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UW-Madison ECON 101 - Cost Examples

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Example 1: You start a consulting firm after college. • Your total revenues are $250K per year • Your cost for office supplies, office space, employees, and travel is $200K per year In accounting terms your profit would be $50K per year. How much is your economic profit? The answer depends on the opportunity cost of your time. Suppose you could get a job and McKinsey and Company making $75,000 per year. The opportunity cost of your time is $75K per year and your economic profits would be negative $25KExample 2: You start a landscaping business. To get the business going you initially must invest $10,000 to purchase a truck, a trailer, some mowers, weed whackers, shovels, and a Bobcat. You also have to purchase gas and pay your workers. The expenditures cost you $20K per year. If the opportunity cost of your time is $20K per year capital depreciates at a rate of 10% per year and the interest rate is 5%, what is your economic cost? • Implicit Costs o Opportunity cost of the $10K invested 0.05*10K o Depreciation on your capital 0.10*10K o Your time $30K • Explicit Costs o Gas and Labor $20K Total Cost=$51,500 A firm can rent or buy capital. If it rents capital the price of capital is going to be the price they pay to rent expressed as a fraction of the total value of the capital. Implicit Rental Rate if Captal (r) – the rental income forgone when you a firm uses its own capital expressed as a total percentage of the value of the capital – Two components o interest cost (implicit or explicit) o depreciationExample 3: You start a landscaping business. To get the business going you initially must invest $10,000 to purchase a truck, a trailer, some mowers, weed whackers, shovels, and a Bobcat. You do not have the money on hand so you borrow it from a bank at a interest rate of 0.10. You also have to purchase gas and pay your workers. The expenditures cost you $20K per year. If the opportunity cost of your time is $30K per year capital depreciates at a rate of 10% per year and the interest rate is 5%, what is your economic cost? • Implicit Costs o Depreciation on your capital 0.10*10K o Your time $30K • Explicit Costs o Bank Interest on your Loan 0.10*10,000 o Gas and Labor $20K Total


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UW-Madison ECON 101 - Cost Examples

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