Gomez runs a small pottery firm He hires one helper at 11500

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 = $

Solution

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).