Digression: Accounting Profit vs Economic Profit

1
Digression Accounting Profit vs Economic Profit

• Accounting Profit Total Revenue - Explicit cost
• Example Self-employed C.P.A. who owns office
• Total revenue 55,000
• Supplies (2,000)
• Accounting Profit 53,000
• Accountants aged 35-45 earn around 65,000
• Office space of like size rents for 13,000/yr

2
Accounting Profit vs Economic Profit

• Economic Profit Total Revenue - Explicit Cost
• - Opportunity Cost
• Example Self-employed C.P.A.
• Total revenue 55,000
• Supplies (2,000)
• Opportunity Cost
• of Office (13,000)
• Opportunity Cost
• of CPA Time (65,000)
• Economic Profit -25,000

3
Examples of Explicit and Implicit Costs
4
Accounting Profit vs Economic Profit

• Normal Accounting Profit
• may be around 10 of investment
• Normal Economic Profit
• revenue covers explicit and opportunity cost
• assumed to equal zero
• Returns have to cover the opportunity cost of the
  investment
• For remaining lecture, we will refer to profit as
  economic profit

5
When should a firm go out of the business in the
short-run?

• 1) When P MC gt ATC
• Profit PQ - ATCQ
• (P - ATC)Q gt 0
• Economic Profit gt 0
• Example P 3, ATC 2.054

6
Revenue PQ
7
Total Cost ATCQ
8
? (P-ATC)Q
?
9
When should a firm go out of the business in the
short-run?

• 2) When P MC
• AVC lt P lt ATC AFC AVC
• Profit PQ - ATCQ
• (P - ATC)Q lt0 (lose money)
• (P - AVC )- AFCQ
• gt -AFCQ -FC
• Keep producing in short run because better than
  swallowing FC, even though economic profit lt0

10
When should a firm go out of the business in the
short-run?

• Example 2 AVC lt P lt ATC
• P 1.75
• AVC 1.55
• ATC 1.83
• AFC 0.28
• Q 357
• Profit (P - AVC - AFC)Q
• (1.75 1.83)357 -28.56 gt -0.28357 -100

11
ATC gt P gt AVC
Revenue
12
ATC gt P gt AVC
Total Cost
13
ATC gt P gt AVC
LOSS
14
ATC gt P gt AVC
LOSS with Shutdown
15
When should a firm go out of the business in the
short-run?

• 3) When P MC ltAVC P-AVC lt 0
• Profit PQ - ATCQ
• (P - ATC)Q
• (P AVC) AFCQ
• lt -AFCQ -FC
• Stop producing in short run because swallowing FC
  is better than producing and losing even more

16
When should a firm go out of the business in the
short-run?

• Example 3 P MC ltAVC
• P 1.25
• AVC 1.50
• ATC 2.00
• AFC 0.50
• Q 200
• Profit (P - ATC)Q
• (1.25 2.00)200 -150 lt -100 -FC

17
Revenue
18
Total Cost
19
Loss
20
Loss with Shutdown
21
When should a firm go out of the business?

• SHORT RUN
• Produce in the short run at P MC when MC gt AVC
• Shut down when P lt AVC
• LONG RUN
• In long run, need to make back fixed costs, so
  only produce if P MC gt ATC