Gail Thompson is evaluating two options. The first option is to start an event p

Question

Gail Thompson is evaluating two options. The first option is to start an event planning business as a self-employed. Based on business plan, she computed the following annual estimates using very conservative assumptions:

Total revenue = $250,000

Purchases = $145,000

Utility costs = $37,000

Gail will operate the business by herself. She does not plan to hire any employees in the first year. She will operate the business from a building that she owns. The building has been paid in full.

The second option is to work for an event planning company as an employee. Her annual salary would be $44,000. She could also rent her building for $24,000 per year.

Using the concepts of accounting profit and economic profit, compare and contrast the two options. (15 points) Which option is the most profitable for Gail Thompson? (10 points)

Part II (25 points)

Bon Appétit is a French restaurant that recently increased the average price of its meals by 4%. As a result, the number of customers dropped by 3%. Based on this information, what is the price elasticity of demand for meals at Bon Appétit? How will this 4% increase of the average price of meals impact total revenue at Bon Appétit? (10 points)

Another French restaurant in the area that competes with Bon Appétit decided to reduce the average price of its meals by 3%. How will this decision likely impact the demand for meals at Bon Appétit? (5 points)

Assume that the average disposable income in the area in which it operates increases by 5% over the last year. As a result, the number of customers at Bon Appétit increased by 3%. Based on this information, what is the income elasticity of demand for meals at Bon Appétit? Are meals at Bon Appétit considered normal goods? (10 points)

Explanation / Answer

Part I:

First Option:

Earnings per year: Total Revenue – Costs

Earnings = $250,000 – ($145,000 + $37,000)

Earnings when self-employed = $68,000

Second Option: (Opportunity Cost)

Annual Salary = $44,000

Rent Allowance $24,000

Earnings when employed = $68,000

For Gail Thompson, both the options are equally profitable.

Part II:

Bon Apetit: French Restaurant

Percentage increase in the price of its meals = 4%

Percentage change (decrease) in the quantity demanded = -(3)

Price elasticity (PED) = -0.03 / 0.04

PED of meals in Bon Apetit = - (0.75).

Since the PED is less than 1 the demand is inelastic. Which means a rise in price leads to a rise in total revenue.

** Cross price elasticity of demand = % change in the quantity demanded of A / % change in the price of B

-0.75 = % change in quantity demand of A / -0.04

On account of another French restaurant reducing the price of meal by 3%:

% change in the quantity demand of Apetit’s meals = -0.75 x -0.04

Percentage change in quantity demanded = 0.03

Demand for Apetit meals will increase by 3%.

** Income elasticity of demand = % change in quantity demanded / % change in price

Income elasticity of demand for meals at Bon Apetit = 0..03 / 0.05

Income elasticity of demand for meals at Bon Apetit = 0.6

As the demand of meals increases when income increases, meals at Bon Apetit are considered to be normal goods.

*****

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