An introduction to economics
Language Problems for The Economist and The Business Person
The Same Terms but Different Meanings
Capital:
In considering the activities of firms, the same term, ‘capital’, is used by both economists and business accountants. Unfortunately they do not both refer to the same thing when they use this term and this can give rise to much confusion. ‘In accounting theory, a person’s (or firm’s) capital is increased by that portion of his periodic income which he has not consumed’ (Accounting Theory and Practice – MWE Glautier and B Underdown).
To the economist, on the other hand, the term ‘capital’ relates to those assets (e.g. buildings, tools, machines equipment etc.) which are used (or consumed) in the production of goods and services. Further confusion arises with regard to the use of the term ‘capital’ in relation to financial transactions when it is used to refer to a merely financial resource – money.
Interest:
The situation is further confused by the use of the same term, ‘interest’, to describe, on the one hand the ‘cost’, and on the other the ‘return’, or ‘earnings’, of these quite different entities that are called the same thing – ‘capital’.
Profit:
The term ‘profit’ is another term that is used a great deal in relation to the wellbeing of a firm. Again we need to be very careful here to distinguish exactly what is meant by the term. To the business accountant ‘profit’ is a residual sum i.e. what is left to the firm from its revenue after all its costs have been met. Employees are not in fact paid out of profit but rather out the value of the product that they create as a result of their work. No work, no product, no wages, no profit! From the business persons point of view however, it is true, that if you can reduce the wage bill you can increase profits.
Looked at from an economic perspective it is clear that profits (paid to the owners of the firm as ‘owners’ only) must come from wages, interest or rent that is not paid to the providers of labour, capital, and land. In economic terms the term ‘profit’ has no clear meaning and is actually misleading for the purposes of economic analysis. Accountants, businessmen and tax collectors however, have great fun with it! Henry George said that speaking of profit as distinct from rent, wages, and interest was like speaking of people as if they were distinct from men and women. The owner of the firm as mere ‘owner’, (rather than to owners who are also managers or entrepreneurs, or the providers of capital, or land-owners), makes no contribution and is not a factor of production, his ‘profit’ is by convention only.
Reminding ourselves here of our definition of a firm for the purposes of economic analysis (i.e. that A firm consists of one or more individuals working as a unit in the production or delivery of goods and or services at a particular place and time) we will realise that business accountants description of ‘profit’ can be very misleading to an unwary economist. In economic terms a firm only consists of ‘workers’ and its assets, however it is owned! If, as in many cases the workers own the firm themselves (as sole trader, partnership or cooperative for example) the earnings of the firm may be allocated to themselves as either profit or wages as suits them best. Where it is allocated as profit it may then be distributed (to themselves as owners) or used to improve the firm’s capital. The tax rules will however have a profound bearing on how they make such allocations and distributions.
