4  Profit

For more information on these topics, see Allen, Doherty, Weigelt, and Mansfield Chapter 1: Introduction.

In this course, we’ll explore formal models to analyze how managerial decisions impact the performance of organizations—be it a business, a government agency, or even an entire country. By the end of the course, you will develop an Economist’s perspective on key concepts such as cost, demand, profit, competition, pricing, market entry strategies, and auction strategies.

4.1 The Manager’s Objective

Managers of any organization aim to increase the organization’s value by maximizing its profit, which is the difference between total revenue and total cost. Moreover, they focus not just on maximizing profit today, but also on maximizing profit in the future. If we denote the expected profit in year \(t\) as \(\pi_t\), the manager’s goal is to maximize the sum of these profits into the future:

\[\pi_1 + \pi_2 + \pi_3 + \ldots\]

However, simply maximizing the sum of future profits isn’t enough because of the time value of money. The time value of money principle states that a dollar received today is more valuable than a dollar received in the future, as it can earn interest or be invested for returns. Therefore, future profits need to be “discounted” to reflect their present value. A manager aims to maximize the present value of expected future profits, where \(i\) is the interest rate:

\[\frac{\pi_1}{1 + i} + \frac{\pi_2}{(1 + i)^2} + \frac{\pi_3}{(1 + i)^3} + \ldots\]

As the interest rate increases, the significance of future profits diminishes compared to profit today.

Practice Question: What is the present value of $5 if you receive it 3 years from now and the annual interest rate is 2%?

$4.76

$4.71

$4.66

$4.60

Practice Question: Which of the following cash flow streams has the higher present value when the interest rate is 2%?

Stream A: $100 today, $100 one year from now, and $100 two years from now

Stream B: $300 two years from now

Both streams have the same present value

It depends on the interest rate

4.2 Cause Marketing

If firms are focused on maximizing profit, why do they engage in activities like donating to charities? Consider the example of www.joinred.com/red/: when you purchase a Dell Red computer, a Motorola Red Motorazr, Red products from the GAP, or use an American Express Red card, these companies contribute to a global fund to fight AIDS, malaria, and tuberculosis in countries like Ghana, Rwanda, and Swaziland.

This practice is known as cause marketing, where companies promote their products alongside commitments to charitable donations, allowing them to position themselves as socially responsible. According to a 2006 poll, 89% of Americans aged 13 to 25 would switch to a brand that supports a good cause if the products and prices are similar. Therefore, cause marketing creates revenue streams, which makes cause marketing very much in harmony with profit maximization.

Practice Question: What is the biggest reason that profit-maximizing firms engage in cause marketing, such as donating a portion of sales to charities?

To reduce their overall profit by giving away money.

To gain tax deductions from charitable contributions.

To enhance their brand image and attract socially conscious consumers, which can lead to increased sales.

To fulfill government regulations that require corporate donations to charities.

4.3 Accounting versus Economic Profit

Opportunity cost is the value of the next best alternative that you give up when you make a decision. It’s the benefit or profit you miss out on by choosing one option over another.

In Economics, profit is measured by considering the opportunity costs of the owner’s capital and labor, unlike in accounting. For instance, imagine a manager who leaves her $65,000 job to start a business. She invests capital that could have earned $24,000 elsewhere and works long hours without a salary. If her start-up earns $100,000 in 2024, the accounting profit would be $100K, but the economic profit is lower. When considering opportunity costs, her economic profit would be $100K - $65K - $24K = $11K, reflecting the true profitability after accounting for what she sacrificed.

Accountants are primarily concerned with daily operations, fraud prevention, legal compliance, and preparing financial records. Economists, however, focus on decision-making and rational choice among alternative strategies. While financial statements are usually based on accounting principles, understanding economic profit is crucial for effective managerial decisions. For example, if the woman is deciding whether to continue her business, she should consider the economic profit. If it’s positive, continuing the business makes sense; if it’s negative, she may want to explore other opportunities.

Practice Question: You bought a non-refundable $150 ticket to a highly anticipated football game next weekend. Now, your best friend invites you on a last-minute trip to a luxury resort, which would be free of charge. What is the minimum value you would need to place on the resort trip to justify skipping the football game?

$1

$76

$151

You should not skip the football game, since your ticket is non-refundable.

4.4 Classwork 4

In class today, please complete koans 8-11: qplot to ggplot, ggplot_aes, ggplot_geom, and lm. Compile them to html and compress them in a zip file in order to submit them onto blackboard.

Here’s some reading that might be useful:

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