1 The Quest for Profit and the Invisible Hand

 According to Adam Smith  People are motivated by self-interest.  The goal of profit maximization will serve society’s collective interest. Slide 2

 Accounting Profit = total revenue – explicit costs (payments for factors of production)  Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners) Slide 3

 Costs incur without explicit money involved  E.g., use your own garage for storage  Forego the opportunity to rent out your garage, the opportunity cost is the lost income from renting the garage out.

 Suppose a firm has the following:  Total Revenue ( TR) = $400,000  Explicit costs (salaries) = $250,000/yr  Machinery and other equipment with a resale value of $1 million Slide 5

 Accounting Profit  $400,000( TR ) - $250,000 (explicit costs) = $150,000 Slide 6

 To calculate economic profits, assume  Annual interest on savings = 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 Slide 7

Slide 8 Total revenue Explicit costs Accounting profit opportunity cost of resources supplied by owners of firm Economic profit Explicit costs

 Why are the distinctions important?  Only economic profit serve the following economic functions:  Rationing function  Allocative function Slide 9

 Should Pudge Buffet stay in the farming business?  He is a corn farmer with payments for land and equipment = $10,000/yr  He supplies only his labor which he values equally to managing a retail store for $11,000/yr  Except for pay, he is indifferent between the farm or the store  Corn sells at a constant price and TR = $22,000 Slide 10

Slide 11 TotalExplicitImplicitAccountingEconomic revenuecostscostsprofitprofit ($/year)($/year)($/year)($/year)($/year) 22,00010,00011,00012,0001,000

 What would Pudge’s economic profit be if TR = $20,000  Economic profit  TR (20,000) – explicit (10,000) and implicit costs (11,000) = -$1,000  Question  Should Pudge stay in farming? Slide 12

 If Pudge owned his own land, should he stay in farming?  Assume  Pudge inherits the land  The land can be rented for $6,000/yr Slide 13

Slide 14 TotalExplicitImplicitAccountingEconomic revenuecostscostsprofitprofit ($/year)($/year)($/year)($/year)($/year) 20,0004,00017,00016,000-1,000

 A Review  Accounting Profit = TR – explicit costs  Economic Profit = TR – explicit costs – implicit costs  Economic Profit = 0 when accounting profit = implicit costs  To remain in business in the long run, economic profits must be greater than or equal to 0 (zero). Slide 15

 The rationing function of price  To distribute scarce goods to those consumers who value them most highly  The allocative function of price  To direct resources away from overcrowded markets and toward markets that are underserved Slide 16

 Profits and Losses Would Ensure  That supplies within a market would be distributed efficiently (rationing function)  Resources would be allocated across markets to produce the most efficient possible mix of goods and services (allocative function) Slide 17

 Markets with firms earning economic profits will attract resources.  Markets where firms are experiencing economic losses tend to lose resources. Slide 18

1.20 Economic profit = $104,000/yr Market price of $2/bushel produces economic profits 2.00 Price 2.00 Slide 19 Quantity (millions of bushels/year) Price ($/bushel) S D 65 Quantity (1000s of bushels/year) Price ($/bushel) MC 130 ATC

Economic profit = $50,400/yr 1.50 Price Slide 20 Quantity (millions of bushels/year) Price ($/bushel) S D 65 Quantity (1000s of bushels/year) Price ($/bushel) Economic profits attract firms, reducing prices and profits 2.00 MC 130 ATC S’

Slide 21 S Quantity (millions of bushels/year) Price ($/bushel) D 1.00 Quantity (1000s of bushels/year) Price ($/bushel) Price Entry of firms continues until all firms earn zero economic profit MC ATC 1.00

1.05 Economic loss = $21,000/year Prices below minimum ATC results in economic losses. Slide 22 Quantity (millions of bushels/year) Price ($/bushel) Quantity (1000s of bushels/year) Price ($/bushel) Price 90 ATC 0.75 MC S D 60

Slide 23 Quantity (millions of bushels/year) Price ($/bushel) 0.75 Quantity (1000s of bushels/year) Price ($/bushel) ATC 0.75 MC 40 S’ Price 1.00 The departure of firms from the industry increases the market price S D 60

 In the long-run, in a competitive market, all firms will tend to earn zero economic profits.  Zero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits. Slide 24

 The equilibrium principle (no cash on the table) predicts, when people confront an opportunity for gain they are almost always quick to exploit it. Slide 25

Slide 26 Quantity (millions of bushels/year) Price ($/bushel) Quantity (1000s of bushels/year) Price ($/bushel) =1.00 D S =LAC LMC Price MC 90 ATC 1.00 Similar ATC curves allow the industry to supply any output at a price equal to minimum ATC.

 The market outcome is efficient in the long run.  P = MC  If output is increased: MC > MB.  If output is reduced: MC < MB. Slide 27

 Long hair and physical fitness become popular these days, what happens to the supply-demand to hair stylists and aerobics instructors? Slide 28

Slide 29 Haircuts/day Price ($/haircut) Haircuts/day D MC H QHQH ATC H 15 S 50 Price ($/haircut)

Slide 30 Classes/day Price ($/class) Classes/day QAQA D MC A ATC A 10 S 20 Price ($/class)

Slide 31 Haircuts/day Price ($/haircut) Classes/day Price ($/class) S D D S Assume: Long hair and physical fitness become popular. Price of haircuts fall the price of aerobics classes rise D’ 12 D’ 300

Slide 32 Haircuts/day MC H QHQH ATC H Price ($/haircut) Classes/day MC A QAQA ATC A Price ($/class) Q’ H Q’ A Economic loss Economic profit The decrease in demand for haircuts causes economic losses while the increase in demand for classes creates economic profits

 Responses to the change in demand for stylists and aerobics instructors  Economic loss for stylists will  Reduce the supply of stylists  Increase the price until zero economic profits occur  Economic profit for aerobics instructors will  Increase the supply of aerobics instructors  Reduce the price until zero economic profits occur Slide 33

 Free entry and exit must exist for the allocative function of price to operate.  A barrier to exit can become a barrier to entry  Yet, barriers to entry can be caused by legal and political constraints as well as unique market characteristics Slide 34

 Economic profits attract resources that push economic profits toward zero. Slide 35

 Economic Rent  That part of a payment for a factor of production that exceeds the owner’s reservation price  Market forces will not push economic rent to zero because inputs cannot be replicated easily Slide 36

 How much rent will a talented chef get?  Assume  A community with 100 restaurants  99 restaurants employ chefs with normal ability for $30,000/yr (the same amount they could earn elsewhere)  The 100 th restaurant employs a talented chef and customers are willing to pay 50% more for their meals Slide 37

 Assume  TR at the each of the 99 restaurants is $300,000, which yields a normal profit  TR at the 100 th restaurant is $450,000 (50% more) Slide 38

 Assume  A talented chef  Earns $180,000 = $30,000 + $150,000  Reservation price = $30,000  Economic rent = $150,000  That the100 th restaurant earns a normal profit Slide 39

 Question  Why not pay the chef less and increase the economic profit for the restaurant? Slide 40

 Opportunities for private gain seldom remain unexploited for very long Slide 41

 Suppose Yao Ming, a star player for the Houston Rockets, can either play basketball or fry hamburger. In fact, he is equally happy and capable of doing either job.  In the 2005 season, Yao made US$4.4 million for playing basketball, while McDonald is happy to hire Yao for US$20,000.  What is Yao’s economic rent of playing basketball?

 If the US federal government dramatically increases personal income tax rate for super- star athletes like Yao, are basketball fans going to bear the tax burden?

 It is argued that pharmaceutical companies earns exorbitant amount of profits from their patents. Some politicians argue to impose a tax on such patents. The pharmaceutical companies argue that taxation on patented drugs will lower research and development expenditures. Do you agree with this statement?

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