Key Concepts in Economics – 7 – The Nature of Revenues, Costs and Profits

If you ask any common person basic questions like “What is revenue?”, “What is cost?” and “What is profit?”, you are likely to get an answer revolving around money. Revenue, you will be told, is the total money you get through sale, cost is the total money expenditure you incur and profit is the net of money revenue over money costs. When money revenue is less than money costs, we say that the person has made a loss. This explanation is perfect from an accounting perspective. Since money is the unit of account, it makes perfect sense to define these terms in this manner.

In economics, however, these terms are defined differently. All these terms are defined around the concept utility. Consider a simple example where A sells 2 horses to B in exchange for a cow. Let us analyse the position of A and B just prior to the sale. This analysis, in economic terms, is called ex ante analysis and against ex post analysis which is done after the exchange happens.

Ex ante, A’s revenue can be of 2 forms

  1. The use value of the cow – This is the utility he gets by using the cow in the service of his own ends
  2. The further exchange value of the cow – This is the utility he gets by consuming some other good that he could exchange the cow for in the future

Similarly, ex ante, A’s cost can be of 3 forms

  1. The foregone use value of the 2 horses – This is the utility he foregoes by losing the opportunity to use the 2 horses in the service of his own ends
  2. The foregone exchange value of the 2 horses for some other good – This is the utility foregone in terms of the other goods that he could exchange the 2 horses for
  3. The foregone opportunity to exchange the 2 horses for something more than 1 cow – While this sounds silly with cows (considering you can’t get ½ a cow), let’s try imagining it with a divisible good. Even in this case, it is the utility of the goods he gets in the future that is relevant.

A’s revenue would be the higher of the 2 utilities he may get and his cost is the highest of the 3 utilities he may forego. The case would be the reverse for B with the words horses and cows swapped for each other.

Thus, A engages in the exchange if his utility received exceeds the utility foregone in the exchange. The same is the case for B, except that his valuations would have to be the reverse of that of A.

In the process, if A feels that the utility received exceeds the utility foregone, he is better off or has attained a profit. However, given that utility is a subjective assessment of the usefulness of a means in satisfying an end and that it is ordinal in nature, how is one to “calculate” A’s (or B’s) profit? Frankly, it just cannot be. Not even the parties to the transaction can. All they can say is that by their subjective assessment, they are better off. This feeling of being better off is essentially a psychic phenomenon. Therefore, in economics, it is said that real profits are psychic profits. Psychic losses are not possible ex ante because man acts to exchange because he assesses himself to be better off as a result.

Thus, we see that in any exchange, both parties to the exchange profit ex ante. The situation could be different ex post. Having exchanged the 2 horses for the cow, let us say that A realizes that he is worse off as a result of the exchange. That knowledge has no bearing for the exchange itself. What it can do is to serve as knowledge that will guide his choices in future exchanges.

What do we learn from this?

The next time you walk into an outlet of Barista or Café Coffee Day and order a cup of coffee and wonder why you should pay Rs. 50 or more for just a cup of coffee, just remember that you are doing so because the cup of coffee in that environment is of greater utility to you than the Rs. 50 or more that you forego. In fact, it has greater utility for you than anything else you can do with that Rs. 50 at that time. So, rather than add to your acidity moping over the “high” price of the coffee, just sit back, enjoy the coffee and thank the owners of the coffee shop for agreeing to trade with you.

Key Concepts in Economics – 7 – The Nature of Revenues, Costs and Profits
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