[...] profit is necessary to stay in business in the long run; positive [...] profit is not.
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Open it Normal profit is necessary to stay in business in the long run; positive economic profit is not.
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2. OBJECTIVES OF THE FIRM quence, the spot price has dramatically increased by 44.3 percent. Economic rent has resulted from this market relationship of a relatively fixed supply of gold and a rising demand for it.
<span>2.2. Comparison of Profit Measures
All three types of profit are interconnected because, according to Equation 4, accounting profit is the summation of normal and economic profit. In the short run, the normal profit rate is relatively stable, which makes accounting and economic profit the two variable terms in the profit equation. Over the longer term, all three types of profit are variable, where the normal profit rate can change according to investment returns across firms in the industry.
Normal profit is necessary to stay in business in the long run; positive economic profit is not. A business can survive indefinitely by just making the normal profit return for investors. Failing to earn normal profits over the long run has a debilitating impact on the firm’s ability to access capital and to function properly as a business enterprise. Consequentially, the market value of equity and shareholders’ wealth deteriorates whenever risk to achieving normal profit materializes and the firm fails to reward investors for their risk exposure and for the opportunity cost of their equity capital.
To summarize, the ultimate goal of analyzing the different types of profit is to determine how their relationships to one another influence the firm’s market value of equity. Exhibit 2 compares accounting, normal, and economic profits in terms of how a firm’s market value of equity is impacted by the relationships among the three types of profit.
Exhibit 2. Relationship of Accounting, Normal, and Economic Profit to Equity Value
Relationship between Accounting Profit and Normal Profit Economic Profit Firm’s Market Value of Equity Accounting profit > Normal profit Economic profit > 0 and firm is able to protect economic profit over the long run Positive effect Accounting profit = Normal profit Economic profit = 0 No effect Accounting profit < Normal profit Economic profit < 0
implies economic loss Negative effect
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