DEMAND AND SUPPLY ANALYSIS: THE FIRM
The theory of the consumer is the study of consumption—the demand for goods and services—by utility-maximizing individuals. The theory of the firm, the subject of this chapter, is the study of the supply of goods and services by profit-maximizing firms. Conceptually, profit is the difference between revenue and costs. Revenue is a function of selling price and quantity sold, which are determined by the demand and supply behavior in the markets into which the firm sells or provides its goods or services. Costs are a function of the demand and supply interactions in resource markets, such as markets for labor and for physical inputs. The main focus of this chapter is the cost side of the profit equation for companies competing in market economies under perfect competition.
The study of the profit-maximizing firm in a single time period is the essential starting point for the analysis of the economics of corporate decision making. Furthermore, with the attention given to earnings by market participants, the insights gained by this study should be practically relevant. Among the questions this chapter will address are the following :
- How should profit be defined from the perspective of suppliers of capital to the firm?
- What is meant by factors of production?
- How are total, average, and marginal costs distinguished, and how is each related to the firm’s profit?
- What roles do marginal quantities (selling prices and costs) play in optimization?
OBJECTIVES OF THE FIRM
The objective of the firm is to maximize profit over the period ahead.
Such analysis provides both tools (e.g., optimization) and concepts (e.g., productivity) that can be adapted to more complex cases, and also provides a set of results that may offer useful approximations in practice. The price at which a given quantity of a good can be bought or sold is assumed to be known with certainty (i.e., the theory of the firm under conditions of certainty). The main contrast of this type of analysis is to the theory of the firm under conditions of uncertainty, where prices, and therefore profit, are uncertain. Under market uncertainty, a range of possible profit outcomes is associated with the firm’s decision to produce a given quantity of goods or services over a specific time period. Such complex theory typically makes simplifying assumptions. When managers of for-profit companies have been surveyed about the objectives of the companies they direct, researchers have often concluded that (1) companies frequently have multiple objectives; (2) objectives can often be classified as focused on profitability (e.g., maximizing profits, increasing market share) or on controlling risk (e.g., survival, stable earnings growth); and (3) managers in different countries may have different emphases.
By defining profit in general terms as the difference between total revenue and total costs, profit maximization involves the following expression:
Types of Profit Measures
Accounting Profit
Accounting profit is generally defined as net income reported on the income statement according to standards established by private and public financial oversight bodies that determine the rules for calculating accounting profit. One widely accepted definition of accounting profit—also known as net profit, net income, or net earnings—states that it equals revenue less all accounting (or explicit) costs. Accounting or explicit costs are payments to non owner parties for services or resources that they supply to the firm. Often referred to as the“bottom line” (the last income figure in the income statement), accounting profit is what is left after paying all accounting costs—regardless of whether the expense is a cash outlay. When accounting profit is negative, it is called an accounting loss. Equation 3-2 summarises the concept of accounting profit:
When defining profit as accounting profit, the TC term in Equation 3-1 becomes total accounting costs, which include only the explicit costs of doing business. Let us consider two businesses: a start-up company and a publicly traded corporation. Suppose that for the startup, total revenue in the business’s first year is h3,500,000 and total accounting costs are h3,200,000. Accounting profit is h3,500,000 h3,200,000 ¼ h300,000. The corresponding calculation for the publicly traded corporation, let us suppose, is $50,000,000 $48,000,000 ¼ $2,000,000. Note that total accounting costs in either case include interest expense—which represents the return required by suppliers of debt capital—because interest expense is an explicit cost
Economic Profit and Normal Profit
Economic profit (also known as abnormal profit or super normal profit) may be defined broadly as accounting profit less the implicit opportunity costs not included in total accounting costs:
We can define a term, economic cost, equal to the sum of total accounting costs and implicit opportunity costs. Economic profit is therefore equivalently defined as:
For the start-up company, economic profit was zero. Total economic costs were just covered by revenues, and the company was not earning a euro more or less than the amount that met then opportunity costs of the resources used in the business. Economists would say the company was earning a normal profit (economic profit of zero). In simple terms, normal profit is the level of accounting profit needed to just cover the implicit opportunity costs ignored in accounting costs. For the publicly traded corporation, normal profit was $1,500,000: normal profit can be taken to be the cost of equity capital (in money terms) for such a company or the dollar return required on an equal investment by equity holders in an equivalently risky alternative investment opportunity. The publicly traded corporation actually earned $500,000 in excess of normal profit, which should be reflected in the common shares’
market price.
Economic Rent
The surplus value known as economic rent results when a particular resource or good is fixed in supply (with a vertical supply curve) and market price is higher than what is required to bring the resource or good onto the market and sustain its use. Essentially, demand determines the price level and the magnitude of economic rent that is forthcoming from the market. Exhibit 3-1 illustrates this concept, where P1 is the price level that yields a normal profit return to the business that supplies the item. When demand increases from Demand1 to Demand2, price rises to P2, where at this higher price level economic rent is created. The amount of this economic rent is calculated as (P2 P1) 3 Q1. The firm has not done anything internally to merit this special reward: It benefits from an increase in demand in conjunction with a supply curve that does not fully adjust with an increase in quantity when the price rises.
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