Due 10 September 2007
PROBLEM SET 2 ANSWERS
Up, Up, and that’ll be $2350:
Luxury Balloon Rides
Accounting profit is simply revenue minus the explicit costs you incur.
Your revenues are
$255,000, while your costs include Carl’s salary of $35,000, the balloon leasing fee of $40,000,
the Hummer leasing fee of $22,000, and the advertising costs of $38,000.
The total of these
costs is $135,000, so it looks like your accounting profit is $120,000.
The economic profit, on the other hand, takes into account all the opportunity costs.
that the explicit costs are set by markets, so that they are accurate measures of the true
opportunity costs of these cost items.
There are also implicit opportunity costs, which must be
These costs include the foregone wages when the entrepreneur contributes labor to
the firm, as in the case of the balloon business, and it always includes the normal profits that can
be expected from engaging in some business.
Normal profit can be thought of as the average
profit that similar businesses earn.
Thus, to the explicit opportunity costs of $135,000 you need to add the implicit opportunity costs
of $85,000 of foregone wages and $33,000 of normal profits, or $118,000 in total.
that the total opportunity costs of the business are $253,000, leaving an economic profit of
Is that good?
Well, usually we expect economic profit to be zero in competitive markets,
primarily because each firm’s profit is driven down to the normal profit level.
Your extra profit
of $2,000 may come because you’re the only luxury balloon ride business in the area, which
allows you to charge higher prices.
The change from Part A is that now you’re buying the balloon instead of leasing it.
you buy an asset, the purchase price really isn’t a cost, because you’re simply trading one asset
(money) for another (a balloon).
But you use up services from this asset, which have some
value, and the services we use up we count as a cost—depreciation.
Ideally, we would calculate
economic depreciation as the difference in market prices of the asset after one period of standard
In the problem, the balloon costs $170,000 new and can be sold after flying it for a year for
$135,000, so the implied economic depreciation is $35,000.
Added to economic depreciation is the foregone interest that you could have earned by investing
the money used to buy the asset into the next-best investment opportunity you have.
In this case,
it’s the 9% interest you could have earned on the cotton-candy concession.
The 6% interest you
owe the bank is an explicit cost that figures into your accounting profit, but it doesn’t necessarily
equal your true opportunity rate of return.
So perhaps a way to think about this is that your cost
is the explicit 6% interest cost, plus an additional 3% return that you should be expected to earn
—it’s an analog to normal profit.
In this case, the 9% interest on a borrowing of $170,000 is