🛒principles of microeconomics review

key term - Economic Profit

Definition

Economic profit is the difference between a firm's total revenue and its total economic costs, which include both explicit costs (such as wages, rent, and raw materials) and implicit costs (such as the opportunity cost of the owner's time and the cost of using the firm's own capital). Economic profit is a more comprehensive measure of a firm's profitability compared to accounting profit, which only considers explicit costs.

5 Must Know Facts For Your Next Test

  1. Economic profit is the true measure of a firm's profitability, as it takes into account both explicit and implicit costs.
  2. Firms will only enter a market if they can earn a positive economic profit, as this ensures they are covering all of their costs, including the opportunity cost of their own resources.
  3. In the long run, firms will continue to enter a perfectly competitive market until economic profits are driven down to zero, as new firms will continue to enter as long as there are positive economic profits.
  4. Efficient resource allocation in a perfectly competitive market requires that firms produce where price equals marginal cost, which occurs when economic profits are zero.
  5. Economic profit is a key factor in a firm's decision to enter or exit a market in the long run, as firms will only remain in a market if they can earn a positive economic profit.

Review Questions

  • Explain how economic profit differs from accounting profit and why it is a more comprehensive measure of a firm's profitability.
    • Economic profit is a more comprehensive measure of a firm's profitability compared to accounting profit because it takes into account both explicit costs, such as wages and raw materials, as well as implicit costs, such as the opportunity cost of the owner's time and the cost of using the firm's own capital. Accounting profit only considers explicit costs and does not account for these implicit costs, which are an important part of a firm's total economic costs. By including both explicit and implicit costs, economic profit provides a more accurate representation of a firm's true profitability and the full cost of operating the business.
  • Describe how the concept of economic profit relates to a firm's entry and exit decisions in the long run for a perfectly competitive market.
    • In a perfectly competitive market, firms will only enter if they can earn a positive economic profit, as this ensures they are covering all of their costs, including the opportunity cost of their own resources. As new firms continue to enter the market, economic profits will be driven down towards zero in the long run. Once economic profits reach zero, firms will be indifferent between staying in the market or exiting, as they are only earning a normal rate of return on their resources. This ensures that resources are allocated efficiently in the long run, as firms will only remain in the market if they can earn at least a normal profit.
  • Analyze how the concept of economic profit is related to the efficiency of resource allocation in a perfectly competitive market.
    • In a perfectly competitive market, efficiency in resource allocation requires that firms produce where price equals marginal cost, which occurs when economic profits are driven down to zero in the long run. When firms are earning positive economic profits, it signals that resources are not being allocated efficiently, as new firms can enter the market and earn those profits. However, as new firms enter, economic profits are driven down, and resources become allocated more efficiently. Once economic profits reach zero, it indicates that resources are being used in the most efficient manner, as firms are only earning a normal rate of return on their resources. Therefore, the concept of economic profit is directly related to the efficiency of resource allocation in a perfectly competitive market, as it provides the incentive for firms to enter or exit the market until the optimal level of production is reached.