Economic Environment of Business - PDF

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					Assignment No. 1

Executive MBA/MPA
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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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 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.

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.

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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.

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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: 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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“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.

For example If we have inflation then £ 100 is going to buy less in the future. Purchasing Power of the Pound (1920 = 100) 1920 100 1930 125 1940 129 1950 98 1960 66 1970 46 1980 133 1990 6.8 1998 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). ii). iii) Demand Pull Inflation Cost Push Inflation Continuing Inflation

“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.

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). ii). iii). iv). Inflation creates uncertainty and confusion Lower Competitiveness Inflationary growth is unsustainable Inflation reduces the value of savings

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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.


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.


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.


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.

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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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: 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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The market system also called the price system performs two important and closely related functions: i). ii). Price rationing Resource Allocation

“Price Rationing is the process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied.”

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).

“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.”

“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 (taxinclusive) or added at the point of sale (tax-exclusive).

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 (per Liter) B $0.53 $0.50 $0.48 A C T=0.05 S+T S

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: 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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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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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.


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,
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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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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.

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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


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)

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

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:


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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Another determinant of demand is called Other Goods. This determinant is defined as the availability and price of substitute and complementary goods.

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).


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.


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.


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.


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: Economic Environment of Business (AIOU)

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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 Annual Rent Annual Business Taxes

= = =

$ 4,80,000 $ 25,000 $ 15,000 $ 3,50,000

Cost of Products to sell = a). Total Explicit Costs = = = = = = = = = = = = = = =

Rent + Taxes + Cost of Products 25,000 + 15,000 + 3,50,000 $ 3,90,000 80,000 (20/100) + 90,000 16,000 + 90,000 $ 1,06,000 Total Revenue - Cost (Explicit) 4,80,000 - 3,90,000 $ 90,000 Total Revenue - Economic Cost Explicit Cost + Implicit Cost 3,90,000 + 1,06,000 $ 4,96,000 4,80,000 - 4,96,000 $ - 16,000

Total Implicit Costs


Accounting Profit


Economic Profit Economic Cost

Economic Profit


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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