Question

Definition of economic costs Raphael lives in San Diego and runs a business that sells guitars. In an average year, he receives $722,000 from selling guitars. Of this sales revenue, he must pay the manufacturer a wholesale cost of $422,000; he also pays wages and utility bills totaling $268,000. He owns his showroom; if he chooses to rent it out, he will receive $2,000 in rent per year. Assume that the value of this showroom does not depreciate over the year. Also, if Raphael does not operate this guitar business, he can work as a paralegal, receive an annual salary of $21,000 with no additional monetary costs, and rent out his showroom at the $2,000 per year rate. No other costs are incurred in running this guitar business.

Identify each of Felix’s costs as either an implicit cost or an explicit cost of selling guitars.

a. The wholesale cost for the guitars that Felix pays the manufacturer
b. The rental income Felix could receive if he chose to rent out his showroom
c. The salary Felix could earn if he worked as a paralegal
d. The wages and utility bills that Felix pays

Complete the following table by determining Felix’s accounting and economic profit of his guitar business.

Profit (Dollars)
Accounting Profit
Economic Profit

Answer 1

a. The wholesale cost for the guitars that Felix pays the manufacturer

• explicit cost (or accounting cost)

b. The rental income Felix could receive if he chose to rent out his showroom

• implicit cost (or opportunity cost)

c. The salary Felix could earn if he worked as a paralegal

• implicit cost (or opportunity cost)

d. The wages and utility bills that Felix pays

• explicit cost (or accounting cost)

Felix's accounting profit = $722,000 - $422,000 - $268,000 = $32,000

Felix's economic profit = accounting profit - implicit costs = $32,000 - ($21,000 + $2,000) = $32,000 - $23,000 = $9,000

Opportunity costs are the extra costs or benefits lost from choosing one activity or investment over another alternative.