Question

Why are these statements wrong? (a) Firms with an accounting profit must be thriving. (b) Firms do not know their marginal costs. A theory of supply cannot assume that firms set marginal revenue equal to marginal cost. (c) To maximize profit, maximize sales.

Short answer

(a) Accounting profits don't imply thriving; implicit costs matter. (b) Firms estimate marginal costs for decision-making. (c) Maximizing profit doesn't mean maximizing sales.

Step-by-step solution

Evaluate Statement (a)

The statement claims that firms with accounting profits are thriving. However, accounting profits only consider explicit costs and do not account for implicit costs and opportunity costs that are part of economic profit. Essentially, a firm can have accounting profits but still suffer a negative economic profit, meaning it isn't necessarily thriving.

Evaluate Statement (b)

This statement challenges the assumption that firms know their marginal costs. In reality, while there may be difficulties in precisely measuring marginal cost, firms generally estimate and track these costs for decision-making purposes. Therefore, theories of supply which assume firms set marginal revenue equal to marginal cost are based on this reasonable and practical estimation process.

Evaluate Statement (c)

The statement suggests profit maximization occurs through maximizing sales. However, this is incorrect because focusing solely on sales can lead to increased costs and reduced profitability. True profit maximization requires balancing revenues and costs, not just maximizing sales figures.

Key concepts

Accounting Profit

Accounting profit is the profit figure that businesses calculate through traditional bookkeeping. It only takes into account explicit costs, which are direct out-of-pocket expenses like salaries and rent.
Firms calculate accounting profit by subtracting these explicit costs from total revenue.

However, accounting profit does not consider implicit costs, such as the opportunity costs of using resources in a particular way.
Therefore, while a firm may showcase a healthy accounting profit, it is not necessarily thriving if it incurs high implicit costs, which leads us to economic profit.

Economic Profit

Economic profit provides a more comprehensive view of a firm's profitability by factoring both explicit and implicit costs into the equation.
Economic profit is calculated by taking accounting profit and subtracting implicit costs, such as the value of the next best alternative use of resources.

When the economic profit is positive, it indicates that the firm is not only covering all its costs but also earning more than it would in the next best alternative.
Conversely, a negative economic profit suggests that the firm's resources might be better utilized elsewhere, even if its accounting profit seems adequate.

Marginal Cost

Marginal cost reflects the cost of producing one additional unit of a good or service. It is crucial for firms to know this to make informed production decisions.
In theoretical terms, it involves calculating the cost change when output is increased by one unit.

Firms often estimate marginal costs using past production data and experiences, understanding that precision can be challenging.
By aligning production levels where marginal revenue equals marginal cost, firms can effectively maximize their profit. Despite complexities, marginal cost remains a cornerstone concept in supply theory.

Marginal Revenue

Marginal revenue is the additional revenue generated from selling one more unit of a product.
For profit-driven firms, understanding marginal revenue is as important as knowing marginal cost because it helps them determine the optimal production level.

If marginal revenue exceeds marginal cost, a firm can increase its profit by producing more units. If it is less, reducing output might be wiser.
The key is finding a balance where marginal revenue equals marginal cost, thus maximizing profit. This equilibrium concept is central to efficient business operations and supply decisions.

Supply Theory

Supply theory in economics focuses on how producers determine the quantity of a product to offer in the market.
It assumes firms aim to maximize their profit by equating marginal revenue with marginal cost.

Supply theory encompasses decisions around production, pricing, and resource allocation.
While challenges exist, such as accurately determining marginal cost and revenue, the basic principle holds that profit maximization requires getting these numbers as closely aligned as possible.
Practical applications show firms continuously adjusting their strategies to meet these theoretical ideals.