Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total revenue = $55,000 Supplies= ($2,000) Accounting Profit= $53,000 Accountants aged earn around $65,000 Office space of like size rents for $13,000/yr

Accounting Profit vs Economic Profit Economic Profit = Total Revenue - Explicit Cost - Opportunity Cost – Example: Self-employed C.P.A. Total revenue = $55,000 Supplies= ($2,000) Opportunity Cost of Office = ($13,000) Opportunity Cost of CPA Time= ($65,000) Economic Profit= -$25,000

Examples of Explicit and Implicit Costs

Accounting Profit vs Economic Profit Normal Accounting Profit – may be around 10% of investment Normal Economic Profit – revenue covers explicit and opportunity cost – assumed to equal zero Returns have to cover the opportunity cost of the investment For remaining lecture, we will refer to profit as economic profit

When should a firm go out of the business in the short-run? 1) When P = MC > ATC Profit = P*Q - ATC*Q = (P - ATC)*Q > 0 Economic Profit > 0 Example P = 3, ATC = 2.054

Revenue = P*Q

Total Cost = ATC*Q

Π П= (P-ATC)*Q

When should a firm go out of the business in the short-run? 2) When P = MC AVC < P < ATC = AFC + AVC Profit = P*Q - ATC*Q = (P - ATC)*Q <0 (lose money) = {(P - AVC )- AFC}*Q > -AFC*Q = -FC Keep producing in short run because better than swallowing FC, even though economic profit <0

When should a firm go out of the business in the short-run? Example 2: AVC < P < ATC P = $1.75 AVC = $1.55 ATC = $1.83 AFC = $0.28 Q= 357 Profit = (P - AVC - AFC)*Q = (1.75 – 1.83)*357 = -$28.56 > -0.28*357 = -100$

Revenue ATC > P > AVC

Total Cost ATC > P > AVC

LOSS ATC > P > AVC

LOSS with Shutdown ATC > P > AVC

When should a firm go out of the business in the short-run? 3) When P = MC <AVC; P-AVC < 0 Profit = P*Q - ATC*Q = (P - ATC)*Q = {(P – AVC) – AFC}*Q < -AFC*Q = -FC Stop producing in short run because swallowing FC is better than producing and losing even more

When should a firm go out of the business in the short-run? Example 3: P = MC <AVC P = $1.25 AVC = $1.50 ATC = $2.00 AFC = $0.50 Q= 200 Profit = (P - ATC)*Q = (1.25 – 2.00)*200 = -$150 < -$100 = -FC

Revenue

Total Cost

Loss

Loss with Shutdown

When should a firm go out of the business? SHORT RUN Produce in the short run at P = MC when MC > AVC Shut down when P < AVC LONG RUN In long run, need to make back fixed costs, so only produce if P = MC >= ATC