Cost & Profit
1. Give a brief summary of economic costs (i.e. how are they different from accounting costs). In the short-run, why might a firm still operate even when there is a loss.
Accounting cost is the explicit monetary value of resources, which have been used in performing a particular activity. It is the historical cost, which is usually reflected in the accounting statements. Accounting costs are very useful in evaluating past performance of a company and in comparing companies within an industry. However, accounting costs are not sufficient for strategic decision-making, since they do not take into consideration the cost of the alternative solutions, which were not implemented. Economic cost is similar to accounting cost, however, it also incorporates the opportunity cost of resources, or the cost of the best alternative forgone, in favour of the chosen method of resource utilization. In order to make a strategic decision, it is more valuable to consider economic rather than accounting costs. They help to identify successful decisions for a company, which faces numerous opportunities and constraints, and has to select one option among the competing alternatives (Besanko, Ranove, Shanley & Schaefer, 2009).
In a perfectly competitive market, production alternatives, which a company faces in the short-run, depend on the unit price of the product, the average total cost of its production and its average variable cost. The difference between average total cost and average variable cost is the average fixed cost, which the company incurs no matter whether it is producing any output. As fixed costs have to be repaid regardless of whether the company stops operation or not, the decision to shut down should be made with the consideration of the average variable cost.
If the average total cost of a product is below its price, then the company is making economic profits, which exceed normal profits (the opportunity cost of the entrepreneurial effort). However, if the price is less than the average total cost, the business is generating losses. In this case, in the short-run the company faces a question, whether it is more efficient to produce or to shut down. If the price is also below the average variable cost, then production should be terminated. In this case, the business does not make any profits and it is not even able to cover its variable costs. Therefore, by continuing production the firm generates a higher loss, then by shutting down. However, if the average variable costs are below the price, the company is still able to minimize losses by producing more units. Thus, although the total revenue is less than the total cost and the firm incurs losses, it is still able to cover its variable costs and even some of the fixed costs, thus minimizing the total loss. In this case, the company can even have an accounting profit, since the total cost already contains a normal profit. Therefore, in the short-run such business can survive and it has an incentive to produce. However, in the long-run, unless it starts generating a normal profit, the company is likely to go out of business (Besanko, ranove, Shanley & Schaefer, 2009).
2. How does this article apply the marginal decision rule to the problem of choosing the mix of factors or production (capital intensive vs. labour intensive methods of production)? How do maquiladoras benefit the U.S. economy?
Marginal decision rule suggests that it is only appropriate to pursue an economic activity, if the marginal benefit of every activity unit exceeds its marginal cost. The mix of factors of production should be chosen at a point of maximum utility, where the rate at which the benefit of substituting one factor by the other is equal to its market cost (Rittenberg & Tregarthen, 2008). Therefore, if an additional unit of labour yields more benefit, than it costs, labour contribution into the mix should be increased. In the case of maquiladoras, production is more labour-intensive, since the cost of each labour unit near the Mexican border is lower than that in the U.S. Therefore, maquiladoras industries are more likely to use more labour and less capital, than the industries in the USA. American economy, however, has also benefitted from maquiladoras. Firstly, these industries import a lot of their inputs from the U.S. Secondly, American border cities have benefitted through the intensified trade, real estate development and flourishing of service industries (hotels, restaurants). Moreover, American companies in maquiladoras find cheaper labour, thus their production cost decreases, yielding higher profits.
3. The type of firm also plays a crucial role in how the firm makes a profit. Describe the characteristics of a perfectly competitive firm in your own words. What will happen to the profits of a perfectly competitive firm in the long run?
The most important feature of a perfectly competitive firm is its acceptance of the market prices, thus it is a “price taker”, rather than a “price maker”. Therefore, the demand for its products is perfectly elastic. Thus, a slight increase in price will result in zero demand for the products. This is caused by the fact that the firm operates with many other companies, which have no impact on the market prices. The products in a perfectly competitive market are homogeneous, therefore there are many perfect substitutes of the company’s products freely available in the market and thus consumers have no preference for one over the other. The company faces no entry or exit barriers in the perfectly competitive market, there are no returns to scale and factors of production are perfectly mobile. The firm also knows all the information about competitors and its customers, it does not incur any transaction costs and profit maximization for a perfectly competitive company occurs at the point, where marginal revenue is equal to marginal cost. In the long-run, the company is only able to make a normal profit, which is equal to the economic cost. Under perfect competition, abnormal profits would attract new firms, thus increasing product supply and thus reducing market prices. Therefore, in the long-run it is not possible for a perfectly competitive company to gain economic profit, and it continues to generate a normal one (Baumol & Blinder, 2011).
4. Compare the profit for the perfectly competitive firm to a monopoly in the long run. Why is it different?
As monopoly is the only company in the market, it can set prices above the marginal cost of production, which is impossible under perfect competition. Although a monopoly is likely to lose some of its customers in this case, the overall benefit of the price increase is still going to be greater than the cost of losing some of the customers. Therefore, a monopoly is able to generate an economic profit, which is the difference between the revenue and the total cost (Baumol & Blinder, 2011). For a perfectly competitive company, on the other hand, it is only possible to generate a normal profit, which is equal to the economic cost. Moreover, monopolies produce less output, than perfectly competitive firm, which indicates imperfect resource allocation. Since, a monopolistic firm is the only producer of a unique product, insufficient amount of the product in the market will not be filled by other firms. Therefore, consumers will be willing to pay more for this product, than in a perfectly competitive market. However, a decrease in market prices for a product will not necessarily impact its amount, produced by the monopoly, due to the scale economies, realized by the company. A perfectly competitive firm, on the other hand, will have to reduce its supply in response to a price decrease, since the demand for its product is perfectly elastic, and consumers will not buy anything above the point, at which marginal cost is equal to the price.
However, the existence of monopolistic profit and monopoly is only possible if there are significant barriers to entry in the market. If there are none, other companies will be attracted by the economic profits, driving the supply of the products up, thus reducing prices and creating conditions, close to the ones under perfect competition.
Baumol, I. J., & Blinder, A. S. (2011). Economics, principles and policy. (12th ed.).
Mason, OH: South-Western Cengage Learning.
Besanko, A., Ranove, A., Shanley, M., & Schaefer, S. (2009). Economics of strategy.
(5th ed.). Hoboken, NJ: Wiley.
Rittenberg, I., & Tregarthen, T. (2008). Principles of microeconomics. Nyack, NY:
Flat World Knowledge.