Recognizing the importance of profit

At its most basic, a firm takes some things in, transforms them in some way, and places what it produced on the market hoping that the difference between what it receives (revenues) is bigger than the costs of taking those things in and transforming them (costs). That difference is called profit (or if you’re unfortunate in running your firm, loss, which economists write as a negative profit). The Greek symbol pi, Π, denotes profit so that you can write the following simple equation:

The equation says that the total profit the firm makes is the difference between all revenues that the firm takes in and all costs that the firm incurs to conduct its activities.

At this stage, you haven’t done anything to break down those costs into corresponding production activities (we do so in Chapter 7), and so for the moment we suggest that the sole proprietor’s costs include not only the cost of goods bought in and the cost of labor, but also the fixed costs of its operation, that is, the rent due on the stall irrespective of how many things are sold individually.

At heart, economists treat every firm in this way. Of course, firms vary considerably in size and complexity, and comparing the activities of a transnational corporation to a market stall trader would be a little simplistic. But all firms share in common the profit motivation, and profit is the indicator of revenues being in excess of costs. A rational firm (in economic terms) seeks to maximize it.

Chapter 7 talks more about profit, revenue, and costs, but we want to make one very important point about profits here: Profits accrue after all relevant costs have been paid, including what the sole proprietor gave up in terms of alternative use of their time in order to open up the stall. This approach is slightly different from an accountant’s point of view, where several different accounting measures and accounting terms are used to indicate firm profitability. Typically, these terms include income, earnings, or net or gross profit, depending on which part of the firm’s accounts you’re looking at.

Economists take a more general view on profit than accountants, and to an economist there is only one way to measure profit.

Discovering types of firms

Many firms are of course significantly more complex than the sole proprietor mentioned in the preceding section.

Company law distinguishes a few types of firms according to how profits or losses earned by the firm are distributed, including:

• Partnership: There are several owners of the firm that are permitted to share in any profits generated by its business and are equally liable for all its losses.
• Limited liability company (LLC): An entity that the law defines as owning the profits which may then be redistributed to those who own the company, called shareholders. In a limited liability company, shareholders are only liable for losses up to the stake they hold in the company.
• Co-operative: Owned and operated by its members. Typically, it redistributes profits to those members.

Each of these types of firm has legal advantages in certain situations and drawbacks in other situations. For instance, the limited liability company has advantages in its ability to raise capital but disadvantages in terms of the ability of the shareholders to run the company or to observe and control the activities of managers. For much more on companies, flip to the later section “From Firm to Company: Why People Form Limited Liability Companies.”

Seeing why economists think as they do

Economists are interested in how the profit motive affects what a firm would do, first and foremost. When they understand that, they can start to look at how firm behavior differs across different industries or markets.

The economist looking at a firm makes simplifications for two reasons:

• You can’t build a model without placing some restrictions on your model. If you rule nothing out, you rule anything in, and before you know it you’ve reenacted the Lewis Carroll story about the map so accurate that it has to be as big as the kingdom it maps.
• You want to compare common features of firms, without focusing on all those details, so that you can zero in on the ones that are most important to building a model of a market.

Peering inside the Black Box: Technologies

The preceding section’s rationale doesn’t mean that economists take the nature of changing inputs into outputs for granted. Since Adam Smith, economists have been describing in various ways the methods a firm can use to transform inputs into outputs, which they call technologies.

A technology is a description of the way a firm transforms inputs into outputs (see Figure 3-1). Economists aren’t restrictive about what makes a technology. Rather than take a narrow definition or restrict the meaning of technology to a particular kind of machine, they take a wider view and say that any method of turning inputs into outputs fits the bill. Whether it involves buying wood and carpentering wood into furniture, or employing people to help clients understand financial planning, it doesn’t matter: Those are both descriptions of a technology.

The inputs that go into a technology are called the factors of production. The three most common factors of production are

• Land
• Labor
• Capital

Let’s take a closer look at each factor in turn.

Minimizing costs

A firm with a given technology makes a choice about how much of each of the factors of production to use to make how much output — and pays the cost for doing so. The question for the firm is how to use its technology and choose its inputs in order to make its profits as large as possible. The way it does so is to choose its inputs in order to make the costs as small as possible (see Figure 3-2). The technology shown in the figure is a specific form known as a Cobb-Douglas production function.

If you’re wondering why economists think this way, consider profit maximization (discussed in detail in Chapter 8). In the following equation (introduced in the earlier section “Recognizing the importance of profit”), profit equals the difference between total revenue and total cost:

A firm can determine what to make and how much to make, but it doesn’t have any control over what consumers choose to buy. Therefore, it makes sense that economists model the things that the firm does control — its own costs — and so they assume that profit maximization is the same thing as cost minimization. (Chapter 4 looks inside the costs of production at how a firm actually makes its decisions.)

Maximizing profits

When discussing a firm, economists generally assume that the firm wants to maximize profits — in other words, that the difference between total revenue and total costs is positive and as large as possible. Economists don’t think there’s anything immoral about profit maximization. Rather, they believe that profit maximization is a goal that helps a firm be efficient, and firms that don’t make profits tend not to operate as firms for very long.

Of course, some nuances apply to this view of profit. For one, the existence of profits in the economist’s sense says nothing about how those profits may be distributed. For example, an LLC may want to retain some profits for future investment and return some to shareholders as dividends. But although a nonprofit company still intends to make a surplus (as it would be called in the accounts, reflecting the different legal as opposed to economic definition of the company), it does different things with that surplus, which may include distribution to workers or to chosen worthy causes.

But beyond this consideration, other reasons may exist why a firm may not be acting as a profit maximizer:

• Tax systems where company taxes fall on profits can provide an incentive to declare lower levels of profit.
• Managers may have different incentives than shareholders and prefer to generate higher salaries for themselves than higher profits for the company (managers’ wages here would be a cost to the company).
• A company may prefer to evaluate its performance using some other measure, such as sales or market share, at least in the short run. Some examples include companies in online markets where interim measures commonly used include market share or number of users.

Is this a problem for microeconomists? Not necessarily. In most situations, they want to make a simplification that helps them understand the world instead of covering every possible case. So, when considering different types of markets the benchmark of the profit-maximizing firm helps economists consider how they may be similar or different.

Economists also want to compare their models to real-world situations. In order to do that, they can start from a simple assumption and then, as things become more complicated, refine it in the light of real-world events.