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Lecture Notes: Oct. 21 |
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Econ. 103, Fall 2002, Prof. Nancy Folbre |
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Homework #4 is due in class on Wednesday–good preparation for mid-term. I’ll go over the answers in class and also review the material that will be covered on the exam, Chapters 1-8 plus lecture notes. I had planned to show a segment from Other People's Money today, but I think I'll save that for after the exam... Review from last time: examples of how the search for profits helps explain the transformation of our economic landscape here in the valley—from the effect of competition from grain farmers in the Midwest in the late nineteenth century to the growth of exports from China.
What we have already covered in Chapter 8–existence of profits for individual firms in a given industry signals other firms of the possibilities–leads to entrance of more firms into the industry, which shifts the supply curve of the industry to the right and lowers the equilibrium price, thus reducing the profits....this is key to the argument that markets are efficient. Today, we look at two refinements of this argument: the distinction between economic profits and accounting profits (and normal profits) and the role of barriers to entry And we take a look at stocks and bonds, what they are and how they work. What's cool is that we now have some technical tools that allow us to better understand the corporate scandals of the last year. Profits Accounting profit is defined as total revenue minus explicit costs. Economic profit is defined as total revenue minus explicit and implicit costs. Explicit costs are costs that must explicitly be paid–as opposed to implicit costs, such as opportunity costs. The biggest opportunity cost is the cost of an owner-entrepreneur's time and talents–and so the distinction that Frank and Bernanke makes a lot of sense for a small firm, like the fellow in the text, in Exercise 8.1, named Pudge. Pudge is a corn farmer–his explicit costs cover land, equipment, and other supplies (he doesn't employ anyone). His explicit costs come to $10,000. His revenue from sales is $22,000 per year. So his accounting profit is $12,000. But what about the value of his time and energy? What's his opportunity cost? If he wasn't farming, he would be managing a retail store for $10,000 a year. So what's his economic profit (what he gets over and above both his explicit and implicit costs)? Only about $1,000 a year. Another example of implicit costs would be rent. For instance, what if Pudge inherits the land that he had previously been renting from his uncle. He no longer has to pay rent–so his explicit costs are reduced. But he should consider what he could be earning in rent if he stopped farming and rented land to someone else–this is the opportunity cost of farming the land himself.... Note that the definition of normal profit in the margin of the text on p. 197 is incorrect. Normal profit plus economic profit equals accounting profit. Normal profits are basically equal to implicit costs... They are normal in the sense that they are going to pay for something that had an actual opportunity cost. But the economic profits represent a "surplus"–an extra–the gravy–the whipped cream and cherries... profits over and above all costs. When we say that competition tends to drive profits to zero, we are talking about economic profits....this is the delectable stuff that attracts other producers to the industry.... a related concept is economic rent–payment for a factor of production that exceeds the owner's reservation price Note: your text describes accounting profits as though they are obvious, transparent, uninteresting. But what the scandals of the last year have shown is that accounting profits are not so easily pinned down–they can be affected by a number of rules, conventions, misrepresentations. The books can be cooked in a variety of ways.... e.g. overstating revenue–Enron created fictional revenue streams by predicting the value of future sales; Dynegy persuaded other firms to book reciprocal sales (you buy $100 worth from me and I'll buy a $100 dollars worth from you; since we're buying and selling the same thing we don't need to actually transport the goods–it's a paper transaction that makes it look that we have both gotten more revenues (and incurred more costs) than we have in reality; World Com treated some raw materials as expenses that could be depreciated over a long time period rather than paid in one year... The textbook also implies that a company would have an interest in concealing or underestimating their profits, for fear of attracting further competition....but it's not companies who make decisions, but their managers, and when managers are paid on the basis of stock prices, they have an incentive to increase those prices....cooking the books to make the firm seem more profitable than it really is drives share prices up (more on this later). How do stock prices affect managers' pay? In addition to receiving large salaries (including so-called golden parachutes in the event of severance of layoff) most CEOs receive stock options, which are options to buy stock at a reduced price and sell it when the price goes up. Standard accounting rules do not treat these stock options as an explicit expense, so shifting toward an option-heavy pay package understated the total payroll costs of the CEO's and overstated their accounting profit. Congressional efforts to reform the rules regarding this provision failed but some companies took the lead in announcing that they would treat stock options as an explicit cost–Coca-Cola was among these. Controversy regarding these issues continues unabated.... over the weekend the business press featured a big story on how Bush has cut back the budget increase he promised the Securities and Exchange Commission, which is the main regulatory enforcer of accounting and reporting rules. Barriers to entry The magical process by which competition supposedly prevents excess profits only works if new firms can enter the industry...if there are barriers to entry that prevent this from taking place, the process doesn't work.... some examples of barriers to entry–
Stocks and Bonds stock– a claim to a share of the current and future accounting profits of that company. price is typically 15 to 20 times the value of earnings per share bid up by speculation and "irrational exuberance" A multiple choice question that came with the book that cracks me up: ___10. The price of one share of a company's stock is A) current accounting profits divided by the number of shares B) driven by speculation, not economic reality C) dependent on the company's current and future accounting profits and the interest rate D) determined by the latest remarks of Alan Greenspan E) current and future accounting profits divided by the number of shares They say the correct answer is C. But I don't think we can rule out B. bond–a fancy IOU Lend me $100 today and I'll pay you $105 next year. What's the implicit interest rate? If I put $100 in the bank today, what would the interest rate have to be to deliver an equivalent return? 5%. You can take the bond, or IOU and sell it to someone else. Let's say I gave you the bond when the interest rate was 5.2%. That's why I sold you the bond, instead of just going to bank and borrowing the money. But now that you're holding the bond, what if the interest rate drops to 3%. You could sell the bond for more than you paid for it, right now. For instance, say you asked $101 for it. The buyer would expect to earn $4 over the course of the year, and that's more than 3% of $101 so the buyer is doing better than he or she would by putting the money in the bank. a useful concept for calculating the present value or PV of a future cost (or benefit) ask how much money would have to be deposited at a given interest rate r to generate the amount of money in question (payment M) PV (1 +r) = M (or value of payment M in one year) PV (1+r) (1+r) = M ( or value of payment M in two years) let t = number of years. Then PV (1+r)t = M PV = M/(1+r)t How much $105 a year from now worth today? If r=5% as in the example above, the PV is $100. If r = 3% PV= 105/(1+r) the efficient markets hypothesis–the theory that the current price of stock in a corporation reflects all relevant information about its current and future earnings prospects this hypothesis is more believable in stable market than in one as volatile as we have been experiencing lately The Pursuit of Self Interest Doesn't Always Benefit Society as a Whole Smart for one–dumb for all. Everybody at a football game stands up. Individual companies start cooking their books.... Capitalists get so self-interested that they start cheating one another. Stay tuned. |