1. The Quest for Profit and the Invisible Hand

2. The Central Role of Economic Profit
According to Adam Smith
People are motivated by self-interest.
The goal of profit maximization will serve society’s collective interest.

3. The Central Role of Economic Profit
Three Types of Profit
Accounting Profit = total revenue – explicit costs (payments for factors of production)

4. The Central Role of Economic Profit
Three Types of Profit
Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners)

5. The Central Role of Economic Profit
Three Types of Profit
Normal Profit = accounting profit – economic profit

6. The Central Role of Economic Profit
Calculating Profit
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

7. The Central Role of Economic Profit
Calculating Profit
Accounting Profit
$400,000(TR) - $250,000 (explicit costs) = $150,000

8. The Central Role of Economic Profit
Calculating Profit
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

9. The Central Role of Economic Profit
Calculating Profit
Normal Profit
Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr

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

11. The Central Role of Economic Profit
Why are the distinctions important?
Example
Should Pudge Buffet stay in the farming business?

12. The Central Role of Economic Profit
Why are the distinctions important?
Assumptions
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

13. Revenue, Costs, and Profit Summary for Pudge
Total Explicit Implicit Accounting Economic Normal
revenue costs costs profit profit profit
($/year) ($/year) ($/year) ($/year) ($/year) ($/year)
22,000 10,000 11,000 12,000 1,000 11,000

14. The Central Role of Economic Profit
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?

15. The Central Role of Economic Profit
Example
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

16. New Revenue, Costs, and Profit Summary for Pudge
Total Explicit Implicit Accounting Economic Normal
revenue costs costs profit profit profit
($/year) ($/year) ($/year) ($/year) ($/year) ($/year)
20,000 4,000 17,000 16,000 -1,000 17,000

17. The Central Role of Economic Profit
A Review
Accounting Profit = TR – explicit costs
Economic Profit = TR – explicit and implicit costs
Economic Profit = 0 when accounting profit = normal profit
To remain in business in the long run, economic profits must be greater than or equal to 0 (zero).

18. The Invisible Hand Theory
Two Functions of Price
The rationing function of price
To distribute scarce goods to those consumers who value them most highly

19. The Invisible Hand Theory
Two Functions of Price
The allocative function of price
To direct resources away from overcrowded markets and toward markets that are underserved

20. The Invisible Hand Theory
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)

21. The Invisible Hand Theory
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.

22. Economic Profit in the Short Run in the Corn MarketMC
ATC
Economic profit
= $104,000/yr
2.00
2.00
Price
Price ($/bushel)
Price ($/bushel)
1.20 D 65
130
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Market price of $2/bushel produces economic profits

23. The Effect of Entry on Price and Economic ProfitS S’ MC
ATC
Economic profit
= $50,400/yr
2.00
2.00
Price ($/bushel)
Price ($/bushel)
1.50
1.50
Price
1.08 D 65 95
120
130
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Economic profits attract firms, reducing prices and profits

24. Equilibrium when Entry CeasesMC
ATC S
Price ($/bushel)
Price ($/bushel)
Price
1.00
1.00 D
115 90
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Entry of firms continues until all firms earn a normal profit

25. A Short-Run Economic Loss in the Corn MarketMC
ATC
Economic loss
= $21,000/year S
Price ($/bushel)
Price ($/bushel)
1.05
0.75
0.75 D
Price 60 70 90
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Prices below minimum ATC results in economic losses.

26. Equilibrium when Exit CeasesMC
ATC S’ S
Price ($/bushel)
Price ($/bushel)
1.00
1.00
0.75
0.75
0.75
0.75
Price D 40 60 90 90
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
The departure of firms from the industry increases the market price

27. The Invisible Hand Theory
Observations
In the long-run, in a competitive market, all firms will tend to earn zero economic profits.

28. The Invisible Hand Theory
Observations
Zero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits.

29. The Invisible Hand Theory
Observations
The equilibrium principle (no cash on the table) predicts, when people confront an opportunity for gain they are almost always quick to exploit it.

30. Long-Run Equilibrium in a Corn Market with Constant Long-Run Average CostMC
ATC
Price ($/bushel)
Price ($/bushel)
LMC
=LAC S
=1.00
1.00 D
Price 90
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Similar ATC curves allow the industry to supply
any output at a price equal to minimum ATC.

31. The Invisible Hand Theory
Two Attractive Features
The market outcome is efficient in the long run.
P = MC
If output is increased: MC > MB.
If output is reduced: MC < MB.

32. The Invisible Hand Theory
Two Attractive Features
The market is fair.
The price the buyers pay is no higher than the cost incurred by sellers.
The cost includes a normal profit.

33. The Invisible Hand Theory
Example
What happens in a city with “too many” hair stylists and “too few” aerobics instructors?

34. Initial Equilibrium in the Markets for HaircutsD
MCH QH
ATCH 15 S 50
Price ($/haircut)
Price ($/haircut)
Haircuts/day
Haircuts/day

35. Initial Equilibrium in the Markets for Aerobics ClassesD
MCA
ATCA 10 S
Price ($/class)
Price ($/class) 20 QA
Classes/day
Classes/day

36. The Short-Run Effect of Demand Shifts in Two Markets15 15 D’
Price ($/haircut)
Price ($/class) 12 10 D D’ D
350
500
200
300
Haircuts/day
Classes/day
Assume: Long hair and physical fitness become popular.
Price of haircuts fall the price of aerobics classes rise.

37. Economic Profit and Loss in the Short Run
ATCH
MCH
ATCA
Economic
loss
Economic
profit
MCA
15.50 15
Price ($/haircut)
Price ($/class) 12 11
Q’H QH QA
Q’A
Haircuts/day
Classes/day
The decrease in demand for haircuts causes economic losses
while the increase in demand for classes creates economic profits

38. The Invisible Hand Theory
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 profits for instructors will
Increase the supply of instructors
Decrease the price until zero economic profits occur

39. The Invisible Hand Theory
The Importance of Free Entry and Exit
Free entry and exit must exist for the allocative function of price to operate
In this case, we assumed people could easily switch into or out of these two occupations.