Understanding Economic Profits and Business Models

Economic Profits

Economic profits are calculated as total revenue (TR) minus accounting (explicit) costs and implicit costs.

Economic costs = accounting (explicit) costs - implicit costs.

In managerial economics, the term "costs" refers to economic costs, and the term "profits" refers to economic profits.

Baumol's Sales Revenue Maximizing Model in Practice

Large firms have research units that develop new product ideas or production techniques. The application of these projects is spread over time to avoid wide swings in the firm's economic performance. Baumol seems to imply that the risk-avoidance and the desire for steady growth of large corporations secure 'orderly markets,' in the sense that they have stabilizing effects on the economy.

O. Williamson's Managerial Utility Maximizing Model

Application of the model: take-overs!

A quick increase in reported profits without altering business fundamentals and the model.

J. Williamson's Integrative Model in Practice

A firm will seek the combination of current revenue and growth rate that gives maximum growth and present value of future sales.

This is dependent upon the extent to which managers can pursue their own objectives when they conflict with others.

Explicit Costs

Explicit costs are the actual expenditures of the firm to hire, rent, or purchase the inputs it requires in production. These are expenses or out-of-pocket costs (e.g., rental price of capital, purchase price of raw materials, wages, fuel, semi-finished products) and are recorded in a firm's accounts.

Implicit Costs

Implicit costs refer to the value of inputs owned and used by the firm in its own production activity. Even though the firm does not incur any actual expenditures to use these inputs, they are not free.

Examples:

• Salary that could have been earned in the best alternative employment.
• Highest return received from investing the capital in the most rewarding alternative use.
• Renting land and building to the highest bidder.
• Leisure time foregone.

Freeman's Contribution to Stakeholder Theory

Stakeholders are defined as "any group or individual that can affect or be affected by the realization of a company's objectives" (Freeman, 1984).

• Managers should perform a value analysis to identify congruency or fit between the firm and its stakeholders.
• This is not about ethics but corporate strategic management.
• Identify the type of effects that stakeholders have on the firm and that the firm has on stakeholders.
• Effects can be economic, technological, social, political, and managerial.

Profit Theory

Profits vary among firms and industries. Several theories explain these variations.

Frictional Theory of Economic Profits

Factors influencing demand and supply are constantly changing, causing profits or losses. Long-term equilibrium requires zero economic profit or normal return adjusted to the level of risk. Profits in an industry attract newcomers; with time, profits are squeezed towards zero economic profit, and less efficient competitors leave the industry. Markets are sometimes in disequilibrium because of unanticipated changes in demand or cost conditions or unanticipated shocks.

Monopoly Theory of Economic Profits

Some firms are sheltered from competition by high entry barriers. Sources of protection include economies of scale, high capital requirements, patents, monopoly over inputs, and government protection (e.g., import prevention). Monopoly profits can arise because of luck or happenstance (being in the right industry at the right time).

Innovation Theory of Economic Profits

Profits arise following successful invention or modernization, including product or process innovations. Profits due to innovation are susceptible to the onslaught of competition from new and established competitors.

Compensatory Theory of Economic Profits

Also known as the profit theory based on managerial efficiency, this theory posits that firms operating at the industry's average level of efficiency receive normal rates of return. Above-normal rates of return reward firms for extraordinary success in meeting customer needs, maintaining efficient operations, etc. Managers find ways to organize, recombine, and coordinate resources, take risks, and use skills and knowledge to create new value and reduce costs.