Economic Profit or Loss Evaluation - Report Example

A manufacturing may face an economic profit or economic loss in the short-run. A short-run is a period of time where no new firm enters of leaves theindustry and hence the number of firms is fixed. For example, if there are 21 firms operating in, let’s say a manufacturing business then in the short-run this number cannot be changed. The logic behind the fixed number of firms in the short-run is that this time period is too short to lure new firms enter into the industry, if the industry is making a profit as there are lot of setup costs and capital expenditure that have to be incurred in order to join this industry. This capital expenditure takes time which cannot be completed in the short-run. Similarly, no existing firm can leave the industry in the short-run. The reason behind this is that whenever a firm sets up in any industry it has to incur some sunk costs. In lay man terms, sunk costs are actually setup costs. These costs are barriers that do not let the firms leave the industry in the short-run as no firm wants to leave the industry without minimizing or cashing in on some of their sunk costs. As we have already discussed, that no firm can be lured into or pushed-out of the industry in the short-run. The reasons that may tempt the other businesses entering into industry are off course profits, as discussed above. There are two types of profit that firm makes in the short run based on its costs and revenue. A firm may be making large profits or break-even in this time-scale. In economic terms break-even is known as normal profit because the calculation includes implicit or opportunity costs, which are not actual cost and hence a firm which is breaking even is making a profit in accounting terms. Normal Profits are usually denoted by AR=AC. Similarly, apart from normal profit a firm might also be making a Supernormal profit denoted by a equation AR>AC. These profits positions can be shown in the following diagrams: In figure 1 we see the condition in which the firm is making a level of profit that is just enough to persuade the firms to stay in the industry in the short-run but not enough to attract new firms. In short-run when the firm is earning normal profits, the firm is just covering total costs. Since the TC (Total Cost Calculations) also includes implicit costs like opportunity cost of capital employed, return of capital in alternative uses etc. These are not actual costs and hence breaking even would mean that firm is earning profit which it could earning in alternative businesses and hence there is no motivation for the firm to go out of the industry. The distinction in this situation, for the firm, is AC= AR and thus TC = TR. (Lipsey and Chrystal, 2003) In figure 2, we see the condition where our assumed manufacturing firm is making an abnormal profit. In this situation the firm earns more than normal profit and hence in this case there is no reason why the firm would leave the industry but instead if it leaves the industry, it won’t be able to make as much profit as it is earning in this industry. In the figure 2, the shaded area “pink” is the amount of supernormal profit that our manufacturing firm is earning. The above two profits positions that a firm could face in the short-run are favorable conditions and hence no rational firm would leave the industry in the prevailing conditions discussed above. However, the problem arises when our manufacturing firm makes an economic loss. An economic loss is a condition when the firm is not able cover its average cost. In this condition, entrepreneurs often face a dilemma whether to continue with the current production or to cease the operation of the firm altogether. However, one interesting point or assumption that we can make here is that even after making an economic loss, sometimes it is feasible for businesses or firms to continue to operate in the industry. The reasons behind this may be economical or non-economical. However, in this case, we will restrict our discussion to economic reasons only. (Sloman, 2002) A situation in which a manufacturing firm experiences a loss is known as subnormal profits. This means that the firm is producing where AC > AR. In simple words, in this situation, a firm incurs more cost than revenue and hence continuing to operate in this situation, gnaw the firm’s profits. In the short-run, our manufacturing firm will continue to operate as long as it is covering the CV i-e till the price to the minimum of AVC (Average Variable Cost) as shown in the figure 3. This is also called the shutdown point i-e if the price falls below this point, the firm will shutdown in the short-run as it will not be covering even the VC or variable costs. Source: (Pindyck and Rubinfield, 2008) In the above diagrams, we can clearly see that AVC is below AC. Since, AC is a sum of AFC and AVC, that is why AVC is always below AC. We can prove this concept through mathematical calculations. AC = AFC + AVC AVC = AC – AFC Since AC is always positive and when you subtract it from AC, the value of AVC will always be less than AC and hence AVC curve will be below AC curve. The AVC curve will come closest to AC curve at very high quantities because at this point the Average Fixed Cost will closest to zero because the cost is being absorbed by so many units. For e.g. if Fixed Cost is $100 and 10,000 units are being produced, then AFC will be 100/10000 = $0.01. This proves that AVC curve will be always below AC curve, because of the fixed cost factor. However, coming back to the original discussion, the firm will continue to produce as long as it is covering its AVC (average variable cost), or in other words, as long as price is above is greater than the minimum point AVC curve. Let’s assume that figure 3 is the diagram of the cost condition that our manufacturing firm is experiencing. In the diagram, we clearly see the minimum point of AC curve is labeled “d”. At point‘d’, MC meets AVC curve, or it is the point of intersection between the MC curve of the firm and its AVC curve. So, in this condition our firm will continue to produce despite making economic losses as long as price is greater than AVC or minimum point of AVC curve. The larger the size of the firm, the bigger chance that it will be able to face losses and its price is likely to be greater than the minimum of AVC and hence it will be covering a bigger part of fixed cost. Similarly, large firms are usually backed by large capital and funds and hence they can endure the loss situation more efficiently than a smaller firm. Hence, the larger the firm is, the greater chances are there that it is going to stay in the industry even after making economic losses as there is more chances that its price will be greater than minimum point and AVC curve. However, if we talk about long-run, the firms will only make normal profit in the long-run. In the long-run firms can freely enter or leave the industry. In case, the firm is making large supernormal profits, other firms will see to it and enter the industry in the search of high profits level. However, their entry is going to distort the market equilibrium by increasing supply. This will shift the prices down until the profit levels of the firms are going to decrease to normal profit and some firm who were already making supernormal profits, the price reduction is going to leave them making losses and in the long run, where there is no compulsion for the firms to stay in the industry, the loss making industries are going to leave the industry. This will bring the industry to situation where only the normal profit is being made. Similarly, losses are going to clean the industry from firms who are not covering their AVC. This is going to reduce the supply in the industry and in turn prices will rise. This price rise is going to convert the losses into normal profits and this recovery is going to lead all the firms making normal profits. (Brue and McConnell, 2001) This is how the industry time period and firm’s cost curves determine the profit position of a firm in the industry. References: Campbell McConnell and Stanley Brue. Economics. McGraw-Hill Companies; 15th edition (October 15, 2001) Richard Lipsey and Alec Chrystal. Oxford University Press; 10th Revised edition (28 Aug 2003) John Sloman. Economics. Prentice Hall; 5 edition (19 Dec 2002) Robin Pindyck and Daniel Rubinfield. Microeconomics. Prentice Hall; 7 edition (June 21, 2008) Read More