Question

Briefly explain whether a firm earning zero economic profit will continue to produce in the long run.

Short answer

Yes, a firm earning zero economic profit will continue to produce in the long run. This is because zero economic profit means that the firm is able to cover all of its explicit and implicit costs, therefore still earning an accounting profit.

Step-by-step solution

Understand Economic Profit

First, you need to be clear about what economic profit means. Economic profit is calculated by subtracting a firm’s total costs (including both explicit and implicit costs) from its total revenue.

Zero Economic Profit

When a firm is making zero economic profit, it means that its total revenue equals its total cost (including implicit cost). In other words, the firm is covering all its explicit and implicit costs.

Explain Long-Run Production Decision

In the long run, a firm will continue to produce if it is able to cover all of its costs. Even if a firm is earning zero economic profit, it can still be covering all explicit costs (and earning an accounting profit) and therefore continue to produce in the long run.

Key concepts

Long-run Production Decision

In the context of economics, the long-run production decision is a strategic choice made by firms based on their assessment of market conditions and their own financial viability over an extended period. Unlike short-run decisions that might focus on immediate profitability, long-run decisions involve planning for sustainability and growth.

For a firm earning zero economic profit, the long-run decision to continue production hinges on whether it is able to cover both its implicit and explicit costs. Even if the profit isn't above zero, as long as the revenue meets these costs, the firm can sustain its operations. This state is known as the break-even point where the firm does not earn additional money beyond costs but is also not losing money.

Implicit costs, such as the opportunity cost of the owner's time or capital, do not involve direct payment but are crucial for a complete understanding of the firm's financial position. Explicit costs include all direct payments to resources not owned by the firm. If both of these costs are met, it indicates that the firm’s resources are being used as effectively as they would be in the best alternative scenario, and thus, there is no economic incentive to cease production.

Total Revenue

Total revenue is a fundamental concept in economics that represents the total income a firm generates from selling its goods or services, calculated by multiplying the price per unit by the number of units sold. It is the starting point for determining a firm's profitability and plays a critical role in long-run production decisions.

While total revenue is essential, it provides an incomplete picture on its own. For instance, high total revenue does not automatically result in economic profit. A firm also needs to consider costs associated with production, such as raw materials, labor, and overheads. Only when total revenue exceeds total costs, including both implicit and explicit costs, does a firm realize an economic profit.

In the situation of zero economic profit, a firm's total revenue is exactly equal to its total costs. This scenario can be sustainable in the long run as long as the firm consistently covers all costs associated with production and operation, ensuring its ability to stay in business.

Implicit and Explicit Costs

Understanding the distinction between implicit and explicit costs is vital when analyzing a firm's financial health and its potential for long-run viability. Explicit costs, also known as accounting costs, are easily quantifiable and involve direct transactions. These include expenses such as salaries, rent, utilities, and supply costs — essentially any outgoing cash flow that can be documented and traced.

On the other hand, implicit costs, also referred to as economic costs, are not as straightforward. They represent the opportunity costs associated with the firm's use of its own resources. These could be the earnings an owner foregoes by investing time in their own business rather than working elsewhere or the interest income lost by investing capital in the business instead of an alternative investment.

These concepts become particularly relevant in the discussion of zero economic profit. A firm must make enough revenue to cover explicit costs to maintain operations and implicit costs to justify the continued use of owner-supplied resources. If a firm only covered its explicit costs, it might briefly appear profitable in an accounting sense, but in economic terms, it would not be generating sufficient returns, potentially leading to a reassessment of its long-term strategy.