Firm's reaction to news about profits
Context for Use
In this activity, students consider a firm's reaction to news reporting about the level of its profits. The exercise presents the puzzle of a firm's alarmed response to news of positive profits. The exercise works well at the beginning of a principles-level examination of firm costs.
Expected Student Learning Outcomes
Upon successful completion of this learning activity students will be able to explain the difference between economic and accounting costs, economic and accounting profits, and between implicit and explicit costs.
Information Given to Students
When news outlets report 4% annual profits for Nike, the company reacts by laying off workers and/or reorganizing divisions, and/or revamping its marketing strategy. What is the best explanation for this phenomenon?
A. Economic profits were positive but investors expected better.
B. The company failed to cover important implicit costs.
C. Accounting profits were negative.
D. Successful companies constantly change the way they operate.
Teaching Notes and Tips
Instructors can change the name of the firm in the exercise to highlight a local producer. Students should not need more than three or four minutes to come to a choice on this activity. While B and D are both defensible choices, B is the best answer.
*Ask student reporters (randomly selected after teams have made their choice) to explain their reasoning.
*There often is a pretty even split between B and D, with a few A answers scattered about. The student reporters should home in on B and D as the plausible answers pretty quickly, though. To decide which of those is the best answer, one should ask something like "Why the urgency to adjust following the profits news?"
*Next, ask a team reporter who has been quiet so far what are the implicit costs that the company has failed to cover. Students might flail around with this one. Let them. Answers will include, "the value of the entrepreneur's time." Follow that up with the question, "how many owner/operators of a publicly traded company are likely to be earning a pay rate determined by the residual between revenues and costs? Answer, "zero." Of course, the implicit cost is the opportunity cost of the investors' resources.
Closing remarks: This is a good time to discuss concepts like, "normal rate of return" and to point out that in economics classes, the terms "cost" and "profit" will always mean "economic cost" and "economic profit."
Staff salaries $500,000
a. What are Nanette's annual accounting profits?
b. If nothing changes, should Nanette continue to operate her own restaurant or should she go back to work in a restaurant owned by someone else?
c. How might Nanette attempt to increase her profits over time?
d. How likely is Nanette to earn above-normal income and return on assets higher than 5% over the long run? Explain.