“The Economic Way of Thinking” 11 th Edition

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko

“The Economic Way of Thinking”

11th Edition

Chapter 7:

Profit and

Loss

© 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 59

Chapter 7 Outline

• Introduction

• Wage, Rent and Interest: Incomes Established in Advance by Contract

• Profit: Income That can be Positive or Negative

• Calculating Profit: What Should be Included in Costs?

• Comparing Economic Profit and Accounting Profit


Chapter 7 Outline

• Uncertainty: A Necessary Condition for Profit

• The Entrepreneur

• The Entrepreneur as Residual Claimant

• Where Does the Buck Stop?

• Not-For-Profit Institutions

• Entrepreneurship and the Market Process


Chapter 7 Outline

• Mere Luck?

• Profit and Loss as Coordinating Signals; The Role of Monetary Calculation

• Varieties of Speculation

• Consequences of Entrepreneurial Speculation

• Commodity Speculators and Futures Markets

• Prophets and Losses


Chapter 7 Outline

• Beware of Experts

• Restrictions on Competition

• Competition on Other Fronts

• Competition for the Key Resource

• Competition and Property Rights

• Appendix: Discounting and Present Values


Introduction

“Perhaps no term or concept in economic discussion is used with a more bewildering variety of well-established meanings than profit.”

-Frank Knight


Introduction

• Profit (net revenue)

– Total revenue minus total cost

• To understand the concept of profit, it would be worthwhile to briefly consider the meaning of wage, rent, and interest.


Wage, Rent and Interest

• Wage is the payment to people for their labor service.

• It is typically established by a contractual agreement between a firm owner and a labor supplier.

• The contractual agreement removes uncertainty.



• Rent represents the payment to landlords and others who lease their property, such as tools and machinery.

• Like wage, rent is also contractually established and reduces uncertainty.

• No one would consider wage and rent payments as profit.



• Interest is NOT:

– The price of money– Payment for the use of money

• Interest IS:

– Paid when we borrow– Ratio between what is paid back and what is obtained

now



• Wage, rent and interest are earned income in a market economy.

– Wage rate = price for labor services– Rental rate = price for rental property– Interest rate = price for credit


Profit: Income that can be Positive or Negative

• Profit = 4th form of income in a market economy (after wage, rent and interest)

• Profit = total revenue – total cost

• Profit is also termed Net Revenue

• Negative Profit = Loss


Calculating Profit: What Should be Included in Costs?

• From the perspective of the profit-seeker, wages, rent and interest are costs of production.

• Remember…Profit is generally defined as total revenue – total cost.

• Opportunity Cost Perspective

– When business owners employ resources they own in their business, they will incur an opportunity cost.

– The self employment of these resources does not involve monetary outlays.


Calculating Profit:What Should be Included in Costs?

• What is Profit?

– Opportunity cost of owner’s labor?– Capital?

• Produced goods that are used to produce future goods

• Buildings– Interest?

• Payment for use of money– The foregone income from these self-employed

resources represent costs, not profits.


Comparing Economic Profit and Accounting Profit

• Accountants measure the explicit costs of production.

• These costs flow out of the business and are incurred to produce a good or service.

• Explicit costs from an economic perspective do not capture the total costs of production.



• Economic profits include both explicit and implicit costs.

• Implicit costs arise when business owners take into account the opportunity costs of using resources they own and commit to their businesses.



An example will help illustrate these concepts.

Consider Ann T., who earns $30,000 as a secretary. Suppose she also owns a building that she rents for $6,000 per year, and she has $23,000 in a certificate of deposit that earns 10% ($2,300) per year. These payments represent contracts that Ann has entered. They represent flows of income which reduce uncertainty in her life.



• Now, suppose Ann quits her job and becomes her own boss.

• She opens a pizzeria.

– Uses her own building– Cashes out the $23,000 CD– Borrows $20,000 @ 10%



• 1st year total revenues = $85,000

• 1st year explicit costs = $45,000

– $43,000 hired labor– $ 2,000 loan interest

• Accounting Profit = $45,000



• However, Ann realizes:

– Her own labor is not a free good as she previously earned $30,000

– The building previously earned Ann $6,000– Her CD earned $2,300



• Thus, her implicit costs are:

– $30,000 foregone wages– $ 6,000 foregone rent– $ 2,300 foregone interest– $38,300 total



• Ann’s economic profit is:

– $85,000 total revenue• $45,000 hired labor• $38,300 implicit costs

– $83,300 total cost– $ 1,700 economic profit



• Economists claim that the accounting measure does not fully capture all the opportunity costs of production.

• People should consider the opportunity costs of their choices.

• Economists say that economic profits (and losses) matter.


Uncertainty: A Necessary Condition for Profit

• Business decisions are influenced by the presence or absence of economic profit.

• If accounting profit were guaranteed, the competition would increase and profit would be reduced to zero.

• Uncertainty is needed to sustain the possibility of profit.


Uncertainty: A Necessary Condition for Profit

• The same issues of uncertainty apply to accounting (and economic) losses.

• No one would embark on a business venture if losses were guaranteed.

• Profit (or loss) is the consequence of uncertainty.


The Entrepreneur

• Entrepreneurs

– Try to organize things differently– Believe reorganization (change) will result in revenues

in excess of costs– Have confidence in their foresight– Are the residual claimants


The Entrepreneur as Residual Claimant

• Who gets to be boss?

– The residual claimant is the boss.– They purchase the consent of everyone else on their

team.– They make a deal with them by meeting their terms.– The entrepreneur must offer credible guarantees.


Where Does the Buck Stop?

• Residual Claimants (Owner)

– The only party with an incentive to take into account everything relevant to costs and revenues.

• The “owner” has an incentive to:

– Consider everything relevant to the business.– Predict future events.– Construct a balance of overall gains and losses.– Has the authority to decide.


Where Does the Buck Stop?

• Example

– “What? I can’t have my money back? I want to talk to the owner!”

• Question

– Why talk to the owner?


Not-For-Profit Institutions

• Questions

– What effect does standing in a line have on quantity demanded?

– Why?– When would the seller be motivated to reduce the

length of the line?– Where are the lines longer, at the post office or the

grocery store?


Not-For-Profit Institutions

• Question

– Do nonprofit institutions have residual claimants?

• Without residual claimants

– Firms do not function effectively.– There is little incentive to reduce waste.– The buck stops nowhere.


Entrepreneurship and the Market Process

• Entrepreneurs engage in arbitrage.

– They seek profit opportunities by attempting to buy goods at a low price and sell them at a higher price.

• Profit is the intended consequence of entrepreneurship.

• Entrepreneurship tends to correct for errors in the market place.

• A loss is the unintended consequence of entrepreneurship.


Entrepreneurship and the Market Process

• Entrepreneurs also engage in innovation.

– They discover new cost structures.• New less costly combinations of resources.

– They are trailblazers.– They introduce new organizational strategies.

• Entrepreneurs also engage in the imitation of previous trailblazing entrepreneurs.


Mere Luck?

• Not every entrepreneur enjoys economic profits.

• Is it good luck or bad luck that will be determinate of profit or loss?

• Some may be due to chance

• But orderly market processes would not appear if only luck ruled.


Profit and Loss as Coordinating Signals

• Not every entrepreneur enjoys economic profits.

• Successful entrepreneurs have a comparative advantage in spotting profitable business projects.

• Market prices provide these signals.


Profit and Loss as Coordinating Signals

• The entrepreneur’s calculation of expected profits provides the information to decide to engage in arbitrage or launch a new enterprise.

• Economic profits provide the incentive to act as an entrepreneur.


Varieties of Speculation

• Speculation is trading in the hope of profit from changes in the market price.

• There are many types of speculators:

– Wall Street “Bear”– Commodity Trader– Students – buying education for future gain– Motorists – timing of fuel purchases

• Do speculators / profiteers take advantage?


Consequences of Entrepreneurial Speculation

• Commodity Markets – well organized

– Facilitates buying or selling for futures– Speculators even out the flow of commodities

• Thus, diminishing price fluctuations• And, in turn, reducing risk to others

– Purchasing risk in hopes of profit– This is the speculator’s comparative advantage– Hedgers – sell to reduce their own risk


Commodity Speculators and Futures Markets

• Futures Markets allow people to:

– Allocate their risks– Deal with uncertainty– Risk avoiders – hedgers– Risk takers – speculators

• Accept risk (at an agreed price) that hedgers avoid• Must respect their risk and pay close attention to

the market conditions• Speculators are the distant early warning system


Prophets and Losses

• Speculators provide information for all

• Middlemen coordinate market exchanges across regions

• Speculators coordinate market exchanges through time

– Tend to bring quantity supplied closer to quantity demanded


Beware of Experts

• The key to a robust and efficient market process is:

– Open entry and exit for those who think that they have a comparative advantage in entrepreneurial activity

– If their judgment is correct, they will earn economic profits

– If not, they face economic losses.


Beware of Experts

• Open entry in the marketplace allows potential pioneers to test the claims of previous successful entrepreneurs to act on what they perceive as profitable, wealth generating, opportunities.

– To discover comparative advantages

• Closed markets stifle competition.


Beware of Experts

Entrepreneurship is …

society’s source of change.


Beware of Experts

• Closed Markets

– Stifle competition– Limit knowledge– Decisions as to market issues by lawmakers and

bureaucrats– Beware of experts who have no risk


Restrictions on Competition

• Profit

– A consequence of uncertainty

• Question

– Why do special-interest groups seek protection from uncertainty?

• Question

– Are there costs associated with patent ownership?


Competition on Other Fronts

• When uncertainty disappears:

– Profits are transformed into costs of production– By competitive bidding– It is the value of your foregone opportunity by not

selling



• Question

– How is the price of a “better” mousetrap patent determined?

• Question

– Loss or Profit?• If the interest earned from investing the proceeds

from the sale of the mousetrap patent exceeds the profit you expect to earn if you keep it, it is a profitable investment.



• Question

– Does someone’s offer to buy your patent affect your costs?

• Factors to Consider

– Affect on net revenue– Nominal interest rates on riskless investments– Number of bidders



• When uncertainty disappears, profit gets transformed into costs of production by competitive bidding.

• Question

– How much must the buyer’s revenue increase in order for the purchase of the patent to be profitable?


Competition for the Key Resource

• Question

– Do price supports have any effect on the price of land?

• Questions

– Do licenses affect costs?– Who gains from a new licensing system?

• Examples

– Taxicabs– VHF television broadcast rights


Competition and Property Rights

• Under certainty, competition will eliminate profit.

• Questions

– Will the pursuit of profit lead to:• Better mousetraps or the attempt to prevent others

from selling?• Production of wheat or higher-priced land?• Better taxi service or higher priced licenses?


Competition and Property Rights

• Questions

– Will the pursuit of profit lead to:• Exploration or retrenchment?• Innovations in technology or in social organization?• A wider range of choice or more restrictions on

choice?

• Answer

– Depends upon the rules of the game and the property rights created.


Appendix: Discounting and Present Values

• Value of something expected to be received in 1 year

– Must be discounted by interest rate to determine present value.


Appendix: What a Present Amount Grows To

• At 12 percent per year and with compound interest, $4,000 will become $5,619.71 in 3 years.

• $4,000 * 1.12 * 1.12 * 1.12 = $5,619.71


Appendix:Present Value of Future Amounts

• What present amount will grow to a specified amount in 1 year?

– If the goal is $4,400• $4,400 / 1.12 = $3,928.57


Appendix:Present Value of Annuities

• First, determine the amount expected at the end of each year

• Second, determine the interest rate or discount rate

– Real interest rate + risk rate = discount rate

• Third, determine the present value by using the appropriate table


Once Over Lightly

• Profit = TR – TC

• Accounting Profit uses explicit costs

• Economic Profit uses implicit costs

• Profit arises from uncertainty

• Economic Profit encourages Entrepreneurs

• Entrepreneurship – arbitrage; innovation and limitation


Once Over Lightly

• Uncertainty is a fact of life

• Everyone is a Speculator in a world of uncertainty

• Professional Speculators coordinate markets through time

• Futures Markets allocate risk exposures

• Competition forms are determined by rules of the game


End of Chapter 7

Questions?

“The Economic Way of Thinking” 11 th Edition

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