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Chapter 21

Rents, Profits, and the Financial

Environment of Business

Copyright ©2014 Pearson Education, Inc. All rights reserved. 21-2

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.


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


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


Chapter Outline

• Economic Rent• Firms and Profits• Interest• Corporate Financing Methods• The Markets for Stocks and Bonds


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.


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.


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


Figure 21-1 Economic Rent



• Economic rent to labor

– Professional sports superstars

– Rock stars

– Movie stars

– World-class models

– Successful inventors and innovators



• 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.



• Economic rent and the allocation of resources

– Economic rent allocates resources to their highest valued use


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?


Table 21-1 Superstar Earnings


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


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



• The legal organization of firms

– Proprietorship

– Partnership

– Corporation


Table 21-2 Forms of Business Organization


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



• Advantages of proprietorships

– Easy to form and dissolve

– All decision-making power resides with the sole proprietor

– Profit is taxed only once



• 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



• 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



• Advantages of partnerships

– Easy to form and dissolve

– Partners retain decision-making power

– Permits more effective specialization

– Profit is taxed only once



• Disadvantages of partnerships

– Unlimited liability

– Decision making more costly

– Dissolution often occurs when a partner dies or leaves the firm.



• 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



• 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



• Advantages of corporations

– Limited liability

– Continues to exist when owner leaves the business

– Raising large sums of financial capital



• Disadvantages of corporations

– Double taxation • Dividends

– Portion of corporation’s profits paid to its owners (shareholders)

– Separation of ownership and control


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.


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



• 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



• 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 of capital



• 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



• 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



• 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



• Economic Profits

– Total revenues minus total opportunity costs of all inputs used

– The total of implicit and explicit costs


Figure 21-2 Simplified View of Economic and Accounting Profit



• 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



• 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


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– 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

1. Length of loan

2. Risk

3. Handing charges


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


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


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


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

PV1 = FV1

1 + i


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


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


Table 21-3 Present Value of a Future Dollar


Interest (cont'd)

• Discounting– The method by which the present value of a

future sum or a future stream of sums is obtained

• Rate of Discount– The rate of interest used to discount future sums

back to present value


Interest (cont'd)

• Your own personal discount rate will determine how willing you are to save and to borrow.

• The market interest rate lies between the upper and lower ranges of personal rates of discount.


What If . . . the government directs credit to favored industries at artificially low interest rates?

• In recent years, government officials have used tax dollars to extend public credit to selected firms at below-market rates of interest.

• A common argument advanced by these officials is that private savers would require an interest rate that is “too high”.

• Implicitly what they mean is that they think private investors discount the future “too much”.


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



• 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

– Bonds are issued in return for funds lent to the firm.


Example: Explaining the Allure of “Century Bonds”

• A perpetual bond pays a fixed annual coupon payment every year forever.– The price people would pay for a perpetual bond

is the sum of the discounted present values of all future coupon payments.

– This turns out to equal the annual coupon payment divided by the interest rate.

• Bonds with 100-year maturities are called century bonds.


Example: Explaining the Allure of “Century Bonds” (cont’d)

• Bonds with 100-year maturities are called century bonds.– Because the discounted present value of coupon

payments to be received more than 100 years from now is so small, the price of a century bond is very close to the coupon payment divided by the interest rate.



• Reinvestment

– Profits (or depreciation reserves) used to purchase new capital equipment

– Sales of stock are an important source of financing for new firms

– Reinvestment and borrowing are the primary means of financing for existing ones


The Markets for Stocks and Bonds

• Economists often refer to the “market for wheat” or the “market for labor”

• These are more conceptual places rather than actual ones

• For securities there really are markets—physical locations


The Markets for Stocks and Bonds (cont'd)

• Securities

– Stocks and bonds



• New York Stock Exchange (NYSE)

• Nasdaq

• London Stock Exchange (FTSE)

• Tokyo Stock Exchange

• Bombay Stock Exchange (BSE)

• Shanghai Stock Exchange



• The theory of efficient markets

– All information entering the market is fully incorporated into stock prices

– Consequently, stock prices tend to drift upward following a random walk theory

– The best forecast of tomorrow’s price is today’s price plus the effect of any upward drift



• Random Walk Theory

– The theory that there are no predictable trends in securities prices that can be used to “get rich quick”


International Example: Utilizing Artificial Intelligence to Try to Beat the Market

• Some global investment firms have developed artificial intelligence (AI) systems to manage their portfolios of stocks and bonds.

• Mathematicians and computer programmers design these AI systems for financial firms who claim that they provide returns higher than those predicted by the random-walk theory.

• But the fact that these systems are often supplemented with human judgment from management teams suggests that AI alone cannot enable people to “get rich quick.”



• 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


Example: Can the Hindenburg Omen Detect an Impending Market Crash?

• In advance of a substantial stock market downturn in 1987, three events occurred that were seen by investors as a signal of an impending stock market crash.– Stock traders call these three coinciding events

the Hindenburg Omen.– In August of 2010, the Hindenburg Omen events

occurred again, and many traders responded by selling stocks. Their sales pushed stock prices lower.


Example: Can the Hindenburg Omen Detect an Impending Market Crash? (cont’d)

• By the end of the following September, stock prices had more than regained their earlier average.

• Careful study reveals that the Hindenburg Omen precedes substantial market declines only about 25 percent of the time.


You Are There: College Hunks Hauling Junk Weighs Partnership Pros and Cons

• Nick Friedman and Omar Soliman established a junk-removal business as a partnership called College Hunks Hauling Junk.

– They hired and managed college students who conducted junk removal using trucks and equipment that the partners had purchased or leased.

– When the business had expanded to 38 franchises, Friedman and Soliman were advised to form a corporation.

– Instead, they merged their business into another company called 1-800-Junk-USA.


Issues & Applications: Shrinking Numbers of New Proprietorships, Partnerships, and Corporations

• Panel (a) of Figure 21-3 on the next slide shows the number of proprietorships and partnerships formed in the U.S.

• Panel (b) shows the number of proprietorships or partnerships reorganized through initial public offerings (IPOs) of stock.

• The drop-off in formation of new business firms likely reflects the dampened state of economic activity since 2008.

• A number of proprietorships and partnerships are, however, choosing to incorporate outside the U.S.


Figure 21-3 Declining Numbers of New Proprietorships, Partnerships, and Corporations in the United States

Sources: U.S. Department of Labor, Securities and Exchange Commission, and author’s estimates.


Summary Discussion of Learning Objectives

• Economic rent serves an efficient allocative function for resources that are fixed in supply

• The main types of business organization– Proprietorship

– Partnership

– Corporation


Summary Discussion of Learning Objectives

• Accounting profit is the excess of total revenue over explicit costs– To arrive at economic profit, we must subtract

implicit costs as well

• Interest is a payment for the ability to use resources today instead of in the future.


Summary Discussion of Learning Objectives (cont'd)

• The present value of a sum to be received in the future can be calculated through discounting

• The three main sources of corporate funds are stocks, bonds, and reinvestment of profits