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

2. 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.

3. 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

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

5. 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???

6. 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.

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

8. 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.

9. 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.

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

11. Table 22-2 Forms of Business Organization

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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.

18. 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

19. 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.

20. 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

21. 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

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

23. 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

24. 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

25. 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.

26. 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.

27. 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

28. 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

29. 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.

30. 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

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

32. 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

33. 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

34. 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.

35. 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.

36. 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

37. 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

38. 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.

39. 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.

40. 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.

41. 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

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

43. 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.

44. 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.”

45. 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

46. Table 22-4 Reading Stock Quotes