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To accounting versus economics profits, the price elasticity of demand, and the invisible hand. We will see how these concepts work together in the decision-making process. Most people would agree, that at the end of the day, the bottom line is what matters the most. But, what exactly is the “bottom line?” There are two ways businesses calculate profits and losses; accounting and economic. Accounting is pretty much straightforward. It’s all about the money. Total revenue – (cost of goods sold + operating expenses + taxes). If my food truck sold $445 worth of food during the lunch break and it cost me $130 in groceries to make the food, plus $20 to park my truck for two hours, and a 4.5% sales tax, my bottom line is $275 profit. We could also subtract the cost of fuel for the truck, generator, and propane appliances.
These are all explicit costs; anything that costs me out of pocket to operate my business. The economic way of calculating profit or loss also factors in implicit, or opportunity, costs. Implicit costs are more subtle than explicit costs and are harder to track. An explicit cost of running my food truck is the lost wages and benefits from working in the factory. However, there is an implicit gain by earning a degree in culinary arts. Another opportunity cost is time; the time required to build and maintain my business. There will be no 40 hours, nine to five, Monday through Friday. On the flip side, I am the boss; I can close up and head home whenever I wish. But, maybe, at the opportunity cost of lost sales for closing early. The goal is to reach a point of zero economic profit or normal profit. This is when total revenue equals explicit plus implicit costs. The idea being that I can’t be making any more money elsewhere, or I would be. Economics looks at the big picture.
How it works
It takes into consideration every opportunity lost or gained and every decisions outcome. This economic way of thinking helps make more intelligent business decisions. Price elasticity of demand is simply how consumers respond to a change in the price of products or services. Comparable and available substitutes determine how elastic or inelastic a product or service is. If I parked my truck at an industrial park or a college campus, consumers would be more likely to pay a slightly higher price for the convenience of not having to leave for food and a lack of choices. This scenario is inelastic. I could maybe raise prices slowly over time and not lose my customer base because of the lack of competition. However, there is still risk involved because people will eventually make a marginal analysis and find a substitution or go without eating. If I parked in a busy downtown or at a special event somewhere, there would be lots of competition.
Arbitrarily raising prices would certainly discourage consumers and sway potential customers away from me. The demand is there, but because my prices are high and not competitive, potential customers choose to go next door. To combat this, I could lower my prices to make a bare minimum profit and hope to make my money on the volume of sales. That is, assuming I have enough food prepped and ready to feed the masses already on board the truck. I could also sell slightly smaller portions and gain some of these losses back from the price reductions. How creative can you be? Moira Vetter wrote on Forbes.com, “American Airlines… [by removing] one olive from each passengers’ salad plate would reduce costs by $40,000.” (The $40,000 olive: How entrepreneurs can spend time making money) The nature of demand affects my every decision. What, where, and when I set up. What is on my menu and for how much. Tourists in downtown Asheville will be willing to pay more than a college kid at lunchtime. Staying open later in Bryson City, after the rest of the eating establishments have closed, will get me the brewery crowds when they close.
Setting up when the tourist train comes and goes will also draw business. Next, we will look at the invisible hand concept. See what I did there? Look at…invisible? Invisible hand refers to the unseen force that keeps a balance between supply and demand in the free marketplace. As individuals pursue their own needs, they inadvertently benefit society around them. If I park my food truck outside a brewpub, I will draw customers that originally only came for a beer and decided to eat, and the brewery will draw customers in the same manner. We form a silent partnership. It’s a win-win situation. Helping each other out wasn’t initially in our plans, but that’s how it all worked out. Like magic. There is stiff, and sometimes unfriendly, competition between food trucks and traditional sit-down restaurants. Competition drives each of us to produce the highest quality products at the lowest possible price. This, in turn, means our suppliers are driven to do the same, and the farmer’s markets and meat markets are driven to do the same, etc.
All this competition, all the drive to do better, to be better, to cut costs without sacrificing quality, goes on every day behind the scenes. It keeps the free market balanced, without government intervention. Understanding all these economic concepts, and how they work, helps me decide where and when I open to serve some food. Who I might make long-term partnerships with, and who I should be wary of. How I set my prices depending on location or what’s on the menu for the day. Understanding these economic principles is key to running a successful business. Measuring profits; accounting or economic? While accounting gives you the raw numbers and is needed for tax purposes and out of pocket expenses, the economic way of thinking gives a much broader view of what’s going on. Economics shows where your inefficiencies are and where improvements can be made. Price elasticity and invisible hand require us to understand the marketplace fully. Fully understanding the marketplace, and how it works, makes us better decision makers. Thinking through every decision to the end and analyzing every possible outcome. Weighing the opportunity costs or gains and reducing costs and spending without sacrificing quality. By utilizing these concepts, intelligent decisions can be made. Where does your $40,000 olive lie?
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