The Quest for Profit and the Invisible Hand

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The Quest for Profit and the Invisible Hand
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• Whats the goal of running business???
• --------Profit!!!

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Three Types of Profit

• Accounting Profit total revenue explicit
  costs (payments
  for factors
• of production)
• Economic Profit total revenue explicit costs
  implicit costs
• (Excess Profit) (opportunity cost of
  the resources supplied by the
  firms owners)
• Normal Profit accounting profit economic
  profit(Implicit Costs)

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• Which of the following is an example of implicit
  costs? (1) Wages paid to workers.(2)
  Interest income of the owner for the fund
  invested in the firm.(3) Salaries paid to
  supervisors. (4) Fees paid for maintenance of
  the firms website.

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• Which of the following is NOT an example of
  implicit costs?(1) The return stockholders
  could have earned with another company.(2)
  The fees the firm could have earned from
  leasing its computers. (3) The revenue the firm
  could have collected from selling its
  furniture. (4) The salary of the CEO that could
  have saved.

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An Example Calculating Profits

• Suppose a firm has the following
• Total Revenue (TR) 400,000/yr
• Explicit costs (e.g., salaries) 250,000/yr
• Machinery and other equipment with a resale
  value 1 million
• assume annual interest on savings 10.
• Then, the 1 million spent on equipment could
  have earned 100,000/yr had it been invested.
  (opportunity cost)

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• TR 400,000/yr
• Explicit costs 250,000/yr
• Opportunity Cost on Capital 100,000/yr

• Accounting Profit 400,000(TR) - 250,000
  (explicit costs) 150,000
• Economic Profit (excess profit )(400,000 (TR) -
  250,000 (explicit cost)
• - 100,000 (implicit cost)
• 50,000
• Normal Profit (implicit cost )
• Accounting Profit (150,000/yr)
• Economic Profit (50,000/yr)
• 100,000/yr
• reward to the owners resources in this
  example capital

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Graphically Speaking The Difference
BetweenAccounting Profit and Economic Profit
(excess profit)
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• Economic profits are(1) the same as accounting
  profits.(2) greater than accounting
  profits.(3) equal to total revenue minus the
  sum of fixed and explicit variable
  costs.(4) equal to total revenue minus both
  explicit and implicit costs.

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Why are the distinctions important?

• Example Should John stay in the farming
  business?
• Assumptions
• He is a corn farmer with payments for land and
  equipment 10,000/yr (explicit cost) land
  rent 6,000, equipment lease 4,000
• He supplies only his labor which he values
  equally to managing a retail store for 11,000/yr
  (implicit cost)
• (Note Except for pay, he is indifferent between
  farming or tending stores.)
• Corn sells at a constant price and TR 22,000
• Lets calculate his profits from the farming
  business.

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Revenue, Costs, and Profit Summary for John
Total Explicit Implicit Accounting Economic Norma
l revenue costs costs profit profit profit (/ye
ar) (/year) (/year) (/year) (/year) (/year)
22,000 10,000 11,000 12,000 1,000 11,000
Question Should Pudge stay farming? After
accounting for his normal profit (i.e., reward
for his labor/entrepreneurship), is there money
left? Note The question is not should Pudge
shutdown or produce a positive amount.
Rather, we are asking the long-run question of
should he exit or not. He should stay
farming if his economic profit (excess profit) is
zero or positive.
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What would Johns economic profit be if TR
20,000
Total Explicit Implicit Accounting Economic
Normal revenue costs costs profit
profit profit (/year) (/year) (/y
ear) (/year) (/year)
(/year)
20,000 10,000 11,000 10,000 -1,000 11,000
Question Should Pudge stay farming? If the
economic profit is negative, then the revenue is
not high enough to give him fully his rightfully
deserved normal profit of 11,000. As such, he
should consider exiting.
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• If John owned his own land, would it be a
  different story? Would it be easier for him to
  reach the decision in favor of staying in
  farming?
• Assume
• John inherits the land from old John
• The land can be rented out for 6,000/yr

Question Should John keep on farming?
Would the decision be any different from the
previous situation?
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The Central Role of Economic Profit Recap

• Accounting Profit TR explicit costs
• Economic Profit TR explicit costs - implicit
  costs
• To remain in business in the long run, economic
  profits must be greater than or equal to zero.
  (Why is zero o.k.?)

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• If economic profits are negative but accounting
  profits are positive, then(1) accounting
  profits are less than implicit costs.(2) total
  revenues are greater than the sum of explicit
  and implicit costs.(3) normal profits are zero.
  (4) explicit costs exceed total revenues.