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Chapter 8: Problem 4

Would a business be expected to survive in the long run if it earned a positive accounting profit but a negative economic profit? Briefly explain.

Short Answer

Expert verified
No, a business is not expected to survive in the long run if it earns a positive accounting profit but a negative economic profit. This is because the negative economic profit indicates that the resources could have been better used elsewhere to generate more value than currently being derived from the business.

Step by step solution

01

Understand Accounting Profit

An accounting profit is the profit declared by following the principles of accounting. It calculates monetary gains by taking the difference between the total revenue and explicit costs. Explicit costs are actual payments like rent, salaries, supplies and other tangible expenses.
02

Understand Economic Profit

Economic profit is a measure of profit where both explicit and opportunity costs (implicit) are considered. Opportunity costs are the value of the best alternative use of the resources. For example, if the resources were not invested in this business, they could have been invested in other ventures or deposits that could earn interest.
03

Apply Concept to The Problem

If a business is earning a positive accounting profit (revenue > explicit costs) but a negative economic profit, it means that the opportunity costs (implicit costs) are higher than the accounting profits. This business essentially isn't performing as well as it could have if its resources were allocated differently. Although currently the business may not be in a financial deficit, given that our interest lies in maximizing profit, this scenario isn't ideal.
04

Conclude

In the long run, a business is unlikely to survive. This is because it must generate at least a normal profit to cover the opportunity costs of the resources used. If the business fails to do this over the long term, it would be better to reallocate these resources to more profitable ventures.

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Most popular questions from this chapter

Distinguish between a firm's explicit costs and its implicit costs and between a firm's accounting profit and its economic profit.

Paolo currently has \(\$ 100,000\) invested in bonds that earn him 4 percent interest per year. He wants to open a pizza restaurant and is considering either selling the bonds and using the \(\$ 100,000\) to start his restaurant or borrowing \(\$ 100,000\) from a bank, which would charge him an annual interest rate of 6 percent. He finally decides to sell the bonds and not take out the bank loan. He reasons: "Because I already have the \(\$ 100,000\) invested in the bonds, I don't have to pay anything to use the money. If I take out the bank loan, I have to pay interest, so my costs of producing pizza will be higher if I take out the loan than if I sell the bonds." Evaluate Paolo's reasoning.

The principal-agent problem arises almost everywhere in the business world, and it also crops up even closer to home. Discuss the principal-agent problem that exists in the college classroom. Who is the principal? Who is the agent? What potential conflicts in objectives exist between this principal and this agent?

(Related to the Apply the Concept on page 259 ) According to an article by Reuters News Agency, in November \(2016,\) Fitch Ratings cut its rating on McDonald's bonds from \(B B B+\) to \(B B B\). a. What is Fitch's top bond rating? Under what circumstances would Fitch, or the other bond rating agencies, be likely to cut the rating on a firm's bonds? b. What will be the likely result of this rating's cut for the interest rate McDonald's will have to pay when it sells new bonds? Briefly explain.

Jay Ritter, a professor at the University of Florida, was quoted in the Wall Street Journal as saying about Facebook: "It's entirely possible for a company to have solid growth prospects while its stock is overvalued." a. What does it mean to describe a stock as "overvalued"? b. Why might a firm's stock be overvalued despite the firm having "solid growth prospects"?
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