Question

5. Explain why one firm sometimes appears to be earning higher profits than another but, in reality, is not.

Answer 1

Taking example to explain, suppose A and B both operate a single proprietorship a bakery that produces wedding cakes. And they both have identical fixed costs. A is much better at making cakes than B, as she learned to bake and some additional tricks in cooking classes and, as a result, has lower average variable and average total costs. It is given that A and B sell their cakes at the same price, A appears to have higher profits than B. We say “appears” because A’s implicit opportunity cost has to be adjusted to reflect the higher pay she could receive if he were to work for someone else making cakes. Once this is done, her variable costs will be the same as b’s, and he will not be making any economic profits. This does not say that a will not be making more dollars than B, only that these “more dollars” are not profits. They are a payment to A’s superior skill at making cakes and without this superior skill, this extra income would not exist.