Chapter 22: Rents, Profits, and the Financial Environment of Business ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 22: Rents, Profits, and the Financial Environment of Business Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Income Sources Wages from the use of labor Rent from the use of natural resources Interest from the use of money capital Profit from the risk of entrepreneurship

Rent Rent is revenue from the use of natural resources Economic rent is payment to the owner of any resource in excess of its opportunity cost.

Economic Rent Who earns economic rent for labor services? Movie Stars Top Athletes Successful innovators

Economic Rent Superstars who earn economic rent are paid more than the minimum they would have to earn in order to continue in their work. But the rent serves an economic function of allocating their labor to the best use. The amount of rent they can earn will be determined by the demand for services only they can offer.

The Legal Organization of Firms Before addressing the profits of firms, it is appropriate to discuss legal organization. Proprietorships 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 Proprietorships About 70 percent of all U.S. firms 10 million firms with sales averaging not much more than $50,000 per year Account for 5 percent of all business revenues

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 Partnerships 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 generally necessary when a partner dies or leaves the firm

The Legal Organization of Firms Corporations 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 Separation of ownership and control

Profits Accounting profit equals total revenue minus explicit costs. If a business earns an accounting profit that is equal to the normal rate of return, then it is earning enough to cover the opportunity cost of capital.

Economic Profit Economic profit equals total revenue minus the total opportunity cost of all inputs used. This is equivalent to saying that economic profit is what remains of total revenue once all explicit and implicit costs have been covered. Economic profit is different than accounting profit.

Examples of Explicit and Implicit Costs

Profits Economic theory assumes that the goal of any firm is to maximize profit. An enterprise cannot obtain capital financing unless it generates the profits necessary to reward investors.

Interest Interest is the price paid by debtors to creditors for the use of financial capital. Interest is the market return earned by capital as a factor of production.

Interest and Credit The interest rate paid depends on Length of the loan Risk Handling charges

Real versus Nominal Interest Rates The nominal interest rate rises along with increases in expected inflation

The Allocative Role of Interest Interest is a price that allocates loanable funds to consumers and businesses. Like any price set by the free market, it can serve to bring about an efficient allocation of a scarce good. In this case, the scarce good is financial capital.

Interest Rates and Present Value The present value of a given amount to be received in the future is the most that someone would pay today in order to be entitled to receive that amount in the future.

Interest Rates and Present Value 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

Interest Rates and Present Value Discounting The process of determining the present value of a sum to be received some time in the future.

Methods of Corporate Financing Selling ownership shares (stock) Using notes of indebtedness (bonds) Some profits retained for reinvestment (profits)

Methods of Corporate Financing 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

Methods of Corporate Financing 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 Issued in return for funds lent to the firm

The Difference Between Stocks and Bonds Stocks Bonds 1. Stocks represent ownership. 1. Bonds represent debt. 2. Common stocks do not have a fixed 2. Interest on bonds must always be dividend rate. paid, whether or not any profit is earned. 3. Stockholders can elect a board of 3. Bondholders usually have no voice in directors, which controls the or over management of the corporation. corporation. 4. Stocks do not have a maturity date; 4. Bonds have a maturity date on which the corporation does not usually the bondholder is to be repaid the face repay the stockholder. value of the bond. 5. All corporations issue or offer to sell 5. Corporations need not issue bonds. stocks. This is the usual definition of a corporation. 6. Stockholders have a claim against the 6. Bondholders have a claim against the property and income of a corporation after property and income of a corporation all creditors’ claims have been met. that must be met before the claims of stockholders.

The Markets for Stocks and Bonds Primary and secondary markets New York Stock Exchange (NYSE) More than 2,500 stocks are traded on the NYSE About 600 brokerage firms pay up to $2,000,000 per seat to trade on the NYSE

The Markets for Stocks and Bonds The theory of efficient markets If all available information about the performance of a company is incorporated in the price of its stock, then the best predictor of tomorrow’s price is today’s price. If some people are trading based on inside Information, then they have an opportunity to profit from their transactions before the market price adjusts to the information.

Chapter 22: Rents, Profits, and the Financial Environment of Business ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 22: Rents, Profits, and the Financial Environment of Business Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.