Economan is setting up a firm.  The annual rent of the building is
$4,000 the cost of the two secretaries is $20,000 per year.  The cost
of electricity and other costs come to $1000 a year.  The total
revenue from the firm is expected to be $50,000 a year.

Economan forfeits $20,000 that he could earn by working for another
firm and $3000 interest earned on savings if he is ot putting them in
this business.

Compute his accounting and economic profit.  Do you think he should
invest in this business?  Explain by giving reasons.

Hi makbool-ga, 

Firstly, lets define accounting and economic profit in terms of
equations. Then we will be able to understand the calculations.

Accounting Profit = (Revenue) - (Expenses)

In the above equation, revenue represents the money he ACTUALLY
expects to make, and expenses represents the money he ACTUALLY expects
to pay in order to run the business.

Economic Profit = (Revenue) - (Expenses) - (Opportunity Cost)

In the equation for economic profit, revenue and expenses represent
the same things as they did in the accounting profit equation. The
difference between accounting and economic profit is opportunity cost,
which is the benefit given up by choosing on option over another.

In your specific question, the total of $23,000 that is being given up
by running the business instead of working and earning interest on
savings.

Now lets classify the numbers in the question:

Revenue:
$50,000 to operate the business

Expenses:
$4000 for rent
$20000 for the two secretaries
$1000 for other costs

Opportunity Costs:
$20000 in wages
$3000 interest

With these numbers classified, we can now complete the calculations:

Accounting Profit = (Revenue) - (Expenses)
                  = ($50,000) - ($4000 + $20,000 + $1000)
                  = $25,000

So from an accounting perspective he projects a profit of $25K/year

Economic Profit = (Revenue) - (Expenses) - (Opportunity Cost)
                = ($50,000) - ($4000 + $20,000 + $1000) - ($20,000 +
$3000)
                = $50,000 - $25,000 - $23,000
                = $2000

From an economic profit perspective, he looks to gain a profit as
well. However, the actual result of $2000 holds value in that it state
HOW MUCH MORE (or less if negative) he would be making if he chose to
set up this firm instead of working and earning interest on his
savings.

for this reason, it is a wise choice to invest in this business
assuming that the projected revenues are accurate and the expenses
that he is facing to set up the business are somewhat stable.

Hope that helps...if you have any problems understanding the
information above please feel free to post a clarification :)

Cheers!

answerguru-ga