1. Chapter 22 – Rents, Profits and the Financial Environment of Business
Understand the concept of economic rent
Distinguish among the main organizational forms of business and explain the chief advantages and disadvantages of each
Explain the difference between accounting profits and economic profits

2. Chapter 22 – Rents, Profits and the Financial Environment of Business
Discuss how the interest rate plays a key role in allocating resources
Calculate the present discounted value of a payment to be received at a future date
Identify the three main sources of corporate funds and differentiate between stocks and bonds

3. Did You Know That . . .
There are almost 800,000 nonprofit organizations in the United States?
There are nearly 28 million profit-seeking businesses in the United States?
These businesses are financed and organized very differently?

4. Economic Rent Economic Rent
A payment for the use of any resource over and above its opportunity cost.
The amount of money an owner of a factor of production must receive in order for that owner to rent out that factor of production.
Factors of production include labor, capital and land.
Thus, rent has a different meaning in economics.

5. Economic Rent

6. Economic Rent Economic rent to labor Professional sports superstars
Rock stars
Movie stars
World-class models
Successful inventors and innovators

7. Economic Rent
Apply the definition of economic rent to the phenomenal earnings these people make.
They would undoubtedly work for considerably less than they earn.
Much of their rent occurs because specific resources cannot be replicated exactly.
No one can duplicate today’s most highly paid entertainment figures.

8. Example: Do Entertainment Superstars Make Super Economic Rents?
Superstars certainly do well financially.
Forbes magazine has ranked them.
How much of these earnings can be called economic rent?

9. Superstar Earnings

10. Firms and Profits
Firms or businesses, like individuals, seek to earn the highest possible returns.
A firm brings together the factors of production to produce a product or service it hopes can be sold at a profit.

11. Firms and Profits
Firm
A business organization that employs resources to produce goods or services for profit
A firm normally owns and operates at least one “plant” or facility in order to produce.

12. Firms and Profits The legal organization of firms Proprietorship
Partnership
Corporation

13. Forms of Business Organization

14. The Legal Organization of Firms
Proprietorship
A business owned by one individual who
Makes the business decisions
Receives all the profits
Is legally responsible for all the debts of the firm

15. The Legal Organization of Firms
Advantages of proprietorships
Easy to form and dissolve
All decision-making power resides with the sole proprietor
Profit is taxed only once

16. The Legal Organization of Firms
Disadvantages of proprietorships
Unlimited Liability
The owner of the firm is personally responsible for all of the firm’s debts.
Limited ability to raise funds
Proprietorship normally ends with the death of the proprietor.

17. The Legal Organization of Firms
Partnership
A business owned and managed by two or more co-owners, or partners, who
Share the responsibilities and the profits of the firm
Are individually liable for all the debts of the partnership

18. The Legal Organization of Firms
Advantages of partnerships
Easy to form and dissolve
Partners retain decision-making power
Permits more effective specialization
Profit is taxed only once

19. The Legal Organization of Firms
Disadvantages of partnerships
Unlimited liability
Decision making more costly
Dissolution often occurs when a partner dies or leaves the firm.

20. The Legal Organization of Firms
Corporation
A legal entity that may conduct business in its own name just as an individual does
The owners of a corporation, called shareholders
Own shares of the firm’s profits
Enjoy the protection of limited liability

21. The Legal Organization of Firms
Limited Liability
A legal concept whereby the responsibility, or liability, of the owners of a corporation is limited to the value of the shares in the firm that they own.

22. The Legal Organization of Firms
Advantages of corporations
Limited liability
Continues to exist when owner leaves the business
Raising large sums of financial capital

23. The Legal Organization of Firms
Disadvantages of corporations
Double taxation
Dividends
Portion of corporation’s profits paid to its owners (shareholders)
Separation of ownership and control

24. The Profits of a Firm Accounting Profit
Total revenue minus total explicit costs

25. The Profits of a Firm Explicit Costs
Costs that business managers must take account of because they must be paid
Examples are wages, taxes and rent

26. The Profits of a Firm Implicit Costs
Expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate
Opportunity cost of factors of production that are owned
Owner-provided capital and owner- provided labor

27. The Profits of a Firm Normal Rate of Return
The amount that must be paid to an investor to induce investment in a business
Also known as the opportunity cost of capital

28. The Profits of a Firm Opportunity Cost of Capital
The normal rate of return, or the available return on the next-best alternative investment
Economists consider this a cost of production, and it is included in our cost examples.

29. The Profits of a Firm
Opportunity cost of owner-provided land and capital
Single-owner proprietorships often exaggerate profit as they understate their opportunity cost of capital.
Consider a simple example of a skilled auto mechanic working at his/her own service station, six days a week.

30. The Profits of a Firm Accounting profits versus economic profits
The term profits in economics means the income entrepreneurs earn.
Over and above all costs including their own opportunity cost of time.
Plus the opportunity cost of capital they have invested in their business.

31. The Profits of a Firm Economic Profits
Total revenues minus total opportunity costs of all inputs used
The total of implicit and explicit costs

32. Simplified View of Economic and Accounting Profit

33. The Profits of a Firm The goal of the firm: profit maximization
Theory of consumer demand: utility (or satisfaction) maximization
Theory of the firm: profit maximization is the underlying hypotheses of our predictive theory

34. Interest
Interest is the price paid from debtors to creditors for the use of loanable funds.
Businesses use financial capital in order to invest in physical capital.

35. Interest Financial Capital Interest
Funds used to purchase physical capital goods, such as buildings and equipment
Interest
The payment for current rather than future command over resources; the cost of obtaining credit

36. Interest
Variations in the rate of annual interest that must be paid for credit depend on
Length of loan
Risk

37. Interest Nominal Rate of Interest Real Rate of Interest
The market rate of interest expressed in today’s dollars
Real Rate of Interest
The nominal rate of interest minus the anticipated rate of inflation

38. Interest
We can say that the nominal, or market, rate of interest is approximately equal to the real rate of interest plus anticipated inflation, or
in = ir + anticipated inflation rate

39. Interest
Interest is a price that allocates loanable funds (credit) to consumers and businesses.
Investment, or capital, projects with rates of return higher than the market rate of interest will be undertaken.
The interest rate performs the function of allocating financial capital thus ultimately allocating physical capital.

40. Interest Businesses make investments which often incur large costs.
They need to compare their investment cost today with a stream of future profits.
They must relate present costs to future benefits.
Interest rates are used to link the present with the future.

41. Interest Present Value
The value of a future amount expressed in today’s dollars
The most that someone would pay today to receive a certain sum at some point in the future

42. Interest
Discounting
The method by which the present value of a future sum or a future stream of sums is obtained

43. Corporate Financing Methods
Share of Stock
A legal claim to a share of a corporation’s future profits

44. Corporate Financing Methods
Bond
A legal claim against a firm
Usually entitling the owner of the bond to receive a fixed annual coupon payment, plus a lump-sum payment at the bond’s maturity date
Bonds are issued in return for funds lent to the firm.

45. Corporate Financing Methods
Reinvestment
Profits (or depreciation reserves) used to purchase new capital equipment
Sales of stock are an important source of financing for new firms.
Reinvestment and borrowing are the primary means of financing for existing ones.

46. The Difference Between Stocks and Bonds
Stocks represent ownership.
Common stocks do not have a fixed dividend rate.
Stockholders can elect a board of directors, which controls the corporation.
Stocks do not have a maturity date; the corporation does not usually repay the stockholder.
All corporations issue or offer to sell stocks. This is the usual definition of a corporation.
Stockholders have a claim against the property and income of a corporation after all creditors’ claims have been met.
Bonds represent debt.
Interest on bonds must always be paid, whether or not any profit is earned.
Bondholders usually have no voice in or over management of the corporation.
Bonds have a maturity date on which the bondholder is to be repaid the face value of the bond.
Corporations need not issue bonds.
Bondholders have a claim against the property and income of a corporation that must be met before the claims of stockholders.

47. The Markets for Stocks and Bonds
Securities
Stocks and bonds

48. The Markets for Stocks and Bonds
Inside Information
Information that is not available to the general public about what is happening in a corporation
One way to “beat the market,” although it is considered illegal, punishable by substantial fines and imprisonment

49. Reading Stock Quotes

50. Summary Discussion of Learning Objectives
Economic rent serves an efficient allocative function for resources that are fixed in supply.
The main types of business organization
Proprietorship
Partnership
Corporation
Accounting profit is the excess of total revenue over explicit costs.
To arrive at economic profit, we must subtract implicit costs as well.

51. Summary Discussion of Learning Objectives
Interest is a payment for the ability to use resources today instead of in the future.
The present value of a sum to be received in the future can be calculated through discounting.
Sources of corporate funds are stocks, bonds, and reinvestment of profits.