Firms, Profits, and Economic Costs

We just read that Toyota had to make a decision about producing a product. Who makes such decisions? It’s the firms and entrepreneurs who choose to take on the risk and effort to launch a new product. They are motivated by the profits that can be earned if the investment proves successful. But how do we measure profits, as properly understood by economists?

This section highlights the important role that firms and entrepreneurs play in producing the goods and services we enjoy as consumers. No matter how the organizational structure is set up, firms and entrepreneurs hold profits as their motivating force. To achieve profits, both revenues and costs must be considered. As we will see, profits can be measured using an accounting approach or an economics approach. These approaches differ in the way costs are measured.

Firms

firm An economic institution that transforms resources (factors of production) into outputs.

A firm is an economic institution that transforms inputs, or factors of production, into outputs, or products. Most firms begin as family enterprises or small partnerships. When successful, these firms can evolve into corporations of considerable size.

In the process of producing goods and services, firms must make numerous decisions. First, they have to determine a market need. Then, most broadly, firms must decide what quantity of output to produce, how to produce it, and what inputs to employ. The latter two decisions depend on the production technology that the firm selects.

Any given product can typically be produced in a wide variety of ways. Some businesses, like McDonald’s franchises and Dunkin’ Donuts shops, use considerable amounts of capital equipment, whereas others, such as T-shirt shops and small eateries, require very little. Even among similar firms, the quality and quantity of resources available often determine what technologies are used. Firms located in areas with an abundance of low-cost labor tend to use low-technology, labor-intensive production methods. In areas in which high-skill, high-wage labor is the norm, production is more often done using high-technology, capital-intensive processes.

165

Innovation, Productivity, and Costs Rule Business

To remain in business, firms must innovate not only by improving the products they make but also by controlling their costs. Controlling costs is done by introducing new technologies in production and increasing productivity. This holds for the service sector as well.

The cost of industrial robots has fallen over 70% since 1992.

Productivity has risen over 50% since 1992

Businesses face a relentless need to lower costs, which has changed the way we live and travel. The percentage of travelers purchasing airline tickets and checking in online highlights this trend.

166

Entrepreneurs

If a product or service is to be provided to the market, someone must first assume the risk of raising the required capital, assembling workers and raw materials, producing the product, and, finally, offering it for sale. Markets provide incentives and signals, but it is entrepreneurs who provide products and services by taking risks in the hopes of earning profits.

Recent research in neuroscience has shown that entrepreneurs’ brains were more active in the region responsible for making risky or “hot” decisions.1 The research compared entrepreneurs who had founded at least two high-tech firms with senior managers from the private and public sectors. When the decisions were “emotionally neutral,” the groups performed the same, but when the decisions were “hot” or risky, the entrepreneurs were more impulsive and more mentally flexible. It is this willingness to take risk to earn profits that distinguishes entrepreneurs from the rest of us.

In the United States, 12% of people ages 18 to 64 classify themselves as entrepreneurs. This means they are running start-up businesses or businesses less than 42 months old. Entrepreneurial rates in Europe are only half the American rate, and Japanese entrepreneurship is less than 2%.2

Entrepreneurs can be divided into three basic business structures: sole proprietorships (one owner), partnerships (two or more owners), and corporations (many stockholders). The United States has more than 25 million businesses, over 70% of them sole proprietorships or small businesses. Only 20% of American businesses are corporations. Nevertheless, corporations sell nearly 90% of all products and services in the United States. Likewise, around the world, the corporate form of business has become the dominant form. To see why, we must first take a brief look at the advantages and disadvantages of each business structure.

sole proprietorship A type of business structure composed of a single owner who supervises and manages the business and is subject to unlimited liability.

Sole Proprietors The sole proprietorship represents the most basic form of business organization. A proprietorship is composed of one owner, who usually supervises the business operation. Local restaurants, dry cleaning businesses, and auto repair shops are often sole proprietorships. A sole proprietorship is easy to establish and manage, having much less paperwork associated with it than other forms of business organization. But the sole proprietorship has disadvantages. Single owners are often limited in their ability to raise capital. In many instances, all management responsibilities fall on this single individual. And most important, the personal assets of the owner are subject to unlimited liability. If you own a pizza shop as a sole proprietor and someone slips on the floor, he or she can sue you and you could lose your house and your life savings if you do not have sufficient insurance coverage.

partnership Similar to a sole proprietorship, but involves more than one owner who share the management of the business. Partnerships are also subject to unlimited liability.

Partnerships Partnerships are similar to sole proprietorships except that they have more than one owner. Establishing a partnership usually requires signing a legal partnership document. Partnerships find it easier to raise capital and spread around the management responsibilities. Like sole proprietors, however, partners are subject to unlimited liability, not only for their share of the business, but for the entire business. If your partner takes off for Bermuda, you are left to pay all the bills, even those your partner incurred. The death of one partner dissolves a partnership, unless other arrangements have been made ahead of time. In any case, the death of a partner often creates problems for the continuity of the business.

corporation A business structure that has most of the legal rights of individuals, and in addition, can issue stock to raise capital. Stockholders’ liability is limited to the value of their stock.

Corporations The corporation is the premier form of business organization in most of the world. In 2012, roughly 5 million American corporations sold over $27 trillion worth of goods and services worldwide. This is an amazing statistic when you consider that the country’s 23 million sole proprietorships had sales totaling just over $1.3 trillion. Clearly, corporations are structured in a way that enhances growth and efficiency.

167

Steve Wozniak (right) and Steve Jobs began their computer business in the Jobs family garage as a partnership before turning it into a public company, Apple, in 1980. Today, Apple is one of the largest companies in the world by market value.
dpa/Landov

Corporations have most of the legal rights of individuals; in addition, they are able to issue stock to raise capital, and most significant, the liability of individual owners (i.e., stockholders) is limited to the amount they have invested in (or paid for) the stock. This is what distinguishes corporations from the other forms of business organization: the ability to raise large amounts of capital because of limited liability.

Some scholars argue that corporations are the greatest engines of economic prosperity ever known.3 Daniel Akst writes:

When I worked for a big company, there was a miracle in the office every couple of weeks, just like clockwork. It happened every payday, when sizable checks were distributed to a small army of employees who also enjoyed health and retirement benefits. Few of us could have made as much on our own, and somehow there was always money left over for the shareholders as well.4

Without the corporate umbrella, most of the jobs we hold would not exist; most of the products we use would not have been invented; and our standard of living would be a fraction of what it is today.

What is it that motivates business owners of all types to take on the risks of creating a product? Profits.

The Vast World of Corporate Offshoring and Profits


Most Americans are aware of the fact that corporations, particularly in manufacturing industries, often relocate factories to developing countries to take advantage of lower costs for labor and raw materials (in a process called offshoring) and to gain access to emerging markets for their products. Yet, another incentive exists for why companies choose to place important offices, even headquarters, abroad, and that is to avoid U.S. regulations and taxes.

At its height in 2011, Zug, Switzerland, was home to 30,000 corporate headquarters from around the world. Impressive for a quiet lakeside town with just 26,000 residents.
Prisma/SuperStock

One common example of corporate offshoring occurs in the cruise ship industry. Despite many cruise ships starting and ending trips at U.S. ports, virtually all large cruise vessels are registered outside of the United States, allowing cruise lines to circumvent, for example, U.S. labor laws (ever wonder how a room steward is able to legally work seven days a week, day and night, at less than minimum wage?).

The more egregious examples of offshoring occur when companies relocate headquarters to certain countries to take advantage of lower tax rates. And by relocating, this often does not mean moving to a shiny new skyscraper in a major European or Asian capital. On the contrary, it sometimes involves merely having a mailbox in an obscure town or island serving as the headquarters for a multimillion dollar enterprise.

Recent media attention exposing the abuse of corporate offshoring has led to new reforms being proposed in the United States and the European Union. Various proposed legislation, such as the 2011 Stop Tax Haven Abuse Act, aimed at curbing the use of corporate offshoring when the sole purpose is to avoid taxes (as opposed to traditional offshoring to take advantage of less expensive inputs of production). But like all new policies, tradeoffs exist, as companies affected by the new legislation claim such rules would reduce competition and raise consumer prices. The costs and benefits of any new policy are likely to be debated extensively before becoming law.

168

Profits

profit Equal to the difference between total revenue and total cost.

total revenue Equal to price per unit times quantity sold.

Entrepreneurs and firms employ resources and turn out products with the goal of making profits. This is not to say that firms put profit above all else (i.e., that they would do something immoral or socially irresponsible to increase profits), but instead that firms do not intentionally make decisions that would knowingly result in lower profit. Profit is the difference between total revenue and total cost.

total cost The sum of all costs to run a business. To an economist, this includes out-of-pocket expenses and opportunity costs.

Total revenue is the amount of money a firm receives from the sales of its products. It is equal to the price per unit times the number of units sold (TR = p × q). Note that we use lower case p and q when we are dealing with an individual firm and use upper case when describing a market. Total cost includes both out-of-pocket expenses and opportunity costs; we will discuss this concept shortly.

Economists explicitly assume that firms proceed rationally and have the maximization of profits as their primary objective. Alternative behavioral assumptions for firms have been tested, including sales maximization, various goals for market share, and customer satisfaction. Although these more complex assumptions for firm behavior often predict different outcomes, economists have not been persuaded that any of them yield results superior to those of the profit maximization approach. Profit maximization has stood the test of time, and thus we will assume it is the primary economic goal of firms.

Economic Costs

economic costs The sum of explicit (out-of-pocket) and implicit (opportunity) costs.

explicit costs Those expenses paid directly to another economic entity, including wages, lease payments, taxes, and utilities.

When economists say “profit,” they mean profits properly understood. Economists approach business costs and profits from the opportunity cost perspective discussed in Chapter 2. They separate costs into explicit costs, or out-of-pocket expenses, and implicit costs, or opportunity costs. Economic costs are the sum of explicit and implicit costs.

implicit costs The opportunity costs of using resources that belong to the firm, including depreciation, depletion of business assets, and the opportunity cost of the firm’s capital employed in the business.

Explicit costs are those expenses paid directly to some other economic entity. These costs include wages, lease payments, expenditures for raw materials, taxes, utilities, and so on. A company can easily determine its explicit costs by summing all of the checks it has written during the normal course of doing business.

Implicit costs refer to all of the opportunity costs of using resources that belong to the firm. Recall that opportunity cost measures the value of the next best alternative use of resources, including that of time and capital. Implicit costs include depreciation, the depletion of business assets, and the opportunity cost of a firm’s capital.

In any business, some assets are depleted over time. Machines, cars, and office equipment depreciate with use and time. Finite oil or mineral deposits are depleted as they are mined or pumped. Even though firms do not actually pay any cash as these assets are worn down or used up, these costs nonetheless represent real expenses to the firm.

Another major component of implicit costs is the capital firms have invested. Even small firms incur large implicit costs from their capital investment. Small entrepreneurs, for example, must invest both their own capital and labor into their businesses. Such people could normally be working for someone else, so their “lost salary” must be treated as an implicit cost when determining the true profitability of their businesses. Similarly, any capital invested in a business enterprise could just as well be earning interest in a bank account or returning dividends and capital gains through the purchase and sale of stock in other enterprises. Though not directly paid out as expenses, these forgone earnings nonetheless represent implicit costs for the firm.

Sunk Costs

sunk costs Those costs that have been incurred and cannot be recovered, including, for example, funds spent on existing technology that has become obsolete and past advertising that has run in the media.

The previous chapter introduced the concept of sunk costs, which are costs that have already been incurred and cannot be recovered. For example, should you leave in the middle of a movie because it stinks? The cost of admission has been paid, and staying until the end might add to the anguish of an already bad situation. Similarly, tuition is a sunk cost. Most colleges and universities do not provide refunds for dropped courses beyond the first week or two of the term. Because sunk costs are not recoverable, future decisions, such as whether to drop a course one is failing, should not depend on them. To a business, the decision to advertise a product in a new magazine depends on the benefits and costs of that advertising, not on how much has been spent on television ads in the past. You will hear the phrase that “sunk costs are sunk,” meaning ignore them, they are gone.

169

Economic and Normal Profits

The primary goal of any firm is to earn a profit. However, how the Internal Revenue Service (IRS) measures profit for tax purposes is different from how an economist determines profit. Suppose that after graduating, you decide to open a new billiards hall on campus. After a year, counting all the revenues and subtracting all explicit costs (costs that you actually pay out), you end up with a profit of $20,000. Is your business a success? The IRS certainly thinks so, as it will collect taxes on these profits. And you might brag to friends that you turned a profit in your first year. But then you start thinking of all the time you spent on the business and the missed opportunities, such as the $40,000 a year job offer you turned down, and the money you could have earned had you invested your savings in stocks or bonds rather than in your business. Now, your business doesn’t feel successful.

accounting profit The difference between total revenue and explicit costs. These are the profits that are taxed by the government.

economic profit Profit in excess of normal profits. These are profits in excess of both explicit and implicit costs.

normal profits The return on capital necessary to keep investors satisfied and keep capital in the business over the long run.

Economists include both explicit and implicit costs in their analysis of business profits. An accounting profit is calculated by including only explicit costs, while an economic profit is calculated using both explicit and implicit costs. Therefore, when a firm is earning economic profits, it is generating profits in excess of zero once implicit costs are factored in. This brings us to an important benchmark called normal profits which occurs when economic profit equals zero. Economists refer to this level of profit as a normal rate of return on capital, a return just sufficient to keep investors satisfied and to keep capital in the business over the long run. If a firm’s rate of return on capital falls below this rate, investors will put their capital to use elsewhere.

Although earning zero economic profit might sound dismal, this simply means that the firm is earning the same profit it would have earned had it chosen its next best alternative use of its capital, which can be quite substantial in terms of accounting profit. For example, if Mark Zuckerberg left Facebook and opened a new business, his new business (assuming he uses the same amount of capital and labor) would have to earn billions of dollars a year just to achieve normal profits. Not bad for zero economic profit. In other words, any profit less than what would be earned at Facebook under his leadership would be considered an economic loss. A firm earning normal profits means that it is earning just enough to cover the opportunity cost of its capital. Therefore, a firm may be earning accounting profits as defined by the IRS for tax purposes, yet still be suffering economic losses, because taxable income does not reflect all implicit costs.

Let’s look at the difference between accounting profits and economic profits further in Table 1, using our example of the billiards hall. Suppose your annual total revenue is $120,000. After subtracting out-of-pocket (explicit) costs of $100,000, you end up with an accounting profit of $20,000. However, if you could have earned $40,000 working elsewhere and $10,000 more by putting your savings into a stock or bond investment rather than into your business, you would incur a $30,000 economic loss.

Economists designate normal profits as economic profits equal to zero. To achieve normal profits, you would need to be just as well off operating the billiard hall as you would if you instead took another job and invested your savings elsewhere, which means earning $50,000 in accounting profits. Because you earned only $20,000 (or $30,000 less than the alternative), this results in an economic loss of $30,000. Normal profits are the profits necessary to keep a firm in business over the long run. This brings us to an important economic distinction, between the short run and the long run.

Short Run Versus Long Run

Although the short and the long run generally differ in their temporal spans, they are not defined in terms of time. Rather, economists define these periods by the ability of firms to adjust the quantities of various resources that they are employing.

short run A period of time over which at least one factor of production (resource) is fixed, or cannot be changed.

As discussed in a previous chapter, the short run is a period of time over which at least one factor of production is fixed, or cannot be changed. For the sake of simplicity, economists typically assume that plant capacity is fixed in the short run. Output from a fixed plant can still vary depending on how much labor the firm employs. Firms can, for instance, hire more people, have existing employees work overtime, or run additional shifts. For discussion purposes, we focus here on labor as the variable factor, but changes in the raw materials used can also result in output changes.

long run A period of time sufficient for firms to adjust all factors of production, including plant capacity.

The long run, conversely, is a period of time sufficient for a firm to adjust all factors of production, including plant capacity. Since all factors can be altered in the long run, existing firms can even close and leave the industry, and new firms can build new plants and enter the market.

170

In the short run, therefore, with plant capacity and the number of firms in an industry being fixed, output varies only as a result of changes in employment. In the long run, as plant capacity and other factors are made variable, the industry may grow or shrink as firms enter or leave the business, or some firms alter their plant capacity.

Because all industries are unique, the time required for long-run adjustment varies by industry. Family-owned restaurants, lawn-mowing services, and roofing firms can come and go fairly rapidly. High-capital industries on the other hand, such as the chemical, petroleum, and semiconductor industries, face obstacles to change that require a long time to overcome, whether these be strenuous environmental regulation, immense research and development requirements, or huge capital costs for plant construction. Adding plant capacity in one of these industries can take a decade or more and cost billions of dollars.

The important point to note from this section is that firms seek economic profits and determine profits by first calculating their costs. These costs may differ over the short run versus the long run. Therefore, we look first at production basics, then consider costs in both the short run and the long run.

FIRMS, PROFITS, AND ECONOMIC COSTS

  • Firms are economic institutions that convert inputs (factors of production) into products and services.
  • Entrepreneurs provide goods and services to markets. Entrepreneurs can be organized into three basic business structures: sole proprietorships, partnerships, and corporations.
  • Corporations are the premier form of business organization because they give owners (shareholders) limited liability, unlike sole proprietorships and partnerships.
  • Profit is the difference between total revenues and total costs.
  • Explicit costs are those expenses, such as rent and the cost of raw materials, paid directly to some other economic entity. Implicit costs represent the opportunity costs of doing business, including depreciation and the firm’s capital costs.
  • Normal profits (or normal rates of return) are equal to zero economic profit. The firm is earning just enough to keep capital in the firm over the long run. Economic profits are those in excess of normal profits.
  • The short run is a period of time during which one factor of production (usually plant capacity) is fixed. In the long run all factors can vary and the firm can enter or exit the industry.

QUESTION: Assume for a moment that you want to go into business for yourself and that you have a good idea. What are the pros and cons of setting up your company as a corporation as opposed to keeping it as a sole proprietorship?



Setting up your firm as a corporation has its benefits and its costs. One benefit of a corporation is limited liability, which means that if your company fails, the company can declare bankruptcy without it affecting your personal assets or credit. Another benefit is the ability to raise capital by issuing bonds or stocks. The downside of setting up a corporation is that profits are potentially shared by many shareholders. Also, corporations involve much more paperwork (such as setting up the firm and filing tax returns) than a sole proprietorship, which is much easier to set up and manage.