“The Economic
Way of Thinking”
11th Edition
© 2006 Prentice Hall Business Publishing
Chapter 7:
Profit and
The Economic Way of Thinking, 11/e
Loss
Heyne/Boettke/Prychitko
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
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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
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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
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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
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Introduction
“Perhaps no term or concept in economic
discussion is used with a more bewildering
variety of well-established meanings than
profit.”
-Frank Knight
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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.
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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.
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Wage, Rent and Interest
• 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.
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Wage, Rent and Interest
• 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
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Wage, Rent and Interest
• 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
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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
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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.
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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.
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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.
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Comparing Economic Profit and
Accounting Profit
• 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.
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Comparing Economic Profit and
Accounting Profit
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.
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Comparing Economic Profit and
Accounting Profit
• 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%
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Comparing Economic Profit and
Accounting Profit
• 1st year total revenues = $85,000
• 1st year explicit costs = $45,000
– $43,000 hired labor
– $ 2,000 loan interest
• Accounting Profit = $45,000
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Comparing Economic Profit and
Accounting Profit
• 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
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Comparing Economic Profit and
Accounting Profit
• Thus, her implicit costs are:
–
–
–
–
$30,000 foregone wages
$ 6,000 foregone rent
$ 2,300 foregone interest
$38,300 total
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Comparing Economic Profit and
Accounting Profit
• 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
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Comparing Economic Profit and
Accounting 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.
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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.
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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.
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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
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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.
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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.
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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?
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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?
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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.
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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.
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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.
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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.
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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.
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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.
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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?
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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
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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
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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
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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.
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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.
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Beware of Experts
Entrepreneurship is …
society’s source of change.
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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
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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?
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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
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Competition on Other Fronts
• 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.
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Competition on Other Fronts
• 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
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Competition on Other Fronts
• 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?
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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
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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?
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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.
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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.
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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
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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
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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
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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
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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
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End of Chapter 7
Questions?
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