End of Chapter in Chapter 15 Entry, Exit, and Long-Run Profitability

Key Concepts

Discussion and Review Questions

Learning Objective 15.1 Assess your business’s economic profitability.

What does the decision to start a business have in common with the decision to attend college? Beyond the explicit financial costs, what are the implicit opportunity costs that you need to account for when making each decision?
Lukia is thinking of quitting her job as TV news editor to start her own business as a freelancer, editing video for media organizations from her home studio. Describe how her accounting profit would be different than her economic profit. How should her analysis of her economic profit (or lack thereof) impact her decision to start her business?

Learning Objective 15.2 Forecast how new entrants will change long-run prices and profitability in your market.

Petra’s private equity firm is considering investing in a highly profitable local CrossFit gym. However, after researching the local gym market, she expects rival gyms to easily enter and exit the industry in the long run. How should she explain to her partners why this leads her to expect that in the long run, the gym’s economic profits will decline to zero.

Learning Objective 15.3 Learn strategies to deter new entrants from competing away your profits.

Half a century ago, foreign banks were prohibited from operating in Britain unless they had an office that was within walking distance of the Bank of England, which served as the industry’s regulator at the time. How would this requirement serve as a barrier to entry into the banking industry in Britain?
For each of the following, briefly explain how it can create a cost advantage for a business.
1. Learning by doing
2. Mass production
3. Research and development

Study Problems

Learning Objective 15.1 Assess your business’s economic profitability.

Joshua owns a small tech start-up that does data analysis for school districts around the country. Which of the following would be included in calculating his business’s accounting profit?
1. He hires several analysts, each of whom is paid an annual salary.
2. He uses his own time to manage the day-to-day operations of the business.
3. His business operates out of a loft space in a building that Joshua owns. He could lease the building to another firm for $100,000 per year.
4. Joshua invested $200,000 to start the business. That money could have generated an additional $20,000 over the past year if Joshua had instead invested the $200,000 in the stock market.
You are considering opening a small flower store. You anticipate that you will earn $100,000 each year in revenue. It will cost you $30,000 each year to rent the space necessary to run your business. Additionally, you will need to spend $10,000 each year buying wholesale flowers, and paying your utilities and other expenses necessary to operate your flower shop. You have just graduated from college with a degree in economics and have received an offer to work for a firm with a yearly salary of $70,000. Should you open the flower store?
A year ago, Shani graduated from college and decided to open her own software company. Over the past year, her start-up has generated $500,000 worth of revenue. She hired two software engineers and paid each of them $150,000 over the past year. She also purchased web-hosting services that cost a total of $30,000. In order to save money, Shani decided to run the business out of the basement of her house. Previously, she had rented this space out to a tenant for $6,000 per year. Instead of opening her own business, she could have gone to work for Microsoft and earned $200,000 over the past year.
1. How much were the accounting profits for Shani’s business over the past year?
2. How much were her economic profits over the past year?
3. Given this information, should Shani have launched her own business?
Lakisha is a professor of economics. She is currently earning $100,000 a year as a professor. She decides to quit her job as a professor and opens a consulting business. In order to do this, she cashes out her retirement fund of $200,000. Her retirement fund has been earning 10% interest each year. At the end of her first year as an economic consultant, she earns $120,000 in accounting profit. What was her economic profit for the year?
Determine if each of the following costs would be included when calculating accounting profit, economic profit, or both.
1. Anna, the owner of a local bike repair shop, uses her time to operate her business instead of accepting an annual salary of $100,000 at Ford Motor Company.
2. Nordstrom pays $50 per square foot to lease space in a shopping mall.
3. In 2018 Amazon opened its new office building in downtown Seattle. Instead of using the new office space itself, Amazon could have rented out the space to local companies for $250,000 per floor per year.
4. In 2018, Boeing paid its Washington State employees nearly $600 million in bonuses.

Learning Objective 15.2 Forecast how new entrants will change long-run prices and profitability in your market.

You run a small but profitable accounting business with many local clients. When you opened your business, there were very few competitors in your area, but you’ve recently learned that several new businesses providing similar services will be entering the market soon.
1. Use a graph to illustrate the impact on your firm’s demand curve when rival businesses enter the market and explain the causes of the change in demand drawn on your graph.
2. Suppose instead you learn that most existing businesses in this market are experiencing negative economic profit. How would your answer to this question change?
3. As a result of rival businesses entering the market, your annual revenue becomes $300,000 and your annual out-of-pocket expenses become $270,000. What is your business’s accounting profits? What additional information do you need to determine economic profit?
Lindsay owns PupUp, a small shop that sells gourmet dog treats from kiosks located in Cleveland-area shopping centers. She is considering expanding her business into Akron and Toledo. The graph below shows the average costs for each kiosk, along with a demand curve for each location.

Four lines are plotted on the graph. The first line, labeled Cleveland’s demand has a negative slope and extends from (400, 6) to (1800, 3). The second line labeled Akron’s demand has a negative slope and extends from (30, 3.2) to (1400, 2.8). The third line labeled Toledo’s demand has a negative slope and extends from (20, 2.8) to (1500, 1.7). The fourth line labeled Average cost starts at (100, 4), slightly slopes down to intersect Akron’s demand line at a point, and slopes up to terminate by passing through a point on Cleveland’s demand line. All data are approximate.
1. Does the demand curve for the Cleveland kiosk indicate that Lindsay earns positive, negative, or zero economic profits? In the long run would you expect other businesses to enter the Cleveland market, exit the market, or neither?
2. Does the demand curve for Akron indicate positive, negative, or zero economic profits? In the long run would you expect other businesses to enter the Akron market, exit, or neither?
3. Does the demand curve in Toledo suggest positive, negative, or zero economic profits? In the long run would you expect other businesses to enter the Toledo market, exit, or neither?
The market for lattes in your town is shown below.

Two lines are plotted on the graph. The first line, labeled Demand has a uniform negative slope and extends from (0, 5) to (2700, 0.5). The second line, labeled Average cost starts at (350, 3.8), slopes slightly downward, then slopes up to terminate by passing through the Average cost line at (1300, 2). All data are approximate.
1. If a coffeehouse charges $4 for a latte, what is its per-unit profit margin on each latte sold? Calculate the profit margin and label it on the graph.
2. Assuming free entry and exit, do you expect more coffeehouses to enter or exit in this market? Why?

Learning Objective 15.3 Learn strategies to deter new entrants from competing away your profits.

As an investor, you’ll want to invest only in businesses that are likely to be profitable in the long run. Assess the barriers to entry in each of these markets, with an eye to forecasting whether they’ll yield positive economic profits in the long run.
1. The market for lawn-care services
2. The market for wireless telecommunications, such as mobile phone service
3. The market for sport-utility vehicles
4. The market for generic aspirin
For each of following scenarios, identify whether it is an example of a demand-side, supply-side, regulatory, or deterrence strategy to limit competition in the market.
1. Delta Airlines provides frequent flyer miles to members when they travel. These miles can be redeemed for travel and upgrades on Delta flights.
2. Toyota, Ford, and General Motors have invested in large manufacturing plants that help them efficiently produce millions of cars each year.
3. The top-selling pharmaceutical drug in the world in 2017 was Humira, which is used to treat rheumatoid arthritis. Abbvie has a patent for Humira.
4. Between 2015 and 2018, Facebook had increased the number of active monthly users from 1.4 billion to 2.19 billion.
For each of the following strategies used by Microsoft to limit competition, identify whether it is a demand-side strategy, a supply-side strategy, or a deterrence strategy.
1. In 2018, more than 80% of all desktop PCs worldwide used the Microsoft Windows operating system.
2. Microsoft spends a large amount of resources to attract independent software developers to write programs and applications for its operating system.
3. Microsoft was charging an average price of $40 to $60 for its operating system to PC hardware companies such as Dell and HP instead of the monopoly profit-maximizing price of $1,800.