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Tutorial 9: Firms With No Market Power (cont.)

 

Economic Profit and Opportunity Cost

From Questions 2 and 3 in the PCFirm workbook you found that at prices below $125 per unit, the firm's economic profit is negative. Why would a firm continue to produce when its economic profit was negative? Well, it depends on the time frame in which the firm is making its output decision. Let's see why.

Suppose the price is $80 per unit. The firm would have an economic profit of $-562 (or, better, an economic loss of $562). Now, what does that mean? Remember that economic profit includes explicit and opportunity costs. That means that after the accountants subtract explicit costs from revenue (revenue - explicit costs), the economists come around and subtract opportunity costs (revenue - explicit costs - opportunity costs). So an economic loss doesn't necessarily mean the firm has negative accounting profits. It does mean that the firm's accounting profits (revenue - explicit costs) are smaller than the owner's opportunity costs. So an economic loss means the firm's accounting profits are not covering the owner's opportunity costs. [Similarly, an economic profit means the firm's accounting profits are more than covering the owner's opportunity costs.]

OK, but how long are the owners willing to let economic losses go on? Well, let's use some familiar words with a different meaning. (Like Humpty Dumpty, we are going to make these words mean what we want them to, neither more nor less... So be careful!) We define the short run as a time frame during which the firm is incurring an economic loss but decides to stay open anyway (we'll see why shortly). We define the long run as a time frame during which the firm will leave the market if economic profit is not at least zero (remember, a zero economic profit means the accounting profits are just high enough to offset the owner's opportunity costs). So at a price of $80 per unit, the firm will experience economic losses of $562 and, although they may stay open in the short run, this will encourage them to close in the long run and take their resources to their next most valued use.

So economic losses encourage a firm to close in the long run. But how high must economic losses go before a firm is encouraged to close right away? Well the simple answer is "when losses are larger if the firm stays open than if it closes". How could the firm have losses if it closes? Remember those fixed costs? Just because a firm closes doesn't mean that it is free of all cost obligations. Even though closing eliminates the need to pay for variable inputs, it must still pay some of its fixed costs (at least until its contractual obligations are up). So if economic losses are less than its fixed costs, the firm is better off staying open -- and praying to the market gods to raise price! On the other hand, if economic losses are greater than its fixed costs, the firm is better off closing down immediately.

 

Now it's time to "do the thing".

Click on the following link to download the Perfectly Competitive Firm Workbook. Work through Questions 4 - 5. This will help you improve your understanding of how to determine when a firm should shut down in the short run. 

Return here when you have finished.

Need help downloading the Excel file?

 

This is a good time to finish or review GFE 19.

 

It is worth repeating what we have discovered here. If a firm's maximum economic profit is positive, then, at its current level of output, accounting profits more than cover the owner's opportunity costs. The firm will happily continue producing this good or service. However, if a firm's maximum economic profit is negative, then accounting profits do not cover the owner's opportunity costs. The firm will have to decide whether to shut down in the short run, or, if market price does not rise, in the long run. The decision to shut down now, rather than later, depends on the relative size of the economic loss and the firm's fixed costs.

Here is a summary of the three steps taken by a firm as it analyzes the profitability of its current output level. These three steps will be followed by any firm whose goal is to maximize economic profit. They will be important for you to remember in Tutorial 10 as well.

In the next part of Tutorial 9 we learn how to model the price-taking firm's supply curve, and discover how that supply curve adjusts to changes in the price of inputs.