Why Do Some Businesses Close Even Though They Are Profitable?
First, watch this short video: https://www.youtube.com/watch?v=a0nUWrnuUdo
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Per Figure 1 economists and accountants measure costs and profits differently.
Economist view of the firm:
An economist measures a firm’s economic profit as
· the firm's revenue (sales)
· minus the firm’s explicit + implicit costs
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Explicit costs are those that require a money outflow.
Implicit cost includes money the firm owner could otherwise be making, including
· profit from other investments such as in the stock market
· working at a job for another firm
…
An accountant measures the firm's accounting profit as
· the firm's revenue
· minus only the firm's explicit, money outflow for costs of running the business
Because the accountant ignores the implicit costs, accounting profit is larger than economic profit.
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Per Figure 2 explicit costs are fixed at $800 and implicit costs are fixed at $700.
From an accountant’s viewpoint:
· at $800 sales the firm is ($800 - $800) breaking even
· at $1000 sales the firm is making a $200 profit
· at $1500 sales the firm is making a $700 profit
· at $2000 sales the firm is making a $1200 profit
From an economist’s viewpoint:
· at $800 sales the firm is ($800 - $1500) losing $700
· at $1000 sales the firm is losing $500
· at $1500 sales the firm is breaking even
· at $2000 sales the firm is making a $500 profit
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Economic profit is the driving motivation for firms.
A firm making economic profit will stay in business because it is more than covering all its costs, both explicit and implicit.
The economic profit is a reward to firm owners for their risk-taking.
Firm owners making accounting profits but not economic profits will close the business, unless they
· expect the firm will make economic profits in the future
· have a non-profit motive for continuing, such as the work is enjoyable
…
Economic profit is constantly driven toward zero because it is a magnet for competitors to jump in.
As competitors reduce prices to gain more sales eventually economic profit is driven down to zero.
Even with competition economic profits can be gained through continual innovations, including
· new product development
· improving service quality
· operating more efficiently to reduce costs
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