Economics Concepts I - JRM

1. Economics Concepts:
• Accounting Profit and Economic Profit
• Marginalism
• Absolute and Competitive advantage
From:
Jay R Modi
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2. #1 Contrast the concepts of “accounting profit” and “economic profit.”
Explain how a mis-reading of accounting profit can lead a firm to
overestimate its profitability. Explain why an economic agent earning a
positive level of economic profit would indicate that the agent is earning a
superior return on its assets.
In economics, a firm is said to be making a normal profit when total
revenues equal total costs. Profit generally is the making of gain in
business activity for the benefit of the owners of the business. The word
comes from Latin meaning "to make progress", is defined in two different
ways, one for economics and one for accounting.
Accounting profit is defined as total revenue (sales) minus accounting
(explicit) costs i.e. monetary payments (or cash expenditures) made to
supply labor services, materials, fuel, transportation services,
depreciation, interest and taxes. For example, if a company invest
$50,000 to start a business and earned $60,000 in profit, than its
accounting profit would be $10,000. Accounting profits tend to be higher
than economic profits as they omit certain implicit costs, such as
opportunity costs
An Economic profit arises when the company’s revenue exceeds the
total (opportunity) cost of its inputs. A positive economic profit indicates
that book value is increasing which over time will yield a positive
shareholder value.
Misreading of accounting profit can lead a firm to overestimate its
profitability because accounting profits doesn’t take into consideration a
firm’s implicit costs such as opportunity costs i.e. the cost of an
alternative that must be forgone in order to pursue a certain action. To
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3. the firm, implicit costs are those cost that are represented by lost
opportunity in the use of a company's own resources, excluding cash.
Economic agent earning a positive level of economic profit is an
indication that agent is earning superior return on its assets because
total cost i.e. both explicit and implicit costs covered by the total
revenue. If a company covers only explicit costs than it can be said that
the company is earning normal profit but if a company covers explicit
cost along with the implicit cost than it can be said that it is making
economic profit and earning a superior return on its assets.
#2 Explain the concept of “Marginalism.” Explain how economists use
marginalism as a decision-making paradigm.
MARGINALISM is the decision-making of forward and not backward
process. Each decision has a corresponding benefit (marginal benefit)
and it has corresponding cost (marginal cost)
The best way to understand the concept of Marginalism is by
understanding it in terms of Marginal benefit and Marginal cost.
Marginal benefit (MB) is the benefit a consumer or user gets after
consuming the next unit of same activity or commodity. Marginal cost
(MC) is the cost associated with the next unit of the same activity.
Economists can use Marginalism as a decision-making paradigm in
following two ways:
If the marginal benefit exceeds the marginal cost than the activity should
be undertaken.
MB > MC--- Undertake the Activity
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4. If the marginal costs exceeds the marginal benefit than the activity
should not be undertaken.
MB > MC--- Undertake the Activity
#3 Social Security is a program that has the effect of redistributing
wealth from income earners to older Americans who for the most part
have retired. Explain why such redistribution might not be seen by
economist as an improvement in economic efficiency
Economic efficiency can be defined as the degree to which the given
amounts of inputs are used to produce the maximum output. In other
words, economic efficiency in economics terms means, ‘‘efficient
distribution’’ i.e. obtaining maximum output out of the least input. When
a wealth is redistributed from income earners to old Americans who are
retired and cannot add value to the economic system, it leads to
economic in-efficiency. There are two reasons for the same:
• Full utilization of resources by the society as by doing this, all the
employed resources will be used by the society to provide the
maximum possible satisfaction of redistributing the wealth, and
• Expectation of decrease in the gap between income earners and old
Americans, as in the future there will be equal number of income
earners and old Americans.
#4 Explain and contrast the concepts of absolute advantage and
comparative advantage. Which of these concepts is the determining
factor in the establishment of trade flows among countries? Explain
Absolute Advantage means the ability of a country, individual, company
or region to produce a good or service at a lower cost per unit than the
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5. cost at which any other entity produces that good or service. For
example; Zambia, the country has an absolute advantage over many
countries in the production of copper
Comparative Advantage means the ability of a country, individual,
company or region to produce a good or service at a lower opportunity
cost than the cost at which any other entity produces that good or
service.
In establishment of a trade flows among two countries comparative
advantage is the determining factor. It can be understood with the help
of following example.
30 China Production possibility
W
H
E 20 Japan
E
T
20 30
RICE
If we look at the above example, we will find that China has absolute
advantage in the production of wheat as it can produce wheat at less
cost than Japan and Japan has the absolute advantage in the
production of rice as it can produce rice at less cost than China.
But if we consider the opportunity cost of China producing one more unit
of wheat, half a unit of rice has been foregone. When Japan produces one
more unit of wheat, two units of rice are foregone. Economics is
concerned with the allocation of scarce resources. Fewer resources are
foregone if China concentrates its resources in the production of maize
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6. and if Japan specializes in the production of rice. Therefore we can
conclude that,
China has a Comparative advantage in the production of Wheat, and
Japan has a Comparative advantage in the production of Rice
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