Chapter 21 Rents, Profits, and the Financial Environment of Business

1. Chapter 21 Rents, Profits, and the Financial Environment of Business

2. Introduction Since the mid-2000s, fewer individually owned or co-owned businesses opened in the U.S. than in prior years. Also, fewer new firms have been formed as corporations. How can economists explain these declines in new business formation? How do firms choose their form of organization? In this chapter, you will learn the answers to these questions.

3. Learning Objectives • 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

4. Learning Objectives (cont'd) • 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

5. Chapter Outline • Economic Rent • Firms and Profits • Interest • Corporate Financing Methods • The Markets for Stocks and Bonds

6. Did You Know That ... • U.S. residents have borrowed more funds to finance their educations than the total amount of debt owed by all residents on their credit cards? • A typical individual who has obtained student loans owes about $25,000 in outstanding debt. • In addition to the amounts borrowed, the student must also repay interest. • What is the economic role of interest? What are alternative ways of measuring interest? • You will explore these questions in Chapter 21.

7. Economic Rent • Economic Rent • A payment for the use of any resource over and above its opportunity cost • Thus, rent has a different meaning in economics.

8. Economic Rent (cont'd) • Determining land rent • Economists originally used the term rent to designate payment for use of land • The concept of economic rent is associated with the British economist David Ricardo

9. Figure 21-1 Economic Rent

10. Economic Rent (cont'd) • Economic rent to labor • Professional sports superstars • Rock stars • Movie stars • World-class models • Successful inventors and innovators

11. Economic Rent (cont'd) • 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.

12. Economic Rent (cont'd) • Economic rent and the allocation of resources • Economic rent allocates resources to their highest valued use

13. Example: Do Entertainment Superstars Make Super Economic Rents? • How much of superstars’ earnings can be called economic rent? • A newcomer would almost certainly work for much less than he or she earns, implying that the newcomer is making high economic rent. • Seasoned entertainers probably have very high accumulated wealth and also a more jaded outlook about their work. It is therefore not clear how much they would work if they were not offered those huge sums of money. • Even if some superstars would work for less, what accounts for their high incomes?

14. Table 21-1 Superstar Earnings

15. Firms and Profits • Firms or businesses, like individuals, seek to earn the highest possible returns • A firm brings together the factors of production—labor, physical capital, human capital and entrepreneurial skill—to produce a product or service it hopes can be sold at a profit

16. Firms and Profits (cont'd) • 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

17. Firms and Profits (cont'd) • The legal organization of firms • Proprietorship • Partnership • Corporation

18. Table 21-2 Forms of Business Organization

19. Firms and Profits (cont’d) • 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

20. Firms and Profits (cont'd) • Advantages of proprietorships • Easy to form and dissolve • All decision-making power resides with the sole proprietor • Profit is taxed only once

21. Firms and Profits (cont'd) • 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

22. Firms and Profits (cont'd) • 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

23. Firms and Profits (cont'd) • Advantages of partnerships • Easy to form and dissolve • Partners retain decision-making power • Permits more effective specialization • Profit is taxed only once

24. Firms and Profits (cont'd) • Disadvantages of partnerships • Unlimited liability • Decision making more costly • Dissolution often occurs when a partner dies or leaves the firm.

25. Firms and Profits (cont'd) • 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

26. Firms and Profits (cont'd) • 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

27. Firms and Profits (cont'd) • Advantages of corporations • Limited liability • Continues to exist when owner leaves the business • Raising large sums of financial capital

28. Firms and Profits (cont'd) • Disadvantages of corporations • Double taxation • Dividends • Portion of corporation’s profits paid to its owners (shareholders) • Separation of ownership and control

29. Policy Example: The Government Considers Allowing “Crowd Funding” of Firms • Under current Securities and Exchange Commission (SEC) rules, a firm can have no more than 499 investing partners before it must subject itself to regulation as a corporation. • The SEC is considering a proposal to permit firms organized as private partnerships to raise financial capital on social networks. • Under this proposal, non-corporate enterprises would be allowed to engage in crowd funding by inviting numerous investors to buy partnership shares with a maximum value of $100.

30. Firms and Profits (cont’d) • Accounting Profit • Total revenue minus total explicit costs • Explicit costs • Expenses that business managers must take account of because they must be paid • Examples are wages, taxes and rent

31. Firms and Profits (cont'd) • 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

32. Firms and Profits (cont'd) • 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 ofcapital

33. Firms and Profits (cont'd) • 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

34. Firms and Profits (cont'd) • 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

35. Firms and Profits (cont'd) • 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

36. Firms and Profits (cont'd) • Economic Profits • Total revenues minus total opportunity costs of all inputs used • The total of implicit and explicit costs

37. Figure 21-2 Simplified View of Economic and Accounting Profit

38. Firms and Profits (cont'd) • 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

39. Firms and Profits (cont'd) • Firms that can provide relatively higher risk-corrected returns will have an advantage in obtaining financing needed to continue or expand production • We would expect a policy of profit maximization to become a dominant mode of behavior for firms that survive

40. 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.

41. Interest (cont'd) • Financial Capital • 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

42. Interest (cont'd) • Variations in the rate of annual interest that must be paid for credit depend on • Length of loan • Risk • Handing charges

43. Interest (cont'd) • Nominal 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

44. Interest (cont'd) • 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

45. Interest (cont'd) • 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

46. Interest (cont'd) • 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

47. Interest (cont'd) • 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

48. Interest (cont'd) where PV1 = Present value of a sum one year hence FV1 = Future sum paid or received one year hence i = Market rate of interest FV1 1 + i PV1 =

49. Interest (cont’d) • Present value of $105 to be received one year from now, if the interest rate is 5%: • PV = 105/(1.05) = $100 • The present value is $100

50. Interest (cont’d) • How much would have to be put in a savings account today to have $105 two years from now if the account pays 5% per year compounded annually? • PV2 x (1.05)2 = $105 • PV2 x $105 = $95.24 (105)2