chapter 15: entry, exit, and long-run profitability

Question 1

what is accounting profit?

Answer 1

the total revenue a business receives, minus its explicit financial costs

Question 2

what is the formula for accounting profit?

Answer 2

accounting profit = total revenue - explicit financial costs

Question 3

what is an explicit financial cost?

Answer 3

all money that leaves your business (rent, wages, cost of raw materials, electric bill, etc)

Question 4

what is economic profit?

Answer 4

the total revenue minus both explicit financial costs and implicit opportunity costs

Question 5

what are the two key implicit opportunity costs?

Answer 5

forgone wages and forgone interest

Question 6

what does the sum of all opportunity costs represent?

Answer 6

annual payment you need for it to be worth investing your time and money into starting a new business

Question 7

what is profit?

Answer 7

economic profit

Question 8

what is costs?

Answer 8

both explicit financial costs and implicit opportunity costs

Question 9

what is average revenue?

Answer 9

revenue per unit

equal to the price if you charge everyone the same price

Question 10

what is the formula for average reveue

Answer 10

avg. revenue = total revenue / quantity = price

Question 11

what is average cost?

Answer 11

cost per unit

Question 12

what is the formula for average cost?

Answer 12

avg. cost = total cost / quantity =

fixed cost/ q + variable cost/ q

Question 13

what is a fixed cost?

Answer 13

the expenses that do not vary with the quantity you produce

includes the opportunity cost of the entrepreneur’s time and money

Question 14

what is a variable cost?

Answer 14

the expenses that do vary with the quantity you produce

tracks the cost of variable inputs (ex. raw materials, electricity, worker time)

Question 15

what is the shape of the average cost curve?

Answer 15

U - shape

Question 16

why is the average cost curve U-shaped?

Answer 16

1. the spreading of fixed costs (gets smaller per unit so this continual decline in fixed costs leads to average cost falling)
2. rising variable costs (reflect emerging inefficiencies - diminishing marginal product and rising input costs per unit)

Question 17

what is profit margin?

Answer 17

your profit margin per unit is the price less the average cost

Question 18

what is the formula for profit margin?

Answer 18

profit margin = price - avg. cost

profit margin = avg. revenue - avg. cost

Question 19

what is the profit margin on a graph?

Answer 19

your profit margin per unit is the gap between your firm’s demand curve and its average cost curve

Question 20

what is short-run analysis?

Answer 20

deciding quantity given today’s market price

Question 21

what is long-run analysis?

Answer 21

planning how much to invest for a business expansion; launch decisions

Question 22

what constitutes as the short run?

Answer 22

1. production capacity cannot change
2. the number and type of competitors you face cannot change

Question 23

what constitutes as long run?

Answer 23

1. expand or shrink production
2. new suppliers may enter the market or existing suppliers may exit

Question 24

what is the rational rule for entry?

Answer 24

enter a market if you expect to earn a positive economic profit which occurs when the price exceeds your average cost

Question 25

what is the rational rule for exit?

Answer 25

exit a market if you expect to earn a negative economic profit, which occurs when the price is less than your average cost

Question 26

What happens when a new competitor enters the market?

Answer 26

you’ll lose customers, this decrease in demand shifts your firm’s demand curve left

you’ll lose market power, this loss flattens your firm’s demand curve (becomes more elastic)

as a result, you sell at a lower price

Question 27

what happens when an existing competitor exits the market?

Answer 27

you’ll gain customers, this increase in demand shifts your firm’s demand curve right

you’ll gain market power, this gain steepens your firm’s demand curve (becomes more inelastic)

as a result, you sell at a higher price

Question 28

what happens in the long run for entry?

Answer 28

entry stops when there’s no longer an incentive to enter - when economic profits are zero

firm demand and average cost curve and tangent

Question 29

where does zero profit occur?

Answer 29

at the point where demand just touches average costs - long run equilibrium

hence in the long run, price = avg. cost

Question 30

what happens when demand cross avg. cost?

Answer 30

economic profit will induce entry

Question 31

what happens when demand lies entirely below avg. cost?

Answer 31

the negative profits will induce exit

Question 32

what is a barrier to entry?

Answer 32

obstacles that make it difficult for new supplier to enter a market

can prevent new entrants from competing away profits of incumbent firms

Question 33

what are the four strategies for creating barriers to entry?

Answer 33

1. demand side strategies
2. supply side strategies
3. regulatory strategies
4. entry deterrence strategies

Question 34

what is demand side strategies?

Answer 34

prevent entrants from winning over your existing customers by creating customer lock in using switching costs and the network effect

Question 35

what are switching costs?

Answer 35

an impediment that makes it costly for customers to switch to buying from another business

Question 36

what is the network effect?

Answer 36

occurs whenever a product becomes more useful when more people adopt it

Question 37

what is supply side strategies?

Answer 37

deter the entry of new rivals by gaining cost advantages that newcomers cannot easily replicate (your avg. cost is lower than the avg. cost of the marginal supplier so you can survive a price war)

Question 38

what are the strategies for developing unique cost advantages?

Answer 38

• your experience can yield efficiency gains through learning by doing which lowers costs
• benefits of mass production
• create cost advantages through research and development
• leverage your relationship with suppliers to get a better deal
• limiting access to key inputs

Question 39

what is the regulatory strategy?

Answer 39

government regulates who can enter a market for two main reasons
1) to counter a market failure
2) because politicians are swayed by corporate lobbyists

Question 40

what are the types of regulatory strategies?

Answer 40

1) patents, copyrights, and trademarks: the government gives you a monopoly over selling your intellectual property in order to incentivize innovation
2) regulations - regulatory burden: many separate procedures are required to open a new business
3) compulsory government licenses: if you manufacture, wholesale, import, or sell alcoholic beverages at a retail location, you need a license, which regulates entry into some markets
4) business lobby: creates new regulator barriers

Question 41

what is entry deterrence strategies?

Answer 41

convince your potential rivals that they enter your market, you will compete very intensively

Question 42

what are the strategies that make your threat seem credible?

Answer 42

1) build excess capacity to signal you’re ready for a fight
2) financial resources signal that you can survive a fight
3) brand proliferation eliminates profitable niches for rivals
4) a reputation for fighting