Assignment No.

ECONOMIC
ENVIRONMENT OF
BUSINESS
(5571)
Executive MBA/MPA

ZAHID NAZIR
Roll.No. AB523655
Semester:Autumn 2008
 Question 1
What is micro Economics? Briefly explain macro
economics. Also explain the factors to be studied in both
Micro and macro Economics in detail.

Marks: 20

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MICRO ECONOMICS
The word micro means a millionth part. Microeconomics is the study
of the small part or component of the whole economy that we are
analyzing. For example we may be studying an individual firm or in
any particular industry. In Microeconomics we study of the price of
the particular product or particular factor of the production.

The Micro Economics theory studies the behavior of individual

decision-making units such as consumers, recourse owners and
business firms. The role of Micro economics is both positive and
normative; it not only tells how economy operates but also how it
should operate in to improve general welfare.

MACRO ECONOMICS
Macro economics is the study of behavior of the economy as a whole.
It examines the overall level of nations out put, employment, price
and foreign trade.

Macroeconomics is concerned with aggregate and average of entire

economy. e.g. In Macro economics we study about forest not about
tree.

In other words in macro economics study how these aggregates and

averages of economy as whole are determined and what causes
fluctuation in them. For making of useful economic policies for the
nation macroeconomics is necessary.

OBJECTS OF MACROECONOMICS
1. A high and rising level of real output.

2. High employment and low unemployment, providing good jobs at

high pay to those who want to work.

3. A stable or gently rising price level, with process and wages

determined by free Markets.

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 4. Foreign economic relations marked by stable foreign exchange
rate and exports more or less balancing imports.

ECONOMIC VARIABLES STUDIED IN MICROECONOMICS

• Micro economics is the study of small part of component of the
whole economy.
• Micro economics is called the Price Theory. It’s explained its
composition, or allocation of total production why more of
something is produced than of others.
• In Micro study about individual consumer behavior or individuals
firm or what happens in any particular industry.
• If it be an analysis of price, we study about the price of a
particular producer or of a particular factor of production.
• If it is demand we analysis demand of an individual or that of an
industry.
• Here we study the income of an individual.
• It is both positive and normative science. It not only tells us how
the economy operates but also how it should be operated to
promote general welfare.
• It can not give an idea of the functioning of the economy as a
whole example. An individual industry may be flourishing whereas,
the economy as a whole may be languishing.
• It assumes full employment, which is rare phenomenon, at any
state in the capitalist world. It is therefore, an unrealistic
assumption.
• Study of individual aspects of economy will lead us now here.

ECONOMIC VARIABLES STUDIED IN MACROECONOMICS

• Macro economics is the study and analysis of economic system as
a whole.
• Macro economics is called income theory. It explains the level of
total production and why the level rises and fall.
• In Macro we study how the aggregates and the averages of the
economy as whole is determined and what causes fluctuation in
them.
• In macro we study the general price level in country.

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 • In macro we study the aggregate demand of the entire country.
• Here we study the national income of the country.
• It shows how an economy grows. It gives bird eye view of
economic world.
• Individual ignored altogether. It is individual welfare, which is the
main aim of economics. Increasing national saving at the expense
of individual welfare is not a wise policy.
• It over looks individual differences for instance, the general price
level may be stable but the prices of food grains may have gone
spelling ruin to the poor.
• The economy as a whole is more important for formulation of
useful economic policies for the nation.

Reference:

http://pgdba.blogspot.com/

http://www.economicshelp.org/

Economic Environment of Business (AIOU)

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 Question 2
a). What is inflation? Differentiate between inflation abd
hyper inflation with examples.
Marks: 10

b). inflation can have a number of negative effects on the

economy. Explain at least four of them with some
suggestions to tackle such problems.

Marks: 10

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a).

INFLATION.

“Inflation is a sustained increase in the average price level of a country.”

“Inflation means that your money won’t buy as much today as you
could yesterday.”

The rate of inflation is measured by the annual percentage change in the

level of prices as measured by the consumer price index.

The model of free markets states the importance of the price

mechanism for determining prices in an economy. When there are
shortages, companies raise their prices, and when there are surpluses,
prices fall. The price mechanism is important for relative prices but with
inflation we are concerned with overall changes in the rate of inflation.

PURCHASING POWER
For example If we have inflation then £ 100 is going to buy less in the
future.

Purchasing Power of the Pound (1920 = 100)

1920 1930 1940 1950 1960 1970 1980 1990 1998

100 125 129 98 66 46 133 6.8 5.33

This table shows us that £ 100 buys less goods in 1998 than
1920,( approx 78% of its value). Therefore inflation is also defined as
decline in the purchasing power of money.

The real value of money is the amount of goods it can buy. If you had
a fixed income of £100 then the nominal value remains unchanged
but the real value has fallen by 95 % in the last 78 years.

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 • The rate of change of the price level is known as the rate of
inflation e.g. if the price level doubles then the rate of inflation is
100%
• If the rate of inflation falls (e.g. from 10% to 2%), prices are still
rising but at a slower rate.

Inflations are of three types:

i). Demand Pull Inflation

ii). Cost Push Inflation

iii) Continuing Inflation

HYPERINFLATION
“Hyperinflation is the inflation that is "out of control", a condition in
which prices increase rapidly as a currency loses its value.”

Another definition is when cumulative inflation rate over three years

approaching 100% to "inflation exceeding 50% a month.

As a rule of thumb, normal inflation is reported per year, but

hyperinflation is often reported for much shorter intervals, often per
month. Hyperinflation is often associated with wars (or their
aftermath), economic depressions, and political or social instability.

Example:

1). The most severe month of hyperinflation occurred in

Hungary in July 1946 when prices increased by 4.19 quintillion
per cent (4,190,000,000,000,000,000 %). In the same year the
Hungarian National Bank issued a 10 quintillion pengo note
(one followed by 19 zeros 10,000,000,000,000,000,000).

2). During the hyperinflation episode in Germany from 1922 to

1923, the Weimar Republic printed postage stamps with a face
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 value of one billion marks, as prices doubled every two days.
At one point in 1923, the exchange rate equaled one trillion
Marks to one dollar.

3). In Yugoslavia prices increased by 5 quadrillion per cent

between October 1, 1993, and January 24, 1995.

b).

EFFECTS OF INFLATION ON ECONOMY

A small amount of inflation can be viewed as having a beneficial

effect on the economy. One reason for this is that it can be difficult
to renegotiate prices and wages. With generally increasing prices it is
easier for relative prices to adjust.

With inflation, the price of any given good is likely to increase over
time, therefore both consumers and businesses may choose to make
purchases sooner than later. This effect tends to keep an economy
active in the short term by encouraging spending and borrowing and
in the long term by encouraging investments. But inflation can also
reduce incentives to save, so the effect on gross capital formation in
the long run is ambiguous.

In general, high or unpredictable inflation rates are regarded as bad.

Inflation can have a number of negative effects on economy. Most
important of them are:

i). Inflation creates uncertainty and confusion

ii). Lower Competitiveness

iii). Inflationary growth is unsustainable

iv). Inflation reduces the value of savings

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i). INFLATION CREATES UNCERTAINTY AND CONFUSION

When inflation is high it also tends to be more volatile. It becomes

more difficult for firms to predict future prices and costs, therefore
they tend to reduce or delay investment decisions. Therefore this
tends to adversely effect economic growth in the long term.

The growth of one’s economy may be burdened by inflation.

However, if policymakers are looking into things seriously, every
nation can hurdle the setbacks of inflation by implementing
measures to overcome the negative effects of inflation.

II). LOWER COMPETITIVENESS

High inflation creates less competitiveness compared to other

possibly balance of payments problems. This is increasingly
important with the globalization of the world economy. If we do lose
competitiveness in the long term it is likely to lead to devaluation in
exchange rate.

III). INFLATIONARY GROWTH IS UNSUSTAINABLE

Economic growth above the long run trend rate also caused inflation
leading to a boom and bust economic cycle. Keeping inflation close to
the government’s target is one of the best ways of avoiding
inflationary growth and maintaining sustainable economic growth.

IV). INFLATION REDUCES THE VALUE OF SAVINGS

This is because inflation erodes the value of money. This is likely to

effect pensioners the most. Therefore inflation is thought to cause a
redistribution of income within society from savers to borrowers.
However this is only a problem if inflation is higher than the rate of
interest. If interest rates are above the value of inflation then savers
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 can still maintain the value of their savings. (so long as they don’t
keep it in cash under their bed).

The impact of inflation to an ordinary family gives us a clear

indication that the value of our money is no longer the same as
yesterday. Wise spending is the name of the game. What the basic
needs are should be prioritized instead of buying things that are of
less importance.

ECONOMICS POLICIES TO CONTROL INFLATION

The control of inflation has become one of the dominant objectives
of government economic policy in many countries. Effective policies
to control inflation need to focus on the underlying causes of
inflation in the economy. For example if the main cause is excess
demand for goods and services, then government policy should look
to reduce the level of aggregate demand. If cost-push inflation is the
root cause, production costs need to be controlled for the problem
to be reduced.

MONETARY POLICY

Monetary policy can control the growth of demand through an

increase in interest rates and a contraction in the real money supply.

The effects of higher interest rates:

• Higher interest rates reduce aggregate demand in three main

ways;
• Discouraging borrowing by both households and companies
• Increasing the rate of saving (the opportunity cost of spending
has increased)
• The rise in mortgage interest payments will reduce
homeowners' real 'effective' disposable income and their
ability to spend. Increased mortgage costs will also reduce
market demand in the housing market.

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 • Business investment may also fall, as the cost of borrowing
funds will increase. Some planned investment projects will
now become unprofitable and, as a result, aggregate demand
will fall.
• Higher interest rates could also be used to limit monetary
inflation. A rise in real interest rates should reduce the
demand for lending and therefore reduce the growth of broad
money.

FISCAL POLICY

• Higher direct taxes (causing a fall in disposable income)

• Lower Government spending

These fiscal policies increase the rate of leakages from the circular
flow and reduce injections into the circular flow of income and
will reduce demand pull inflation at the cost of slower growth and
unemployment.

DIRECT WAGE CONTROLS - INCOMES POLICIES

Incomes policies (or direct wage controls) set limits on the rate of
growth of wages and have the potential to reduce cost inflation.
Wage inflation normally falls when the economy is heading into
recession and unemployment starts to rise. This causes greater job
insecurity and some workers may trade off lower pay claims for some
degree of employment protection.

The key to controlling inflation in the long run is for the authorities to
keep control of aggregate demand (through fiscal and monetary
policy) and at the same time seek to achieve improvements to the
supply side of the economy. The credibility of inflation control
policies can often be enhanced by the introduction of inflation
targets.

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SUGGESTION TO TACKLE INFLATION
Inflation is like a monster. It can net be controlled by taking single
measures. Here are few suggestions to tackle inflation.

• Containing Money Supply: The monetary supply should be kept

within reasonable limits.
• Reducing Budgetary Deficit: The budgetary deficit should be kept
at low level. The deficit should be met by disciplined policy of
demand management.
• Emphasis on Commodity Producing Sectors: The government
should give special attention to the production of cotton, wheat,
vegetables, edible oil etc it will have soothing effect on inflation.
• Commodity Balance: The government should have a strict watch
on the prices of essential commodities in the country. It should
take immediate steps in changing the import and export duties
and maintain the availability of goods in reasonable prices.

References:

http://tutor2u.net/economics/

http://www.economicshelp.org/

http://answers.yahoo.com/

economics Environment of Business (AIOU)

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 Question 3
a). Describe the role of price as rationing device?

Marks: 10

b). The government gains revenue by imposing a sales

tax. Who stands to lose the most, the consumer or the
producer, or both? Quote original examples.

Marks: 10

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a).

THE PRICE SYSTEM

The market system also called the price system performs two
important and closely related functions:

i). Price rationing

ii). Resource Allocation

PRICE RATIONING

“Price Rationing is the process by which the market system allocates

goods and services to consumers when quantity demanded exceeds
quantity supplied.”

ROLE OF PRICE AS RATIONING DEVICE

In market economics, rationing artificially restricts demand. It is done
to keep price below the equilibrium (market-clearing) price
determined by the process of supply and demand in an unfettered
market. Thus, rationing can be complementary to price controls. An
example of rationing in the face of rising prices took place in the
Netherlands, where there was rationing of gasoline in the 1973
energy crisis. A reason for setting the price lower than would clear
the market may be that there is a shortage, which would drive the
market price very high. High prices, especially in the case of
necessities, are unacceptable with regard to those who cannot afford
them.

Rationing is needed due to the scarcity problem. Because wants and

needs are unlimited but resources are limited, available commodities
must be rationed out to competing uses. Markets ration
commodities by limiting the purchase only to those buyers willing
and able to pay the price.

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 Price rationing works like this. A decrease in supply of a commodity
creates a shortage. Quantity demanded is greater than the quantity
supplied. Price will begin to rise. The lower total supply is rationed to
those who are willing and able to pay the higher price.

ALTERNATIVE RATIONING MECHANISMS

• A price ceiling is a maximum price that sellers may charge for a

good, usually set by government.
• Queuing is a non-price rationing system that uses waiting in
line as a means of distributing goods and services.
• Favored customers are those who receive special treatment
from dealers during situations when there is excess demand.
• Ration coupons are tickets or coupons that entitle individuals
to purchase a certain amount of a given product per month.

The problem with these alternatives is that excess demand is

created but not eliminated.

b).

TAX

“It is a compulsory contribution or payment paid by a person to

the public authority to cover the cost of services rendered by
the state for the general benefit of its people and the person
who pays tax cannot claim a definite service in return.”

SALES TAX

“A sales tax is a consumption tax charged at the point of

purchase for certain goods and services.”

The tax is usually set as a percentage by the government

charging the tax. When you buy the products subject to sales
taxes, you pay the price tag plus the tax. In Pakistan sales taxes
cover a large number of goods and services. There is usually a

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 list of exemptions. The tax can be included in the price (tax-
inclusive) or added at the point of sale (tax-exclusive).

WHO STANDS TO LOOSE MORE – PRODUCER or

CONSUMER?
Most sales taxes are collected by the producer, who pays the tax
over to the government which charges the tax. The economic burden
of the tax usually falls on the purchaser, but in some circumstances
may fall on the seller. Sales taxes are commonly charged on sales of
goods, but many sales taxes are also charged on sales of services.
Ideally, a sales tax is fair, has a high compliance rate, is difficult to
avoid, is charged exactly once on any one item, and is simple to
calculate and simple to collect. This can be best explained by the
following example:

Price of
Gasoline S+T
(per Liter)
S
B T=0.05
$0.53

$0.50 A
$0.48 C

D
30 40
Quantity (millions of Liters)

As in the above figure, when the sales tax is introduced, it leaves the
demand curve intact while it raises the supply curve by the amount
of tax, $0.05. To see the logic remember that the supply curve
represents the quantities that a firm is to offer at alternative process.

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 The supply curve in figure reflects prices excluding taxes charged by
the seller. When the tax is levied, the price charged by the seller
must reflect the tax. Therefore the supply curve jumps up (a
decrease in supply) by the amount of tax (5 cents on vertical axis).
Note that this shift is a parallel shift since the amount of tax is fixed
per liter of gasoline and does not change with the volume of
consumption. The tax inclusive supply curve reflects the fact that
sellers are willing to supply the same quantities only if they get paid 5
cents more than before per liter. The 5 cents added to the price is
the seller’s new obligation to the government.

At new equilibrium, point B, the price has risen and volume of

transactions has fallen. However the equilibrium price of $0.53 is the
price paid by consumers. Note that the price does not rise by the full
amount of 5 cents to consumers even though the government has
levied a 5 cent tax. In order to see this point more clearly, remember
that the vertical distance b/w the two supply curves is 5 cents. As
long as the demand curve is not perfectly vertical, consumer will pay
only a portion of tax. The remaining portion is paid by the sellers
(producer) that are receiving $0.48 per liter as opposed to $0.50
(point C). Therefore the burden of tax is shared by both consumers
and producers, 3 cents by the consumer and 2 cents by the seller.
The government collects its 5 cents regardless how the burden is
shared.

In this example, consumer’s share in sales tax (3 cents) is greater

than the producer’s share (2 cents). In general, who is going to loose
more is the function of slopes of demand and supply curve. The
steeper the gasoline demand curve, greater will be the portion paid
by the consumers, the flatter the demand curve, smaller will be the
consumer’s share. Also, the flatter the supply curve, greater the
portion paid by the consumer and vice versa.

Reference:

http://www.economicshelp.org
http://en.wikipedia.org
Principles of Economics by Karl and ray
Economic Environment of Business (AIOU)

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 Question 4
a). Define the concepts (i) Price elasticity of demand, (ii)
Cross elasticity of demand, and (iii) Income elasticity of
demand. How are these elasiticities estimated? Explain
why it might be important for a firm to know there values.

Marks: 10

b). In what respect would you expect determinant of

demand for computers to differ from the determinants of
demand for milk?

Marks: 10

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a).

i). PRICE ELASTICITY OF DEMAND:

An important aspect of a products demand curve is how much the
quantity demanded changes when the price changes. The economic
measure of this response is called price elasticity of demand.

PED measures the responsiveness of a change in demand, after a

change in price.

The formula for the Price Elasticity of Demand (PED) is:

PEoD = % change in Quantity Demanded.

% change in price

To calculate the price elasticity, we need to know what the

percentage change in quantity demand is and what the percentage
change in price is. It's best to calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded

The formula used to calculate the percentage change in quantity

demanded is:

[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)

Calculating the Percentage Change in Price

Similar to before, the formula used to calculate the percentage

change in price is:

[Price(NEW) - Price(OLD)] / Price(OLD)

Final Step of Calculating the Price Elasticity of Demand

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

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 IMPORTANCE OF PRICE ELSTICITY OF DEMAND.

Price elasticity of demand it is used to see how sensitive the demand

for a good is to a price change. The higher the price elasticity, the
more sensitive consumers are to price changes. A very high price
elasticity suggests that when the price of a good goes up, consumers
will buy a great deal less of it and when the price of that good goes
down, consumers will buy a great deal more. A very low price
elasticity implies just the opposite, that changes in price have little
influence on demand.

ii). CROSS ELASTICITY OF DEMAND

It is also known as cross price elasticity of demand.

The Cross-Price Elasticity of Demand measures the rate of response

of quantity demanded of one good, due to a price change of another
good.

The common formula for the Cross-Price Elasticity of Demand

(CPEoD) is given by:

CPEoD = (% Change in Quantity Demand for Good X)/(% Change in

Price for Good Y)

Substitute goods are alternative. There CPEoD will be positive,

• The weak substitutes like tea and coffee will have a low CPEoD.
• Dawn bread and Gourmet bread are close substitutes so CPEoD is
higher.

Complements goods, these are goods which are used together,

therefore CPEoD is negative.

• If the price of DVD players fall, then there will be a increase in

demand for DVD disks,

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 IMPORTANCE OF CROSS PRICE ELSTICITY OF DEMAND.

The cross-price elasticity of demand is used to see how sensitive the

demand for a good is to a price change of another good. A high
positive cross-price elasticity tells us that if the price of one good
goes up, the demand for the other good goes up as well. A negative
tells us just the opposite, that an increase in the price of one good
causes a drop in the demand for the other good. A small value (either
negative or positive) tells us that there is little relation between the
two goods.

• If CPEoD > 0 then the two goods are substitutes

• If CPEoD =0 then the two goods are independent (no relationship
between the two goods
• If CPEoD < 0 then the two goods are complements

iii) INCOME ELASTICITY OF DEMAND

The Income Elasticity of Demand measures the rate of response of

quantity demand due to a raise (or lowering) in a consumers income.
The formula for the Income Elasticity of Demand (IEoD) is given by:

IEoD = (% Change in Quantity Demanded)/(% Change in Income)

IMPORTANCE OF CROSS PRICE ELSTICITY OF DEMAND

Income elasticity of demand is used to see how sensitive the demand

for a good is to an income change. The higher the income elasticity,
the more sensitive demand for a good is to income changes. A very
high income elasticity suggests that when a consumer's income goes
up, consumers will buy a great deal more of that good. A very low
price elasticity implies just the opposite, that changes in a
consumer's income has little influence on demand.

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 If IEoD > 1 then the good is a Luxury Good and Income Elastic
If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income
Inelastic
If IEoD < 0 then the good is an Inferior Good and Negative Income
Inelastic

b).

DETERMINANTS OF DEMAND
The demand curve can also shift in response to a change in tastes
(desire), income, the availability of other goods, or a change in
expectations associated with income, prices, and tastes.

The factors which cause the demand curve to shift are known as
determinants of demand. These are:

i). INCOME

One of the determinants of demand is income. Income refers to the

amount of income the consumer has. Changes in consumer income
can affect the amount and type of consumer purchases. If a
consumer receives an increase in his/her salary, the consumer has
more money to spend on goods and services thereby affecting the
demand for goods and services by this consumer.

For example you want a new computer and choose one you like. The
price is PKR 100,000. You don’t buy. One reason is that income is not
large enough to be able to afford this amount. Therefore income is
one of the factors that affect the demand for computers.

In case of the milk, income is not the factor that affect the demand
for milk as it’s a cheaper item compared to computer.

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ii). OTHER GOODS

Another determinant of demand is called Other Goods. This

determinant is defined as the availability and price of substitute and
complementary goods.

A). THE PRICE OF A COMPLEMENT.

A complementary good is a good that is frequently consumed

with another good.

Return to the example of buying a computer. Assume that you

are willing to pay the price and have sufficient income. Other
factors which might enter into the decision, for example the
method for payment of computer i.e. borrowing money. The
price of borrowing money is called the interest rate and this is
an example of price of complement. Computer and borrowing
money tends to go together. If the interest rates rises, the
demand for computers will falls as peoples are less likely to
borrow. If the do not borrow, they will not buy computers.
Therefore the relationship is: If the price of complement rises
(falls), the demand for the product falls (rises).

This is also true in case of milk. Milk and cereal are frequently
consumed together. If the price of milk rises (falls), the
demand for cereals will fall (rises).

B). THE PRICE OF A SUBSTITUTE GOOD.

A substitute good is a good that can substitute for another

good.

If you prefer one particular brand of drink (Coca-Cola) pop and

it is not available but another brand (Pepsi) is available, you
may consume that brand. This is an example of a substitute
good. Substitute goods are goods that can substitute for each
other. As the price of substitute (Pepsi) rises (falls), the
demand for the product rises (falls).

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 This determinant is not applicable on computers and milk as
there is no substitute for them.

iii). TASTE

Taste is the desire for a particular product compared to other

products. Our desire for a particular product can change over time.

For example, if you are hungry, your desire for milk may be high, but
after you have consumed the milk, you may no longer be thirsty and
so your desire for milk is much lower.

iv). EXPECTATIONS.

The next determinant of demand is called Expectations. This is

defined as the consumer’s expectation for income, prices, and any
changes in taste.

Income expectation refers to a consumer’s expectation for changes

in income. If a consumer expects to receive a salary increase,
spending may increase immediately. If a consumer expects to be laid
off from his/her job, spending may immediately decline.

Expectations for prices refer to anticipated changes in the prices of

goods and services. If prices are expected to fall, consumers will
delay purchasing many goods and services in the hope that prices will
decline. If prices are expected to rise, consumers may purchase
goods and services immediately rather than wait for an actual need
for those items.

This determinant of demand is true for the computers as they can be

stocked but not true for milk as it is consumable.

v). POPULATION

Finally the last determinant is Population (Number of Buyers).

Number of buyers refers to the number of consumers seeking to
purchase a good or service, and the availability of the product.

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 Goods or services in high demand by buyers may result in inventory
depletion which will leave many potential buyers without an
opportunity to purchase the product.

If at the price of PKR 100, Zahid wants to buy 2 packs of milk, Sana
wants to buy 3 packs of milk and Asim wants to but 1 pack of milk,
then off course the market demand is 6 packs. If Tariq becomes a
buyer and wishes to buy 4 packs, the market demand rises to 10
packs. Therefore If there are more buyers, there must be more
market demand.

Reference:

http://economics.about.com

http://www.economicshelp.org
http://www.netmba.com/econ/micro/
Economic Environment of Business (AIOU)
http://ezinearticles.com/?Determinants-of-Demand

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 Question 5
Your friend operates a variety store that provides a
annual revenue of $ 4,80,000. Ecah year he pays $ 25,000
in rent for the store, $ 15,000 in business taxes and
$ 3,50,000 on products to sell. He estimates he could put
the $ 80,000 he has invested in the store into his friend’s
restaurant business instead and earn an annual 20%
profit on his funds. He also estimates that he nad his
family could earn a total annual wae of $ 90,000 if they
worked somewhere other than the store.
a). Calculate the total explicit costs and total implicit
costs of runnin the variety store.
b). What is the accounting profit of the variety store?
c). What is the economic profit?
d). In what way economic profit is superior to
accounting profit as an indicator of the overall
performance of his business? Given the advantage of
economic profit as a performance indicator, explain why
the concept of economic profit is not often used in
accounting.
e). Should your friend closing down this business? Why?

Marks: 20

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 Annual Revenue = $ 4,80,000
Annual Rent = $ 25,000
Annual Business Taxes = $ 15,000
Cost of Products to sell = $ 3,50,000

a). Total Explicit Costs = Rent + Taxes + Cost of Products

= 25,000 + 15,000 + 3,50,000
= $ 3,90,000

Total Implicit Costs = 80,000 (20/100) + 90,000

= 16,000 + 90,000
= $ 1,06,000

b). Accounting Profit = Total Revenue - Cost (Explicit)

= 4,80,000 - 3,90,000
= $ 90,000

c). Economic Profit = Total Revenue - Economic Cost

Economic Cost = Explicit Cost + Implicit Cost
= 3,90,000 + 1,06,000
= $ 4,96,000
Economic Profit = 4,80,000 - 4,96,000
= $ - 16,000

d). Everyone strives to acquire as much profit as possible. Profit is the

positive gain from an investment or business operation after
subtracting all the expenses. But still profit remains to be one of the
most misunderstood features of finance.
Profit was taken from the Latin word "to make progress" which then
denotes two things- economic and accounting progress. There is the
economic profit which is the increase in wealth that an investor gains
from the investment activities he/she has engaged into, taking into
considerations all cost associated in the investment. These costs may
include opportunity cost of capital. Accounting profit, on the other
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 hand, pertains to the difference between the price and the costs of
setting up in the market whatever enterprise you have. These costs
include the component cost of delivered services and goods, as well
as, operating costs.
An economic profit is acquired whenever the revenue exceeds the
total opportunity cost of its inputs. The opportunity cost here is the
value of opportunity given up. In calculating economic profit, the
opportunity cost is deducted from the revenues earned. These
opportunity costs are the alternative returns forgone by using the
selected inputs.
Accountants measure profit differently. They do it in terms of the
sales of firms less costs like wages, rent, fuel, raw materials, interest
on loans and depreciation. Profit is synonymous to income.
Accounting profits is mainly the company’s total earnings, calculated
based on the Generally Accepted Accounting Principles (GAAP).
It is important for traders and investors to carefully analyze the
economic and accounting profit because these enables them to
evaluate their personal investment strategy, prospective markets, as
well as, performances.

Advantages of economic profit as performance indicator.

Overall performance is better indicated by economic profit. It
considers all the opportunities (explicit and implicit costs) to conduct
economic activity in a more profitable way.

e). Although the business have accounting profit but he should close
down his business as his economic profit is showing a loss and
business is all about making money therefore he should pursue the
other two options to get more profit.

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