Transcription
How's it class? So today we're going to discuss chapter 21. Chapter 21 has to do with the concept of economic rent.
Now, where we just came from in the earlier chapter, we're talking about utility, which we really looked at it from a consumer's perspective or an individual, but essentially, uh, not a firm, not a business perspective. Now we're switching our perspective and we're primarily from the majority of the chapters moving forward, actually for the next few chapters, I think we're going to be looking toward the perspective of the firm. And so now you kind of have to shift hats and you kind of need to think like a business owner or entrepreneur or someone who's worried about making profits.
So let's look at the concept of economic rent. The economic rent is essentially a payment for the use of any resources over and above its opportunity cost. Now, it's a very important concept, this idea of an opportunity cost. The opportunity cost is how economists look at things. We always look at what is foregone, what we, what we give up whenever we take undertaken action. So, for example, economic rent to labor, uh, it's a concept that will really apply to, for example, professional sports superstars. You're looking at LeBron James, Michael Jordan, uh, Stephen Curry, and then rock stars, movie stars, world-class models, and of course, successful inventors and innovators. One of the things about economic rent is that there's high levels of economic rent paid to these types of people because it's what their comparative advantage is. It's what they seek value. It's what directs them to these activities because of their skill sets, and it directs them to the appropriate use.
So, economic rent and the allocation of resources. Essentially, economic rent allocates resources to their highest valued use. Considering some concepts, let's look at the concept of a firm. A firm is a business organization that employs resources to produce goods or services for profits. So, a lot of, a lot of concepts now that we're going forward with, we'll be looking at things from the idea of a firm. There's a legal organization of firms, and we can break it up into these three basic ones: proprietorship and partnership, as well as a corporation.
Um, so if we're going to be looking at the profits of a firm, we need to understand how we're going to measure these profits, and there's going to be two perspectives: the accounting versus the economic. Now, does it mean that accountants don't look at the concept of economic profit coming up after this? No, it doesn't mean that. But in terms of what they record, how they record things in terms of their ledgers and so forth, their balance sheets and whatnot, it tends to be focused on accounting profit. And you need to make sure that you incorporate concepts of such as opportunity costs to have a fuller understanding beyond what the books on the ledgers of what the numbers on the ledger reveals.
So, an accounting profit is essentially total revenue minus total explicit cost. So please keep this concept in mind. Generally, we look at total revenue, uh, minus total costs, uh, right now we're breaking up total costs into explicit as well as implicit costs. Accounting profit only looks at explicit cost. Explicit costs are essentially costs taken into account because they must be paid. So, if you're a firm, you're looking at costs such as wages that you pay, the taxes that you pay, as well as rent, whether it be rent for your physical capital or rent for your location. Explicit costs are what are, what is typically calculated. It's the things that have a dollar value attached to it, things that you must write a check for or dip into your petty cash.
Implicit costs, however, this is the concept that separates economists from the accountant's perspective. Implicit costs are not out of pocket and hence not normally explicitly calculated. Implicit costs are the, is the opportunity cost of factors of production that are owned or the sacrificed alternative. So, owner-provided capital and owner-provided labor all have implicit costs attached to it. Now, one important thing is that a lot of, uh, I, I think at this level, this concept of normal rate of return is not oftentimes how students think of things. They don't incorporate this concept of normal rate of return. But as many of you are probably trying to get into business, into the finance world, there is a normal rate of return that must be accounted for. It's the amount that must be paid to an investor to induce investment in a business. It is the opportunity cost of capital.
Another perspective or angle to look at that is imagine that somebody you know has a million dollars and you need to borrow some of it. So maybe it's your, maybe it's your uncle, or maybe it's, uh, it's a close friend, and you figure, hey, I need to borrow a hundred thousand dollars, maybe you want to start up a business. And so this hundred thousand dollars, you're hoping that they could just maybe loan it to you. Now, uh, if they loan it to you, you might not expect them to charge you interest because their families are, because their friend. But, and this is oftentimes how rich people get rich or maintain wealth, is that they always make sure that their resources are doing what's appropriate. Now, if you had a million dollars liquidity as a resource, you would not be having it sitting in your mattress unless you're a special type of individual who might not be trusting the banking system or whatnot. But normally people know that they, they have a million dollars, it shouldn't just be sitting there gathering dust. It should be gathering interest. It's a resource that you could be capitalizing upon. So you would expect, let's just say the going rate of interest for a million dollars is five percent. That's incredibly high, uh, if it's just like sitting in a savings account because normally savings accounts are somewhere between 0.25, maybe up to 2 percent. But let's just say it happens to be 10. That's the going rate. That would be the normal rate of return that they would expect. So if they loaned it to you, it wouldn't be interest-free because they're giving up by loaning it to you, they're giving up that 10 percent that they could be earning out there in the marketplace. That's the normal rate of return that they would expect.
Same thing applies to nothing, something's not so easy as a million dollars, but maybe a piece of physical capital or a piece of commercial property. They would expect it to earn some sort of money, some normal rate of return. They wouldn't just let it sit there empty because they're giving up that normal rate of return and in a sense would be taking a loss by letting it sit there empty.
If we're talking about a commercial property, so the opportunity cost of capital, the available return on the next best alternative investment, and it is considered a cost of production. Now, it's an opportunity cost, so sometimes it's not always clear, and therefore it's, it falls into the implicit cost category and not represented in the accounting explicit cost.
So, if we're going to specifically discuss accounting profits versus economic profits, profits in economics means the income entrepreneurs earn that is over and above all costs, including their own opportunity cost of time, plus the opportunity cost of capital that they have invested in their business. So, the first point, over and above all costs, including their own opportunity cost of time. Their time is valuable, and they expect a certain normal rate of return. LeBron James probably doesn't get out of bed for a commercial unless he's making a minimum of a couple million dollars. That is his opportunity cost of his time, um, as well as other things that he might go into play in terms of capital. It might not just be, uh, something, uh, like his presence and his skill set, but it might be things like a building or whatever else that that might come into play.
So, economic profits. Economic profits are total revenues minus the total opportunity costs of all inputs used. So, more specifically, it's a total of implicit and explicit costs.
Taking a look at this chart, we have two sides of it representing the same things. At the very top, we have total revenue. So here we have total revenues, here total revenues, all topped out over here. Now, if we're going to the right side, we're talking about accounting costs. So this would all be the explicit cost, and this is the things that must be paid, and it's, it's very easy. The rent that goes into into there, the taxes that go into there, your input costs, very easy. And so you got your total revenues minus your total cost. What you're left with is your profit on the accounting side, it's your accounting profit. However, on the left side is the same concept in terms of total revenues, but now in terms of our costs, we're expanding it. We're looking at economic costs. So we're looking at the accounting costs plus the normal rate of return to investment and opportunity cost of capital plus all other implicit costs. So whereas the accounting side just looked at explicit costs, now this section here, that's the normal rate of return on the investment that we would have expected. So, for example, it would be the foregone 10 percent interest that your million dollars or 100,000 that you're going to loan out could have been earning in the marketplace. Now you're going to count that as a cost, and therefore the profit is no longer that entire green area here in terms of accounting profit. Now economic profit shrinks because costs now include the implicit costs, which is this blue area, which is the way economists think. So now we always look at what did we also give up by undertaking this activity, whether it be a business investment or whether it be, uh, some sort of other business activity. Now we have our explicit plus implicit costs calculated in here. So we have a better idea of truly what type of profit we are capturing.
So, in your homework sets, you're going to be seeing problems where you're asked to calculate, uh, certain things. What is your economic profit, for example? Or, uh, so essentially, what you might be given is a list of things. You might be given things like, uh, wages that you pay. So wages that you pay, um, you might be looking at utility costs, you might be looking at rent, all things that are explicit and that have a dollar value that are clearly mentioned. But you might have, in terms of your cost, you might have used some of your own funds. Maybe you had a hundred thousand dollars to invest in your business, and you're trying to figure out the costs. That hundred thousand dollars that you invest in your business, well, it's still yours, so that's not part of it. But that hundred thousand dollars could have been earning, let's just say 10 percent. And that 10 percent would be this portion here that you also need to account for that you gave up by now investing into your business instead of investing it into the money markets, for example. So you need to calculate and add that implicit cost, that foregone opportunity, to capture the true idea of what costs you're bearing, because you want explicit plus implicit costs.
Getting back to the goal of the firm, the goal of the firm is profit maximization. That sounds very obvious, but you're going to see questions in in economics all the time that might sound right. For example, without seeing this right here, and you heard the question, the goal of the firm is to maximize revenues. And that might sound good. You're saying, yeah, goal of the firm might be to maximize revenues, that sounds good. But that's only one side of the equation. It's overlooking the cost concept. So therefore, we're really looking at the goal of the firm is to maximize profits because you can maximize revenues, but your costs may grow by so much that your profits might actually turn negative, and that's not worth it. So maximizing revenues is actually not the goal of the firm, it's to maximize profits.
So, if you recall the theory of consumer demand, uh, the idea was utility satisfaction or utility maximization. The theory of the firm is now profit maximization. Now, one of the things that we're going to be incorporating is understanding how interest comes into play, because interest is oftentimes the opportunity cost that is foregone that we need to account for and work into our cost analysis. 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. Now, usually, when a business, physical capital is so expensive that oftentimes businesses need to take out loans to acquire the liquidity to purchase the physical capital because they need whatever money they have, maybe for for operating expenses, so they can't, uh, invest into something like fixed capital. So they often have times have to get a loan and therefore bear interest.
Now, uh, the reason for interest, the variations in the rate of annual interest for the credit depend on, for example, the length of the loan, risk, and the hand, it says handing, it's supposed to be handling charges. Handling charges. So the length of the loan, the larger you ask some, uh, uh, somebody who has money to be separated from that money so you can use it, the longer you ask them to do that, the more interest it's going to cost you to have them separate that. So like a 30-year mortgage, you might be paying four percent interest right now in these really low interest, or even three, three point something percent, uh, but if you go down to a 15-year mortgage, because you're separating the bank from their money for a shorter period of time, you get a lower interest cost that you got to pay them. But you extend out to a 30-year mortgage, you're going to hold it, you're going to use their money for that long, they're going to charge you a higher interest rate. Risk, of course, the higher risk you are, in other words, risk in terms of default, not being able to pay back the money that you're borrowing, the higher the risk, the higher the interest you're going to pay. And then handling charges, uh, the more that it costs in terms of, uh, processing fees and so forth, oftentimes gets incorporated into the interest, and there's other handling charges as well, but we'll keep it simple like that for now.
Now, we're going to be understanding the concept of nominal rate of interest versus the real rate of interest. The nominal rate of interest is the market rate of interest expressed in today's dollars because over time inflation occurs. That's the general rule, and the dollar loses purchasing power, it loses value. So as the dollar changes, uh, as the dollar loses its value or gains value based on inflation or deflation, we need to account for the real rate of interest, which is the nominal rate of interest minus the anticipated rate of inflation.
Now, nominal, our market rate of interest is approximately equal to the real rate of interest plus anticipated inflation, or I sub n is equal to I sub r plus anticipated inflation rate. I'm going to write it a little bit differently in a sense. I'm going to write I, which is the nominal rate of interest, is equal to R, which is the real rate of interest, plus pi, which is the anticipated inflation rate. This is oftentimes, uh, referred to as the Fisher effect. And by the way, usually real rate of interest is considered fixed. In other words, when price changes don't come into play, when inflation or deflation doesn't come into play, then then we look at, then we can look at the interest rate is a little bit more meaningful. Meaning that, like, if I'm going to borrow without inflation occurring, I'm gonna borrow a hundred thousand dollars from you. The normal, the, we might say that well, the market base is at 10 percent, so I'm gonna have to pay you the real rate of interest of 10 percent. But when inflation occurs, that changes the value of the money I'm paying back. Here's the inflation aspect. So if inflation occurs, then it changes the nominal interest rate that I must pay, if it is adjustable to compensate for the fact that the amount that I'm paying you is actually worth less than when we agreed upon. So if inflation occurs, that means the value of the dollars that I'm paying you back now loses value, it buys less. So to compensate for that, assuming you would write it into the, into the, uh, into the loan agreement, which is the equivalent of an adjustable rate, uh, interest rate, the nominal rate would increase. So you get more dollars back as inflation occurs to compensate for the loss of purchasing power. So therefore, we kind of maintain this, this parity, this this equality of what we're trying to, uh, establish in our loan agreement, that I pay you back a certain amount because you expect to be able to do certain things with the amount that you earn from me by loaning it to me.
Okay, so businesses make investments which often incur large costs. They need to compare their investment costs today with a stream of future profits, and they must relate present costs to future benefits. Now, interest rates are used to link the present with the future. Remember, interest rates become so prevalent in, if you're planning to get into business and finances, the world becomes about interest rate for you. That's going to be your main concern in life. What type of interest are you earning? Are you beating the market rate? Are you beating the other hedge fund managers who are trying to earn money for their big wealthy investors? That's every, everything becomes measured in interest. How much are you paying? How much are you earning in terms of interest? It becomes so prevalent.
Okay, so present value. The value of a future amount expressed in today's dollars. It is the most that someone would pay today to receive a certain sum at some point in the future. It's all based on this concept of interest rate as an opportunity cost. What could you have been earning, or what could someone have been earning on a certain amount in terms of a dollar value?
So, looking at the formula for present value, it's going to be present value is equal to the future value divided by one plus the interest rate quantity to the nth power, where PV one is the present value of some one year hence, FV is the future val, future sum paid or received one year hence, I is going to be the market rate of interest, and N is going to equal to the number of years, or it could be the number of compounding periods. For example, the problem could say compounded monthly. We're not going to see that. We're going to be generally, it's done annually, but I'm just telling you that and could be depending based on the parameters of the problem, it could be annually, could be monthly, it could be daily, who knows, depends.
Okay, so discounting. It's the method by which the present value of the future sum or future stream of sums is obtained. So, for example, let's just say we have an agreement where I'm supposed to pay you five thousand dollars in five years. Now, you want it today. You just say, you know what, I know our agreement is I get 5,000 from from me, I'm supposed to pay you in in five years, but for whatever reason, you need it today. So give me 5,000 dollars. I'm gonna say, no, I'm not gonna give you 5,000 dollars because what I was supposed to give you is 5,000 dollars in five years. What I'm gonna give you is a discounted amount. I'm gonna give you four thousand two hundred eleven dollars and thirty-five cents. Why? Because that four thousand two hundred dollars and whatever I said, if you take that and invest it at the going interest rate for five years, compounding interest, that will equal to five thousand dollars. What I just did was I took that five thousand dollars five years hence and I discounted it to a lower amount that you, when if you got that lower amount, invested it for five years, you would come out with a five thousand dollars. So the rate of discount, it's the rate of interest used to discount future sums back to present value.
So, let's take a look at a couple of formulas. The one that was given was this one: the present value is equal to the future value divided by 1 plus I to the nth. I'm also adding the future value, which is the future value is equal to present value times one plus I to the nth. All they are are just rearrangements of each other. So if I wanted to get the future value, I would use the present value and I would isolate the future value, and what it would give me is the above formula. Okay, but let's start off with one that is probably a little more, uh, common in terms of what students think, basically the freshman, sophomore level, they tend to look at things in that's comfortable with the future value calculations. So let's see what future value calculation first.
So, taking a look at this problem, we want to know what the future value is if the principal amount, the present value that we have, is five thousand dollars, and the going interest rate is three percent, and in five years, what is the future value of this five thousand dollars? So we're gonna use that future value formula, which is this: the future value is equal to the present value, five thousand dollars, one plus the three percent interest to the five years that we're compounding. And compounding, by the way, is earning interest upon interest. So you earn interest, you keep it in there as in your investment, and now you earn interest on the principal plus the interest you just earned, and it just continues so forth and so on. So here we have the future value is going to equal to 5000 times that by 1.03 to the fifth power, and that's going to be 5796 dollars and 37 cents. Okay, so that's the future value. This is the one that usually people look for. They look today, we invest it, and we project it forward. That's the future value. But we're also talking about discounting, looking at what an investment supposed to yield in the future and what it's valued then today, considering the interest rate.
So, let's do another problem going the other direction. So this is a situation where we're looking at, you're going to be given 5,000 or earned 5,000 in five years. The going interest rate is 3. Now, let's just say you don't want that 5,000 in five years, you'd want it today. So the person is willing to pay it to you today, but they're gonna do it discounted. They're gonna discount it to its present value. So what is the present value? So using that present value calculation, 5000 divided by 1.03 to the fifth power. Now we have it discounted. So the present value of five thousand dollars five years hence today is gonna be worth five thousand, four thousand three hundred and thirteen dollars and four cents, given an interest rate of three percent compounded annually. Okay, hope that makes sense.
Okay, so getting back to it, let's look at, uh, some more concepts tied into, uh, business and corporations and investment and so forth. So there's some corporate financing methods. One is a share of stock. That's one way that a corporation can raise, uh, financial capital, and they can issue shares of shares of stock. And a share of stock is a legal claim to a share of a corporation's future profits. Two types of stock: common stock, which incorporates certain voting rights regarding major policy decisions of the corporation, as well as preferred stock, which includes the common stock benefits, but owners are accorded preferential treatment in the payment of dividends on top of that. So, uh, common stock, uh, get, uh, may not get the dividends that a preferred stock owner may get.
Now, the bond, on the other hand, a little different. Uh, stocks and bonds, you've heard those lumped together, but they're very different. Stock is the share of ownership, whereas a bond is a legal claim against a firm. It's kind of like an IOU. You can look at that. It's also referred to like a note or an IOU. A bond is a legal claim against the 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, and bonds are issued in return for funds lent to the firm.
Then there's the concept of securities, which is generally just stocks and bonds. So you have the Securities and Exchange Commission, which oversees the trading and the rules and regulations within stocks and bonds. Now, the markets for stocks and bonds can be in the following. You see the New York Stock Exchange, Nasdaq, London, Tokyo, Bombay, Shanghai, and so forth. There's market indexes which measure, uh, certain areas. So the Dow Jones Industrial Average, Standard & Poor's 500, and there's, uh, goes so forth and so on.
Okay, now when it comes to the stock market, uh, there's some ideas behind it that people either consider or disregard depending. There's one of the big theories is the theory of efficient markets. The theory of efficient markets says that all information entering the market is fully incorporated into stock prices, and then consequently, stock prices tend to drift upwards following what we call a random walk theory. And then the best forecast of tomorrow's price is today's price plus the effect of this kind of just upward drift that tends to occur. Now, the theory of efficient markets essentially saying that it's really hard to get an advantage. If you think that this is going to be a really bad natural disaster season and therefore it's going to depress certain stocks and therefore you're going to invest in it and hopefully, uh, are, I'm sorry, not invest in it, but invest in other stocks instead of these depressed ones and therefore maybe these other ones might have a higher rate of return. Well, the theory of efficient markets says all this information that you are considering, because there's big money people in involved and they hire experts to help them either protect their wealth or gain wealth, uh, it's all considered already. You're not some genius that's gonna think of something that other people already haven't, especially people who are paid big bucks to think of these things. They've already incorporated it in. Therefore, you're not going to get an advantage in terms of stock prices because of this. That's the theory of efficient markets. But the general, the general trend for stocks is to increase over time. So that's your gain. This, this random walk theory, this upward drift is where you get your overall gain.
Now, I have a family member who's in Hong Kong. He used to manage one of the DFS, duty-free stores, of the billionaires, uh, finances, and he used to also be a hedge fund manager in other areas. And he was telling me that, you know, it's really funny that he sees that this concept of efficient markets is is still taught because in his big money world, people like him, they take advantage of the fact that this theory of efficient markets doesn't exist. He says, I make my money because the markets do not fully incorporate these, uh, incorporate this, this information. So he says, they, he gets certain advantages that others don't, and he's able to take advantage of it. Therefore, the theory of efficient markets is not really valid. Now, that's just his opinion being stated. I, I might, if you ask me which side, I might say that there's certainly something to what he says on some area, but there is also the theory of efficient markets does have a place in terms of your understanding of the stock market.
This random walk theory, it's a theory that there are no predictable trends in security prices, uh, that can be used to, quote, get rich quick, except maybe inside information. But inside information is information that is not available to the general public about what is happening in a corporation. It is considered illegal and punishable by substantial fines and imprisonment. However, you're going to be seeing, especially in the news, you're going to be seeing politicians who have are on committees, they are on different types of groups where they have inside information to trends and legal decisions that can have huge impacts on the marketplace. And what you're going to see is that especially when they make the news, is that certain politicians maybe sold their stocks or before something occurred where the stock market tumbled, therefore they sell their stocks, then the information gets released about whatever policy is being implemented, and then the stock market tumbles. And maybe they buy in after that at a discounted price after it tumbles, they buy their stock back at a cheap price, and then they can experience the gains again when it rebounds, but they avoided the loss. And that's con, comprises insider information and insider trading. That is illegal. But in this day and age, it seems like, uh, those types of laws carry a lot less weight, and certain types of people in certain positions tend to get away with things that normally investors like you and I would be persecuted as well as prosecuted for.
Anyway, that's, uh, it for this chapter. I hope a lot of this made sense. Um, hopefully you guys are staying well, stay healthy, and I look forward to talking to you guys soon. Aloha.