Foundation for Teaching Economics | Incentives, Profit and the Entrepreneur

Incentives, Profit and the Entrepreneur

Key Terms:

Profit
Competition
Property rights
Incentives
Entrepreneur
Residual claimant
Resource allocation

National Content Standards Addressed:

Standard 4 - People respond predictably to positive and negative incentives.

Standard 8 - Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.

Standard 9 - Competition among sellers lowers costs and prices and encourages producers to produce more of what consumers are willing and able to buy. Competition among buyers increases prices and' allocates goods and services to those people who are willing and able to pay the most for them.

Standard 14 - Entrepreneurs are people who take the risks of organizing productive resources to make goods and services. Profit is an important incentive that leads entrepreneurs to accept the risks of business failure.

Standard 15 - Investment in factories, machinery, new technology, and in the health, education, and training of people can raise future standards of living.

Lesson Objectives (8)

All people respond to incentives.
- Review the definition of incentives from lecture #2.
- Elicit examples of both positive and negative incentives; elicit examples of both positive and negative incentives in a market.
Profit is an incentive; it motivates entrepreneurs to accept the risk of acquiring and organizing resources to seek market opportunities.
- Discuss profit as total revenue - total cost (including opportunity cost).
- Differentiate between accounting profit and economic profit; emphasize that the difference lies in consideration of all opportunity costs.
An entrepreneur is a "residual claimant."
- The entrepreneur takes whatever profit or loss results from an enterprise.
- The entrepreneur acquires the cooperation of others (by meeting their terms - that is, their opportunity costs) in a productive endeavor and accepts responsibility for the outcome.
The expectation of profit encourages increases in production and attracts new suppliers; lack of profit signals businesses to reduce production or exit the market.

Competition, including entry of new businesses, reduces margins of profit and encourages an on-going search for improved products and lower-cost methods of production.

Governments encourage entrepreneurial activity when they secure clear property rights and protect freedom of exchange.

When there is no residual claimant, there is less incentive to reduce the costs of providing goods and services or to improve product quality and service.

Examples of collective ownership or government providers of services, like the Department of Motor Vehicles, illustrate the problems associated with the absence of these incentives.

Sample Interactive Discussion Problems:

Pose an example of something with an "outrageous" price and ask for explanations of why this price persists in a competitive market.

Suppose that, since so many Americans are angry about the profiteering of drug companies, a bill has been introduced in Congress to have the FDA take over the production of all drugs.
- Predict the result of such legislation:
  - What will happen to the price of drugs?
  - Who will pay?
  - How will we decide which drugs will be produced?
  - What will happen to the discovery of new, safe, and effective drugs?
  - How will decisions be made about which diseases drug research should target?
  - In what ways do the incentives facing government producers differ from those facing private entrepreneurs?
  - How does the existence of private drug companies, run by entrepreneurs, change your answers to the above questions?
You may want to let students discuss the question of what is the right or acceptable level of profit.
- Ask them to determine how profit should be measured: For example, if it is measured as a percentage, then of what should it be a percentage? (Both students and teachers tend to be under the misconception that there is some sort of correct answer to this question.)
- Ask them to predict the consequences of setting acceptable levels of profit. Consider how this changes incentives for both buyers and sellers.

Definitions

Entrepreneur - One who is willing to risk loss in the attempt to make a profit from reorganizing market resources from low-valued to high valued uses. Entrepreneurs undertake the task of coordinating the employment of land, labor, and capital to produce goods and services.

Incentives - Rewards or punishments for behavior.

Profit - The difference between total revenue and total cost.

Property rights - The conditions of ownership, including the rights and restrictions regarding use, ownership, and sale.

Residual claimant - The owner of whatever is left (either profit or loss) when all the costs of production and sale have been accounted for. Entrepreneurs, by virtue of their willingness to risk failure, are the residual claimants to the profits of their enterprises.

Resource allocation - The method(s) used to determine ownership (property rights) to land, labor, and capital.