Rents, Profits, and the Financial Environment of Business Chapter 22 Rents, Profits, and the Financial Environment of Business

Economic Rent Economic Rent A payment for the use of any resource over and above its opportunity cost A.K.A. - The minimum payment that would be necessary to make that resource available Thus, rent has a different meaning in economics.

Economic Rent (cont'd) Determining land rent Economists originally used the term rent to designate payment for use of land. But…the term economic rent can be applied to other things, not just land

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

Economic Rent (cont'd) Apply the definition of economic rent to the phenomenal (ridiculous) earnings these people make. They would undoubtedly work for considerably less than they earn. Then why do they make so much???

Economic Rent (cont'd) Much of their rent occurs because specific resources cannot be replicated exactly. No one can duplicate today’s most highly paid entertainment figures.

Table 22-1 Superstar Earnings Next up…Firms and Profits

Copyright © 2008 Pearson Addison Wesley. All rights reserved. Firms and Profits Firms or businesses, like individuals, seek to earn the highest possible returns. A firm brings together the factors of production (what are they?) to produce a product or service it hopes can be sold at a profit. Copyright © 2008 Pearson Addison Wesley. All rights reserved.

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

Table 22-2 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 (cont'd) 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 (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

The Legal Organization of Firms (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

The Legal Organization of Firms (cont'd) 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 (cont'd) 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 (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

The Legal Organization of Firms (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.

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

The Legal Organization of Firms (cont'd) 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 (cont'd) 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 (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

The Profits of a Firm (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.

The Profits of a Firm (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.

The Profits of a Firm (cont'd) Economic Profits Total revenues minus total opportunity costs of all inputs used The total of implicit and explicit costs

The Profits of a Firm (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

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

Interest (cont'd) 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 (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

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.

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.

Corporate Financing Methods When it all began—1602 Dutch East India Company raised financial capital by Selling ownership shares (stock) Using notes of indebtedness (bonds) Some profits were retained for reinvestment

Corporate Financing Methods (cont'd) Share of Stock A legal claim to a share of a corporation’s future profits Common stock Incorporates certain voting rights regarding major policy decisions of the corporation Preferred stock Owners are accorded preferential treatment in the payment of dividends

Corporate Financing Methods (cont'd) Bond A legal claim against a firm Usually entitling the owner of the bond to receive a fixed annual coupon payment (based on interest rates), 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 (cont'd) Reinvestment Profits are used to purchase new capital equipment Sales of stock are an important source of financing for new firms.

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. 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.

The Markets for Stocks and Bonds (cont'd) New York Stock Exchange (NYSE) Nasdaq London Stock Exchange (FTSE) Tokyo Stock Exchange Bombay Stock Exchange (BSE) Shanghai Stock Exchange

Market Indexes Dow Jones Industrial Average (DOW)(DJIA) S&P 500 FTSE 100 CAC 40 Nikkei Hang Seng

The Markets for Stocks and Bonds (cont'd) The theory of efficient markets All information entering the market is fully incorporated into stock prices. The best forecast of tomorrow’s price is today’s price plus the effect of any upward drift.

The Markets for Stocks and Bonds (cont'd) Random Walk Theory The theory that there are no predictable trends in securities prices that can be used to “get rich quick.”

The Markets for Stocks and Bonds (cont'd) 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

Table 22-4 Reading Stock Quotes