Gomez runs a small pottery firm. He hires one helper at $11,500 per year, pays a

Question

Gomez runs a small pottery firm. He hires one helper at $11,500 per year, pays annual rent of $7,000 for his shop, and spends $22,500 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $6,500 per year if alternatively invested. He has been offered $22,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $4,500 per year (input cost for organizing resources). Total annual revenue from pottery sales is $80,000. Calculate the accounting profit and the economic profit for Gomez’s pottery firm.

Accounting Profit = $

Economic Profit = $

Explanation / Answer

Let me first tell you what it is, so that you understand better -

In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs. As a result, you can have a significant accounting profit with little to no economic profit.

For example, say you invest $100,000 to start a business, and in that year you earn $120,000 in profits. Your accounting profit would be $20,000. However, say that same year you could have earned an income of $45,000 had you been employed. Therefore, you have an economic loss of $25,000 (120,000 - 100,000 - 45,000).

Per Annum Helper Salary 11,500 Shop Rent 7000 material cost 22500 Gomez funds 40000 Alternate Investment income 6,500 Gomez goodwill talent 4500 Annual Sales Revenue 80000 Annual Salary as potter 22000 Total Salary when working as Potter 22000+6500 = 28,500 Total Cost Helper Salary 11,500 Shop Rent 7000 Material cost 22500 Gomez entrepreneurial talent 4500 45,500 Annual Sales Revenue 80000 Accounting profit 80,000 -45,500 = 34,500 Economic Profit =34,500 -28,500 =6000

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