The MidNight Hour, a local nightclub, earned $100,000 in accounting profit last year. This year the owner, who had invested $1 million in the club, decided to close the club. What can you say about economic profit (and the rate of return)in the nightclub business?
To determine the economic profit and rate of return in the nightclub business, we need to consider both the accounting profit and the opportunity cost.
First, let's define the terms:
1. Accounting Profit: It refers to the difference between total revenue and explicit costs. It measures the actual monetary profit obtained from a business, considering only the explicit costs (such as wages, rent, utilities, etc.) and excludes implicit costs (such as the opportunity cost of invested capital).
In this case, the accounting profit of the MidNight Hour nightclub is $100,000.
2. Economic Profit: It takes into account both explicit costs and implicit costs (including opportunity cost), unlike accounting profit. Economic profit is the difference between total revenue and the total cost (explicit + implicit costs). It represents the true economic gain or loss, considering all costs involved, including the opportunity cost of capital.
Now, let's calculate the economic profit considering the given information:
Since the owner invested $1 million in the club, we need to account for the opportunity cost of this capital. The implicit cost is the return the owner could have earned by investing that $1 million elsewhere (such as in a different business, stocks, bonds, or other investment options).
Assuming a reasonable rate of return (discount rate) for the owner's investment, let's say it is 5%, the implicit cost of the capital invested in the nightclub would be $1 million * 5% = $50,000.
To calculate the economic profit, we deduct this implicit cost from the accounting profit:
Economic Profit = Accounting Profit - Implicit Cost
Economic Profit = $100,000 - $50,000
Economic Profit = $50,000
So, the economic profit in the nightclub business, taking into account the opportunity cost of invested capital, is $50,000. It indicates the true economic gain after considering both explicit and implicit costs.
Regarding the rate of return, it is calculated as:
Rate of Return = Economic Profit / Total Investment * 100
Rate of Return = $50,000 / $1,000,000 * 100
Rate of Return = 5%
Therefore, in the nightclub business, the economic profit is $50,000, and the rate of return is 5% when considering the owner's $1 million investment and the opportunity cost of capital.