Question

Joe, who has no skills, no job experience, and no alternative employment, runs a shoeshine stand. Other operators of shoeshine stands earn \(\$ 10,000\) a year. Joe pays rent of \(\$ 2,000\) a year, and his total revenue is \(\$ 15,000\) a year. Joe spent \(\$ 1,000\) on equipment, which he used his credit card to buy. The interest on a credit card balance is 20 percent a year. At the end of the year, Joe was offered \(\$ 500\) for his business and all its equipment. Calculate Joc's opportunity cost of production and his economic profit.

Short answer

Joe's opportunity cost of production is \text{\textbackslash}\text{13200} USD, and his economic profit is \text{\textbackslash}\text{1800} USD.

Step-by-step solution

Determine Explicit Costs

Explicit costs are the direct costs associated with running the business. Joe's explicit costs include rent and equipment: Rent: \(\text{\textbackslash}\text{2000}\) Equipment: \(\text{\textbackslash}\text{1000}\) Total explicit costs: \(\text{\textbackslash}\text{2000 + 1000 = 3000}\)

Calculate Interest on Equipment

Joe borrowed \(\text{\textbackslash}\text{1000}\) for equipment using a credit card with an interest rate of 20%. Calculate the interest for one year: \text{\textbackslash}\text{Formula: Total Interest = Principal \(\times\) Interest Rate}Total Interest = \(\text{\textbackslash}\text{1000} \text{\times} \text{0.20 = 200}\)

Calculate Total Explicit Costs

Add the interest cost to the previous total explicit costs: Total Explicit Costs = Rent + Equipment + Interest Total Explicit Costs = \(\text{\textbackslash}\text{2000 + 1000 + 200 = 3200}\)

Determine Implicit Costs

Implicit costs for Joe include the earnings he forgoes by not working in another shoeshine stand. Other operators earn \(\text{\textbackslash}\text{10000}\) per year.Implicit Costs: \(\text{\textbackslash}\text{10000}\)

Calculate Opportunity Cost of Production

Opportunity cost is the sum of explicit and implicit costs: Opportunity Cost = Explicit Costs + Implicit Costs Opportunity Cost = \(\text{\textbackslash}\text{3200} + \text{\textbackslash}\text{10000 = 13200}\)

Calculate Total Revenue

Joe's total revenue from his shoeshine stand is: Total Revenue = \(\text{\textbackslash}\text{15000}\)

Calculate Economic Profit

Economic profit is the total revenue minus the opportunity cost: Economic Profit = Total Revenue - Opportunity Cost Economic Profit = \(\text{\textbackslash}\text{15000} - \text{\textbackslash}\text{13200 = 1800}\)

Key concepts

explicit costs

Explicit costs are the direct, out-of-pocket expenses a business incurs. These costs are easily visible and recorded in the business's financial statements. For Joe's shoeshine stand, the explicit costs include:

• Rent of \$2000 per year
• Cost of equipment which is \$1000

Total explicit costs for Joe would be the sum of rent and equipment expenses. Additionally, don't forget the interest paid on the credit card used to purchase equipment. If Joe borrowed \$1000 at a 20% interest rate, the interest would be:
\( \text{Interest} = 1000 \times 0.20 = 200 \)
So, Joe's total explicit costs become:
\( \text{Total Explicit Costs} = 2000 + 1000 + 200 = 3200 \)

implicit costs

Implicit costs represent potential earnings Joe sacrifices by choosing to run his shoeshine stand instead of doing something else. These are not direct payments but opportunity costs. For Joe, the primary implicit cost is the earnings he misses out by not working in another shoeshine stand. Other operators earn \$10,000 a year. Hence, Joe's implicit costs are:
\( \text{Implicit Costs} = 10000 \)

economic profit

Economic profit considers both explicit and implicit costs. It provides a more comprehensive understanding of Joe's profitability compared to simply looking at accounting profit. First, we need to calculate the opportunity cost of production, which is the sum of explicit and implicit costs:
\( \text{Opportunity Cost} = 3200 + 10000 = 13200 \)
Then, subtracting this from his total revenue gives Joe's economic profit:

\( \text{Economic Profit} = \text{Total Revenue} - \text{Opportunity Cost} \)
\( \text{Economic Profit} = 15000 - 13200 = 1800 \)
This shows not just the money Joe made but how profitable his decision to run a shoeshine stand is relative to other available opportunities.

total revenue

Total revenue is the total income generated from selling your product or service before any costs are subtracted. It’s a crucial figure for any business as it acts as a starting point for calculating profit. Joe's total revenue from his shoeshine stand is calculated as:

\( \text{Total Revenue} = 15000 \)
This amount is what Joe earns from his business operations over the year.

interest calculation

Interest calculation is vital for determining the additional cost on borrowed money. If you purchase equipment using credit, it is essential to consider this interest as part of your expenses. Using the formula:
\( \text{Interest} = \text{Principal} \times \text{Interest Rate} \)
For Joe, who borrowed \$1000 to buy equipment at a 20% interest rate, the calculation would be:
\( \text{Interest} = 1000 \times 0.20 = 200 \)
This interest amount is added to Joe’s explicit costs, increasing his total outlay and affecting his overall profit calculation.