indessed roscivs

Strictly speaking, economic profit is accounting profit minus opportunity costs—so if I decide to quit my job and start a laundromat, and the laundromat brings in $100k a year, but costs $60k a year to maintain (building rent, advertising, cost of the machines, etc.) then my accounting profit is $40k a year—that’s how much my business makes. But my “economic profit” is the difference between my previous job’s salary and that $40k. If I was making $50k a year previously, then I’m actually in the red in terms of economic profits—meaning I’d be $10k better off financially if I ditched the laundromat and went back to my old job.

In a perfectly competitive market, according to economic theory, economic profit is supposed to be exactly zero in the long run. If I make less than my opportunity cost running the laundromat, I’ll eventually quit and do whatever it is that would make me more money than the laundromat. If I make more than my opportunity cost running the laundromat, then other people with similar opportunity costs will open their own laundromats and start undercutting my prices. I’ll be forced to go out of business or keep cutting my own prices as well, until the only businesses left in the market are those making exactly zero economic profit.

In the short run, however, the lure of economic profit is what drives entrepreneurs. And certainly there are plenty of markets today in which economic profit is ripe for the taking. The iPhone example is surely one of them.

Apple has some accounting costs in each iPhone it creates, such as the parts, the labor, the shipping, the advertising, and so forth. It has some opportunity costs as well—the amount of money it could be making elsewhere if it chose to abandon the whole iPhone concept and spend its finite resources on something else. If you add those two numbers together, you arrive at the smallest dollar amount Apple could feasibly sell their iPhone for and still have it be worth their while. That number is certainly much less than $600—let’s pretend, for the sake of argument, that it’s around $500.

If I, as a connoisseur of Apple products, intrinsically value the iPhone at around $700—that is to say, for any dollar amount below $700, I’d probably buy one, but for any dollar amount above that, I’d consider it too expensive to be worth it—then at the $600 price tag I’d be benefitting from the transaction to the tune of $100. Apple, meanwhile, would be benefitting (assuming the $500 number) around the same amount. Since we’re both benefitting equally from the transaction, we’re both likely to consider it fair.

If Apple suddenly slashes their prices to $400, however, then obviously the $500 estimate for their costs is completely off. It’s likely to be more around $300. So suddenly, even though I’m still $100 better off from the transaction than I was before Apple ever invented their iPhone, I realize that they raked in $300 from our transaction. Suddenly I’m less likely to consider this fair—if they’d have been willing to sell it to me for $500, then I’d have an extra hundred bucks in my pocket—and each of us would have gained $200 from the deal, benefitting equally.

So while specialization and trade make everyone wealthier and make everyone better off, they don’t do so equally—and wealth inequity is one of the greatest problems facing our planet. It causes more strife, more wars, and more unhappiness than any other factor I can think of.

This entry was posted on Wednesday, February 27th, 2008 at 9:04 am and is filed under economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.