20 • Economics Primer: Basic Principles

In the end, it might be driven out of business by firms that are better at seizing profit-enhancing opportunities, or it may find itself starved for capital as investors bid down its stock price Whenever we depict a cost function or discuss cost throughout this book, we have in mind the idea of costs as including all relevant opportunity costs.

Economic Profit versus Accounting Profit

Having distinguished between economic cost and accounting cost, we can now distinguish between economic profit and accounting profit:

•Accounting Profit 5 Sales Revenue 2 Accounting Cost.

•Economic Profit 5 Sales Revenue 2 Economic Cost

5 Accounting Profit 2 (Economic Cost 2 Accounting Cost).

To illustrate the distinction between the two concepts, consider a small software development firm that is owner operated. In 2009, the firm earned revenue of $1,000,000 and incurred expenses on supplies and hired labor of $850,000. The owner’s best outside employment opportunity would be to earn a salary of $200,000 working for Microsoft. The software firm’s accounting profit is $1,000,000 2 $850,000 5 $150,000. The software firm’s economic profit deducts the opportunity cost of the owner’s labor services and is thus $1,000,000 2 $850,000 2 $200,000 5 2 $50,000. This means that the owner made $50,000 less in income by operating this business than she could have made in her best outside alternative. The software business “destroyed” $50,000 of the owner’s wealth in that, by operating the software business, she earned $50,000 less income than she might have otherwise.

DEMAND AND REVENUES

The second component of profit is sales revenue, which is intimately related to the firm’s pricing decision. To understand how a firm’s sales revenue depends on its pricing decision, we will explore the concept of a demand curve and the price elasticity of demand.

Demand Curve

The demand function describes the relationship between the quantity of product that the firm is able to sell and all the variables that influence that quantity. These variables include the price of the product, the prices of related products, the incomes and tastes of consumers, the quality of the product, advertising, and many other variables commonly thought to make up the firm’s marketing mix. With so many variables, it would be difficult to depict the demand function on a graph.

Of special interest is the relationship between quantity and price. To focus on this important relationship, imagine that all the other variables that influence the quantity demanded remain fixed, and consider how the quantity demanded would change as the price changes. We can show this simple relationship on a graph. Figure P.7 depicts a demand curve. We would expect the demand curve to be downward sloping: the lower the price, the greater the quantity demanded; the higher the price, the smaller the quantity demanded. This inverse relationship is called the law of demand.