If you are a regular news watcher, you will be familiar with
the idea of businesses reporting their profits (or loss) for past periods. One
intriguing result of such reports is that some firms will report a loss for the
past period or sometimes consecutive periods, but will still not shut down
rather than incur loss. I think its worth pointing out what we mean by a loss;
A loss in business is a negative profit, a situation where a business spends more
than it earns (expenses are greater than revenues), which means the extra
expenses is financed from some where else, perhaps from savings or a loan.
So why don’t businesses just shut down when they are making a
loss and make zero profits rather than operating at a loss? One obvious answer
might be prospective profits; that firms operate believing that the loss is for
short-term and that the future is bright, however a seconds thought will tell
you that if this was the case, then all firms in same industry will pretty much
stay operating if they are making a loss, but this is not the case, In fact
even firms in same industry quit at different time periods if they continue
incurring losses.
It turns out that Variable costs are the determinants of
exit decisions for firms. Costs in business are divided into two; fixed and
variable costs. Fixed costs are costs that are fixed, regardless of the level
of production, e.g. rent, which you pay whether you produce a single unit or
nothing, Variable costs are costs that directly vary with output, e.g. wages
and raw materials cost, this costs changes as the level of output changes.
When firms make decisions about whether to stay in business
or shut-down, they only consider their variable cost’s and ignore the fixed
costs. Here is why you see some firms making a loss but still stay in business
in the short-run; If a firm is making a loss, but it’s profits are more than
it’s variable cost’s, then the firm is better off operating at that loss level
than shutting down, on the other hand if a firm is making a loss that it’s
profits are less than it’s variable cost, then the firm is better-off by
totally shutting down. The technique behind the analysis here is the fact that
firms have to pay the fixed cost in the short run regardless of either they
produce or shut down, so if they shutdown their business in the short-run they
make a loss equal to their fixed cost, now if they are making a profit that is
more than their variable cost, then they can pay the difference towards
reducing their fixed cost (which they would have to pay for in full otherwise).
Here is the trick, firms pay their fixed cost regardless of whether they
produce or not, so it makes business sense when ever a business is making a
profit more than its variable cost to stay operating in order to minimise lost.
The idea of firm decision making is better explained with an
example; consider a Sole trader who operates’s a convenient store in downtown
New York with the following costs;
One year property lease @ $2000/month
Wages of two employees @ $1500/month each
If the traders monthly revenues are $4000
Then the Traders monthly profit/loss statement will be as
follows:
Total Revenue
|
4000
|
Minus Expenses:
|
|
Variable Costs:
|
|
Wages employee A
|
1500
|
Wages employee B
|
1500
|
Profit
Before Fixed Cost
|
1000
|
Less Fixed Cost:
|
|
Rent
|
2000
|
Net
Profit:
|
-1000
|
Now this trader is definitely making a monthly loss of
$1000, the interesting question is should s/he shut down? And the answer is no!
The trader should operate at a loss of $1000 in the short run. If he chose to
shut down, here is what is going to happen, he will be paying the rent of $2000 because this is
fixed regardless of whether he sell or not, remember he signed a one year lease
contract, normally businesses pay their rent in advance. However the firm should just shut
down anytime the revenue goes below $3000, because his profit won’t even cover
his variable cost, it’s left to the reader to change the total revenue to any
amount less than $3000 and observe what happen to the profit/loss at that level.
At any level of total revenue less than $3000 the trader will be making a loss
more than his rent of $2000/ month, hence it’s better for him to stop trading
and only pay the rent in the short run than incur a cost more than $2000 when
he could do better.
It’s due to this reason that you see that some firms leave
the industry so quick once loss hits whiles others in same industry continue
operating while still making a loss. The nature of a firms cost determines when
to exit the business and this is at any point where profit is less than
variable cost.
I have be talking about short-term all along this article,
but what do I actually mean by short-term? In economics short term is referred
to as the time period within which at least one input of production is fixed
and cannot be changed (In order words no specific time period attached to it).
These is a very important definition with regards to firms exit decisions,
because once all inputs are variable and can be changed, then it doesn’t make
any sense for a firm to operate a
business at a continuous loss. Let’s revisit our previous sole trader example,
if this guy can re-transfer his Lease (re-rent) to a third party, then it is no
more a fixed cost and then he will be better off by just shutting down and make
zero profits, however in general we don’t expect such processes to be very
immediate, hence the name short-term.
If firms are making a loss, but their revenue is greater
than their Variable cost, they will continue to operate until they can get rid
of their fixed cost, this take different times for different firms, since every
firm have different cost structures, that’s why we witness the shut down of
Blockbuster happened so quick when sales
dwindle.
“An Economist is a man who states the obvious in terms of the
incomprehensible”
Alfred A Knopf.
Spot on with this write-up, I seriusly feedl this website needs a
ReplyDeletegreat deal more attention. I'll probably be returning tto read
more, thanks for the info!
My web-site: wweb page - -
it is so helpful.
ReplyDeletegood read! helps me to understand better :)
ReplyDeleteThat's great stuff neh
ReplyDeleteindeed bro
DeleteGood article
ReplyDeleteThanks but is that all
ReplyDeleteSome truly wonderful work on behalf of the owner of this internet site , perfectly great articles . Brasa Capital Management
ReplyDelete🙏🏼
ReplyDeleteVery clear, thank you.
ReplyDelete