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The Quest for Profit and the Invisible Hand
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 2
The Central Roleof Economic Profit
According to mainstream economists People are rational and motivated by self-interest.
“homogenous globules of desire” But empirical research shows this assumption rarely
holds (e.g. behavioral economics) “Sales Are Colossal, Shares Are Soaring. All Amazon Is
Missing Is a Profit”
The goal of profit maximization will serve society’s collective interest.
but only in perfect markets and only if we believe that maximizing monetary value is
in society’s collective interest and the underlying distribution of wealth and resources is desirable.m
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 3
Three Types of Profit: 1
Accounting Profit = total revenue – explicit costs (actual payments made to factors of production)e.g. money a farmer gets for selling his
milk, minus wages to hired hand, interest on loan for purchase of new tractor, costs of fuel, etc.
What is left out here?
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 4
Three Types of Profit: 2
Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners) E.g. also subtract money farmer could have made
working elsewhere, money he could have made renting his land to someone else, etc.
Payments to factors of production (explicit and implicit) Payment to labor (human capital) = wage to land (natural capital) = rent (unearned income) to capitalists (finance and machinery/built capital)
= interest
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 5
Three Types of Profit: 3
Normal Profit = accounting profit – economic profit= fair payment to implicit costs
i.e. normal profit occurs when all factors of production, owned and unowned, earn their expected returnsE.g. Farmer earns as much farming as he
would working elsewhere and renting his land to a neighbor.
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 6
The Central Roleof Economic Profit
Calculating ProfitSuppose a firm has the following:
TR [Total Revenue] = $400,000Explicit costs (salaries) = $250,000/yrMachinery and other equipment with a resale
value of $1 million (implicit cost = returns to capital = interest, i.e. the amount of money he would earn by investing the $1 million elsewhere)
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 7
The Central Roleof Economic Profit
Calculating ProfitAccounting Profit
$400,000(TR) - $250,000 (explicit costs) = $150,000
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 8
The Central Roleof Economic Profit
Calculating ProfitTo calculate economic profits, assume
Annual interest on typical investment = 10% [Then the $1 million spent on equipment could
have earned $100,000/yr had it been invested]Economic Profit
$400,000 (TR) - $250,000 (explicit cost) - $100,000 (implicit cost) = $50,000
i.e. profits above and beyond a fair return to the factors of production
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 9
The Central Roleof Economic Profit
Calculating ProfitNormal Profit
Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr
Normal profit is a fair return on the factors of production you own, in this case the $1 million in capital
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 10
The Difference BetweenAccounting Profit and Economic Profit
Totalrevenue
Explicitcosts
Accountingprofit
Normal profit = opportunity cost ofresources supplied
by owners of firm
Economicprofit
Explicitcosts
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 11
Why are the distinctions important?
ExampleShould a Vermont farmer stay in the farming
business?He should stay as long as he can pay for all
his hired factors of production (e.g. hired workers, rented machinery), makes as high a return on his labor as he would working elsewhere, and makes as much on his land as he would if he rented it, or else sold it and invested the profits.
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
You are a small business owner who owns the land and capital required for your business. You bring in $500,000 per year in revenue, and pay out $250,000 per year for the labor and raw materials you require.
Practice at home:
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The difference between your total revenue and the $250,000 you pay for factors of production represents:A. Implicit costsB. Economic profitsC. Normal profitsD. Accounting profitsE. Explicit costs
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The potential return on your land, capital and labor, if allocated towards the best alternative activity, represents:A. Implicit costsB. Economic profitsC. Normal profitsD. Accounting profitsE. Explicit costs
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The different between your accounting profits and the potential return on your land, capital and labor represent:A. Implicit costsB. Economic profitsC. Normal profitsD. Accounting profitsE. Explicit costs
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 16
The Central Roleof Economic Profit
A ReviewAccounting Profit = TR – explicit costs, Economic Profit = TR – explicit and
implicit costs Normal profit = a fair return on the factors
of production; economic profits = 0To remain in business in the long run,
economic profits must be greater than or equal to 0 (zero) i.e. P>=min ATC.
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 17
Two Functions of Price: 1
The rationing function of price To distribute scarce goods to those
consumers who value them most highlyBUT as economists determine value, you
can only value something if you have money.
Amerindians in the Amazon do not value the forest
Poor people do not value life saving medicine, e.g. eflornithine
There is no role for ethical, moral or social values
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 18
Two Functions of Price
The allocative function of priceTo direct resources away from
overcrowded markets and toward markets that are underserved
BUT, from the economists perspective, markets in life saving medicines for poor people are overcrowded, while markets for facial hair loss formulas for rich people are underserved.
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 19
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 20
The Invisible Hand Theory
Resources are allocated across firms to produce the most efficient (i.e. profitable) possible mix of goods and services (allocative function) Inputs will go to those producers who can pay the most for
them (i.e. who can create the highest valued products from them)
Goods and services are efficiently (i.e. maximizing monetary value) allocated across consumers (rationing function) Outputs will go to those consumers who value them the
most (i.e. who can pay the most)
Markets balance possibility with desirability
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 21
Responses to Profits and Losses
Markets with firms earning economic profits will attract resources.
Markets where firms are experiencing economic losses tend to lose resources.
Shifts in demand will raise or lower prices, hence profits, leading to entry or exit of firms, returning prices to their ‘fair’ level
GRAPHS ON BOARD
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This graph depicts a situation in which:A.Economic profits will allocate more resources to this industryB.Economic losses will lead firms to leave this industryC.An industry in which firms are earning normal profitsD.An industry in which firms are making short run lossesE.An industry in which firms are making long run losses
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 23
Economic Profit in the Short Run in the Corn Market
Market Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
S
D
65Firm Quantity (1000s of
bushels/year)
Pri
ce (
$/b
ush
el)
2.40
Market price of $4/bushel produces economic profits
4.00 Price4.00
MC
130
ATC
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 24
3.00
Economic profit declines as price falls
3.00 Price
12095
The Effect of Entry onPrice and Economic Profit
Market Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
S
D
65Firm Quantity (1000s of
bushels/year)
Pri
ce (
$/b
ush
el)
Economic profits attract firms, reducing prices and profits
4.00 4.00
MC
130
ATCS’
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 25
Equilibrium when Entry Ceases
S
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
D
2.00
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
Price
90115
Entry of firms continues until all firms earn a normal profit
MCATC
2.00
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 26
2.10
Economic loss= $21,000/year
Prices below minimum ATC results in economic losses.
A Short-Run Economic Loss in the Corn Market
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
70
1.50Price
90
ATC
1.50
MC
S
D
60
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 27
Equilibrium when Exit Ceases
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
1.50
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
90
1.50
90
ATCMC
40
S’
Price2.00 2.00
The departure of firms from the industry increases the market price
S
D
60
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 28
Efficiency & community development
How does the cost structure of Wall-mart compare with the little store on Church street?
What happens when a Wall-mart comes to town?
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 29
Communities, again
What happens when all other stores close?
Does this serve society’s collective interest?
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 30
The Invisible Hand Theory
In the long-run, in a competitive market, all firms will tend to earn zero economic profits. Consumer gets the good as cheaply as possible But remember, normal profits cover all the costs of
production Zero economic profits are the consequence of
price movements caused by the entry and exit of firms trying to maximize economic profits.
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 31
Long-Run Equilibrium in a Corn Market with Constant Long-Run Average Cost
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
=1.00D
S=LACLMC
Price
MC
90
ATC
1.00
Similar ATC curves allow the industry to supplyany output at a price equal to minimum ATC.
Is this realistic? What factors of production are fixed in th long run?
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 32
Two Attractive Features
The market outcome is efficient in the long run.P = MC= min ATC
The market is fair.The price the buyers pay is no higher than
the cost incurred by sellers.The cost includes a normal profit.Normal profits include payments to all
factors of production, including a CEO making 100 million a year.
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 33
The Invisible Hand in Action
The Invisible Hand and Cost-Saving InnovationsIn a competitive market
Firms are price takersP = MCZero economic profits exist in the long run
QuestionWhy do these firms have an incentive to
introduce cost-saving innovations?
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 34
Free Entry and Exit
Free entry and exit must exist for the allocative function of price to operate Barriers to entry can be caused by legal
constraints and unique market characteristics Patents and copyrights
Medicine prices in US and Canada Textbook prices in US and Europe
Compatibility between products Firm size Quotas
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 35
Economic RentVersus Economic Profit
Economic RentThat part of a payment for a factor of
production that exceeds the owner’s reservation price
Think about land, fossil fuels, etc.Market forces will not push economic rent
to zero because inputs cannot be replicated easily
But taxes can push it to zero
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 36
Economic RentVersus Economic Profit
An absentee landowner rents farmland to a corn farmer for $30,000 yr.
Farmer generates an income (TR-explicit costs) of $30,000 yr (normal profit)
A new government subsidy for ethanol increases revenue from the farmland by $30,000 year
What happens to the rent, the farmer’s income, and the price of the land?
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 37
Economic RentVersus Economic Profit
An absentee landowner rents farmland to a corn farmer for $30,000 yr.
Famer generates an income of $30,000 yr (normal profit)
The government raises taxes on the land by $30,000 year
What happens to the rent, the farmer’s income, and the price of the land?
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Landowner cannot pass on tax
30K
60K
excess supplytax?
taxdemand
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Chapter 8: The Quest for Profit and the Invisible Hand Slide 39
The Invisible Hand in Action
The Invisible Hand in Antipoverty Programs, e.g. the green revolutionHow will an irrigation project affect the
incomes of poor farmers who rent land?
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand Slide 40
The Invisible Hand in Action
AssumeAn unskilled worker has two job choices
Textile workerRenting land to grow rice
A state funded irrigation program doubles output without changing the market price.
What happens to income of landless?
What happens to price of land? Who benefits?