The answer to my pop quiz

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Hasta la clase que viene
Hasta la clase que viene

In my previous post, I set up a very simple hypothetical market. Someone buys a vacuum cleaner for BsF 1,200 and prices it at BsF 1,500. The wholesaler informs the vendor that the wholesale price has shot up to BsF 2,200. I asked, are you making a profit?

Many of you had the right idea, but only Manuel had the 100% correct answer. The right answer to this question is: which profit?

There are two types of profits we are interested in: accounting profits, and economic profits.

Accounting profits take into account the actual costs and actual prices of things – even things that don’t have an actual cash cost, like depreciation. In the example above, assuming there are no fixed costs and no other variable costs, assuming your only cost is the wholesale price of the vacuum cleaner, then yes, you’re making a profit of BsF 300 per vacuum cleaner.

But economists are not accountants. We are interested in actual human behavior. We want to know the costs that will affect how firms will behave, and the choices they will end up making.

The economic profit for the firm is -700. The reason is that the firm is selling a vacuum cleaner for BsF 1,500, while its real value (i.e., the value in the marketplace) is BsF 2,200.

Think of it this way: if the person goes ahead and sells the vacuum cleaner at 1,500, it is making less money than the next best alternative. That person could have joined the wholesaler and sold the vacuum cleaner for BsF 2,200 (if it’s profitable for the wholesaler, why wouldn’t it be profitable for the retailer?), but instead chooses to sell at a lower price. The lost opportunity, the lost earning the company could have made, is part of its calculation for “profit.”

Ultimately, a firm in this situation will choose to either raise its price to take into account the actual (i.e. market) cost of the vacuum cleaner, or exit the retail vacuum cleaner business altogether. A rational agent will decide that if he can’t engage in the best possible outcome for his money, he will simply decide to keep his money in the bank (or sell dollars in the black market or whatever). Nobody wants to sell at a loss, even if its accounting “profits” are positive.

This is a basic concept in economics. Without understanding it, it is virtually impossible to handle an economy. I dare say that many people in our government, and yes, our business sector, do not understand this basic precept of economics.

Think of this next time some chavista goon talks about “setting margins for companies” and what the “fair prices” are. If you don’t understand the concept of “margin” or “profit” from an economic point of view (the one that really matters) – how can you possibly aspire to set margins by fiat?

(Side note: Miguel Ángel Santos put it nicely the other day: if a fair price leads to empty shelves, then that isn’t the fair price)

This deeply-embedded economic illiteracy is at the core of many of our social problems. It’s the reason we have Cadivi, cheap oil prices, traffic in Caracas, and even crumbling public schools.

We simply have to overcome this if we are ever to have a chance.

1 COMMENT

  1. I will add here yet another twist to this discussion:

    If a price is a compromise point between what buyers are willing to pay, and what sellers are willing to sell, the concept of “fairness” has no sense whatsoever under this context. It has nothing to do with “justice”.

    I.e.: There can’t be a “fair price” in the same way that there are no “fair triangles”, “kind equations” or “fragrant algorithms”. Those pairs of concepts just simply don’t go together. You can put them together, but they are misleading at best, and often just effective lies to manipulate people.

    I’ve been hearing that kind of nonsense for a while now, and, being repeated over and over, people all over the place have started to miss the stupidity of what they are saying.

    And, by the way, think about this the next time you hear about “fair wages”.

    • A(n equilibrium) price is NOT a compromise between what sellers are willing to pay and buyers are willing to accept. An equilibrium price is exactly the price buyers are willing to pay for the equilibrium quantity demanded and is exactly the price producers are willing to sell for the equilibrium quantity supplied.

    • Addendum to what Dago added: The word “fair” is an entirely subjective human concept that has little basis in reality. As good parents will often tell their children, “The world is not fair.” The concept is useful, but it is only a subjective “feeling”. It has no objective meaning that can be codified.

      So, anytime you hear someone complaining about prices or wages not being “fair”, think of a 13 year-old girl stamping her feet, because her mother won’t buy her tickets to the concert that all her friends are going to and saying “It’s not fair!”.

  2. I’m afraid YOUR logic is basically flawed, Juan Cristobal. You’re talking about economic and financial logic. This, unfortunately has nothing at all to do with communist reasons, as their whole mindset is based on destroying in order to dominate.

    Therefore, with THAT goal in mind, all one can deduce is that THEIR actions make perfect sense: they are doing a very good job of destroying… and of dominating.

    Forget all the “Maduro’s crazy” (he is, but not because he’s mistakenly betting on things getting better with his actions), “Don’t they know ANYTHING?” (they do, they do), “People won’t stand for this!” (they won’t?)

    Instead of all those spectator-sports comments made with sensible people in mind (and which actually alter or deter or improve nothing), one has to come back to the basic “radical” tenet that somebody has to STOP these people, or they’ll simply go on… and on…and on…

    And, woe and behold, that “somebody” has to be somebody, not any ethereal “they”.

    The problem 15 years into this disaster, is not one of opening people’s eyes. Those whose eyes are openable are already open. Those whose eyes are not, are not. Simple.

    So, it comes down to what has to be done? And, shudder, WHO? And the answer, like in early 2001, ain’t nowhere but in the mirror.

  3. I would go further from a business owners perspective. Businesses are inherently playing a long game, not a short game. Sure you could have sold it with a 300 straight profit which might work as a one time transaction, but what then? The business will need to replenish its inventory by putting more vacuums on the shelf. To get those future vacuums on the shelf you will need to pay 2200. So now you must sell the vacuum for 2200 plus your fixed cost plus a profit so you can do such extravagances as pay yourself. Selling at 1500 can certainly empty the anaqueles, but it will leave them that way…

  4. Not to muddle the point too much, Juan, I am not sure that it is only the Venezuelan government that does not seem to understand accounting and economic profit. When I make an investment in the USA, the IRS is only interested in my accounting profit. As long as I sell for more than I paid for any commodity (take a house or stocks for instance), the IRS says I made a profit. Inflation or the actual price of the commodity at the time of selling has no bearing in their consideration (this is particularly the case for a house you might sell many years fater you purchased it. Inflatioin might have eaten all of the profits one could make on the sale). So, is this not a similar situation as to how the Venezuelan government perceives profits?

  5. hgdam; when I sold my home in the US, I didn’t have to pay taxes on any profit less than $250,000 because it was my first home, primary place of residence and I had lived there for X number of years.

      • Essentially you are correct. The government concerns itself with accounting profit. Why should it care about economic profit as regards tax collection?

        I’m not trying to be flippant when I say this. There is a world of difference between a government collecting taxes and a government intervening in business operations and essentially disposing of the inventory thereby eradicating both accounting and economic profits of said enterprise.

        Bear in mind that when an investor makes a capital deployment decision, it should be less on accounting profit per se and more about economic profit as manifested in the required rate of return which accounts for things such as anticipated taxation and inflation amongst others. Barring a shock of some sort, long term tax rates tend to be rather stable. Inflation can vary, but the greater the variability, the higher the required rate of return.

        From a rational viewpoint, the government should expect the market/investors to be concerned about economic profits and leave the taxation on accounting profits to its taxing entity. If accounting taxes are irrationally high this will manifest itself in the higher RRoR, and by conjunction, less capital investment/FDI as capital moves elsewhere where there is both less risk and more opportunity. Ultimately in a relatively normalized economy, a bad business that is taxed on accounting profits but has economic losses will be driven from the market, not because of the taxes, but rather because it was unable to compete.

        The government’s tendency to intervene and create policies that disrupt trade/business and effectively destroy suppliers is a primary reason why no one, outside of oil companies, invests in Venezuela. Its not an accounting exercise insomuch that it is an economic risk analysis one.

        • Thank you! You are of course correct. Taxation is a different matter from intervention. Of course, in a country with low and stable inflation, the two types of profits are fairly similar. I do understand that this is not the situation in Venezuela.

  6. For most Venezuelans, be they chavistas or not, business folks brought this upon themselves by overcharging for merchandise. You´d really be wasting your time if you try explaining demand- supply equilibrium and arbitrage to anybody in that country.

    I would invite anyone to visit the comments sections in lapatilla.com, noticias24, or other sites. It’s truly shocking. Lots of -yes- oppositon people with arguments in the line of “we are not defending the speculators but are worried about the consequences over the economy?”

    Is that in Venezuela dude, if you’re a businessman or an entrpreneur you already fall in the category of speculator. And if you are successful, well then that means you necessarily stole the money from someone.

    People just adore the socialist creed down there!

  7. I see it (and correct me if I’m wrong), from a different perspective. As you explain it, the economic cost is represented by the opportunity cost of the new price set by the wholesaler, since:
    “..it is making less money than the next best alternative..”
    But actually, I see it as just a loss. Simply put: I ONLY have 1200 Bs F, and I decide to invest into selling the product. I buy it for exactly 1200, and sell it for 1500. I now have exactly 1500. I need to go and buy the next unit, and the price is 2200. I simply CAN’T pay for it (only have 1500), so I cannot continue with the business. One might argue that because of the first unit sale I’m now 1200-1500=300 Bs F richer, but taking into account that the reason for the 2200 raise was INFLATION, my money is now worth LESS than before, so even if I quit the business and leave with the +300 accounting profit, my purchasing power is lower than when I started, so I’m (no matter how you see it) loosing. The only way in which an earning would be perceived would be to sell at a profit margin greater than inflation.

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