Entry, Exit, and Long-Run Profitability
Revenues, Cost, and Economic Profits
Scenario A: You are working as the manager of a coffee shop, and, after having
gained a few years of experience, you are now considering opening your own
coffee shop. You have made some forecasts as part of your business plan: You
expect to earn R 350,000 per year in revenue, and you expect to incur R 275,000
per year in business-related expenses.
Given the above information, should you launch your startup? To answer this
question, it depends. The best decision for you to launch your start-up depends
on your opportunity costs. For example, you will need to quit your current job
and the wages you will lose should be considered. Only after considering all the
costs, including the opportunity costs, can you determine whether it is worth
starting a new business.
Economic Profit versus Accounting Profit
Accounting profit – is the total revenue a business receives, less its financial
costs. Accounting profit = Total Revenue – Explicit financial costs. All the
money that goes in and out of your business needs to be tracked; total revenue
is all the income received from all sources, and explicit financial costs are all
the money that leaves your business (rent, wages, electricity bill, etc). This
answers the question of where the money went from your business.
Economic profit – this is the total revenue a business receives, less both explicit
financial costs and the entrepreneur’s implicit opportunity costs. Economic
profit = Total Revenue – Explicit Costs – Entrepreneur’s implicit
opportunity costs. The key implicit opportunity costs are the forgone wages –
if you do not launch this startup, how much will you earn pursuing your next best
career option? Forgone interest – if your funds are not invested in this startup,
how much annual interest will you earn by investing it elsewhere? The sum of all
your opportunity costs can be thought of as the annual payment you need for it
to be worth investing your time and money into starting a new business.
Scenario B: You expect to earn R 350,000 per year in revenue, incur R
275,000 per year in business-related expenses, and your current job pays
you R 40,000 per year. You invest R 30,000 into your coffee shop instead of
keeping it in the bank where it earns 2% interest per year. What is the
accounting profit? The accounting profit is R 350,000 [Total Revenue] –
R 275,000 [Explicit financial costs] = R75,000. The economic profit is
350,000 – 275,000 – 40,000 – 2% x 30,000 = R34,400. The 40,000 and the
2% x 30,000 are considered as implicit opportunity costs. This answers that
you should open your startup because you will be R 34,400 better off than your
next best alternative.
An Evaluation of Whether Entrepreneurs should enter a market, or
existing businesses should exit
From here on, profit will always be considered as economic profit and costs will
include explicit financial costs and implicit opportunity costs. A business's
profitability can be assessed based on two key metrics:
1. Average Revenue – This is your revenue per unit, calculated as the total
revenue divided by the quantity supplied. Average Revenue is equal
to the price if you charge everyone the same price. Remember that your
firm’s demand curve shows the price you can charge for any given
, quantity. This implies that your firm’s demand curve is also your average
revenue curve.
2. Average Costs – Your average cost is your cost per unit, calculated as
your total costs divided by the quantity produced. The total cost
includes fixed and variable costs. Fixed costs are the expenses that do
not change with the quantity you produce. An example of these is the cost
of land, capital equipment, etc. Variable costs are the expenses that do
change with the quantity you produce, for example, raw materials and
ingredients, electricity, etc.
The average cost curve is U-shaped. This is caused by the influence of the fixed
costs and the variable cost. The fixed cost spreads, while the variable costs rise.
Each influence is discussed below.
The Spreading of Fixed Costs
Fixed costs do not change with output. For example, your monthly rent for a
store is R 6,000 despite how much you produce. As you produce more and more,
these fixed costs get spread over more and more units, so it becomes smaller
on a per-unit basis. There is a continuous decline in fixed costs per unit which
leads to average costs falling.
Rising Variable Costs
The rise of variable costs reflects emerging inefficiencies. Diminishing marginal
products reduces the productivity of your workers. This may be due to crowding,
etc. Rising costs per unit relate to you paying your workers overtime, etc. All this
causes the average cost curve to rise.
Profit Margins
Your profit margin per unit is your unit price less average cost. Since the price
can be equated to average revenue, the profit margins can also be average
revenue less average cost. Visually, for any given quantity, your profit margin
per unit is the gap between your firm’s demand curve and its average cost
curve. There is a profit anytime the demand curve lies above the average cost
curve.
Shor-Run versus Long-Run
Change occurs over different timelines across various industries. The short run is
the period during which production capacity remains fixed, and the number and
type of competitors you encounter do not change. The long run refers to the
period in which you or your rivals can expand or reduce production, and new
suppliers may enter the market while existing suppliers may exit.
Free Entry and Exit in the Long Run
What would lead you to enter a specific market? We use the cost-benefit
principle to see whether it is worth entering a new market if the benefits are
greater than the costs. Benefits are the revenue you will earn, and costs are the
explicit financial costs along with the implicit opportunity costs.
Economic profit measures the difference between the benefits and the costs.
There is a rational rule for market entry that states, "Enter a market if you
expect to earn a positive economic profit, which you get when the price (average
revenue) is greater than the average cost.”
Revenues, Cost, and Economic Profits
Scenario A: You are working as the manager of a coffee shop, and, after having
gained a few years of experience, you are now considering opening your own
coffee shop. You have made some forecasts as part of your business plan: You
expect to earn R 350,000 per year in revenue, and you expect to incur R 275,000
per year in business-related expenses.
Given the above information, should you launch your startup? To answer this
question, it depends. The best decision for you to launch your start-up depends
on your opportunity costs. For example, you will need to quit your current job
and the wages you will lose should be considered. Only after considering all the
costs, including the opportunity costs, can you determine whether it is worth
starting a new business.
Economic Profit versus Accounting Profit
Accounting profit – is the total revenue a business receives, less its financial
costs. Accounting profit = Total Revenue – Explicit financial costs. All the
money that goes in and out of your business needs to be tracked; total revenue
is all the income received from all sources, and explicit financial costs are all
the money that leaves your business (rent, wages, electricity bill, etc). This
answers the question of where the money went from your business.
Economic profit – this is the total revenue a business receives, less both explicit
financial costs and the entrepreneur’s implicit opportunity costs. Economic
profit = Total Revenue – Explicit Costs – Entrepreneur’s implicit
opportunity costs. The key implicit opportunity costs are the forgone wages –
if you do not launch this startup, how much will you earn pursuing your next best
career option? Forgone interest – if your funds are not invested in this startup,
how much annual interest will you earn by investing it elsewhere? The sum of all
your opportunity costs can be thought of as the annual payment you need for it
to be worth investing your time and money into starting a new business.
Scenario B: You expect to earn R 350,000 per year in revenue, incur R
275,000 per year in business-related expenses, and your current job pays
you R 40,000 per year. You invest R 30,000 into your coffee shop instead of
keeping it in the bank where it earns 2% interest per year. What is the
accounting profit? The accounting profit is R 350,000 [Total Revenue] –
R 275,000 [Explicit financial costs] = R75,000. The economic profit is
350,000 – 275,000 – 40,000 – 2% x 30,000 = R34,400. The 40,000 and the
2% x 30,000 are considered as implicit opportunity costs. This answers that
you should open your startup because you will be R 34,400 better off than your
next best alternative.
An Evaluation of Whether Entrepreneurs should enter a market, or
existing businesses should exit
From here on, profit will always be considered as economic profit and costs will
include explicit financial costs and implicit opportunity costs. A business's
profitability can be assessed based on two key metrics:
1. Average Revenue – This is your revenue per unit, calculated as the total
revenue divided by the quantity supplied. Average Revenue is equal
to the price if you charge everyone the same price. Remember that your
firm’s demand curve shows the price you can charge for any given
, quantity. This implies that your firm’s demand curve is also your average
revenue curve.
2. Average Costs – Your average cost is your cost per unit, calculated as
your total costs divided by the quantity produced. The total cost
includes fixed and variable costs. Fixed costs are the expenses that do
not change with the quantity you produce. An example of these is the cost
of land, capital equipment, etc. Variable costs are the expenses that do
change with the quantity you produce, for example, raw materials and
ingredients, electricity, etc.
The average cost curve is U-shaped. This is caused by the influence of the fixed
costs and the variable cost. The fixed cost spreads, while the variable costs rise.
Each influence is discussed below.
The Spreading of Fixed Costs
Fixed costs do not change with output. For example, your monthly rent for a
store is R 6,000 despite how much you produce. As you produce more and more,
these fixed costs get spread over more and more units, so it becomes smaller
on a per-unit basis. There is a continuous decline in fixed costs per unit which
leads to average costs falling.
Rising Variable Costs
The rise of variable costs reflects emerging inefficiencies. Diminishing marginal
products reduces the productivity of your workers. This may be due to crowding,
etc. Rising costs per unit relate to you paying your workers overtime, etc. All this
causes the average cost curve to rise.
Profit Margins
Your profit margin per unit is your unit price less average cost. Since the price
can be equated to average revenue, the profit margins can also be average
revenue less average cost. Visually, for any given quantity, your profit margin
per unit is the gap between your firm’s demand curve and its average cost
curve. There is a profit anytime the demand curve lies above the average cost
curve.
Shor-Run versus Long-Run
Change occurs over different timelines across various industries. The short run is
the period during which production capacity remains fixed, and the number and
type of competitors you encounter do not change. The long run refers to the
period in which you or your rivals can expand or reduce production, and new
suppliers may enter the market while existing suppliers may exit.
Free Entry and Exit in the Long Run
What would lead you to enter a specific market? We use the cost-benefit
principle to see whether it is worth entering a new market if the benefits are
greater than the costs. Benefits are the revenue you will earn, and costs are the
explicit financial costs along with the implicit opportunity costs.
Economic profit measures the difference between the benefits and the costs.
There is a rational rule for market entry that states, "Enter a market if you
expect to earn a positive economic profit, which you get when the price (average
revenue) is greater than the average cost.”
