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

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

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?

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.

Economic Rent

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

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.

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?

Superstar Earnings

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.

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.

Firms and Profits The legal organization of firms Proprietorship Partnership Corporation

Forms of Business Organization

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

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

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.

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

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

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.

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

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.

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

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

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

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

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

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

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.

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.

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.

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

Simplified View of Economic and Accounting Profit

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

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.

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

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

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

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

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.

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.

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

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

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

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.

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.

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.

The Markets for Stocks and Bonds Securities Stocks and bonds

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

Reading Stock Quotes

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.

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.