For this reason, we always expect the economic profit to be zero. Or, at least, moving towards zero. Example Let’s say there are two choices of investment in firms in the same industry. In this industry, the risk- free return is 5% and the risk premium is 5%: Buy stock in company A for $100 per share and earn $10 per year in profit. Buy stock in company B for $60 per share and earn $9 per year in profit. The profit on investment B is 15%, but in company A it is 10%. So the economic profit from owning B will be 5%. But, because of this, everybody will want to buy B. When the demand for a good increases, the price goes up, and in this case, the price will go up until the percent profit is the same as company A. The economic profit will be driven towards zero. This helps us define how much profit a firm "should" make. In the first lesson, I counseled against "should" statements, because they are normative statements, and as objective and disinterested observers of the real world, we are only interested in "positive" statements. So maybe we can rephrase the question: how much profit does a firm have to make in order to make it an attractive investment? Well, we know that it has to make at least the risk free rate plus the risk premium. If it is making exactly this amount, it is making zero economic profit, and the investor should be indifferent to this investment and all others that make zero economic profit. If it is making more than zero economic profit, it is a very attractive investment, and because a lot of people will want to get at the "free money" that this firm is making, the stock price should go up, driving the economic profit to zero. The opposite will happen to a firm that is making negative economic profits.
The textbook author talks about "explicit" and "implicit" costs - explicit costs refer to things that a firm has to purchase in order to operate - paying wages to staff, purchasing raw materials and energy, paying rent and taxes, and so on. The other type of costs are implicit, and these refer to the use of the owner's resources - the owner's time and effort. This is the "return to the owner" I spoke of above. The return to the owner is equal to the opportunity cost of his/her time - the value of the best alternative use. Any business enterprise should be compensating the owners of the firm at a level that at least matches the opportunity cost of capital, on a risk-adjusted basis. If it does not, it makes more sense for an owner to invest elsewhere. This informs us about the cost structure of a firm. When a firm is selling its product, it has to be selling at a price that is high enough to ensure accounting profits sufficient to generate enough of a return to cover the risk-free rate plus the risk premium - the payment that the owner must get in return for investing his money in the firm.
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- Spring '19
- Farid Tayari
- Supply And Demand, producer