Archive for January, 2014

What “profits” means.

January 15, 2014

The general dialog often refers to company profits. This is especially true when the discussion turns to minimum wage and corporate taxes. A common belief is that companies require profit in order to remain in business. There appears to be a bit of misunderstanding of what “profit” is, precisely. This lack of precision leads to mistaken conclusions.

There are to fields of study from which to draw a definition of “profit”. These are economics and business accounting. The two yield the same final understanding though alone they both are a bit lacking. The reason is simply that the precise definition often depends on what the point is. Economics, when concerned with profit maximization, isn’t concerned so much with taxes. Business accounting can be all over the map with revenues, earnings before taxes, earnings before interest and taxes, earnings after taxes, and on and on.

The best precise definition that gets to the point of profit is that it is the final amount of monies remaining after all costs, interest, salaries, and taxes have been paid.

The math goes like this;

Costs = wages*labor_hours + rents*equipment.

equipment includes facilities and capital equipment. Wages includes all wages, hourly or salary.

Revenues = price * quantity.

Earnings = Revenues – Costs

Earnings are before taxes and interests which is referred to as EBIT in business accounting. Typically, interest is deductible from earnings before the tax rate is applied.

EBIT = Revenues – Costs

EBT = Revenues – Costs – Interest

Earnings After Taxes = Profit

Profit = (1-t) * EBT

What is significant here is that if EBT is zero, there are no profits and no taxes. It is obviously necessary for a business to be able to cover costs. At the very least, revenues need to equal cost plus interest. But, when all is said and done, as long as revenues cover interest and costs, there is no necessity that a company earn profits or even end up paying taxes.

And, in fact, this is how businesses do tend to operate. Of 25 million companies operating in the US in 2012, they paid a total of about $191 billion in taxes. This amounts to about $7000 per company in taxes. With an effective tax rate of about 26%, the total per company profits amounted to about $21,000. $21,000 per company is pocket change. It doesn’t even cover the income of one minimum wage worker. It is, for all practical purpose, insignificant.

This is not unexpected as it is exactly what is predicted by basic classical economics. In a free market, any profit attracts competition. Competition drives down prices which quickly drive profits to zero.


Market Power

January 5, 2014

I have been looking for a measure of market power.  There are many good micro economic texts that include generalities of market power.  For instance, “Microeconomic Theory, Basic Principles and Extensions”, Nicholson & Snyder, 10th Edition includes chapters dealing with monopolies and imperfect information.  While excellent material, it isn’t quite what I am looking for.

The measure that I have in mind is based upon demand and supply elasticity.  Consider gasoline or home heating fuel.  Demand tends to be inelastic.  This inelasticity that results from the high utility of fuels presents a level of market power on the supply side.  As well, economies of scale creates additional supply side power.

Elasticity is given as

    e = [Percentage Change in Quantity]/[Percentage Change in Price]  : Prose definition

       = (Δ%q)/(Δ%p)  : Algabreic definition

       = (dq/q)/dp/p)        : Calculus definition

      =  (dq/dp)*(p/q)    : Derivative definition

(It should be noted that the axis for elasticity are flipped from the standard supply and demand diagram axis.  The definition for elasticity places quanity on the independent axis.  The only significance is that of being acustomed to thinking about supply and demand in terms of price being on the horizontal axis.  And, because elasticity is defined in terms of the slope of the line, diagramatically it is slightly different from the customary diagram.)


With this in mind, high elasticity is a steeper slope.  For high elasticity, a small change in price is associated with a large swing in quanity.  HIgh elasticity is greater than one, e>1. 

For low elasticity, a large price change in necessary to affect quanity.  Low elasticity, or inelastic, is less than one, e<1.

Supply elasticity is typically positively sloped while demand is typically negatively sloped. 

Gasoline demand tends to have low demand elasticity, |e|< 1 or e > -1.  That is, relatively large market price changes do not appreciabely affect quanity demanded. 

Gasoline supply tends to have high elasticity as marginal cost is small for changes in quantity, |e|> 1 or e > 1.   Small changes in market allow for large changes in the quanity produced and supplied.

So, for gasoline, the demand curve is near horizontal, with 0> e_d > -1,  while the supply curve is near vertical,  with  e_s > 1.

The elasticity of one curve affects the shift of the other. 

For gasoline, it takes a larger change in market price to induce small changes in supply output.