Chapter 1

What Does Economics Have to Do with Running a Business?

What Is Economics All About?

Mention the word “economist” and one conjures up a vision of an academic who scours over macroeconomic data and utilizes sophisticated statistical techniques to make forecasts. Indeed, many economists do just that. But some people may be surprised to learn that economics is a social science, not a business science. Like psychology, sociology, anthropology, and the other social sciences, economics studies human behavior. That includes consumer behavior, firm behavior, and the behavior of markets.

Economic theory is mired in simple logic. We assume people pursue a goal and things get in the way. How they deal with the constraints is the discipline of economics. Consider a simple example. A manager in Milwaukee has to call on a client in downtown Chicago. One way to get to Chicago from Milwaukee is to get on I-94 and drive south to downtown Chicago. The distance is 90 miles and the trip should take two hours. This is not the only way to get to Chicago. An alternative is to take I-94 west to Madison, take I-39 south to I-80, go east until I-94, and then go due north until he reaches downtown Chicago. The alternative route will cover 310 miles and take five-and-a-half hours to complete. Given a choice, economists predict he’ll take the 90-mile, two-hour route.

You are unlikely to be impressed with this prediction, but it is the essence of economics. The manager’s goal is to reach Chicago. We assume the manager values his free time and would rather not spend it driving. If he had it his way, he’d snap his fingers and he’d be in Chicago. But this is not an option. Wanting to use up as little free time as possible, he scouts out all available routes. If the manager travels to Chicago via the direct route, he foregoes two hours of free time. If he travels by way of Madison, he gives up five-and-a-half hours of free time. Because he cannot eliminate the constraint, his objective is to reach Chicago and forego as little free time as possible. This is why he chooses the direct route.

The theory of the firm is similar. Economists typically assume the goal of your firm is to maximize profits. However, your business must deal with constraints. You are going to need workers to produce your good. Because wages paid to employees reduce the firm’s profits, you want to pay them as little as possible. How much, at a minimum, must you pay them? If an individual works for you, he cannot work for someone else at the same time. Therefore, if you want to hire a worker, you must offer a salary that’s at least as good as what he can get from another employer.

Your firm will also require raw materials to produce the good. Payments to suppliers mean less profit for the firm. You want to pay them as little as necessary. How much must they be paid? Any item the suppliers sell to you cannot be sold to someone else. If you want their business, you must offer a price that’s at least as attractive as what they can get from another firm.

Notice the parallel between the firm and the manager who needs to go to Chicago. The distance between Milwaukee and Chicago is 90 miles. The manager can do nothing to shorten this distance, so he tries to deal with it by taking the most direct route he can. The firm cannot hope to attract workers or raw materials without compensation. The cheapest means to secure the necessary labor and materials is to pay them what they’re worth to competing firms.

Beyond production costs, the firm’s profits are also constrained by the options available to the consumers. Consumers don’t have to buy the good from your firm. They can buy it from another firm. They can decide not to buy the good at all. If you want consumers to buy from you, you must offer a good at a price/quality that is commensurate with what they can get from other firms.

There are innumerable obstacles that can get in the way of profitability, and economists dedicate themselves to studying how profit-seeking firms deal with these constraints. And that’s what economics has to offer the business manager. Managers have to deal with the threat of competition, legal constraints, changing consumer tastes, a complex, evolving labor force, and a myriad of other obstacles. The essence of economics is to determine how to deal with the forces of nature that get in the way of the firm’s goals.

The Role of Opportunity Cost

The most important concept in economics is opportunity cost. For any action one takes, he foregoes alternatives. If you stay late at the office, you may miss an opportunity to see your daughter’s piano recital. You may miss a football game on television. You may miss an opportunity for a good home-cooked meal. To justify working late, the value of the extra time at the office must exceed the alternative on which you place the most value. You may consider the additional work to be more important than either the football game or the home-cooked meal. But unless it is also more important than the piano recital, you will not work late. Opportunity cost is the highest valued alternative foregone. On many days, you might be able to leave the work until the next morning. If so, the value of working late is relatively small, allowing you to attend the recital. However, you may have to meet a critical deadline. If this is the case, the value of staying late at the office may exceed the value of the recital. In either circumstance, opportunity cost plays a role in your decision. Because the recital is the most important of all foregone activities, you will not work late unless the value of staying at the office exceeds the highest valued alternative foregone.

If you review the previous discussion, you’ll see opportunity cost pop up over and over. If an employee works for your firm, he cannot work for another firm during the same hours. Consequently, if you don’t offer enough money, he will work for someone else. If a supplier of industrial equipment sells a machine to you, it cannot sell the exact same machine to another firm. Thus, if you aren’t willing to pay a price that’s commensurate with what other firms are paying, the supplier won’t sell the good to you. If a consumer purchases from you at a given price, he cannot spend the money on other goods he values. If you don’t offer a good that offers an overall value that is competitive with what other firms are charging, the consumer will not buy from you. Therefore, opportunity cost dictates the wage you pay, the price you pay to suppliers, and the price you charge for your product.

Opportunity costs should be distinguished from payments. When a student enrolls in college, his opportunity cost is not simply what he could have purchased with his tuition money. It also includes the foregone income from having a full-time job and the free time he gives up by studying late at night.

Opportunity costs should also not be confused with past expenses. Decisions are always forward looking; hence, opportunity cost refers to the highest valued alternative foregone if the firm takes a given action. As an example, suppose you want to entertain clients at a baseball game and you buy three nonrefundable tickets for $50 each. As you meet outside the gate, you learn that one of the clients had to cancel at the last minute. Rather than throw the ticket away, you sell it to a scalper for $30. The historical cost of the ticket was $50. On paper, you lost $20. However, because the ticket was nonrefundable, you found yourself with two choices: throw it away or sell it for $30. By selling it to the scalper, you’re $30 better off than your next best alternative.

Let’s reiterate this point again: because decisions are always forward thinking, the opportunity cost associated with the decision should not be equated with past expenses. But this is precisely what cost accountants do. They record the cost of a transaction after the decision has been made. The firm purchases raw materials and the cost of the transaction is recorded. As partially completed units flow through departments, additional costs are logged as they are incurred. When the units are sold, the accountant records the cost of goods sold. At no time does the accountant record the opportunity cost of a future decision. Rather, he logs the historical cost of decisions that have already been made.

If unit costs are recorded in historical terms, but opportunity costs are forward thinking, what is the value of unit cost estimates? To understand, consider the ramifications of having no cost estimates. With each decision, the manager would have to undergo a search for all relevant information that might allow him to assess opportunity cost. Unit cost estimates provide a benchmark that substitute for a lot of inefficient searching. Although cost-accounting estimates should not be equated with opportunity cost, they serve as a useful starting point for assessing opportunity cost.

Opportunity cost plays a critical role in capital budgeting decisions. Suppose a firm is considering purchasing an expensive piece of machinery that is likely to reduce unit costs by 10% over its useful life. The firm is considering financing the purchase out of its retained earnings. Is it worthwhile? The cost of capital used to determine net present value represents the opportunity cost of the purchase. If the firm does not buy the machinery, the money could be distributed to stockholders as dividends. The stockholders may be willing to forego the dividends if they believe the cost savings will yield an even greater benefit to them in the future. The cost of capital should reflect the return stockholders require in exchange for foregoing dividends.

For example, in 2012, Mercator Minerals completed a feasibility study for the potential development of a large-scale, low-cost copper mine in northern Mexico. To evaluate the investment, the firm relied on a cost of capital of 8%, implying that its investors required a minimum return of 8% to justify the venture. Based on an estimated mine life of 13 years, the analysis determined that the project would increase the firm’s after-tax wealth by $417 million over and above the earnings that could have been generated by simply investing the funds in a portfolio with an annual yield of 8%.¹

Economic Theory in Decision Making

Let’s use an applied example to illustrate the value of economic theory in decision making. In 1967, the college town of Jonesboro, Arkansas, built the Indian Mall. As Jonesboro was the commercial hub of northeast Arkansas, the Indian Mall was “the place to shop” for 40 years. The town nearly doubled in size over the next few decades, and in 2006, a new mall, the Mall at Turtle Creek, opened for business. The shift of shoppers from the old mall to the new one was immediate and significant. At many Indian Mall stores, customer traffic was half of what it had been the year before.² Some stores closed their doors immediately, whereas others remained open until their leases expired. The mall officially closed in February 2008 and was demolished four years later.

Let’s use this example to examine strategic decision making. The businesses leasing space at the Indian Mall knew that the exodus of customers was permanent. Why did most stores close their doors immediately, whereas others remained open? Quite conceivably, some firms may have decided to close their doors because they were losing money and had no chance of making a profit. Why did some stores remain open? If customer traffic had fallen so significantly, it is likely that they were losing money, too. Perhaps they were locked into a lease and figured that as long as they were forced to lease a space in the mall, they might as well use it.

So who’s right: the firm that shut down because it was losing money or the firm that chose to stay open because it had to make monthly payments on its lease anyway? Ironically, both rationales are flawed. The firm that closed because it was losing money is guilty of looking at its bottom line rather than the opportunity cost of shutting down. Indeed, the business was losing money, and that wasn’t likely to change with the new mall in town, but some of the expenses listed on its income statements, such as the lease payments, are fixed and would be paid whether it remained open or not. Therefore, if the firm rationalized shutting down because it was losing money, it was overestimating the opportunity cost of remaining open.

Does that mean that the firm that stayed open for business made the right decision? Not necessarily. To understand why, let’s alter the scenario. Suppose you take a job in St. Louis that pays $80,000 and sign a year’s lease at an apartment for $1,000/month. Three months into the lease, you get a job offer in Charlotte that promises an annual salary of $750,000. Clearly, you can’t continue to live in your St. Louis apartment if you took the job in Charlotte. Would you refuse the offer because you’re stuck with the lease in St. Louis? Hardly. The opportunity cost of staying in St. Louis far exceeds the benefit. A better decision would be to take the job in Charlotte and use a portion of your new salary to pay off the St. Louis lease. The same is true for the store that’s saddled with a lease. “We have to pay for the lease anyway; therefore, we might as well stay open” is a poor rationale for remaining open for business. What is the opportunity cost of staying open? The firm may find that it loses less money by shutting down.

To make the right decision, the business needs to consider the available alternatives (aka the opportunity set) and identify the opportunity cost associated with each alternative. Let’s create a hypothetical income statement for a shoe store at the older mall. Table 1.1 shows the store’s income statement one month before the new mall opened and four months after it opened. If we jump to the bottom line, we can see the store earned an after-tax profit of $32,900 before the opening of the new mall, but lost $10,254 four months after the new mall opened for business.

Table 1.1. Income Statements Before and After the New Mall Opens

At first glance, it seems obvious that the store should close its doors. It’s already losing more than $10,000/month, and with the new mall responsible for the drop-off in business, it is not a situation that is likely to reverse itself.

But this is why the economic approach to decision making is so important. Income statements report the sum of all revenues and expenses incurred between two discrete points in time. The key is to look for changes in revenues and expenses that are tied to specific decisions.

The shoe store was thriving before the new mall was built, but is likely to continue to lose money in its present location. What are its alternatives? Let’s begin with the obvious one: shutting down. What is the opportunity cost of shutting down? The income statement shows a revenue stream of nearly $76,000/month. If the store shuts down, will it lose $76,000/month? Not necessarily. If the store is part of a chain, it may be able to transfer its inventory to another retail outlet where the shoes could be sold at a higher price. If so, the foregone revenue from shutting down may be less than $76,000/month.

For the sake of simplicity, let’s assume that this is not the case: that the shoe store is a sole proprietorship. If so, shutting down the store will cause monthly revenues to fall by roughly $76,000/month.³

Next, we need to determine the costs relevant to shutting down. The first cost item in the income statement is the cost of sales. This reflects the cost of the inventory that was sold. Clearly, if the store closes its doors, the firm will no longer have to stock inventory. Under our assumption of a sole proprietorship, the cost of sales represents a decrease in costs associated with closing the store.

Let’s proceed to the next line item, which is composed of sales and marketing expenses. Clearly, if the firm shuts down, it will no longer purchase ads or mail promotional materials to potential customers. However, the decreased cost may exceed the $12,265 that appears in Table 1.1. With the decline in foot traffic, retailers at the Indian Mall were concerned that customers were not aware that they were still in business or that they were offering their inventory on sale, so they were increasing their promotional expenditures beyond the normal level.⁴

The next items are the general and administrative expenses. The income statement reveals a monthly payroll of $20,120. Clearly, this expenditure will be eliminated if the store closes; hence, it is relevant to this decision. Will the payroll decline by $20,120? Not necessarily. The payroll reflects the number of persons employed to handle the flow of customers. With demand on the decline, the firm may not have to staff as many employees, particularly during the leanest hours.

What about depreciation? Although the income statements list a monthly depreciation expenditure of $2,250, this is not a cash flow. Rather, depreciation is an accounting procedure to allow the cost of assets to be spread out over their useful life. Because the assets have already been purchased, they are not part of the opportunity cost of shutting down.

The shoe store’s rent consists of two components: fixed rent and percentage rent. Fixed rent refers to a monthly payment that must be made to lease the space regardless of the volume of sales. By contrast, percentage rent frequently appears in lease agreements for retailers in shopping malls. Typically, a breakpoint level of sales is negotiated between the mall and the retailer. If sales exceed the breakpoint, additional rent (usually a small percentage of the additional sales revenues) must be paid to the mall. If sales fail to reach the breakpoint level, no additional rent is paid beyond the fixed amount.

The income statements in Table 1.1 reveal a monthly fixed payment of $5,000. Because the retailer must honor the lease regardless of whether it remains open or shuts down, the fixed rent is not relevant to the decision. However, lease agreements often contain clauses that call for fixed payments if the lease is terminated prematurely. These are frequently much less than the remaining monthly fixed payment for the duration of the lease. As an example, suppose the retailer has eight months remaining on the lease (or a total of $40,000 in fixed lease payments), but can get out of the lease if the retailer pays $10,000. In this case, the net change in lease payments is relevant to the decision. By closing down, the store reduces its fixed rent by $30,000. One should note, however, that for each month the store remains open, the reduction in fixed lease payments falls by $5,000.

The percentage rent is potentially relevant to this decision because it is tied to sales. No percentage rent is paid if the retailer ceases to do business. However, because the rent is paid only for sales beyond the prenegotiated breakpoint level, the income statement suggests that the firm’s sales are currently below the breakpoint. Assuming this is a permanent state of affairs, shutting down will not result in any decrease in percentage rent.

Although insurance may be relevant to the shut-down decision, it is perhaps not for the immediate short term. The firm may have a contractual arrangement that may be terminated relatively quickly. Until the retailer is in a position to terminate its policy, insurance is not relevant.

Interest payments are expenses for debts already accumulated. Because they reflect past decisions, they are not relevant to the shut-down decision. Taxes are clearly a relevant cost because the shoe store’s profits will no longer be taxed if it closes.

So what’s the final verdict? To begin with, we have to assess whether the revenues and expenses captured in the most recent income statement are an accurate reflection of the state of affairs for the remainder of the lease. Perhaps sales will continue to decline. For the sake of argument, let’s assume a fairly static income statement for the remaining eight months of the lease such that the revenues and expenses relevant to the shut-down decision decline by the amounts listed on the statement. We’ve assumed that as a sole proprietorship, the store will lose its monthly revenues of $75,670. The cost of sales will fall by $43,889/month. The $12,265 in promotional expenses will also be eliminated if the store ceases to exist. Similarly, the firm will not have to incur its monthly payroll expense of $20,120. Assume the insurance expense is fixed.

According to the figures (summarized in Table 1.2), shutting down will save the store $76,274/month in operating expenses while sacrificing $75,670/month in revenues. If these figures were ironclad, the firm would save $604/month by closing. But recall that these numbers may require some tweaking. This is why decision makers need to think beyond historical costs when evaluating opportunity cost. The recorded expenses make for a reasonable starting point, but may not accurately capture the opportunity of shutting down. Promotional expenses are equal to 16% of revenues. Can the store reduce its advertising without cutting appreciably into its revenue stream? The payroll is very nearly the same as it was before the decline in sales. Is the store staffing too many employees relative to the current level of demand? Because demand has been falling, should the store consider cutting the price of its shoes to increase revenues?

Suppose the owner infers that he can reduce operating expenditures such that the store can make a small profit over the remainder of the lease. Should the store remain open? Not necessarily. Recall that the opportunity cost of shutting down is not restricted to accounting expenses. As an alternative to keeping the store open, the owner could invest the monthly operating expenses and earn interest and dividends. He could move the store to another location or get into another business entirely. The foregone earnings from remaining at the Indian Mall comprise the opportunity cost of remaining at the mall and will factor into his decision.

So what does economics have to offer to the business manager? Quite a lot, obviously. Whereas balance sheets summarize a stock of assets and liabilities, and the income statements report the flow of revenues and expenses between two points in time, economics focuses on evaluating opportunity costs. As the mall example illustrates, microeconomic theory contains many useful insights that can help a business manager make more effective decisions.

Summary