4) A. Gomez runs a small pottery firm. He hires one helper at $12,000 per year,
ID: 1165898 • Letter: 4
Question
4)
A. Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop,and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. Total annual revenue from pottery sales is $72,000. What is the economic profit of Gomez’s pottery firm? Explain your reasoning.
B. You own a cigar company in Cuba. You produce 999 boxes of cigars per year. Your average cost per box is $1.00. Paul Martin offers you $5.00 to produce an extra box so that he can give it to his best friend George W. Bush. If you accept his offer you average costs per box will be $1.01. What should you do?
Explanation / Answer
Answer : 4) a) From given informations we have,
Explicit cost = 12,000 + 5,000 + 20,000 = $37,000 per year.
Implicit cost = 4,000 + 15,000 = $19,000 per year .
Total Revenue = $72,000 (annually)
Now,
Economic profit = Total Revenue - Explicit cost - Implicit cost
=> Economic profit = 72,000 - 37,000 - 19,000
=> Economic profit = $16,000 .
Therefore, pottery firm's economic profit is $16,000.
b) From given informations we get,
In case of 999 cigar box, the average cost is $1 per box.
Total cost of 999 cigar box = Average Cost per cigar box × Total number of produced cigar box
=> Total Cost of 999 cigar box = 1 × 999 = $999.
Now if the cigar company accept the offer of Paul Martin then the cigar company's total production of cigar box increase by 1 box. This means after accepting Paul Martin's offer the cigar company produces total 1000 cigar box. In case of 1000 cigar box production, the average cost is $1.01 per box.
Total Cost of 1000 cigar box = Per box average cost × Total produced cigar box = 1.01 × 1000 = $1,010
According to the given informations, Paul Martin gives $5 for making an extra cigar box. But if the cigar company accept this offer then the company's total cost is increased by (1,010 - 999) = $11. This means that the cigar company faces $11 total cost for producing an extra cigar box while Paul Martin gives only $5 for producing an extra cigar box. Now it is clear that if the cigar company accept the offer of Paul Martin then the company face loss of (11 - 5) = $6. Hence, the cigar company should not accept the offer of Paul Martin to make an extra cigar box.
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