Chapter 8: The Invisible Hand in Action In a free market, individuals act in their own interests Utility maximization Profit maximization So, how, in a free market, are limited resources allocated efficiently?

Accounting Profit vs. Economic Profit Accounting profit = total revenue – explicit costs Explicit costs are payments firms make to purchase Resources (labor, land, etc.) and Products from other firms Economic profit = total revenue – explicit costs – implicit costs Also called excess profit Implicit costs are the opportunity cost of the resources supplied by the firm's owners Normal profit = accounting profit - economic profit

Three Kinds of Profit Total Revenue Explicit Costs Explicit Costs Total Revenue = Explicit Costs + Accounting Profit Explicit Costs Explicit Costs Accounting Profit Economic Profit = Accounting Profit – Normal Profit Normal Profit Economic Profit

Economic Profits Guide Decisions Pudge Buffet's decision: keep farming or quit? Farming Explicit farm costs are $10,000 Total revenue is $22,000 Alternative job Earn $11,000 per year working retail Calculate accounting and economic profits of farming Accounting Profit Economic Profit Normal Profit $12,000 $1,000 $11,000

Economic Profits Guide Decisions What changes if Pudge inherits the land? His explicit costs decrease by the rent of the land ($6000) Now he could choose to rent out the land for $6000 Total Revenue Explicit Costs Implicit Costs $22,000 $4,000 $17,000 Accounting Profit Economic Profit Normal Profit $18,000 $1,000 $17,000 Pudge should stick with farming

Two Functions of Price Rationing function of price distributes scarce goods to the consumers who value them most highly Allocative function of price directs resources away from overcrowded markets to markets that are underserved Invisible Hand Theory is that actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resource Articulated by Adam Smith in eighteenth century

Response to Economic Profits Markets with excess profits attract resources P 2 Quantity (000s of bushels/year) Price $/bu MC 130 ATC 1.20 Typical Corn Farm Quantity (M of bushels/year) S D 65 Corn Industry Economic Profit

Shrinking Economic Profits Supply increases P Quantity (000s of bushels/year) Price $/bu MC 130 ATC Typical Corn Farm 2 Quantity (M of bushels/year) S D 65 Corn Industry Economic Profit S' 1.50 95 120

Market Equilibrium Zero economic profits P Quantity (000s of bushels/year) Price $/bu MC 130 ATC Typical Corn Farm 2 Quantity (M of bushels/year) S D 65 Corn Industry S' 1.50 115 1 S" 90

Economic Losses Resources leave 1.05 Quantity (M of bushels/year) Quantity (000s of bushels/year) 70 0.75 P 90 ATC MC S D 60 Price $/bu

Market Equilibrium No economic losses Quantity (M of bushels/year) Quantity (000s of bushels/year) 70 0.75 P 90 ATC MC S D 60 Price $/bu 1 S' 40

The Ubiquitous Power of the Invisible Hand Haircut market vs. aerobics market Price ($/haircut) Haircuts/day Classes/day Price ($/class) S D 500 15 200 10 350 D' 12 300 Haircut Market Aerobics Market

The Ubiquitous Power of the Invisible Hand The invisible hand and the cost-saving innovations The invisible hand and the integrated labor market of the European Union The invisible hand and the stock market