Profits and LossI. ProfitA. The most common definition is simply total revenue (P x Q) minus total costB. A synonym would be net revenueII. Wage, Rent, and Interest: Incomes Established in Advance by ContractA. Put simply, wage represents the payment to labor, rent represents payments to landlords and others who lease their property, such as tools and machinery, and an interest rate represents payment to lenders of financial capital.B. Wage, rent, and interest represent a price: a price for labor services, a pricefor rental property, a price for credit.C. They are earned income.III. Profit: Income That Can Be Positive or NegativeA. Profit is the fourth form of earned income in a market economy, but it is different than wage, rent, or interest.B. Profit is the residual, or the difference, between revenues and costs.C. Profits can be positive or negative!D. A negative profit is called a loss.E. Unlike the laborer, who will get paid for his labor services, the entrepreneur seeking profits can never be sure that personal effort will in fact be profitable.IV. Calculating Profit: What Should Be Included In Costs?A. Remember that “cost” means the next-best forgone opportunity.B. Part of the cost of doing business is the owners’ own labor (Dave and Tonyexample) even if they write no paycheck to themselves.C. Why?V. Comparing Economic Profit and Accounting ProfitA. Accountants measure explicit costs—the expenses that are incurred to produce a good or service,B. However, in the economic way of thinking, the expenses do not capture the total costs of production.C. Economic profit includes the explicit and implicit costs of production—the value of all scarce resources used in the production process. D. ExampleSuppose we have a woman named Eva who is an employee at a firm that pays her $30,000 a year. Suppose also that she owns a small building that she rents for $6,000 per year, and she has $23,000 in a certificate of deposit that earns 10 percent ($2,300 per year).Now suppose Eva quits her job to become her own boss. She opens up a restaurant and works full-time. She uses her own building and cashes out her $23,000 CD, and also borrows an additional $20,000 (at 10 percent annual interest) for hired labor, equipment, payment for ingredients, etc. for the first year. There are no guarantees that Eva’s restaurant will prosper. She has become an entrepreneur who is willing to take the gamble.Suppose Eva’s total revenues are $85,000 after one year. What is her profit? Well, that depends on what will be included in the “total costs” of her businessoperation. Her accounting profit would be:Accounting Profit = TR – TC (all explicit costs)= $85,000 - $45,000 ($43,000 for hired labor, ingredients, equipment, etc., plus $2,000 for interest on the loan)= $40,000But Eva also realizes that:*Her own labor is not a free good. She used to earn a salary*Her building is not a free good. She used to earn rent*Her financial capital is not a free good. She used to earn interest on her CD.So, her forgone wage, rent, and interest are very real opportunity costs for her. These added together ($38,300) represent Eva’s implicit costs (something that does not show upon her accounting ledger because they don’t show up as monetary expenses).Therefore, Eva’ s economic profit is:Economic Profit = TR – TC (all costs, explicit PLUS implicit)= $85,000 – ($45,000 + $38,300)= $1,700The $1,700 economic profit is the return to Eva’s entrepreneurial skills. E. The key point is that profit is due to uncertainty. It is the result of predicting the future more accurately than others have predicted it and then acting on that prediction.F. The Meaning of Zero Economic Profit1. Where total revenue = total opportunity cost of production. Or when firms earn a “normal rate of return.”2. Entrepreneurs do earn a positive accounting profit , but at zero economic profit, they make no more than what their money would have earned through the prevailing rate of return on any other investment.VI. So What Does Making a Profit Prove?A. First, let’s not be surprised that businesses want to make a profit!B. Are you evil when you want to make as much as possible in terms of your salary or hourly wage? I think you would answer “No.”C. So, then why are we supposed to be angry when we hear “Exxon made record profits this year” or “Microsoft’s profit went up 50% over last year making Bill Gates even richer” ?D. Bottom line: if a company is making a profit (assuming no special government privileges), then they must be doing something right! They must be providing a good or service that consumers want. “But we have tobuy their product…” Really? No…you just prefer buying their product than having to deal with substitutes!E. And after all, when the company makes a profit, let’s not forget, a company is not some nebulous being. It is composed of people! So, when the “company” does well, so do its employees who provide homes, schooling, and food for their families, as well as benefiting investors—again, people—not all of whom are millionaires. Some are just ordinary middle-class Americans.Costs and the Supply of GoodsI. Economic Role of CostsA. Economic Role of Costs1. The demand for a product indicates the intensity of consumer’s desires for an item.2. The (opportunity) cost of producing the item indicates the desire of consumers for other goods.B. Explicit and Implicit Costs1. Costs may explicit or implicit.a. Explicit costs result when a monetary payment is made.b. Implicit costs involve resources owned by the firm and don’t involve amonetary payment.(1) e.g.: Owners time running the firm or the normal rate of return on the owner’s financial investment (opportunity cost of equity capital).C. Total Cost1. Total Cost = explicit + implicit costsD. Accounting and Economic Profit1. Economic profit is total revenues minus total costs (including all opportunity costs).2. Economic profit requires an above normal rate of return, a rate of return greater than the opportunity cost of capital.a. Firms earning zero economic profit are earning exactly the market rateof return.3. Accounting profit is total revenue minus expenses of firm over a designated time period.a. Often excludes implicit costs such the opportunity cost of equity capital.b. Accounting profit is generally greater than economic profitII. Short Run and Long RunA. Short Run1. The short run is a period of time so short that at