The Midnight Hours, a local nightclub earned 100,000 in accounting profits last year, this year the owner, who had invested 1,000,000 in the club, decide to close the club. What can you say about the economic profit (and the rate of return) in the night-club business?
Take a shot, what do you think?
Hint: be sure to distinguish between economic profits and accounting profits.
To determine the economic profit in the night-club business, we need to consider the explicit and implicit costs involved. Explicit costs are the actual out-of-pocket expenses, whereas implicit costs refer to the opportunity cost of the owner's investment (in this case, the foregone return on the $1,000,000).
The accounting profit of $100,000 accounts only for the explicit costs and does not consider the implicit costs. Therefore, we first need to deduct the implicit cost, which is the rate of return the owner could have earned if they invested the $1,000,000 elsewhere.
Let's assume that the rate of return on a comparable investment was 5% per year. In that case, the implicit cost would be 5% of $1,000,000, which equals $50,000.
Now, we can calculate the economic profit by subtracting both the explicit and implicit costs from the accounting profit:
Economic profit = Accounting profit - Implicit cost
Economic profit = $100,000 - $50,000
Economic profit = $50,000
Therefore, the economic profit in the night-club business would be $50,000.
To determine the rate of return, we need to calculate the percentage return on the owner's investment. Since the owner invested $1,000,000 and earned an economic profit of $50,000, the rate of return is given by:
Rate of return = (Economic profit / Investment) * 100
Rate of return = ($50,000 / $1,000,000) * 100
Rate of return = 5%
So, the rate of return in the night-club business is 5%, which is the same as the assumed rate of return on a comparable investment.