Is economic profit a cost of production?

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

Is economic profit a cost of production?

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.

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