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.
Chapter 8: The Quest for Profit and the Invisible Hand

3. The Central Role of Economic Profit
Three Types of Profit
Accounting Profit = total revenue – explicit costs (payments for factors of production)
Chapter 8: The Quest for Profit and the Invisible Hand

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)
Chapter 8: The Quest for Profit and the Invisible Hand

5. The Central Role of Economic Profit
Three Types of Profit
Normal Profit = accounting profit – economic profit
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

7. The Central Role of Economic Profit
Calculating Profit
Accounting Profit
$400,000(TR) - $250,000 (explicit costs) = $150,000
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

9. The Central Role of Economic Profit
Calculating Profit
Normal Profit
Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

11. The Central Role of Economic Profit
Why are the distinctions important?
Example
Should Pudge Buffet stay in the farming business?
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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?
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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).
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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)
Chapter 8: The Quest for Profit and the Invisible Hand

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.
Chapter 8: The Quest for Profit and the Invisible Hand

22. Economic Profit in the Short Run in the Corn MarketD 65 MC
130
ATC
1.20
Economic profit
= $104,000/yr
Market price of $2/bushel produces economic profits
2.00
Price
Price ($/bushel)
Price ($/bushel)
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Chapter 8: The Quest for Profit and the Invisible Hand

23. The Effect of Entry on Price and Economic ProfitS’ S MC
ATC
1.50
Economic profit
= $50,400/yr
Price
120 95
2.00
2.00
Price ($/bushel)
Price ($/bushel) D 65
130
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Economic profits attract firms, reducing prices and profits
Chapter 8: The Quest for Profit and the Invisible Hand

24. Equilibrium when Entry Ceases
Quantity (millions of bushels/year)
Price ($/bushel) D
1.00
Quantity (1000s of bushels/year)
Price 90
115
Entry of firms continues until all firms earn a normal profit MC
ATC
Chapter 8: The Quest for Profit and the Invisible Hand

25. A Short-Run Economic Loss in the Corn Market
Quantity (millions of bushels/year)
Price ($/bushel)
Quantity (1000s of bushels/year) 70
0.75
Price 90
ATC MC S D 60
1.05
Economic loss
= $21,000/year
Prices below minimum ATC results in economic losses.
Chapter 8: The Quest for Profit and the Invisible Hand

26. Equilibrium when Exit CeasesMC
ATC S D 60 40 S’
Price
1.00
The departure of firms from the industry increases the market price
Price ($/bushel)
Price ($/bushel)
0.75
0.75
0.75
0.75 90 90
Quantity (millions of bushels/year)
Quantity (1000s of bushels/year)
Chapter 8: The Quest for Profit and the Invisible Hand

27. The Invisible Hand Theory
Observations
In the long-run, in a competitive market, all firms will tend to earn zero economic profits.
Chapter 8: The Quest for Profit and the Invisible Hand

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.
Chapter 8: The Quest for Profit and the Invisible Hand

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.
Chapter 8: The Quest for Profit and the Invisible Hand

30. Quantity (millions of bushels/year) Quantity (1000s of bushels/year)
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)
=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.
Chapter 8: The Quest for Profit and the Invisible Hand

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.
Chapter 8: The Quest for Profit and the Invisible Hand

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.
Chapter 8: The Quest for Profit and the Invisible Hand

33. The Invisible Hand Theory
Example
What happens in a city with “too many” hair stylists and “too few” aerobics instructors?
Chapter 8: The Quest for Profit and the Invisible Hand

34. Initial Equilibrium in the Markets for HaircutsD
MCH QH
ATCH 15 S 50
Price ($/haircut)
Price ($/haircut)
Haircuts/day
Haircuts/day
Chapter 8: The Quest for Profit and the Invisible Hand

35. Initial Equilibrium in the Markets for Aerobics ClassesD
MCA
ATCA 10 S
Price ($/class)
Price ($/class) 20 QA
Classes/day
Classes/day
Chapter 8: The Quest for Profit and the Invisible Hand

36. The Short-Run Effect of Demand Shifts in Two Markets
500 15
200 10
Assume: Long hair and physical fitness become popular.
Price of haircuts fall the price of aerobics classes rise.
350 15 D’ 12
300
Price ($/haircut)
Price ($/class)
Haircuts/day
Classes/day
Chapter 8: The Quest for Profit and the Invisible Hand

37. Economic Profit and Loss in the Short Run
Haircuts/day
MCH QH
ATCH
Price ($/haircut)
Classes/day
MCA QA
ATCA
Price ($/class)
Q’H
15.50 12
Q’A 15 11
Economic
loss
profit
The decrease in demand for haircuts causes economic losses
while the increase in demand for classes creates economic profits
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

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
Chapter 8: The Quest for Profit and the Invisible Hand

40. The Invisible Hand Theory
The Importance of Free Entry and Exit
Barriers to entry can be caused by legal constraints and unique market characteristics
Chapter 8: The Quest for Profit and the Invisible Hand

41. The Invisible Hand Theory
The Importance of Free Entry and Exit
A barrier to exit can become a barrier to entry
Chapter 8: The Quest for Profit and the Invisible Hand

42. Economic Rent Versus Economic Profit
Important Note
Economic profits attract resources that push economic profits toward zero.
Chapter 8: The Quest for Profit and the Invisible Hand

43. Economic Rent Versus Economic Profit
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
Chapter 8: The Quest for Profit and the Invisible Hand

44. Economic Rent Versus Economic Profit
Example
How much rent will a talented chef get?
Chapter 8: The Quest for Profit and the Invisible Hand

45. Economic Rent Versus Economic Profit
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 100th restaurant employs a talented chef and customers are willing to pay 50% more for their meals
Chapter 8: The Quest for Profit and the Invisible Hand

46. Economic Rent Versus Economic Profit
Assume
TR at the each of the 99 restaurants is $300,000, which yields a normal profit
TR at the 100th restaurant is $450,000 (50% more)
Chapter 8: The Quest for Profit and the Invisible Hand

47. Economic Rent Versus Economic Profit
Assume
A talented chef
Earns $180,000 = $30,000 + $150,000
Reservation price = $30,000
Economic rent = $150,000
That the100th restaurant earns a normal profit
Chapter 8: The Quest for Profit and the Invisible Hand

48. Economic Rent Versus Economic Profit
Question
Why not pay the chef less and increase the economic profit for the restaurant?
Chapter 8: The Quest for Profit and the Invisible Hand

49. The Invisible Hand in Action
Key Concept
Opportunities for private gain seldom remain unexploited for very long
Chapter 8: The Quest for Profit and the Invisible Hand

50. The Invisible Hand in Action
Economic Naturalist
Why do supermarket lines tend to be roughly the same length?
Why do all lanes on a crowded, multilane freeway move at about the same speed?
Chapter 8: The Quest for Profit and the Invisible Hand

51. 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?
Chapter 8: The Quest for Profit and the Invisible Hand

52. The Invisible Hand in Action
Example
How do cost-saving innovations affect economic profit in the short run? In the long run?
Chapter 8: The Quest for Profit and the Invisible Hand

53. The Invisible Hand in Action
Assume
40 companies transport oil from the middle east to the U.S.
The cost/trip, including normal profit, is $500,000
One company uses a new propeller that saves $20,000/trip
Chapter 8: The Quest for Profit and the Invisible Hand

54. The Invisible Hand in Action
Short Run
No impact on price
Economic profits for the company will increase $20,000/trip
Chapter 8: The Quest for Profit and the Invisible Hand

55. The Invisible Hand in Action
Long Run
Other companies use the propeller
Market supply increases and the price falls
Zero economic profits after all firms have adopted the new propeller
Any firm without the new propeller would have an economic loss of $20,000/trip
Chapter 8: The Quest for Profit and the Invisible Hand

56. The Invisible Hand in Action
Economic Naturalist
Why do New York City taxicab medallions sell for more than $250,000?
Assume
Annual cost of operating the cabs = $40,000
TR/year = $60,000
Annual interest on savings = 8%
Chapter 8: The Quest for Profit and the Invisible Hand

57. The Invisible Hand in Action
Economic Naturalist
Will the medallion owner earn an economic profit?
If the medallion is free, economic profit = $20,000/year
Chapter 8: The Quest for Profit and the Invisible Hand

58. The Invisible Hand in Action
Economic Naturalist
The economic profit will attract entry into the taxi market.
Chapter 8: The Quest for Profit and the Invisible Hand

59. The Invisible Hand in Action
Economic Naturalist
How much would you pay for a medallion?
$100,000
Forego $8,000 in interest
Earn $20,000
Chapter 8: The Quest for Profit and the Invisible Hand

60. The Invisible Hand in Action
Economic Naturalist
How much would you pay for a medallion?
$250,000
Forego $20,000 in interest
Earn $20,000
Zero economic profit
Economic rent = $20,000
Chapter 8: The Quest for Profit and the Invisible Hand

61. The Invisible Hand in Action
Economic Naturalist
Why did major commercial airlines install piano bars on the upper decks of Boeing 747s in the 1970s?
Chapter 8: The Quest for Profit and the Invisible Hand

62. The Invisible Hand in Action
Economic Naturalist
Regulated prices generated economic profits
With regulated fares, competition could not drive down price
Airlines added more flights on each route until economic profit equaled zero.
Chapter 8: The Quest for Profit and the Invisible Hand

63. The Invisible Hand in Action
Economic Naturalist
Airlines engaged in “quality wars”: a piano bar, gourmet meals, etc.
Intrastate carriers found price competition more efficient
Chapter 8: The Quest for Profit and the Invisible Hand

64. The Invisible Hand in Action
The Invisible Hand in Antipoverty Programs
Example
How will an irrigation project affect the incomes of poor farmers?
Chapter 8: The Quest for Profit and the Invisible Hand

65. The Invisible Hand in Action
Assume
An unskilled worker has two job choices
Textile worker for $8,000/yr
Renting land to grow rice
Rent = $5,000/yr
Non-labor cost = $3,000/yr
TR = $16,000/yr
Net income = $8,000/yr
A state funded irrigation program will double output and not change the market price.
Chapter 8: The Quest for Profit and the Invisible Hand

66. The Invisible Hand in Action
Question
What will be the impact of the irrigation program?
TR will increase to $32,000
Income will increase to $24,000
The demand for land will increase and the rent on the land will rise to $21,000
The land owners gain, not the farmers
Chapter 8: The Quest for Profit and the Invisible Hand

67. The Invisible Hand in Action
The Invisible Hand in the Stock Market
Calculating the value of a share of stock
The price of a share of stock depends on
The company’s accounting profit
The market interest rate
Chapter 8: The Quest for Profit and the Invisible Hand

68. The Invisible Hand in Action
The Invisible Hand in the Stock Market
Example
How much will a share of stock sell for?
Assume
Accounting profit = $1 million
1,000 shares of stock
Annual interest rate = 5%
Chapter 8: The Quest for Profit and the Invisible Hand

69. The Invisible Hand in Action
The Invisible Hand in the Stock Market
Question
How much will a share of stock sell for?
Price/share
Each share pays $1,000/year ($1 million/1,000)
At 5% a $20,000 savings account pays $1,000
The stock price = $20,000
Chapter 8: The Quest for Profit and the Invisible Hand

70. The Invisible Hand in Action
Calculating the Present Value of Future Costs and Benefits
Earnings received in the future are less valuable than earnings today.
The time value of money
Money deposited today will grow in value over time
Chapter 8: The Quest for Profit and the Invisible Hand

71. The Invisible Hand in Action
Calculating the Present Value of Future Costs and Benefits
Present Value (PV)
The amount that must be deposited today, at a given interest rate (r), to generate a given balance (M) at a specified time (T) in the future.
Chapter 8: The Quest for Profit and the Invisible Hand

72. The Invisible Hand in Action
Calculating the Present Value of Future Costs and Benefits
Example
Deposit r = 10% or 0.10
After 1 year
$100(1.10) = $110
After 2 years
$100(1.10)(1.10) = $100(1.10)2 = $121
Chapter 8: The Quest for Profit and the Invisible Hand

73. The Invisible Hand in Action
Generally
PV deposited r will generate:
PV(1 + r) after 1 year
PV(1 + r)2 after 2 years
Chapter 8: The Quest for Profit and the Invisible Hand

74. The Invisible Hand in Action
Example
What is the value of a company today if it will earn its only accounting profit of $14,400 in two years?
PV of $14,400(M) = PV(1 + r)2 or
Chapter 8: The Quest for Profit and the Invisible Hand

75. The Invisible Hand in Action
Example
If r = 0.20, then
Chapter 8: The Quest for Profit and the Invisible Hand

76. The Invisible Hand in Action
Example
If $10,000 is deposited today at 20%, it will equal ($10,000)(1.20)2 = $14,400 in two years.
The value of the company today is $10,000 at 20% interest rate.
Chapter 8: The Quest for Profit and the Invisible Hand

77. The Invisible Hand in Action
Calculating Present Value
Chapter 8: The Quest for Profit and the Invisible Hand

78. The Invisible Hand in Action
The Invisible Hand in the Stock Market
Future profits are not certain.
There is a market for information that can indicate future profits.
This information influences stock prices.
Chapter 8: The Quest for Profit and the Invisible Hand

79. The Invisible Hand in Action
The Efficient Market Hypothesis
The current price of a stock reflects all relevant information about its current and future earnings prospects.
Chapter 8: The Quest for Profit and the Invisible Hand

80. The Invisible Hand in Action
What do you think?
Can you increase your profit in the stock market by using information from the mass media?
Do stocks in well-managed companies perform better than those in poorly managed companies?
Chapter 8: The Quest for Profit and the Invisible Hand

81. The Distinction Between and Equilibrium and a Social Optimum
The equilibrium (no-cash-on-the-table) principle means that there are no unexploited opportunities in markets that are in equilibrium.
Chapter 8: The Quest for Profit and the Invisible Hand

82. The Distinction Between and Equilibrium and a Social Optimum
The market equilibrium does not imply that the resulting allocation is necessarily best from the point of view of society as a whole.
The smart for one, dumb for all principle
Chapter 8: The Quest for Profit and the Invisible Hand

83. The Distinction Between and Equilibrium and a Social Optimum
Equilibrium will not be socially optimal when the cost and benefits for the individuals differ from society as a whole.
Chapter 8: The Quest for Profit and the Invisible Hand

84. The Distinction Between and Equilibrium and a Social Optimum
Economic Naturalist
What do you think?
Are there “too many” smart people working as corporate earnings forecasters?
Chapter 8: The Quest for Profit and the Invisible Hand

85. End of
Chapter