Why Will a Firm Continue Business When It Is Making Zero Economic Profits?

Introduction

Economic profits can be defined as total revenues – Total opportunity cost or as total revenues less explicit and implicit costs. Then, why will a firm continue business when it is making zero economic profits? The answer to this question will be explored using many avenues. To begin with the main goal of a firm is profit maximization and it is underlying hypothesis of the theory of the firm and production. The goal of the firm is to maximize economic profits, and the firm is expected to try to make the positive difference between total revenues and total costs as large as it can. To derive the economic profit that you might have earned last year from the farm, you must subtract from total revenues the full opportunity cost of all factors of production used.

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Alternative explanations of why a firm can remain in business when these profits are zero can be provided. Let me explore some reasons why a firm remains in business under zero profits. This reasons include; restrictions to entry, innovation, and reward for bearing uninsurable risks.

Barriers/restrictions to Entry: – barrier of entry to an industry and easier exit will give a firm some hope that some companies will exit thus creating profits in the long run.

Innovation: – Economic profits are created by innovation and this can be defined as the creation of a new organizational strategy, a new marketing strategy, or a new product. This means that an innovator creates new economic profit opportunities through innovation. The successful innovator obtains a temporary monopoly position, garnering temporary economic profits. When other firms catch up, those temporary profits disappear.

Example of firms that have economic profits in Vietnam include taxicabs, cable television franchises, and hospitals

Main body

Variable cost, which is directly related to output produced. In the short run if AVC<MC

Cost volume profit analysis examines the behavior of total revenues, total costs, and operating income as changes occur in the output level, the selling price, the variable price per unit and the fixed price of a product. One assumption of this analysis variable cost per units is known and constant. This assumption is ideal and not realistic on ground. Therefore it affects realistic analysis on ground which calls for complex approach with multiple revenue drivers, multiple cost drives, and cost functions that are not linear only if doing so will significantly improve decisions. Always assess whether a simplified Cost volume profit analysis generates sufficiently accurate predictions of how total revenues and total costs behave. One of the Vietnam Company that has variable costs is Hewlett-Packard Vietnam ltd. They produce printers and other related products.

Different people may be charge different prices or different unit prices for successive units sought by a given buyer due to equity. Take an example of a doctor treating two patients from poor background and extremely very rich background. Will be equitable to charge them uniform prices or different prices? Equity answers this question.

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However it must be clear at the outset that charging different prices to different people or for different units that reflect differences in the cost of service to those particular people does not amount to price discrimination. This is Price differentiation: differences in price that reflect differences in marginal cost. Again I must state that a uniform price does not necessarily indicate an absence of price discrimination. Charging all customers the same price when production costs vary by customer is actually a case of price discrimination.

Firstly, the markets must display differences in the price-elasticity of demand for the product. This implies that differences in marginal revenue in different markets are associated with any particular price. Profit maximization in all markets therefore implies variations in price between markets.

Secondly, in order for price discrimination to be effective it must not be possible for purchasers in a ‘cheap’ market to sell the product in a ‘dear’ market; if it is possible, then in the long run the price differential cannot be sustained. Thus, there must be barriers of some kind between markets.

A company from the USA that sells products in the Vietnam market at a price lower than what is charged in USA includes Dell ltd. The main reason is that the elasticity of the dell computers in Vietnam is not the same as in USA.

Industrial growth in Vietnam has followed the ‘industrial cluster’ approach which considers competition and parts of the production chains that helps the firm to gain competitive advantage by locating close to each other and forming industrial clusters. The Vietnamese have placed a lot of emphasis on the development of industrial clusters. The structures are determined by the concentration of the firms in the industry, the barriers to entry that area available and branding that is used.

The performance of these industries depended mostly on the activities undertaken by firms in the same industry such as promotional approach, product mix, marketing mix, investment strategies, mergers undertaken and research and development. These activities are evaluated through performance measurement. Performance is evaluated through checking of the price and it was accepted in the market. The activities are measured through how efficient is the production action. The performance of the activities is also measured quality of the product and profitability of the product.

Vietnam has laid emphasis on capital formation, labour skill enhancement, upgrading industrial structure, technology transfer, technology spill over, and improved capability for international trade. Vietnam today manufactures most of the items that are consumed locally. There is no doubt that the low cost of goods and labour has helped attract industry ranging from furniture making to electronic components manufacturing indicating the ability and willingness of the Vietnamese people to adopt and adapt to new technologies. The open-door policies and other economic reforms have reduced tariff barriers, which has encouraged the structure of the industries in Vietnam.

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Moral hazard whereby individuals do not face the exact consequence of their resolutions to reconstruct or go without getting insurance because they are aware that in the event of an occurrence of a disaster, the government would automatically step in. Moral hazard problems can be solved by making employees the outstanding claimants on their endeavor. If persons own all their production, they will competently match the subsidiary benefits of their efforts to the subsidiary cost. In the case of Sri-Lanka a moral hazard was the destruction of the roads while in other places buildings were destroyed. The usage of funds to rebuild the roads at percentage of the cost of reconstruction is solving a moral hazard.

Rebuilding decisions should not just be geared towards reduction of future disaster risks but should also be aimed at meeting the day to day social and environmental requirements of the communities that have been affected. Relevant mechanisms need to be developed at the local levels to ensure articulate what directly affect them so that they participate fully in decision making processes. The government can achieve this through collection of primary information from the community members so as to determine a proper way of action. And as reconstruction takes place, there is always the need for an intensive dialogue within the habitation level. Coordination within the civil society groups together with the local government is likely to facilitate the process. An all-inclusive public awareness and well coordinated information programs are desirable in the development of a wider understanding of risk mitigation decisions. The government of Vietnam uses cost plus contracts especially in the construction sector. This helps in keeping infrastructure safe and smooth.

In determining optimal capital structure various factors such as the cost of equity, cost of debt, growth prospects of the company and nature business. Apart from the above mentioned factors the market and other macroeconomic factors play an important role in determining the optimal capital. The nature of its business also determines the optimal capital structure and how operations of the company run. If the economy is scaring the majority of the population in regards to their job security, then it is only reasonable that these people will cut down on their discretionary spending on some products this will increase in financing assets of the company. Another added factor is the interconnection between the industries that are affected by the inflation and economic recession.

The optimal capital structure is that mixtures of capital, that is debt and equity, which at the maximum debt the company can get without affecting the future continuity and the cost of capital is minimized. The main objective at the optimal capital structure is maximizing the shareholders wealth and at this point, the liquidity and the risky of technical default should be avoided. Therefore businesses take into account of such factors as levels of interest rates, tax advantages of loan interest relative to dividends, and the stability of their operating cash flows to decide on an optimal mix of financing methods, which they then try to establish and maintain. Such targets are not, presumably, established for all time; changes in interest rates, tax rules may cause a change to a new target, which may then rule for several years.

These factors makes demand of various sources of capital be similar to that of ordinary demand. If the company requires debt capital it will be demanded thus it will be supplied by market at the interest rate that is suitable.

Moving average is the average that is calculated on a time series while exponential is not on time series. The term moving average is used to explain this procedure of averages where each average is computed by dropping the first observation in the bunch and including the next observation till the end. The averaging ‘moves’ through the time series until the final elements is computed at each observation for which all elements of the average are available. The number of data points for each average remains constant although variations on moving averages allow the number of points in each average to change. Moving averages are used to smooth a time series data in order to estimate or highlight the underlying trend while weighted moving averages are used as simple forecasting methods for time series data. Moving averages often form the building blocks for more complicated methods of time series smoothing, decomposition and forecasting. The smoothed data appear like smoother in curve than the original data. The shape of the graph is the same in the three scenarios but the mean of the scenarios is different. The 3 cantered moving averages are higher than the 3 moving averages. The 3 moving averages and the 4 moving averages are not much different.

Companies prefer moving average in considering prices movements. It uses time series and linear parameters. Most companies prefer this method because it uses most current data. It is also easier to compute and understand. It is easier to capture the trend of the data used as the values are almost equal. This trend has been done using moving average.

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Marginal products of labor are the change in output resulting from the addition of one more worker to the production system. The marginal product of labor for each employee is the change in total output due to hiring the extra worker while or other factors of production are held constant. The following table shows the marginal product of labor for each level of employment.

If the union demands a real wage rate of $ 5 per hour then the real employment will be

For nominal wage rate 5 and new technology

Number of workers Units of output MPN rental Value of marginal product of labour($) Nominal wage rate($) Marginal product ($)
0 0
20 60 60 10 420 5 294
40 105 45 10 315 5 189
60 135 30 10 210 5 84
80 160 25 10 175 5 49
100 179 19 10 75 5 100
120 195 16 10 112 5 -14
140 208 13 10 91 5 -35

The company is making the right decision.

The demand for labor or ay other variable input is derived from the demand for the final product. The marginal revenue product is equal to marginal physical product time’s marginal revenue. Therefore any change in the price of the final product will change MRP. This happened when we derived the market demand for labor.

A change in labor productivity will shift the market labor demand curve in the same direction.

Conclusion

The demand for labor in America is, other things held constant, greater, conversely, labor is relatively scarcer in the United States than it is in many other countries. One result of relatively greater demand and relatively smaller supply is a relatively higher wage rate.

It is argued that a firm reaches its most efficient size when its cost of production per unit of output is lowest; such a firm is said to have reached its optimum size. At that size there will be no motive for further expansion, for at any other size, either larger or smaller, it would be less efficient.

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