Economics Concepts: Accounting Profit and Economic Profit Marginalism Absolute and Competitive advantage

From:Jay R Modi

1

#1 Contrast the concepts of “accounting profit” and “economic profit.”

Explain how a mis-reading of accounting profit can lead a firm to

overestimate its profitability. Explain why an economic agent earning

a positive level of economic profit would indicate that the agent is

earning a superior return on its assets.

In economics, a firm is said to be making a normal profit when total

revenues equal total costs. Profit generally is the making of gain in

business activity for the benefit of the owners of the business. The

word comes from Latin meaning "to make progress", is defined in two

different ways, one for economics and one for accounting.

Accounting profit is defined as total revenue (sales) minus

accounting (explicit) costs i.e. monetary payments (or cash

expenditures) made to supply labor services, materials, fuel,

transportation services, depreciation, interest and taxes. For example,

if a company invest $50,000 to start a business and earned $60,000 in

profit, than its accounting profit would be $10,000. Accounting profits

tend to be higher than economic profits as they omit certain implicit

costs, such as opportunity costs

An Economic profit arises when the company’s revenue exceeds the

total (opportunity) cost of its inputs. A positive economic profit

indicates that book value is increasing which over time will yield a

positive shareholder value.

Misreading of accounting profit can lead a firm to overestimate its

profitability because accounting profits doesn’t take into consideration

a firm’s implicit costs such as opportunity costs i.e. the cost of an

alternative that must be forgone in order to pursue a certain action. To

§2

the firm, implicit costs are those cost that are represented by lost

opportunity in the use of a company's own resources, excluding cash.

Economic agent earning a positive level of economic profit is an

indication that agent is earning superior return on its assets because

total cost i.e. both explicit and implicit costs covered by the total

revenue. If a company covers only explicit costs than it can be said

that the company is earning normal profit but if a company covers

explicit cost along with the implicit cost than it can be said that it is

making economic profit and earning a superior return on its assets.

#2 Explain the concept of “Marginalism.” Explain how economists use

marginalism as a decision-making paradigm.

MARGINALISM is the decision-making of forward and not backward

process. Each decision has a corresponding benefit (marginal benefit)

and it has corresponding cost (marginal cost)

The best way to understand the concept of Marginalism is by

understanding it in terms of Marginal benefit and Marginal cost.

Marginal benefit (MB) is the benefit a consumer or user gets after

consuming the next unit of same activity or commodity. Marginal cost

(MC) is the cost associated with the next unit of the same activity.

Economists can use Marginalism as a decision-making paradigm in

following two ways:

If the marginal benefit exceeds the marginal cost than the activity

should be undertaken.

MB > MC--- Undertake the Activity

§2

If the marginal costs exceeds the marginal benefit than the activity

should not be undertaken.

MB > MC--- Undertake the Activity

#3 Social Security is a program that has the effect of redistributing

wealth from income earners to older Americans who for the most part

have retired. Explain why such redistribution might not be seen by

economist as an improvement in economic efficiency

Economic efficiency can be defined as the degree to which the given

amounts of inputs are used to produce the maximum output. In other

words, economic efficiency in economics terms means, ‘‘efficient

distribution’’ i.e. obtaining maximum output out of the least input.

When a wealth is redistributed from income earners to old Americans

who are retired and cannot add value to the economic system, it leads

to economic in-efficiency. There are two reasons for the same:

Full utilization of resources by the society as by doing this, all the

employed resources will be used by the society to provide the

maximum possible satisfaction of redistributing the wealth, and

Expectation of decrease in the gap between income earners and

old Americans, as in the future there will be equal number of

income earners and old Americans.

#4 Explain and contrast the concepts of absolute advantage and

comparative advantage. Which of these concepts is the determining

factor in the establishment of trade flows among countries? Explain

Absolute Advantage means the ability of a country, individual,

company or region to produce a good or service at a lower cost per

§2

unit than the cost at which any other entity produces that good or

service. For example; Zambia, the country has an absolute advantage

over many countries in the production of copper

Comparative Advantage means the ability of a country, individual,

company or region to produce a good or service at a lower opportunity

cost than the cost at which any other entity produces that good or

service.

In establishment of a trade flows among two countries comparative

advantage is the determining factor. It can be understood with the help

of following example.

30 China Production possibility W H E 20 Japan E T

20 30 RICE

If we look at the above example, we will find that China has absolute

advantage in the production of wheat as it can produce wheat at less

cost than Japan and Japan has the absolute advantage in the

production of rice as it can produce rice at less cost than China.

But if we consider the opportunity cost of China producing one more

unit of wheat, half a unit of rice has been foregone. When Japan

produces one more unit of wheat, two units of rice are foregone.

Economics is concerned with the allocation of scarce resources. Fewer

resources are foregone if China concentrates its resources in the

production of maize and if Japan specializes in the production of rice.

Therefore we can conclude that,

§2

China has a Comparative advantage in the production of Wheat, and

Japan has a Comparative advantage in the production of Rice

§2