Civil Engineering Reference
In-Depth Information
construction output in Europe. In fact, more than 20 per cent of the European
construction sector workforce is estimated to be self-employed; in the UK the
comparable figure is closer to 40 per cent. Indeed, the construction industry may be
characterised by risk-taking entrepreneurs.
Larger corporations, such as public limited companies, typically have many
shareholders. They are the owners of the firm, which means that theoretically they
are the entrepreneurs. In practice, they do not usually get involved in the day-to-
day running of the firm. They do not, for example, determine the level of prices or
output. These tasks are delegated to salaried managers, leaving shareholders with
one sole interest - the level of profit that the firm manages to generate.
Profit
The costs of production must include an element of profit to provide a payment to
the entrepreneur. If the level of profits falls in one area of activity, entrepreneurs
may move their resources to an industry where the returns are higher. To illustrate
this behaviour economists employ a concept of
normal profit
. Normal profit may be
defined as:
a minimum level of reward required to ensure that existing entrepreneurs are
prepared to remain in their present area of production.
Normal profit is included in the cost of production, as it is an essential minimum
reward necessary to attract the entrepreneur into economic activity. The concept
of normal profit also highlights that all resources can be employed in several ways
(that is, all resources have alternative uses). Note that what is meant by 'profit'
by economists differs from its general meaning in everyday usage. To portray the
general everyday meaning of profit, the following formula could be used:
profits = total revenues - total costs
For economists, an alternative formula is required:
economic profits = total revenues - total opportunity cost of all inputs used
The economic profits formula will become clearer by looking at two areas of
resource allocation and the related cost accounting calculations. The first resource is
capital, and the second is labour.
OPPORTUNITY COST OF CAPITAL
Firms enter or remain in an industry if they earn, at a minimum, a normal rate of
return (NROR) - that is, normal profit. By this term, we mean that people will not
invest their wealth in a business unless they obtain a positive competitive rate of
return - in other words, unless their invested wealth pays off. Any business wishing
to attract capital must expect to pay at least the same rate of return on the capital
as all other businesses of similar risk are willing to pay. For example, if individuals
can invest their wealth in almost any construction firm and get a return of 10 per
cent per year, then each firm in the construction industry must expect to pay 10
per cent as the normal rate of return to present and future investors. This 10 per
cent is a cost to the firm - formally referred to as the
opportunity cost of capital
.
The opportunity cost of capital is the amount of income, or yield, forgone by giving
