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Supply and Demand
Production, Process, and Costs
Organization of a Firm
Economics of Information
Government in the Marketplace
Profit - the difference between economic and accounting costs, economic profit, economic losses, and zero economic profit
Economic and accounting costs
- Accounting costs are the costs most often associated with the costs of producing. Economic costs are not only the costs of producing a good, it also includes the oppurtunities forgone by producing this product.
If a firm is producing Computers then the accounting costs are the costs incurred for producing the computers. Economic costs include the cost of producing the computers as well as oppurtunity cost. Suppose, If this firm could lease its office and the plant for say $100,000 then that is the oppurtunity cost.
Economic profit (or) loss -
It is the difference between total revenue and total opputunity cost. If a firm's total oppurtunity cost is less than the total revenues then the firm is making economic profit. If a firm's total oppurtunity cost is greater than the total revenues then the firm is making economic losses. If the firm is making economic losses then the firm would be better off by not producing the goods on its own.
Zero economic profit
- If a firm is receiving just enough to cover its average costs then the firm is making the zero economic profit. Price is equal to the Marginal cost and also equal to the minimum of average cost when the firm is making zero economic profit.
Economic profit or loss is referred as the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. This can be used as another name for "
|economic value added" (EVA). EVA will be further explained.
While accounting profit is defined as total revenue minus explicit costs, economic profit is defined as total revenue minus explicit and implicit costs. Stated otherwise, it is the difference between the total opportunity cost of production and the total revenue received by a firm.
Explicit costs are costs that must explicitly be paid–as opposed to implicit costs, such as opportunity costs. As you can conclude, economic cost is a more broad term than accounting cost in that it takes into account not only explicit costs but also implicit costs such as opportunity cost.
A firm is said to be making an economic profit when its revenue exceeds the total cost of its inputs. Note that total cost includes opportunity costs as well. It is said to be making an accounting profit if its revenues exceed the accounting cost the firm "pays" for those inputs.
In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs. Accordingly, you can have a significant accounting profit with little to no economic profit.
Real world examples
As an example, imagine investing $200,000 to start a small business, and earning $220,000 in profits. Your accounting profit would be $20,000 (220,000-200,000). On the other hand, say that same year you could have earned an income of $45,000 if you had you been employed. Hence, your economic loss would be $25,000 (220,000 - 200,000 - 45,000). As is clear with the example, economic loss includes opportunity cost, unlike accounting loss.
As another example, it is a known fact that stock prices affect managers' pay. In addition to receiving large salaries, CEOs receive stock options, which are options to buy stock at a reduced price and sell it when the price goes up. Standard accounting rules such as GAAP do not treat these stock options as an explicit expense, so shifting toward an option-heavy pay package understated the total payroll costs of the CEO's and overstated their accounting profit. Stock option would be used in economic profit, while not used in accounting profit. In short, economic profit equals net earnings, in the accountant’s sense, minus the opportunity costs of capital and of any other inputs supplied by the firm’s owners.
When we say that competition tends to drive profits to zero, we are talking about economic profits. It is noteworthy that in general profit refers to economic profit in that opportunity cost is everywhere is life. Why not include the foregone cash inflows of a specific division? Why not include stock option that may easily be quantified?
From a corporate finance perspective, the economic profit or loss (also referred as EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating
|profit (adjusted for taxes on a cash basis). This measure was developed by Stern Stewart & Co. Economic value added attempts to capture the true economic profit of a company.
The formula for calculating EVA is as follows: EVA=Net Operating Profit After Taxes (NOPAT) - (
|Capital * Cost of Capital)
If the econ profit is positive, then the firm’s decisions are optimal; that is, its price and output yield a profit larger than any alternatives prices and outputs. On the other hand, if the econ profit is negative, then the firm’s decisions are optimal; that is, there exists at least one alternative price-output combination that is more profitable. Can the economic profit be zero? If the econ profit is zero, then the firm’s decisions are still satisfactory; because its price and output yields as much profit as the best available alternative. Breakeven output is, for instance, a production level that achieves zero economic
received by a firm at the breakeven output just matches the
incurred. Nevertheless, because total cost includes a
is zero. A firm generally reports a positive
at the breakeven level of production. In the long run, in a competitive market, all firms tend to earn zero economic profits. It is also useful to note that zero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits. Long-run equilibrium in a perfectly competitive market is the point at which firms are earning just a normal profit (zero economic profit). In other words, at zero economic profit, firms are producing at the lowest possible cost that there is no waste.
1. In long run equilibrium, all firms in the industry earn
a. Positive economic profits
b. Zero economic profits
c. May or may not earn profits
d. None of the above
Answer: B. The theory of perfect competition assumes that there are no entry or exit barriers to new participants in an industry. With free entry, positive economic profits induce new entrants. As these firms enter, the supply curve shifts to the right, causing a fall in the equilibrium price of the product. Entry will stop, and equilibrium will be achieved, when economic profits have fallen to zero.
2. Which of the following represents an economic cost to the firm?
a. Normal Profit, because it represents the excess of total revenue over total no economic costs.
b. Normal profit, because it compensates for the time and other resources the business owner supplies to the firm
c. Economic profit, because it compensates for the time and other resources the business owner supplies to the firm
d. Economic profit, because it represents the excess of total revenue over total economic costs
Answer: B. Normal profit is defined as the payment for—the cost of—the entrepreneur's contributions to the firm
3. Which of the following is true?
a. In a perfectly competitive market, the market price is different from the marginal cost of production.
b. If economic profit is zero, firms would exit the market.
c. A firm enters an industry when it knows that in the long run accounting profit will be zero.
d. A firm enters an industry when it knows that in the long run economic profit will be zero.
Answer: D. Firms enter an industry when they expect to earn economic profit. These short-run profits are enough to encourage entry. Zero economic profits in the long run imply
returns to the factors of production, including the labor and capital of the owners of firms. For example, the owner of a small business might experience positive accounting profits before the foregone wages from running the business are subtracted from these profits. If the revenue minus other costs is just equal to what could be earned elsewhere, then the owner is indifferent to staying in business or exiting.
4. The cost incurred to obtain the resources the entrepreneur supplies to the firm is:
a. Normal profit
c. Economic profit
d. roundabout cost
Answer: A. Normal profit is the amount required to compensate owners for their supplied resources. Economic profit is any profit in excess of this amount
5. In a specific competitive industry, prices are rising and output is falling. Which of the following most likely represents the market conditions in this industry?
a. Economic profits are negative
b. Economic profits are positive.
c. Normal profits are higher than usual
d. The industry is in equilibrium.
Answer: A If economic profits are negative—normal profits are lower than usual—then firms' owners are not being fully compensated for the resources they are providing. This will cause some of them to pull out of the industry, reducing output and causing the price to rise.
In a specific industry, economic profits are zero but normal profits are positive. We should expect that:
a. firms will enter the industry
b. firms will exit the industry
c. product prices will rise in the industry
d. firms will neither exit nor enter the industry, as it is in equilibrium
Answer: D. Positive economic profits are the signal that firms will enter an industry; economic losses the signal that firms will leave. If economic profits are zero, the industry is in equilibrium.
Economists assume that firms seek to maximize:
a. accounting profit
b. economic profit
c. economic profit per unit
d. total revenue minus explicit costs
Answer: B. Economic profit is total revenue minus all opportunity costs, both implicit and explicit. Maximizing economic profit provides the greatest possible net gain to the entrepreneur.
Econ Textbook - Dr. Baye
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