Firm's reaction to news about profits

Phil Ruder, Pacific University,
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Summary

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.

Context for Use

This activity is appropriate for a principles course. Students should have read the textbook chapter on firm production and costs. There are no class size limitations. This is a short activity, requiring approximately 20 minutes of class time, including student work in teams on choosing an answer, the debriefing process, and closing remarks.

Overview

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

No introductory remarks are necessary. This activity should come soon after the RAP on firm production and costs.
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.
Debriefing suggestions:
*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."

Assessment

In an economy where people can borrow and lend at an interest rate of 5%, Nanette Francois, a famous chef, leaves a job that paid her $200,000 per year to start her own restaurant. She rents a building and invests $1,000,000 of her savings in the equipment necessary to furnish the kitchen and dining room. Nanette values working for herself rather than for others at $50,000 per year. Her annual revenues and other costs are as follow:
Revenue $4,000,000
Rent $48,000
Staff salaries $500,000
Ingredients $3,000,000
Insurance,
marketing fees,
etc. $200,000

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.

References and Resources

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