Question

Consider a small firm in a perfectly competitive industry. The firm is worth $600,000 and the return on investment elsewhere in the economy is 5.25 percent. Suppose the firm’s revenue in a year is $1.2 million and its operating expenses are $768,000.

a.        What is the firm’s accounting and economic profits in this case?

b.        Explain what would happen in this market in the long-run. What conditions are necessary for this to happen?

Answer 1

a> The accounting profit of the firm is ${1,200,000-768,000}=$432,000

The investment profit in the market would have been $600,000*0.0525=$31,500

The economic profit of the firm is $432,000-$31,500=$400,500

b> Since the firm is providing abnormal profit, more firms will enter the market until the conomic profit goes down to zero. Thus, in the long tun, the economic profit would be zero.

Low barrier to entry is the necessry factor for that to happen.