Class Summary #42 for 12/12/11

Today was our last day of class, and Prof. Rizzo spoke about profits, losses and entrepreneurs. Below is all that we learned about in class today

• Definition of profit: The difference between your total revenues and total costs…
•  Total revenues - total costs = profit
• A wage is nothing more than a contract. A contract between worker and firm that specifies exactly what I’ll be doing and what I’ll not be allowed to do and in exchange it says how and what ill be compensated. In advance I know what I’ll earn, they know it advance what it will cost them. The whole point of a wage is to eliminate uncertainty.

Rent- The reason rents are paid are to eliminate uncertainty. You know you will get a good and they know how much they will get. In short, the point of both a wage and rent is to eliminate uncertainty.

Then we learned about interest. Interest is a price. Where do prices come from? They come from supply/demand. What supply/demand process does it come from? The market for loanable funds. Interest emerges from the fact that people want to attain purchasing power that they haven’t quite earned. The price of attaining unearned resources= interest.

In short, we learned that profits are not wages, rent or interest. They are an economic calculation of how much someone gains from doing something.

Prof. Rizzo used an example of his wife to represent a mathematical example of how to derive a profit. Here it is:

Rachel used to earn $30k as a secretary

-       also owns a building that rents for $6k a year

-       Also owns a savings account at bank with $23k in it, and it pays 10% interest

Suppose she quits job and then opens up a pizza shop. She works full time for herself and uses her own building and sells her savings account (cashes it out). She also borrows $20k for pizza parlor equipment.

Profit= total revenues – total costs

P= $85,000- ($23,000+$20,000+$20,000 * (10%) ) = $40k in an accounting sense, she has made $40k as profits. 

But is this the number she should use to weigh whether she made a good decision? No, she must consider opportunity costs as well. She must subtract “implicit costs” in profit formula, which are lost salary from another job, lost chance to rent building to someone else for more money. She also loses $23k *10% for taking money out of bank.

Therefore, real economic profits = total revenues – total explicit costs – total implicit costs

Profits = $1,700  = “price”

That’s what Rachel is left over with after she spends all of her resources on working

That’s her economic return to being an entrepreneur in pizza industry. Doesn’t mean how much cash you have, it means if you make decision to open pizza parlor, that’s how much profit you make over next best cost.

Bottom line: profits exist only in a world where we have uncertainty  because we just don't know exactly what will happen economically speaking. Therefore if I incorrectly predict, could still make money but profit economically speaking could still be negative.

Then, Prof. Rizzo concluded class by talking to us about markets and stuff relating to markets, specifically relating to pizza parlor industry.

When new firms enter market, profits are pushed down, which thus lowers prices. The more aggressively people compete in pizza market, prices fall. Inefficient produces get rationed out of market, efficient ones get ushered in to market. Consumers and producers are better off.

Thus in cheese market, demand will increase, supply will increase, price will increase for cheese.

Big problem with economic losses:  They destroy resources, burning up carpets, destroying environment and building, etc.. Taking resources from valuable uses and putting them towards destructive uses is what happens when they are economic losses.

Finally, Prof. Rizzo ended class with the following words: 

Capitalism is all based on individual decision making

No system in history has encouraged economic activity quite as well as capitalism.