The Quest for Profit and The Invisible Hand

Adam Smith Self-interest moves the economy Consumers seek to maximize utility from purchases Firms seek to maximize profit from production It serves society’s interest It is due to profit opportunities With it, the entrepreneur “intends only his own gain,” he is “led by an invisible hand to promote an end which was no part of his intentions

Adam Smith Self interest = “greed”? With it, the entrepreneur and consumer “intends only his own gain,” yet she is “led by an invisible hand to promote an end which was no part of her intentions

Invisible Hand Invisible Hand Theory The actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources I.E., markets are efficient

Equilibrium When markets reach equilibrium there is no more “cash on the table” It says that all opportunities for gain are exhausted It implies that the prices of resources privately owned will tend to reflect their economic value It implies those making profits are first to act on profit making opportunities

Markets and Social Optimum Market equilibrium does not mean the resulting allocation of resources is the best one viewed from society’s perspective Smart for one, dumb for all For example, some market activities that produce profits for some may produce pollution (externalities) for many

Functions of Price Rationing function of price Prices distribute scarce goods to those consumers who value them most highly Allocative function of price Prices direct resources away from overcrowded markets and toward markets that are underserved

Functions of Price Where price is relative to average total costs of production (ATC) will determine firm profits and serve to allocate firm resources. P > ATC => positive profits P < ATC => negative profits Changes in price may therefore reallocate resources.

2 Types of Costs and 2 Types of Profit Explicit Costs Actual payments made to factors of production and other suppliers Implicit Costs All the opportunity costs of the resources supplied by the firm’s owners Eg: opportunity cost of owner’s time Eg: opportunity cost of owner-invested funds

Three Types of Profit Accounting Profit Economic Profit Normal Profit Total Revenue – Explicit Costs Economic Profit Total Revenue – Explicit Costs – Implicit Costs Normal Profit The difference between accounting profit and economic profit The opportunity cost of the resources How much accounting profit is needed for econ profit to be exactly = 0? Economic Loss An economic profit less than zero

Figure 8.1 The Difference Between Accounting Profit and Economic Profit

The Difference Between Accounting Profit and Economic Profit Revenue – Acct Costs = Acct Profit Revenue – Econ Costs = Econ Profit Revenue – Explicit Costs = Acct Profit Revenue – (Explicit + Implicit costs) = Econ Profit Acct Profit – Implicit Costs = Econ Profit If Acct Profit exactly = Implicit Costs => Econ Profit = 0, and the firm is said to be earning a “normal profit”

Econ vs. Acct Profits True or False: Economic profits are always less than or equal to accounting profits.  TRUE If some implicit costs exist  economic cost > accounting cost  Economic profit < accounting profit (ie: we are subtracting more costs from the same revenue)

To Farm or Not To Farm? Pudge Buffet sells corn his revenues are $22,000/yr he pays $10,000/yr in explicit costs he could earn $11,000 at another job he likes equally well (implicit costs) Pudge’s economic profit is $22,000 - $10,000 - $11,000 = $1,000 Earning more than a normal profit

Example: After graduation from the CSB with a degree in economics, you face the following job choice: Option 1: IBM in RTP Salary = $50K/year Option 2: Suntan shop in Key Largo Salary = $15K/year If you choose option 2, you have to drain your $10,000 savings to start the business. Assume that you could have earned 10% on that money.

Example continued Suppose you choose option 2… 1st year analysis: Revenue = $50,000 Costs of inventory = $8,000 Labor expenses = $15,000 Rent = $12,000 acounting economic - inventory - inventory - rent - rent - wages for worker - wages for worker - opp cost of Labor ($50k) - opp cost of funds = $1000  the normal rate of return on capital.

Example continued Accounting profit = 50 – 8 – 15 – 12 = 15 Economic profit = 50 – 8 – 15 – 12 – 50 – 1 = -36 Earning less than a normal profit How much is a normal profit for this firm? Should this firm exit this industry in the long-run?

Market Forces and Economic Profit Positive Economic Profit means the firm (owner) is more than covering opp costs Doing better than the next best alternative Price must be higher than ATC Firms enter this industry Supply increases Price falls Profits fall

Market Forces and Economic Profit Negative Economic Profit means the firm (owner) is not covering opp costs Doing worst than the next best alternative Price must be below ATC Firms exit this industry Supply decreases Price rises Losses fall Zero profit tendency of competitive markets

Fig. 8.2 The Effect of Economic Profit on Entry

Fig. 8.3 The Effect of Economic Losses on Exit

Free Entry and Exit The implications of The Invisible Hand Theory depend critically on freedom of firms to enter and exit Barrier to entry Any force that prevents firms from entering a new market Economic (e.g., large scale cost advantages, resource ownership) Legal, (e.g., copyright laws, patents) Natural (e.g., product compatibility) Allows price to be higher than the opportunity costs of production

The Invisible Hand Operates Even in regulated markets, resources flow in response to profit and loss signals Misunderstanding the logic of the invisible hand can lead to inefficient government regulation and programs

Economic Rent Economic Rent Part of the payment for a factor of production that exceeds the owner’s reservation price Reservation price: The price below which the owner would not supply the factor Economic rent accrues to inputs that cannot be replicated easily

Cost-Saving Innovations Firms that develop and introduce cost-saving innovations Reap economic profits in the short run Supply curves shift right Prices fall Firms that do not use the new technology will earn economic losses Competition assures that the cost savings is passed along to consumers