Question

Would a business be expected to survive in the long run if it earned a positive accounting profit but a negative economic profit? Briefly explain.

Short answer

No, a business is not expected to survive in the long run if it earns a positive accounting profit but a negative economic profit. This is because the negative economic profit indicates that the resources could have been better used elsewhere to generate more value than currently being derived from the business.

Step-by-step solution

Understand Accounting Profit

An accounting profit is the profit declared by following the principles of accounting. It calculates monetary gains by taking the difference between the total revenue and explicit costs. Explicit costs are actual payments like rent, salaries, supplies and other tangible expenses.

Understand Economic Profit

Economic profit is a measure of profit where both explicit and opportunity costs (implicit) are considered. Opportunity costs are the value of the best alternative use of the resources. For example, if the resources were not invested in this business, they could have been invested in other ventures or deposits that could earn interest.

Apply Concept to The Problem

If a business is earning a positive accounting profit (revenue > explicit costs) but a negative economic profit, it means that the opportunity costs (implicit costs) are higher than the accounting profits. This business essentially isn't performing as well as it could have if its resources were allocated differently. Although currently the business may not be in a financial deficit, given that our interest lies in maximizing profit, this scenario isn't ideal.

Conclude

In the long run, a business is unlikely to survive. This is because it must generate at least a normal profit to cover the opportunity costs of the resources used. If the business fails to do this over the long term, it would be better to reallocate these resources to more profitable ventures.

Key concepts

Accounting Profit

Accounting profit is a measurement of a company's financial performance using traditional accounting methods. It represents the difference between total revenues and total explicit costs—costs that involve direct, out-of-pocket payments such as wages, rent, and materials. For a business, achieving a positive accounting profit indicates they are making more money than the costs incurred in operations. This measurement is crucial as it provides the initial insight into profitability and helps in filing taxes or financial reporting.

However, while helpful for understanding financial health, accounting profit does not consider all types of costs. It does not account for opportunity costs, which are indirect costs associated with choosing one option over another. By only looking at tangible costs like salaries and supplies, it might present an overly optimistic view of a company's profitability. Thus, it's essential for businesses to look at both accounting profit and other measurements to get a full picture of their economic health.

Opportunity Costs

Opportunity costs go beyond the scope of traditional accounting and represent the potential benefits missed when one option is chosen over another. These are implicit costs and they are pivotal in evaluating the true economic profit of a business.

Consider a scenario where a business owner chooses to invest in their current business instead of another venture or savings account that earns interest. The foregone profit from the alternative choice becomes an opportunity cost. These costs can significantly alter how we perceive a company's profitability, as they reflect the profit that could have been earned elsewhere.

The concept of opportunity cost underscores the importance of carefully considering how resources are allocated. By evaluating both explicit and opportunity costs, businesses can make better decisions that maximize economic profits rather than just accounting profits. It's crucial in strategy planning, especially when deciding the most effective use of resources to ensure long-term success.

Long-Run Viability

Long-run viability refers to a business's ability to sustain its operations over an extended period, ensuring that it remains profitable and competitive. To consider a business viable, it must at least achieve a normal profit, which covers both explicit and implicit costs, including opportunity costs.

When a business only earns a positive accounting profit but faces a negative economic profit, there's a risk that it will not be viable in the long run. This situation suggests that the resources might be better allocated elsewhere, as the opportunity costs are higher than the gains. Even if a business is not losing money on paper, if its economic profit is negative, it is essentially underperforming.

For long-run survival, a business needs to evaluate whether its use of resources yields the highest possible return. This involves reconsidering its strategy, potentially looking for better investment opportunities, reducing waste, or innovating. Achieving long-run viability is crucial for retaining competitiveness and ensuring that the business can navigate challenges and capitalize on growth opportunities over time.