Chapter 7 | Opportunity Costs, Economic Profits/Losses, Miracle of Markets Flashcards

1
Q

What Accountants Miss: Accounting Profits and Hidden Opportunity Costs

A

Accounting profits equal revenues minus all obvious costs, including depreciation. But accounting profits miss the hidden, implicit opportunity costs of a business owner’s time and money.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Obvious costs (explicit costs)

A

— costs a business pays directly. Accountants count all obvious business costs and include depreciation:

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

depreciation:

A

– decrease in the value of equipment over time because of wear and tear and because it becomes obsolete.
– allowable yearly depreciation cost is the price of equipment divided by number of years it lasts.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Accounting profits

A

— Revenues – Obvious Costs (including depreciation).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Implicit costs

A

— hidden opportunity costs of what business owner could earn elsewhere with time and money invested.

– Opportunity cost of time — best alternative use of business owner’s time.
– Opportunity cost of money — best alternative use of business owner’s money invested in the business; must include compensation for risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Risk compensation depends on attitudes toward risk.

A

– A risk-loving investor does not require much compensation for taking risks.
– A risk-averse (risk-avoiding) investor requires a high compensation for taking risks.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What Economists Find: Normal Profits and Economic Profits

A

Smart business decisions return at least normal profits — what a business owner could earn from the best alternative uses of her time and money. There are economic profits over and above normal profits when revenues are greater than all opportunity costs of production, including hidden opportunity costs.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Normal profits:

A

– compensation for business owner’s time and money
– sum of hidden opportunity costs (implicit costs)
– what business owner must earn to do as well as best alternative use of time and money
– average profits in other industries

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Economic profits equal

A

– Revenues minus all Opportunity Costs
– Revenues − (Obvious Costs + Hidden Opportunity Costs)
– Revenues − (Obvious Costs + Implicit Costs)
– Revenues − (Obvious Costs + Normal Profits)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Key difference between economists and accountants is that economists subtract hidden opportunity costs when calculating profits.

A

– Economic profits are less than accounting profits.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Economic losses

A

— negative economic profits.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Economic losses — negative economic profits.

A

– If revenues are less than all opportunity costs, business owner has not made a smart decision and would be better off in alternative uses of time and money.
– With economic losses, business owner is earning less than normal profits, less than average profits in other industries.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

How Economic Profits Direct the Invisible Hand

A

The simplest rule for smart business decisions is “Choose only when economic profits are positive.” When businesses pursue economic profits, markets produce the products and services consumers want.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Economic profits (and losses) serve as signal for smart business decisions.

A

– With economic losses (red light): businesses leave industry, supply decreases, pushing prices up, until prices just cover all opportunity costs of production and economic profits are zero.
– With breakeven point (yellow light): businesses just earning normal profits. Market equilibrium with zero economic profits or losses. No tendency for change.
– With economic profits (green light): businesses expand and enter industry, supply increases, pushing prices down, until prices just cover all opportunity costs of production and economic profits are zero.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

With breakeven point (yellow light):

A

businesses just earning normal profits. Market equilibrium with zero economic profits or losses. No tendency for change.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

With economic losses (red light):

A

businesses leave industry, supply decreases, pushing prices up, until prices just cover all opportunity costs of production and economic profits are zero.

17
Q

With economic profits (green light):

A

businesses expand and enter industry, supply increases, pushing prices down, until prices just cover all opportunity costs of production and economic profits are zero.

18
Q

Short-run market equilibrium

A

— quantity demanded equals quantity supplied, but economic losses or profits lead to changes in supply.

19
Q

Long-run market equilibrium

A

quantity demanded equals quantity supplied, economic profits are zero, no tendency for change.

– The price consumers are willing and able to pay just covers businesses’ opportunity costs of production, including normal profits.
– The difference between short-run and long-run market equilibrium is the additional time it takes for supply changes to adjust economic profits to zero.

20
Q

On the supply side of markets, economic profits are the key signal directing businesses to produce the products and services that consumers want. Changes in economic profits trigger changes in supply, which changes prices, moving an industry from a short-run market equilibrium to a long-run market equilibrium.

A

On the supply side of markets, economic profits are the key signal directing businesses to produce the products and services that consumers want. Changes in economic profits trigger changes in supply, which changes prices, moving an industry from a short-run market equilibrium to a long-run market equilibrium.