Chapter 15 – Entry, Exit, and Long-Run Profitability

Revenues, Costs, and Economic Profitability

• Three pillars explored in Chapter 15:
  • Revenues, Costs, and Economic Profits
  • Free Entry and Exit in the Long Run
  • Barriers to Entry (preview; details follow in later slides)
• Central question: “Should you start, stay in, expand, shrink, or exit a business?” Answer hinges on measuring profit correctly—​using economic (not just accounting) concepts.

Accounting Profit

• Definition: The money‐based profit recorded on your income statement.
• Formula: \text{Accounting Profit}=\text{Total Revenue}-\text{Explicit Financial Costs}
• Explicit financial costs = all cash outflows (rent, wages paid to employees, raw materials, utilities, loan payments, etc.).
• Tells you: “Where did my money go last year?” Good for record‐keeping, taxes, and lender reports.

Economic Profit

• Definition: Profit after subtracting both explicit financial costs and implicit opportunity costs.
• Formula: \text{Economic Profit}=\text{Total Revenue}-\text{Explicit Financial Costs}-\text{Implicit Opportunity Costs}
• Key implicit costs to remember:
  • Forgone wages (salary + benefits you walk away from)
  • Forgone interest (return you could have earned if the capital were invested elsewhere)
• Answers strategic questions: “Is this the best use of my time and money? Should I enter/exit?”

Coffee-Shop Startup Example

• Forecasts:
  • Revenue: \$350{,}000
  • Explicit business expenses: \$275{,}000
  • Forgone salary: \$40{,}000
  • Initial capital: \$30{,}000 placed in business instead of a 5 % savings account.
• Calculations:
  • Accounting profit: 350{,}000-275{,}000=\$75{,}000
  • Forgone interest: 0.05\times30{,}000=\$1{,}500
  • Economic profit: 350{,}000-275{,}000-40{,}000-1{,}500=\$33{,}500
• Decision: Enter. You will be \$33{,}500 better off than in your next‐best alternative job/investment.

Concept Check – Mariana’s Ice-Cream Shop

• Forecasted data:
  • Revenue: \$500{,}000
  • Explicit costs: \$340{,}000
  • Current compensation (wage + benefits): \$50{,}000+\$10{,}000=\$60{,}000
  • Capital invested: \$50{,}000 at 3 % bank interest.
• Results:
  • Accounting profit: 500{,}000-340{,}000=\$160{,}000
  • Forgone interest: 0.03\times50{,}000=\$1{,}500
  • Economic profit: 500{,}000-340{,}000-60{,}000-1{,}500=\$98{,}500
• Advice: Launch the business—economic profit is strongly positive.

Average Revenue (AR)

• Definition: Revenue earned per unit of output.
• Formula: \text{AR}=\frac{\text{Total Revenue}}{Q}
• If everyone pays the same price P, then \text{AR}=P.
• The firm’s demand curve doubles as its average‐revenue curve: any point (Q,P) on the demand curve is simultaneously (Q,AR).
• Example: Lemonade stand sells 20 cups at \$0.50 each → \text{AR}=0.50.

Average Cost (AC)

• Definition: Total cost per unit.
• Formula: \text{AC}=\frac{\text{Fixed Cost}+\text{Variable Cost}}{Q}
• Fixed costs (FC): do not vary with output (rent, capital equipment, the owner’s implicit wage/interest).
• Variable costs (VC): do vary with output (ingredients, electricity, labor hours, overtime).
• Average cost = average fixed cost + average variable cost.

Shape of the Average‐Cost Curve

• Typically U-shaped due to two opposing forces:
  1. Spreading of fixed costs
  • FC stays constant → as Q rises, \frac{FC}{Q} falls.
  • Drives AC downward at low output levels.
  1. Rising variable costs
  • Diminishing marginal product, crowding, coordination problems, overtime, higher marginal input prices.
  • Causes AVC (and thus AC) to rise at higher output levels.
• Result: AC first declines, flattens, then rises—giving the textbook U-shape.

Profit Margin per Unit

• Formulae:
  • \text{Profit Margin}=P-AC
  • Equivalently: \text{Profit Margin}=AR-AC
• Graphically: vertical gap between the demand (=AR) curve and the AC curve at a given quantity.
• Rule of thumb: Positive profit whenever the demand (AR) curve lies above the AC curve.

Short Run vs. Long Run

• Short run
  • Production capacity (plant size) fixed.
  • Number & identity of competitors fixed.
  • Managerial focus: choose optimal quantity given today’s price.
• Long run
  • Firms can expand/contract capacity; new firms can enter; existing firms can exit.
  • Managerial focus: investment, entry/exit, or capacity‐planning decisions.
• Time horizon differs by industry—no universal calendar length.

Key Take-Aways on Profit Measurement

• Accounting profit
  • Great for tracking cash flows.
  • Ignores implicit costs.
• Economic profit (the one to use for strategic choices!)
  • Incorporates both explicit and implicit costs.
• Formulas recap:
  • AR=\frac{TR}{Q}=P
  • AC=\frac{FC+VC}{Q}
  • Positive profit whenever AR(=P)>AC.

Entry and Exit Analysis in the Long Run

• Cost-Benefit Principle
  • Enter if benefits exceed costs; exit if costs exceed benefits.
  • Benefits: revenues; Costs: explicit + implicit (opportunity) costs.
• Rational Rule for Entry
  • Enter if P>AC \;\Rightarrow\; \text{Economic Profit}>0.
• Rational Rule for Exit
  • Exit if P<AC \;\Rightarrow\; \text{Economic Profit}<0.
• Across many competitive industries, continuous entry and exit drive long‐run equilibrium toward zero economic profit, where P=AC.

What Happens When Rivals Enter or Exit?

• Rival entry:
  • Your demand curve shifts left (fewer customers) and becomes flatter (more elastic).
    • Smaller quantity sold.
    • Lower price received.
• Rival exit:
  • Your demand curve shifts right and becomes steeper.
    • Larger quantity sold.
    • Higher price received.
• Visualization: after entry—new demand curve lies left/below the old; after exit—new curve lies right/above the old.

Barriers to Entry (Preview)

• Although not detailed in these pages, later sections analyze factors that keep long-run profits positive by preventing rapid imitation/entry:
  • Legal protections (patents, licenses)
  • Control of scarce resources
  • High fixed costs or economies of scale
  • Network effects, brand loyalty, switching costs, etc.