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Chapter 21
Rents, Profits,
and the Financial
Environment
of Business

Introduction
Since the mid-2000s, fewer individually owned or coowned 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.

21-2

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


21-3

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


21-4

Chapter Outline
•
•
•
•
•

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


21-5

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.

21-6

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.


21-7

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


21-8

Figure 21-1 Economic Rent


21-9

• Economic rent to labor
– Professional sports superstars
– Rock stars
– Movie stars
– World-class models
– Successful inventors and innovators


21-10

• 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.


21-11

• Economic rent and the allocation of
resources
– Economic rent allocates resources to their
highest valued use


21-12

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?


21-13

Table 21-1 Superstar Earnings


21-14

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


21-15

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


21-16

• The legal organization of firms
– Proprietorship
– Partnership
– Corporation


21-17

Table 21-2 Forms of Business
Organization


21-18

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


21-19

• Advantages of proprietorships
– Easy to form and dissolve
– All decision-making power resides with the sole
proprietor
– Profit is taxed only once


21-20

• 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


21-21

• 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


21-22

• Advantages of partnerships
– Easy to form and dissolve
– Partners retain decision-making power
– Permits more effective specialization
– Profit is taxed only once


21-23

• Disadvantages of partnerships
– Unlimited liability
– Decision making more costly
– Dissolution often occurs when a partner dies or
leaves the firm.


21-24

• 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


21-25

• 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


21-26

• Advantages of corporations
– Limited liability
– Continues to exist when owner leaves the
business
– Raising large sums of financial capital


21-27

• Disadvantages of corporations
– Double taxation
• Dividends
– Portion of corporation’s profits paid to its owners
(shareholders)

– Separation of ownership and control


21-28

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.


21-29

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


21-30

• 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


21-31

• 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


21-32

• 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


21-33

• 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


21-34

• 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


21-35

• Economic Profits
– Total revenues minus total opportunity costs of
all inputs used
– The total of implicit and explicit costs


21-36

Figure 21-2 Simplified View of
Economic and Accounting Profit


21-37

• 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


21-38

• 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


21-39

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.


21-40

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


21-41

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


21-42

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


21-43

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


21-44

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


21-45

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


21-46

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


21-47

Interest (cont'd)

PV1 =

FV1
1+i

where
PV1 = Present value of a sum one year hence
FV1 = Future sum paid or received one year hence
i

= Market rate of interest


21-48

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


21-49

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


21-50

Table 21-3 Present Value of a Future
Dollar


21-51

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


21-52

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.


21-53

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”.


21-54

• 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


21-55

(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


21-56

(cont'd)
• 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.


21-57

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.


21-58

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.


21-59

(cont'd)
• 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


21-60

• 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


21-61

(cont'd)
• Securities
– Stocks and bonds


21-62

(cont'd)
• New York Stock Exchange (NYSE)
• Nasdaq
• London Stock Exchange (FTSE)
• Tokyo Stock Exchange
• Bombay Stock Exchange (BSE)
• Shanghai Stock Exchange


21-63

(cont'd)
• 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


21-64

(cont'd)
• Random Walk Theory
– The theory that there are no predictable trends
in securities prices that can be used to “get rich
quick”


21-65

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.”


21-66

(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


21-67

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.


21-68

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.


21-69

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.


21-70

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.


21-71

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.

21-72

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


21-73

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.


21-74

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


21-75

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