Economic Versus Accounting Concepts of Profit and Loss

Economic profit equals total revenue minus total cost, where cost is measured in the economic sense as opportunity cost. An economic loss (negative economic profit) is incurred if total cost exceeds total revenue.

Accountants include only explicit costs in their computation of total cost. Explicit costsCharges that must be paid for factors of production such as labor and capital. include charges that must be paid for factors of production such as labor and capital, together with an estimate of depreciation. Profit computed using only explicit costs is called accounting profitProfit computed using only explicit costs.. It is the measure of profit firms typically report; firms pay taxes on their accounting profits, and a corporation reporting its profit for a particular period reports its accounting profits. To compute his accounting profits, Mr. Gortari, the radish farmer, would subtract explicit costs, such as charges for labor, equipment, and other supplies, from the revenue he receives.

Economists recognize costs in addition to the explicit costs listed by accountants. If Mr. Gortari were not growing radishes, he could be doing something else with the land and with his own efforts. Suppose the most valuable alternative use of his land would be to produce carrots, from which Mr. Gortari could earn $250 per month in accounting profits. The income he forgoes by not producing carrots is an opportunity cost of producing radishes. This cost is not explicit; the return Mr. Gortari could get from producing carrots will not appear on a conventional accounting statement of his accounting profit. A cost that is included in the economic concept of opportunity cost, but that is not an explicit cost, is called an implicit costA cost that is included in the economic concept of opportunity cost but that is not an explicit cost..

The Long Run and Zero Economic Profits

Given our definition of economic profits, we can easily see why, in perfect competition, they must always equal zero in the long run. Suppose there are two industries in the economy, and that firms in Industry A are earning economic profits. By definition, firms in Industry A are earning a return greater than the return available in Industry B. That means that firms in Industry B are earning less than they could in Industry A. Firms in Industry B are experiencing economic losses.

Given easy entry and exit, some firms in Industry B will leave it and enter Industry A to earn the greater profits available there. As they do so, the supply curve in Industry B will shift to the left, increasing prices and profits there. As former Industry B firms enter Industry A, the supply curve in Industry A will shift to the right, lowering profits in A. The process of firms leaving Industry B and entering A will continue until firms in both industries are earning zero economic profit. That suggests an important long-run result: Economic profits in a system of perfectly competitive markets will, in the long run, be driven to zero in all industries.

Eliminating Economic Profit: The Role of Entry

The process through which entry will eliminate economic profits in the long run is illustrated in Figure 9.14 "Eliminating Economic Profits in the Long Run", which is based on the situation presented in Figure 9.7 "Applying the Marginal Decision Rule". The price of radishes is $0.40 per pound. Mr. Gortari’s average total cost at an output of 6,700 pounds of radishes per month is $0.26 per pound. Profit per unit is $0.14 ($0.40 − $0.26). Mr. Gortari thus earns a profit of $938 per month (=$0.14 × 6,700).

Profits in the radish industry attract entry in the long run. Panel (a) of Figure 9.14 "Eliminating Economic Profits in the Long Run" shows that as firms enter, the supply curve shifts to the right and the price of radishes falls. New firms enter as long as there are economic profits to be made—as long as price exceeds ATC in Panel (b). As price falls, marginal revenue falls to MR₂ and the firm reduces the quantity it supplies, moving along the marginal cost (MC) curve to the lowest point on the ATC curve, at $0.22 per pound and an output of 5,000 pounds per month. Although the output of individual firms falls in response to falling prices, there are now more firms, so industry output rises to 13 million pounds per month in Panel (a).

Eliminating Losses: The Role of Exit

Just as entry eliminates economic profits in the long run, exit eliminates economic losses. In Figure 9.15 "Eliminating Economic Losses in the Long Run", Panel (a) shows the case of an industry in which the market price P₁ is below ATC. In Panel (b), at price P₁ a single firm produces a quantity q₁, assuming it is at least covering its average variable cost. The firm’s losses are shown by the shaded rectangle bounded by its average total cost C₁ and price P₁ and by output q₁.

Because firms in the industry are losing money, some will exit. The supply curve in Panel (a) shifts to the left, and it continues shifting as long as firms are suffering losses. Eventually the supply curve shifts all the way to S₂, price rises to P₂, and economic profits return to zero.

Entry, Exit, and Production Costs

In our examination of entry and exit in response to economic profit or loss in a perfectly competitive industry, we assumed that the ATC curve of a single firm does not shift as new firms enter or existing firms leave the industry. That is the case when expansion or contraction does not affect prices for the factors of production used by firms in the industry. When expansion of the industry does not affect the prices of factors of production, it is a constant-cost industryIndustry in which expansion does not affect the prices of factors of production.. In some cases, however, the entry of new firms may affect input prices.

As new firms enter, they add to the demand for the factors of production used by the industry. If the industry is a significant user of those factors, the increase in demand could push up the market price of factors of production for all firms in the industry. If that occurs, then entry into an industry will boost average costs at the same time as it puts downward pressure on price. Long-run equilibrium will still occur at a zero level of economic profit and with firms operating on the lowest point on the ATC curve, but that cost curve will be somewhat higher than before entry occurred. Suppose, for example, that an increase in demand for new houses drives prices higher and induces entry. That will increase the demand for workers in the construction industry and is likely to result in higher wages in the industry, driving up costs.

An industry in which the entry of new firms bids up the prices of factors of production and thus increases production costs is called an increasing-cost industryIndustry in which the entry of new firms bids up the prices of factors of production and thus increases production costs.. As such an industry expands in the long run, its price will rise.

Some industries may experience reductions in input prices as they expand with the entry of new firms. That may occur because firms supplying the industry experience economies of scale as they increase production, thus driving input prices down. Expansion may also induce technological changes that lower input costs. That is clearly the case of the computer industry, which has enjoyed falling input costs as it has expanded. An industry in which production costs fall as firms enter in the long run is a decreasing-cost industryIndustry in which production costs fall in the long run as firms enter..

Just as industries may expand with the entry of new firms, they may contract with the exit of existing firms. In a constant-cost industry, exit will not affect the input prices of remaining firms. In an increasing-cost industry, exit will reduce the input prices of remaining firms. And, in a decreasing-cost industry, input prices may rise with the exit of existing firms.

The behavior of production costs as firms in an industry expand or reduce their output has important implications for the long-run industry supply curveA curve that relates the price of a good or service to the quantity produced after all long-run adjustments to a price change have been completed., a curve that relates the price of a good or service to the quantity produced after all long-run adjustments to a price change have been completed. Every point on a long-run supply curve therefore shows a price and quantity supplied at which firms in the industry are earning zero economic profit. Unlike the short-run market supply curve, the long-run industry supply curve does not hold factor costs and the number of firms unchanged.

Figure 9.16 "Long-Run Supply Curves in Perfect Competition" shows three long-run industry supply curves. In Panel (a), S_CC is a long-run supply curve for a constant-cost industry. It is horizontal. Neither expansion nor contraction by itself affects market price. In Panel (b), S_IC is a long-run supply curve for an increasing-cost industry. It rises as the industry expands. In Panel (c), S_DC is a long-run supply curve for a decreasing-cost industry. Its downward slope suggests a falling price as the industry expands.

Changes in Demand

Changes in demand can occur for a variety of reasons. There may be a change in preferences, incomes, the price of a related good, population, or consumer expectations. A change in demand causes a change in the market price, thus shifting the marginal revenue curves of firms in the industry.

Let us consider the impact of a change in demand for oats. Suppose new evidence suggests that eating oats not only helps to prevent heart disease, but also prevents baldness in males. This will, of course, increase the demand for oats. To assess the impact of this change, we assume that the industry is perfectly competitive and that it is initially in long-run equilibrium at a price of $1.70 per bushel. Economic profits equal zero.

The initial situation is depicted in Figure 9.17 "Short-Run and Long-Run Adjustments to an Increase in Demand". Panel (a) shows that at a price of $1.70, industry output is Q₁ (point A), while Panel (b) shows that the market price constitutes the marginal revenue, MR₁, facing a single firm in the industry. The firm responds to that price by finding the output level at which the MC and MR₁ curves intersect. That implies a level of output q₁ at point A′.

The new medical evidence causes demand to increase to D₂ in Panel (a). That increases the market price to $2.30 (point B), so the marginal revenue curve for a single firm rises to MR₂ in Panel (b). The firm responds by increasing its output to q₂ in the short run (point B′). Notice that the firm’s average total cost is slightly higher than its original level of $1.70; that is because of the U shape of the curve. The firm is making an economic profit shown by the shaded rectangle in Panel (b). Other firms in the industry will earn an economic profit as well, which, in the long run, will attract entry by new firms. New entry will shift the supply curve to the right; entry will continue as long as firms are making an economic profit. The supply curve in Panel (a) shifts to S₂, driving the price down in the long run to the original level of $1.70 per bushel and returning economic profits to zero in long-run equilibrium. A single firm will return to its original level of output, q₁ (point A′) in Panel (b), but because there are more firms in the industry, industry output rises to Q₃ (point C) in Panel (a).

A reduction in demand would lead to a reduction in price, shifting each firm’s marginal revenue curve downward. Firms would experience economic losses, thus causing exit in the long run and shifting the supply curve to the left. Eventually, the price would rise back to its original level, assuming changes in industry output did not lead to changes in input prices. There would be fewer firms in the industry, but each firm would end up producing the same output as before.

Changes in Production Cost

A firm’s costs change if the costs of its inputs change. They also change if the firm is able to take advantage of a change in technology. Changes in production cost shift the ATC curve. If a firm’s variable costs are affected, its marginal cost curves will shift as well. Any change in marginal cost produces a similar change in industry supply, since it is found by adding up marginal cost curves for individual firms.

Suppose a reduction in the price of oil reduces the cost of producing oil changes for automobiles. We shall assume that the oil-change industry is perfectly competitive and that it is initially in long-run equilibrium at a price of $27 per oil change, as shown in Panel (a) of Figure 9.18 "A Reduction in the Cost of Producing Oil Changes". Suppose that the reduction in oil prices reduces the cost of an oil change by $3.

A reduction in production cost shifts the firm’s cost curves down. The firm’s average total cost and marginal cost curves shift down, as shown in Panel (b). In Panel (a) the supply curve shifts from S₁ to S₂. The industry supply curve is made up of the marginal cost curves of individual firms; because each of them has shifted downward by $3, the industry supply curve shifts downward by $3.

Notice that price in the short run falls to $26; it does not fall by the $3 reduction in cost. That is because the supply and demand curves are sloped. While the supply curve shifts downward by $3, its intersection with the demand curve falls by less than $3. The firm in Panel (b) responds to the lower price and lower cost by increasing output to q₂, where MC₂ and MR₂ intersect. That leaves firms in the industry with an economic profit; the economic profit for the firm is shown by the shaded rectangle in Panel (b). Profits attract entry in the long run, shifting the supply curve to the right to S₃ in Panel (a) Entry will continue as long as firms are making an economic profit—it will thus continue until the price falls by the full amount of the $3 reduction in cost. The price falls to $24, industry output rises to Q₃, and the firm’s output returns to its original level, q₁.

An increase in variable costs would shift the average total, average variable, and marginal cost curves upward. It would shift the industry supply curve upward by the same amount. The result in the short run would be an increase in price, but by less than the increase in cost per unit. Firms would experience economic losses, causing exit in the long run. Eventually, price would increase by the full amount of the increase in production cost.

Some cost increases will not affect marginal cost. Suppose, for example, that an annual license fee of $5,000 is imposed on firms in a particular industry. The fee is a fixed cost; it does not affect marginal cost. Imposing such a fee shifts the average total cost curve upward but causes no change in marginal cost. There is no change in price or output in the short run. Because firms are suffering economic losses, there will be exit in the long run. Prices ultimately rise by enough to cover the cost of the fee, leaving the remaining firms in the industry with zero economic profit.

Price will change to reflect whatever change we observe in production cost. A change in variable cost causes price to change in the short run. In the long run, any change in average total cost changes price by an equal amount.

The message of long-run equilibrium in a competitive market is a profound one. The ultimate beneficiaries of the innovative efforts of firms are consumers. Firms in a perfectly competitive world earn zero profit in the long-run. While firms can earn accounting profits in the long-run, they cannot earn economic profits.