Question

Hiro owns and operates a small business that provides economic consulting services. During the year he spends \(\$ 57,000\) on travel to clients and other expenses. In addition, he owns a computer that he uses for business. If he didn't use the computer, he could sell it and earn yearly interest of \(\$ 100\) on the money created through this sale. Hiro's total revenue for the year is \(\$ 100,000 .\) Instead of working as a consultant for the year, he could teach economics at a small local college and make a salary of \(\$ 50,000\). a. What is Hiro's accounting profit? b. What is Hiro's economic profit? c. Should Hiro continue working as a consultant, or should he teach economics instead?

Short answer

a. Hiro's accounting profit is \(43,000. b. Hiro's economic profit is \)-7,100. c. Given that Hiro's economic profit is negative when compared to the salary he could earn teaching, he may be financially better off teaching economics instead of working as a consultant.

Step-by-step solution

- Calculating Hiro's Accounting Profit

To calculate Hiro's accounting profit, subtract the explicit costs of his business from the total revenue. Explicit costs are the out-of-pocket expenses, in this case, the travel and other expenses. So, accounting profit = Total Revenue - Explicit Costs.

- Determining Hiro's Accounting Profit

Using the values given: Accounting Profit = Total Revenue (\(100,000) - Travel and Expenses (\)57,000). Now, perform the subtraction to determine the accounting profit.

- Calculating Hiro's Economic Profit

Economic Profit takes into account both explicit and implicit costs. Implicit costs are the opportunity costs of using resources where they could have been used for the next best alternative. In this case, the implicit costs are the forgone interest from not selling the computer, and the foregone salary from not teaching. So, Economic Profit = Accounting Profit - Implicit Costs.

- Determining Hiro's Economic Profit

Using the values given, the implicit costs are the interest Hiro could have earned (\(100) plus the salary he forsakes by not teaching (\)50,000). Now, calculate the economic profit using the accounting profit obtained in step 2.

- Deciding Between Consulting and Teaching

To decide if Hiro should continue as a consultant or become a teacher, compare his economic profit from consulting to the salary he would earn as a teacher. If his economic profit is greater, he should continue consulting; if less, he should consider teaching.

Key concepts

Accounting Profit

Accounting profit is a financial calculation that represents the difference between total revenues and explicit costs. It reflects the monetary gains a business or individual acquires after accounting for the out-of-pocket expenses directly related to the business activities.

For example, Hiro's consulting business racked up \(\$ 57,000\) in travel and other explicit costs. When calculating his accounting profit, we look solely at these clear-cut expenses against his total revenue of \(\$ 100,000\). Thus, Hiro's accounting profit is the subtraction of his explicit costs from his revenue, which is \(\$ 100,000 - \$ 57,000 = \$ 43,000\).

This figure is important for tax purposes and offers a snapshot of the financial health of the business based purely on transactions that involve actual monetary outflow.

Opportunity Cost

Opportunity cost represents the benefits an individual, investor or business misses out on when choosing one alternative over another.

Regarding Hiro's situation, he faces an opportunity cost for not selling his computer to earn the \(\$ 100\) interest annually. Additionally, by choosing to work as a consultant rather than teaching, he forfeits a \(\$ 50,000\) salary. The sum of these foregone alternatives, \(\$ 50,100\), is considered Hiro's opportunity cost.

Recognizing opportunity costs is crucial when assessing the economic profitability of a business, as it accounts for the income potential that is lost when resources are allocated in a certain way. It's an economic concept that encompasses both explicit and implicit costs.

Explicit and Implicit Costs

Explicit costs are the direct, out-of-pocket payments a business makes to keep it running, such as rent, supplies, and employee wages. These are the costs recorded on a company's financial statements. For instance, Hiro had explicit costs of \(\$ 57,000\) for travel and other expenses directly linked to his consulting business.

Implicit costs, on the other hand, are more subtle. They represent the potential income lost when a business uses resources for one purpose over another without a direct cash transaction. Examples include using a business owner's time or using a piece of equipment that could have been otherwise rented out. For Hiro, his implicit costs include the \(\$ 100\) of interest he did not earn from the computer and, more significantly, the \(\$ 50,000\) salary he forfeited by not teaching.

Understanding both types of costs is essential for making informed and economically rational business decisions, as it paints a complete picture of the total expenses involved in running a business.