1. Efficiency, Exchange, and The Invisible Hand in Action
Chapter 7
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2. Learning Objectives How to optimize your decision in time?
Define and explain the differences between accounting profit, economic profit, and normal profit
Explain the Invisible Hand Theory and show how economic profit and economic loss affect the allocation of resources across industries
Explain why economic profit, unlike economic rent, tends toward zero in the long run
Identify whether the market equilibrium is socially efficient, and explain why no opportunities for gain remain open for individuals when a market is in equilibrium
Calculate total economic surplus and explain how it is affected by policies that prevent the market from reaching equilibrium
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3. Present Values and Future Values (1)
You deposit $1,000 at your bank with an annual interest rate of 10%.
The future value (FV) of your $1,000 is $1,100.
If you leave your money at the bank for T years – and the interest rate (r) = 10% doesn’t change over time, your FV of the $1,000 will be:
In general form:

4. Present Values and Future Values (2)
You expect to receive $1,000 a year from now, and the annual interest rate is 10%.
The present value (PV) of your $1,000 is $1,000/1.1 = $
If you receive $1,000 for T years, starting next year – and the interest rate (r) = 10% doesn’t change over time, your PV of your income flow will be:
In general form:

5. Present Value – Future Value
Your monetary income in year 0 is m0, in year 1 is m1, the market rate of interest is r%.
(m0, m1) C1 C0

6. Optimal Choice in Time
Your consumption in year 0 is C0, in year 1 is C1.
(m0, m1) C1 C0
Time
preference
(c*0, c*1)

7. How fast can your wealth grow?
The discount factor (in PV):
If your discount factor is low (the market rate of interest is high) then your wealth grows faster than the wealth of that person (country) who (which) prefers current consumption to future consumption:

8. Bonds, Stocks and Annuities
When would you buy a corporate or government bond?
How much would you pay for a company’s share?
How much is an annuity worth to you?

9. Markets Are Dynamic
Every time you see one of these signs, you see the market dynamics at work:
Store for Lease
Going Out of Business Sale
Everything Must Go
Now Open
Close-Out Model
Under New Management
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10. The Invisible Hand Individuals act in their own interests
Aggregate outcome is collective well-being
Profit motive
Produces highly valued goods and services
Allocates resources to their highest value use
Jon Stewart does not wait tables
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11. Accounting profit = total revenue – explicit costs
Most common profit idea
Accounting profit = total revenue – explicit costs
Explicit costs are payments firms make to purchase
Resources (labor, land, etc.) and
Products from other firms
Easy to compute
Easy to compare across firms
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12. Economic Profit
Economic profit is the difference between a firm's total revenue and the sum of its explicit and implicit costs
Also called excess profits
Implicit costs are the opportunity costs of the resources supplied by the firm's owners
Normal profit is the difference between accounting profit and economic profit
Normal profits keep the resources in their current use
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13. Three Kinds of Profit Total Revenue Explicit Costs Explicit Costs
Total Revenue = Explicit Costs + Accounting Profit
Explicit
Costs
Explicit
Costs
Accounting
Profit
Normal Profit
Economic
Profit
Economic Profit = Accounting Profit – Normal Profit
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14. Example: Economic Profit Guides Decisions
Pudge Buffet's decision: continue farming or quit?
Quit farming and earn $11,000 per year working retail
Explicit farm costs are $10,000
Total revenue is $22,000
Pudge should stick with farming
His economic profit is positive
Accounting Profit
Economic Profit
Normal Profit
$12,000
$1,000
$11,000
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15. Example: Economic Profit Guides Decisions, A Change in Revenue
Pudge Buffet's decision: continue farming or quit if total revenue decreases to $20,000?
Quit farming and earn $11,000 per year working retail
Explicit farm costs are $10,000
Total revenue is $20,000
Pudge should quit
His economic profit is negative
Accounting Profit
Economic Profit
Normal Profit
$10,000
-$1,000
$11,000
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16. Example: Owned Inputs
Rent for the farm land is $6,000 of the $10,000 in explicit costs
What changes if Pudge inherits the land?
His rent payments become an implicit cost
Pudge should quit farming
Total Revenue
Explicit Costs
Implicit Costs
$20,000
$4,000
$17,000
Accounting Profit
Economic Profit
Normal Profit
$16,000
-$1,000
$17,000
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17. Two Functions of Price
Rationing function of price distributes scarce goods to the consumers who value them most highly
Allocative function of price directs resources away from overcrowded markets to markets that are underserved
Invisible Hand Theory states that the actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources
Articulated by Adam Smith in eighteenth century
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18. Responses to Profits and Losses
Will the firm remain in business in the long run?
If it covers ALL of its costs
Firms that earn normal profit recover only their opportunity cost
Firms that earn positive economic profit recover more than their opportunity cost
Markets in which firms are earning economic profit will attract resources
Markets in which firms are suffering economic losses will lose resources
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19. Response to Economic Profits
Markets with excess profits attract resources P 2
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
1.20
Typical Corn Farm
Quantity (M of bushels/year) S D 65
Corn Industry
Economic Profit
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20. Shrinking Economic Profits
Supply increases P
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
Typical Corn Farm 2
Quantity (M of bushels/year) S D 65
Corn Industry
Economic Profit S'
1.50 95
120
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21. Market Equilibrium Zero economic profits P
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
Typical Corn Farm 2
Quantity (M of bushels/year) S D 65
Corn Industry S'
1.50
115 1
S" 90
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22. Economic Losses Resources leave 1.05 Quantity (M of bushels/year)
Quantity (000s of bushels/year) 70
0.75 P 90
ATC MC S D 60
Price $/bu
Corn Industry
Typical Corn Farm
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23. Market Equilibrium No economic losses Quantity (M of bushels/year)
Quantity (000s of bushels/year) 70
0.75 P 90
ATC MC S D 60
Price $/bu 1 S' 40
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24. Constant-Cost Industry
In the long run, corn costs $1/bu regardless of the size of the industry
Quantity (M of bushels/year)
Quantity (000s of bushels/year)
1.00 D S P MC
ATC
Price $/bu
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25. Features of the Invisible Hand
Benefits of Invisible Hand
Cost – Benefit Principle applies
P = MC
Marginal benefit of last buyer equals marginal cost of last unit produced
Price paid by buyers is no greater than cost to the seller
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26. Example: Movement Toward Equilibrium
All markets are in equilibrium when
Demand for haircuts decreases
Demand for exercise increases
Price of haircuts goes down; hair stylists have losses
Price of aerobics classes go up; instructors have excess profits
Eventually the long-run prices of haircuts and aerobics class return to long-run equilibrium
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27. Short-Run Adjustments
Price ($/haircut)
Haircuts/day
Classes/day
Price ($/class) S D
500 15
200 10
350 D' 12
300
Haircut Market
Aerobics Market
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28. Short-Run Adjustments
MCH QH
ATCH
Price ($/haircut)
Q'H
15.50 12
Economic
loss
MCA QA
ATCA
Price ($/class)
Q'A 15 11
profit
Typical Hair Salon
Typical Aerobics Studio
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29. Free Entry and Exit
Barrier to entry: any force that prevents firms from entering a new industry
Legal constraints
Practical factors
Free entry and exit is required for the Invisible Hand to work
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30. Economic Rent Economic profits tend toward zero, yet people get rich
Economic rent is the portion of a payment to a factor of production that exceeds the owner's reservation price
People who love their work
Non-reproducible input
The case of the talented chef
Unique talent for cooking
In equilibrium, pay the chef the increase in revenue from his talent
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31. Invisible Hand in the Supermarket
No Cash on the Table Principle says short check-out lines get longer – quickly
Information is freely available
Start in the shortest line
Observe the pace of all lines
Missing price in your line
Complaining customer next to you
Decide whether to switch
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32. Invisible Hand and Cost-Saving Innovations
Competitive firms are price takers
Cost management required
Innovation lowers cost for one firm
Profits increase by amount of cost savings
Information is freely available
Industry costs decrease
Equilibrium price decreases by amount of cost savings
No excess profit
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33. Example: Shipping Innovation
40 companies compete in trans-Atlantic shipping
Cost per trip is $500,000
One firm innovates to save $20,000 in fuel per trip
Short-run economic profit
Over time, competitors copy the innovation
Industry costs decrease by $20,000
Equilibrium price decreases by $20,000
In the long run, no firm earns economic profit
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34. Market Equilibrium and Big Payoffs
Equilibrium leaves no opportunities for individuals to gain
Non-equilibrium opportunities benefit individuals
Exploiting opportunities moves the market toward equilibrium
Three ways to earn a big payoff:
Work exceptionally hard
Have some unique skill or talent
Be lucky
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35. Invisible Hand and Socially Optimal Outcome
Markets work best when
Buyers' marginal benefits = sellers' marginal costs
AND
Society's marginal benefits = society's marginal costs
Individual spending to improve a stock price forecast may benefit the individual
Some other individual loses
Return to society of the investment is less than the benefit
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36. Market Equilibrium and Efficiency
Economic efficiency exists when no change could be made to benefit one party without harming the other
Sometimes called Pareto efficiency
Different from engineering efficiency
Equilibrium price and quantity are efficient
Prices above or below equilibrium are not
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37. Price Below Equilibrium
Suppose milk is $1 per gallon
2.50
Quantity (1,000s of gallons/day)
Price ($/gallon) 1 2 3 4 5
2.00
1.50
1.00
0.50 D S
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38. Price Below Equilibrium
A buyer offers $1.25 S
2.50
2.00
1.50
Price ($/gallon)
1.25
1.00
0.50 D 1 2 3 4 5
Quantity (1,000s of gallons/day)
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39. Price above Equilibrium
2.50
Quantity (1,000s of gallons/day)
Price ($/gallon) 1 2 3 4 5
2.00
1.50
1.00
0.50 D S
1.75
Only equilibrium price is efficient
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40. Efficiency Conditions
Perfectly Competitive Markets
No Costs or Benefits Shifted
Market Efficiency
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41. Trade-Offs Efficiency Equity Basic Needs Maximum Total Surplus
Fairness
Basic Needs
Maximum Total Surplus
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42. The Cost of Preventing Price Adjustments
Price ceilings
A maximum allowable price, specified by law
Price subsidies
Meant to assist low-income consumers, governmental funding of “essential” goods and services
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43. Example: Heating Oil MarketD S
2.00
Quantity (1,000s of gallons/day)
Price ($/gallon) 1 2 3 4 5
1.60
1.20
1.00
.80
1.80
1.40 8
Producer surplus = $900/day
Consumer surplus = $900/day
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44. Price Ceiling on Heating Oil
2.00
Consumer surplus = $900/ day
1.80 S
1.60
1.40
Lost surplus = $800/ day
1.20
Price ($/gallon)
1.00
0.80
Producer surplus = $100/ day D 1 2 3 4 5 8
Quantity (1,000s of gallons/day)
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45. Surplus Lost to a Price Ceiling
$800 underestimates surplus loss
Consumers place different values on heating oil
If a person with a lower reservation price gets the oil, there is additional surplus lost
Shortages increase non-market costs
Waiting in line
Side payments
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46. Alternative Heating Oil Policy
Surplus with Price Controls
Surplus with Income Transfers Only R P R P
R = high income
P = low income
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47. Example: Price Subsidy for Bread
Imported bread costs $2
Perfectly elastic supply
Government program to subsidize bread
Government imports bread for $2
Government sells bread for $1
Results
More bread
Less efficiency
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48. Price Subsidies for Bread
Quantity (millions of loaves/month) 2 4 6
$3.00
$1.00
$4.00 8
$2.00 D S
Price ($/loaf)
Consumer Surplus = $4 M/month
Consumer Surplus = $9 M/month
BUT…
S with subsidy
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49. The Cost of the Subsidy
The bread subsidy appears to increase consumer surplus from $4 million to $9 million
BUT …
The government loses $1 on every loaf
Imports 6 million loaves for $2 per loaf
Government losses are $6 million
The net benefit of the subsidy program
Consumer surplus – government losses
Net benefit = $3 million
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50. Price Subsidies for Bread
Price ($/loaf)
Consumer Surplus
$4.00
Total Surplus Lost = $1 M/month
$3.00 S
$2.00
Government Losses
$1.00
S with subsidy D 2 4 6 8
Quantity (millions of loaves/month)
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51. Invisible Hand in Action
Economic Efficiency
Invisible Hand
Resource Allocation
Profits
Market Equilibrium
Economic Rents
Examples
Price Ceilings
Subsidies
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