In the last few posts in the Demand and supply analysis series, we covered the elasticity of demand and supply and factors that effect consumer demand. In this post we will look into the different types of profit.
Accounting profit is revenue minus explicit costs. Explicit costs to a firm are the payments made for the resources used for producing the output.
Economic profits is accounting profit minus implicit costs. In other words, it is revenue minus explicit costs minus implicit costs. Implicit costs are the opportunity costs of the resources used in the production of output. Opportunity cost is the next best avenue where the resource could be used but was not used so that it could be used here. (Opportunity costs have been covered in detail in earlier posts.). Explicit costs and implicit costs together are called economic costs.
Normal profit is the accounting profit that makes economic profit zero. That is the firm is earning accounting profits just enough to cover the implicit costs. From this it follows that;
economic profits = accounting profit – normal profit
When accounting profits are more than the implicit costs, the economic profit is positive and when it is less than the implicit costs it is negative.
When there is zero economic profits, there is no incentive for a firm to either leave or enter the industry as the firm is earning just the required rate of return.
Comparing the profit measures:
Normal profit is the minimum profit needed for a firm to continue its operations. Earning less than the normal profit, i,e a negative economic profit will decrease a firm’s equity while a positive economic profit will increase it.
Economic rent is the payment made for a resource in excess of its value in the next best avenue where it can be used. The value in the next best avenue is the opportunity cost. Economic rent can therefore be described as the excess payment made for retaining a resource in its current use. For example the excess payment made to an employee to prevent him from changing jobs.
Comparing total, average and marginal revenue:
Total revenue is price multiplied by the quantity sold.
Average revenue is total revenue divided by quantity sold.
Marginal revenue is the marginal increase in the total revenue from the sale of one additional unit of the product.
In a perfectly competitive market, average revenue and marginal revenue are equal to the price of the product. In imperfect competition, in order to sell more quantity the seller has to adjust the price downwards. Therefore, in imperfect markets we have downward sloping demand curves and the sellers are called price searchers. With the assumption that all the goods are sold at a single price, in an imperfect market, average revenue is equal to price as to sell more quantities the prices of all the goods have to be reduced equally. However the marginal revenue is not equal to the price. Under imperfect competition, average revenue and marginal revenue both decline as quantity sold increases, however, marginal revenue declines more than average revenue and price. Total revenue is maximised when marginal revenue is zero, i.e. no additional revenue is earned from selling one more additional unit.
That’s all in this post …..Thanks for reading….in the next part we will learn about total, marginal, variable and fixed costs…
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For solved examples please refer to the CFA Institute Books or any other study notes that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
To be continued…..