Question

Dane decides to give up a job earning \(\$ 200,000\) per year as a corporate lawyer and converts the duplex that he owns into a UFO museum. (He had been renting out the duplex for \(\$ 20,000\) a year.) His explicit costs are \(\$ 75,000\) per year paid to his assistants and \(\$ 10,000\) per year for utilities. Fans flock to the museum to see his collection of extraterrestrial paraphernalia, which he could easily sell on eBay for \(\$ 1,000,000\). Over the course of the year, the museum brings in revenues of \(\$ 200,000\). a. How much is Dane's accounting profit for the year? b. Is Dane earning an economic profit? Explain.

Short answer

a. Dane's accounting profit for the year is \$115,000. b. No, Dane is not earning an economic profit as it's negative (-\$1,105,000), indicating that he would have been better off financially by not operating the UFO museum and instead working as a corporate lawyer, renting the duplex and selling his collection on eBay.

Step-by-step solution

Calculation of Accounting Profit

Accounting profit is calculated as total revenues minus the explicit costs. Here, the total revenue is given as \$200,000 and explicit costs as (\$75,000 + \$10,000) = \$85,000. Hence, accounting profit = \$200,000 - \$85,000 = \$115,000.

Calculation of total implicit costs

The implicit costs include the income foregone from the next best alternative. Here, there are 3 main implicit costs: 1. Dane's forgone salary as a corporate lawyer (\$200,000), 2. Foregone rental income (\$20,000), 3. The alternative cost of selling his collection on eBay (\$1,000,000) So, total implicit cost = \$200,000 + \$20,000 + \$1,000,000 = \$1,220,000.

Calculation of Economic Profit

Economic profit is calculated as accounting profit minus the sum of implicit costs. Hence, economic profit = \$115,000 - \$1,220,000 = -\$1,105,000. Economic profit is negative, implying that Dane is not earning an economic profit by running the museum.

Key concepts

Accounting Profit

Accounting profit is a straightforward calculation used to assess the actual profit a business makes after deducting its explicit costs from total revenues. In this case, accounting profit is essential to understand because it provides a clear picture of the business's earnings without considering any implicit costs, which are not directly visible in financial statements. Here's how accounting profit is calculated:

• First, identify the total revenue earned by the business. For Dane's UFO museum, this is $200,000 per year.
• Then, subtract the explicit costs involved in running the museum. Explicit costs include expenses like salaries for assistants ($75,000) and utilities ($10,000), totaling $85,000 for the year.
• The accounting profit is therefore the difference between the total revenue and explicit costs: $200,000 - $85,000 = $115,000.

This amount shows how much money remains after covering the direct, out-of-pocket costs. Keep in mind that accounting profit is different from economic profit as it doesn't account for opportunity costs.

Implicit Costs

Implicit costs, unlike explicit costs, are the non-monetary opportunity costs associated with a business decision. They represent the potential benefits or income a business owner sacrifices by choosing one option over another. In Dane's case, several implicit costs reflect what he gave up to start his museum.

• First, consider the forgone salary of $200,000 from his previous job as a corporate lawyer. By leaving this job, Dane sacrificed a substantial income.
• Additionally, by converting his duplex into a museum, he misses out on $20,000 in rental income. This is another implicit cost of running the museum.
• Lastly, his collection's eBay resale value, $1,000,000, is also an implicit cost. Selling the collection could potentially yield this significant amount.
• Adding these implicit costs together, they amount to $1,220,000 in Dane's scenario.

Implicit costs are crucial for assessing economic profit, as they provide a clearer view of the overall opportunity cost involved.

Explicit Costs

Explicit costs are the direct, out-of-pocket expenses a business incurs during its operations. These costs are easy to identify and document as they involve actual payments of money. In Dane's UFO museum venture, explicit costs are crucial to calculating accounting profit.

• For Dane's museum, explicit costs sum up to $85,000 annually.
• This amount includes $75,000 paid to assistants who help run the museum, ensuring its operations function smoothly.
• Additionally, $10,000 is spent on utilities to keep the museum's lights on and climate control for its precious exhibits.

These explicit costs represent necessary expenditures directly related to the museum's day-to-day functioning, clearly documented in its financial ledger.

Opportunity Costs

Opportunity costs are a fundamental concept in economics that reflect the benefits or profits one foregoes by choosing one alternative over another. Understanding opportunity costs is critical when making informed business decisions. Dane's switch from a corporate lawyer to a museum owner clearly shows his opportunity costs.

• His foregone income as a lawyer, which amounts to $200,000 per year, forms a major part of his opportunity costs.
• Additionally, by using his duplex as a museum, he misses out on $20,000 in annual rental income.
• Lastly, by using his extraterrestrial collection in the museum instead of selling it on eBay, he sacrifices $1,000,000.

Total opportunity costs, therefore, equal $1,220,000. Incorporating these costs helps determine the economic profit, highlighting whether the business decision is financially viable or not.