have earned. If he would rather watch TV instead, then the value of his time is equal to the utility he obtains from watching it. Either way, by devoting his time to making chain mail he forgoes other opportunities and therefore incurs certain opportunity cost. In order to make a sensible decision, these costs need to be taken into account as well.

c. If Shelby talks his girlfriend into joining him in his hobby and buys another set of tools, would you consider it the short run or the long run decision? Explain the difference between the two.

Sounds like in this case all of his inputs - labor, capital, and, naturally, materials - are variable, which makes it a long-run decision. This is in spite of the fact that it doesn't take long to make these changes. But you must remember that it is not the passage of time that matters but rather the conditions in which the firm operates.

3. Your firm has discovered a cheap and efficient technology of turning used plastic bottles and bags into various products. You limit your attention to the following two production opportunities: you can produce plastic utensils or helmets for Boilermakers' fans. In the first case your estimated annual revenue is $25,000, while the production will cost you $8,000. However, in your second option, you expect to sell 2000 helmets every year at $10 each, and the average total cost of every helmet will be $2.

a. Which production opportunity will you choose and why?

If you produce utensils, your accounting profit would be
TR - Explicit Costs = $25,000 - $8,000 = $17,000
If you make helmets, your accounting profit would be
TR - TC = P x Q - ATC x Q = (P - ATC) x Q = ($10 - $2) x 2000 = $16,000
I will choose making utensils since it gives me higher profit.

b. If you do so, what will be your economic profit?

While calculating economic profit we need to take the opportunity costs into account. Opportunity cost is the value of the next best alternative. As we decide to make utensils, our next best alternative is making helmets, with the value $16,000.
Econ.profit = Acctg.profit - Opp.cost = $17,000 - $16,000 = $1,000

4. Kendra and Steve run their own business. Every Friday they take two gas grills and grill burgers in front of the Memorial Union. Working from noon till 6pm, they are able to serve 250 hungry customers. They are both equally good in what they are doing, so their wages are equal.
One day Steve was not feeling well, so Kendra had to go there alone. Of course, she has chosen to use only one grill. Within the same period of time she was able to serve 120 customers.

a. What has happened to the average cost of each burger? Show your work.

ATC = TC/Q. The average cost of each burger consists of the cost of a bun and a beef patty (they stay constant) plus the cost of capital (using grill) and labor, divided by the total number of burgers produced. These two costs decreased by half, while the new amount of output is less than a half of the old one (120/250 = 0.48)
ATC(new) = TC(new)/Q(new) = 0.5 x TC(old)/(0.48 x Q(old)) =ATC(old) x 0.5/0.48 > ATC(old).
The average cost of each burger has increased.

b. What can be said about the returns to scale for their business? Explain.

In this case smaller scale of production corresponds to a higher average cost. That means that the average cost is decreasing when the scale of production increases. Whenever we see this happening in the long run, this is an indication that this business operates under increasing returns to scale.

5. If a firm makes zero economic profit, then the firm
a) earns revenue that exceeds its economic costs.
b) must shut down.
c) can be earning positive accounting profit.
d) has no fixed costs.

6. True or False? The concept of economies of scale cannot be applied to the short run.

True. The concept of economies of scale, or returns to scale deals with the effects of a proportional increase in all inputs. Since in the short run some inputs are fixed, a proportional increase in all inputs becomes impossible, therefore the idea of returns to scale cannot be applied.

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