Question

Jim resigns from his job, from which he was earning $40,000 per year, and then uses his own savings as the only source of capital to start a new firm. In the first year, his revenue is $120,000 and the total explicit cost is $60,000. Jim does not want to reveal how much own-savings he uses in his business, but implies that if the interest rate was higher than 5%, he would prefer not to start his own business.

Answer 1

Answer

Option 2

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Accounting profit =total revenue -total explicit costs

=120000-60000

=$60000

Opportunity cost is equal to the interest and the salary

Economic profit before interest =accounting profit -salary=60000-40000=20000

The opportunity cost of interest is equal to $20000 if the interest rate is 5%

amount =20000/0.05=400000

so he took $400000 from saving

if the interest rate decreases the interest decreases and economic profit increases and if the increase rate is above 5% he is in economic losses.

as

Economic profits =accounting profit -implicit costs

implicit costs =interest amount +salary forgone=20000+40000=60000 ...........@i=5%

Economic profit =60000-60000=0 as he will not prefer to take the risk because there is no economic profit above 5% but as the interest rate decreases the economic profit increases.