Profit= total revenue - total cost
Why do we get wages and pay rents?
What is a wage and why can we get the wage?
Wage is a contractual agreement between worker and employer that specifies precisely what worker will be doing and what employer will be getting and giving.
Contract lays out what a worker should do and how much he can get; employer knows how much he gets and how much cost he bears to hire the worker.
So the whole essence of wage is to eliminate uncertainty.
Rent also functions to reduce the uncertainty.
Lenders know how much he can get as compensation and borrowers know how much he must produce.
What is interest?
It is the price of using money today rather than future.
Price comes from demand and supply.
People want purchasing power that they don't possess now, so interest is the price of obtaining unearned resources, the price to persuade lenders to give their current purchasing power to the borrowers.
So wages are return of working, rent are return of leasing machinery, interest is return of loaning out purchasing power.
What is the distinction between accounting profit and economic profit?
Application:
Suppose Rachel can earn $30000 per year as a secretary. She owns a building that rents for $6000 per year. She also has a savings account $23000, and the interest rate is 10%.
Now Rachel wants to quit her current job and open a pizza shop. She will use her own building, cash out all 23000 bucks and borrow 20000 dollars from the bank. She estimated that she can have revenue of 85000 dollars.
Question: Is it a good choice for Rachel?
Explicit cost: 23000+20000+20000*10% So account profit is 40000
Implicit cost: foregone wages 30000, normal rate of return 23000*10%, foregone rent 6000
So econ profit is revenue-implicit-explicit= $1700, which means that Rachel will be $1700 richer to be an entrepreneur than if she choose second best option.
When there is a profit, new competitors will come in to get profit they will (1)lower price (2)increase quality, but the consequence is that total revenue will be lower and less efficient producers will be rationed out of the market, leaving the most competent ones to compete.
The prosperity of pizza market will increase demand for raw material and thus the total cost will increase.
So in a perfect market, price will be the marginal cost of good.
Econ profit is the return of entrepreneur ability
Question: why does econ profit exist?
(1)people's wants are unlimited (2)licensure and patent
Losses are key to market because it's the signal whether you are good at what you do.
What's the problem of insulating losses?
(1) Losses destroy resources
(2) U lose feedback, having no idea whether you are good at what you do or not.
(3) people will be more audacious.
The incentives between profit and non-profit organizations are different.
Capitalism is full of uncertainty and it's too dynamic for some people.
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