Question

As you consider small "Mom and Pop firms" like inner city grocery stores, or small family owned restaurants, they often do not earn economic profits. How can this be explained? How and why might the decision be different in the short-run versus the long-run? Why is it important for a business to understand the different aspects of their production costs (fixed, variable, averages, and marginal) along with with the overall cost structure?

Answer 1

Accounting profits are calculated as:
Accounting profits = Total revenue- Explicit costs.

Economic profits are calculated as:

Economic profits = Total revenue - (Explicit costs + Implicit costs)

As you can see, the difference between the two arises from implicit costs. What are implicit costs? They are defined as the opportunity cost of using the resources already owned by the firm. In this case, they include salary of the shop owners which they would have earned had they worked in a salaried job instead of running the business. They can also include leisure time which the owners would have got, if they had to work for lesser hours in the salaried job instead of running the business. Often, small business owners are unable to earn economic profits as such small businesses don't have the advantage of large businesses, that is economies of scale, economies of scope, etc. Setting up a small business requires time and cumulative efforts and this can be another reason that initially, such firms don't earn economic profits.

Over the long run, in perfectly competitive markets, all firms tend to have zero economic profits. This is because if an industry is profitable, more firms enter it in the long run and thus reduce economic profits- till they become zero, at which point new firms don't enter the market. In the long run, small businesses too can face such a situation, or they can adapt to the market better and continue making economic profits by doing product differentiation and being better than their competitions.

A business needs to understand the different aspects of their production costs, as each of them gives them different insights about their profitability. Fixed costs are important whenever the business has to be set up or expanded, and usually make up for the largest proportion of the total costs. Variable costs can have a significant impact on operational profits, hence they need to be looked at separately. Marginal costs tell a firm at what point should they produce goods such that they'll maximise profits. Average costs help in calculating the total profits by comparing them with average revenue.