John Jones owns and manages a cafe in College town. His monthly revenue is $5000
ID: 1218656 • Letter: J
Question
John Jones owns and manages a cafe in College town. His monthly revenue is $5000. Monthly expenses are shown in the following list: LO1, LO2 Calculate John's monthly accounting profit. John could earn $ 1000/month as a recycler of aluminum cans. However, he prefers to run the cafe. In fact, he would be willing to pay up to $275/month to run the cafe rather than to recycle. Is the cafe making an economic profit? Will John stay in the cafe business? Explain. Suppose the cafe's revenues and expenses remain the same, but recyclers earnings rise to $1100/month. Is the cafe still making an economic profit? Explain. Suppose that instead of borrowing $10 000 at a monthly interest rate of 10 percent to buy equipment, John had invested $10 000 of his own money in equipment. How would your answers to parts (a) and (b) change? If John can earn $ 1000/month as a recycler and he likes recycling just as well as running the cafe, how mu Ch additional revenue would the cafe have to collect each month to earn a normal profit?Explanation / Answer
a. Calculate John's annual accounting profit.
John's accounting profit is his revenue minus his explicit costs, or $750 per week.
b. John could earn $1,000 per year as a recycler of aluminum cans. However, he prefers to run the cafe. In fact, he would be willing to pay up to $275 per year to run the cafe rather than to recycle. Is the cafe making an economic profit? Should John stay in the cafe business? Explain.
Yes: his opportunity cost of his labor to run the café is $1,000 - $275, or $725 per week. Adding this implicit cost to the explicit costs implies that the café is making an economic profit of $25 per week. And since $25>0, John should stay in business.
c. Suppose the cafe's revenues and expenses remain the same, but recyclers' earnings rise to $1,100 per year. Is the cafe still making an economic profit? Explain.
John's opportunity cost rises by $100, to $825 per week. The café is thus now making an economic loss of $75 per week.
d. Suppose John had not had to get a $10,000 loan at an annual interest rate of 10 percent to buy equipment, but instead had invested $10,000 of his own money in equipment. How would your answer to parts a and b change?
The accounting profit would now be $1,750/yr. The answer to part b. would not change. If John had $10,000 of his own to invest in the café, he would forgo $1,000/yr in interest by not putting the money in a savings account. That amount is an opportunity cost that must be included when calculating economic profit.
e. If John can earn $1,000 a year as a recycler, and he likes recycling just as well as running the cafe, how much additional revenue would the cafe have to collect each year to earn a normal profit?
To earn a normal profit, the café would have to cover all its implicit and explicit costs. The opportunity cost of John's time is $1,000/yr, whereas the café's accounting profit is only $750/yr. Thus, the café would have to earn additional revenues of $250/yr to make a normal profit.
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