MBMC The Quest for Profit and the Invisible Hand

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 2 The Central Role of 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 returns E.g. Farmer earns as much farming as he would working elsewhere and renting his land to a neighbor.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 6 The Central Role of Economic Profit Calculating Profit Suppose a firm has the following:  TR [Total Revenue] = $400,000  Explicit costs (salaries) = $250,000/yr  Machinery 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)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 7 The Central Role of Economic Profit Calculating Profit Accounting Profit  $400,000(TR) - $250,000 (explicit costs) = $150,000

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 8 The Central Role of Economic Profit Calculating Profit To 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 9 The Central Role of Economic Profit Calculating Profit Normal 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 10 The Difference Between Accounting Profit and Economic Profit Total revenue Explicit costs Accounting profit Normal profit = opportunity cost of resources supplied by owners of firm Economic profit Explicit costs

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 11 Why are the distinctions important? Example Should 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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:

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. The difference between your total revenue and the $250,000 you pay for factors of production represents: A. Implicit costs B. Economic profits C. Normal profits D. Accounting profits E. Explicit costs

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. The potential return on your land, capital and labor, if allocated towards the best alternative activity, represents: A. Implicit costs B. Economic profits C. Normal profits D. Accounting profits E. Explicit costs

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. The different between your accounting profits and the potential return on your land, capital and labor represent: A. Implicit costs B. Economic profits C. Normal profits D. Accounting profits E. Explicit costs

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 16 The Central Role of Economic Profit A Review Accounting Profit = TR – explicit costs, Economic Profit = TR – explicit and implicit costs Normal profit = a fair return on the factors of production; economic profits = 0 To remain in business in the long run, economic profits must be greater than or equal to 0 (zero) i.e. P>=min ATC.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 highly BUT 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 18 Two Functions of Price The allocative function of price To 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 19

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. This graph depicts a situation in which: A.Economic profits will allocate more resources to this industry B.Economic losses will lead firms to leave this industry C.An industry in which firms are earning normal profits D.An industry in which firms are making short run losses E.An industry in which firms are making long run losses

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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) Price ($/bushel) S D 65 Firm Quantity (1000s of bushels/year) Price ($/bushel) 2.40 Market price of $4/bushel produces economic profits 4.00 Price 4.00 MC 130 ATC

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide Economic profit declines as price falls 3.00 Price The Effect of Entry on Price and Economic Profit Market Quantity (millions of bushels/year) Price ($/bushel) S D 65 Firm Quantity (1000s of bushels/year) Price ($/bushel) Economic profits attract firms, reducing prices and profits 4.00 MC 130 ATC S’S’

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) Price ($/bushel) D 2.00 Quantity (1000s of bushels/year) Price ($/bushel) Price Entry of firms continues until all firms earn a normal profit MC ATC 2.00

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide Economic loss = $21,000/year Prices below minimum ATC results in economic losses. A Short-Run Economic Loss in the Corn Market Quantity (millions of bushels/year) Price ($/bushel) Quantity (1000s of bushels/year) Price ($/bushel) Price 90 ATC 1.50 MC S D 60

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) Price ($/bushel) 1.50 Quantity (1000s of bushels/year) Price ($/bushel) ATC MC 40 S’S’ Price 2.00 The departure of firms from the industry increases the market price S D 60

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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) 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. Is this realistic? What factors of production are fixed in th long run?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 Innovations In a competitive market  Firms are price takers  P = MC  Zero economic profits exist in the long run Question Why do these firms have an incentive to introduce cost-saving innovations?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 35 Economic Rent Versus Economic Profit Economic Rent That 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 36 Economic Rent Versus 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 37 Economic Rent Versus 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Landowner cannot pass on tax 30K 60K excess supply tax? tax demand

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 revolution How will an irrigation project affect the incomes of poor farmers who rent land?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 40 The Invisible Hand in Action Assume An unskilled worker has two job choices  Textile worker  Renting 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?