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ECO404 Managerial Economics Assignment 1 Solution Spring 2013

Pak Elektron Limited (PEL) as the pioneer manufacturer of electrical goods in Pakistan was established in 1956 in technical collaboration with M/s AEG of Germany. Later on, it was taken over by Saigol Group of Companies in October 1978. Since its inception, the company has always been contributing towards the advancement and development of the engineering sector in Pakistan by introducing a range of quality electrical equipments and home appliances. Appliances division of PEL consists of appliances manufacturing like Air Conditioners, Refrigerators, Deep Freezers etc. Power division of PEL is one of the major electrical equipment suppliers to Water and Power Development Authority (WAPDA) and Karachi Electrical Supply Corporation (KESC), which are the largest power utilities in Pakistan. A hypothetical study was conducted on PEL in year 2012 which revealed that annually, on average, the company receives Rs.59,35,680 from selling its products while spends, Rs.12,55,000 in wages of its employees and on producing hundreds of engineers, skilled workers and technicians through its apprenticeship schemes and training programmes, Rs.6,45,000 in payments of rented buildings, and Rs.5,62,000 in interest payments on bank loans taken for production process. The study also found the fact that if PEL’s manager would work for some other renowned, emerging local and multinational electronics company, he could earn at most Rs.22,18,000 per year.
Requirement:
Part A
Read the case very carefully and from the given information, calculate the following for PEL Company:
a) Total explicit cost
b) Total implicit cost
c) Business profit
d) Economic profit
Part B
In that hypothetical study, the following regression function was estimated for PEL Refrigerators:
QR = 690 – 0.2PR + 0.7N + 0.4Y + 0.8PW
Where,
QR = Sales of PEL Refrigerators
PR = Price of PEL Refrigerators
N = Number of consumers in the market
Y = Consumers’ income
PW = Price of Waves Refrigerators (a substitute product)
Suppose in year 2012, PR = Rs.53,000, N = 250, Y = Rs.45,000, PW = Rs.51,000 then calculate:
a) Total sales of PEL Refrigerators
b) Price elasticity of demand for PEL Refrigerators
c) Income elasticity of demand for PEL Refrigerators
d) Cross price elasticity of demand for PEL Refrigerators with respect to Waves Refrigerators
Outcomes of the study:
After solving this assignment, student will be able to:
 Distinguish between explicit and implicit costs and how to calculate these costs
 Distinguish between business and economic profits and how to calculate these profits
 Know what the regression function is and how to estimate different types of elasticities from the given regression function Marking Scheme: (Part A: 2+2+2+2), (Part B: 3+3+3+3)

Solution Idea: 

Economic vs. Accounting Costs  You know that the value of the best alternative forgone is the economic cost of anything from lard to romance. All costs, whether monetary or nonmonetary are opportunity costs. One way to break down economic (opportunity) costs of production is to view them as either explicit or implicit costs.

Explicit costs require outlays of money.

For example, wages paid to employees, rent payments, and utility bills are all explicit costs.

Implicit costs are the opportunity costs of resources the firm’s owner makes available for production with no direct cash outlays.

Examples include the value of an entrepreneur’s labor and the interest that could be earned were the owners’ assets (including the values of stock in corporations) not tied up in the business. In entering the software business and creating Windows, and subsequently Microsoft, Bill Gates dropped out of college and made a conscious decision to surrender what wages he could have made as a college graduate if his endeavor failed. Though it paid off for him, similar decisions are made on a daily basis by people all over the world and it doesn’t always end favorably for everyone. Firms must all bear both implicit and explicit costs into consideration to make rational business decisions.

Economic costs of production include both explicit and implicit costs.

On the other hand, bookkeeping tends to focus on monetary costs. Bookkeeping is a mechanical exercise focused only on explicit costs; it primarily records flows of funds and provides a base for computing taxes. Accounting requires evaluation of data for decision-making, a purpose not well served by some standard bookkeeping practices for cost accounting or tax accounting. Fortunately, standards for managerial accounting increasingly conform to the economic view of cost. Let us look at some problems that emerge when implicit costs are ignored.

Economists include explicit and implicit costs when they think of total (opportunity) cost, while bookkeepers commonly fail to include in total cost many implicit costs incurred by the owners of a firm.

Economic profit occurs only when a firm’s revenue exceeds all costs, including explicit and implicit costs.

Here is an example of how economic profits and accounting profits differ. Imagine that two years after receiving your college degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000 yearly, and your financial assets generate $3,000 per year in interest. On New Year’s Day, after deciding to be your own boss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop.

At the end of the year, your books tell the following story:

 

Total Sales Revenue                   $130,000

Cost of pogo sticks                       $85,000

Employees’ wages                      $20,000

Utilities                                         $5,000

Taxes                                            $5,000

Advertising expenses                   $10,000

Total (Explicit) Costs                 $–125,000

(subtract from revenue)

 

“Congratulations,” your

bookkeeper pipes up, “you

made a

 

Net (Accounting) Profit of         $5,000!”

 

 

“Hold it just a moment,” you say, “I have studied economics. You forgot to subtract my implicit costs. Being in this business caused me to lose as income:

Salary                                           –$28,000

Rent                                              –$10,000

Interest                                         $3,000

Total Implicit Costs                    –$41,000;

 

Therefore, I’ve had an

economic profit that’s

negative, a loss of                         –$36,000

This business is a loser!”

If, however, you enjoy operating the pogo-stick shop more than your best alternative (assistant store manager), your higher job satisfaction is called psychic income. Psychic income is an implicit revenue that refers to nonmonetary satisfaction gained from an activity. Bookkeeping profit typically overstates economic profit because bookkeepers fail to subtract implicit costs, which tend to be significant, while implicit benefits are usually small (e.g. you no longer have to ride the bus to work to your old assistant manager job, whereas you can live where you work at the pogo stick factory, saving 500 dollars per year in transportation).

The explicit cost data used to compute accounting profit for tax purposes are more accessible than the additional implicit cost data needed to estimate economic profits or losses. Thus, taxes and national income accounts are based on accounting data. Business decisions tend to be rational, however, and so are most frequently based on expected economic costs and profits.

Accountants typically recognize that conventional bookkeeping costs and profits are inadequate; after calculating taxable profits, they subtract estimates of implicit costs from bookkeeping profit. This type of managerial accounting provides a better picture of a firm’s track record.

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