Accounting Profit and Economic Profit

Question

Walter used to work as a high school teacher for $40,000 per year but quit in order to start his own painting business. To invest in his painting business, he withdrew $20,000 from his savings, which paid 3 percent interest, and borrowed $30,000 from his uncle, whom he pays 3 percent interest per year. Last year Walter paid $25,000 for supplies and had revenue of $60,000.

1. What is Walter’s total explicit cost? 
2. What is Walter’s total opportunity cost of the business? 
3. What is Walter’s accounting profit?
4. What is Walter’s economic profit?
5. Is Walter better off in his painting business than when he was a schoolteacher?

Answer 1

1. Explicit costs = Interest on borrowed money + Cost of supplies = (3% of $30,000) + $25,000 = $25,900.
2.  Implicit costs of the business = High school teacher’s salary given up by Walter + interest foregone on the amount that Walter withdrew from his savings account to invest in the business = $40,000 + (3% of $20,000) = $40,600. Total opportunity cost = Explicit Costs + Implicit Costs = $25,900 + $40,600 = $66,500.
3. Accounting profit = Total Revenue – Explicit Costs = $60,000 - $25,900 = $34,100.
4. Economic profit = Total Revenue – Explicit Costs – Implicit Costs = $60,000 - $25,900 - $40,600 = -$6,500.
5. Walter is not better off in his painting business, as he is making a loss of $6,500. He is making $34,100 (accounting profit) in his business. When he was a schoolteacher, his income was $40,600 ($40,000 salary + $600 interest on $20,000 savings at 3%). So, he is getting $6,500 less in the business. This is his economic loss.