1 Frank & Bernanke 3 rd edition, 2007 Ch. 5: Ch. 5: Demand - The Benefit Side of The Market.
1 Frank & Bernanke 3 rd edition, 2007 Ch. 8: Ch. 8: The Quest for Profit and the Invisible Hand.
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Transcript of 1 Frank & Bernanke 3 rd edition, 2007 Ch. 8: Ch. 8: The Quest for Profit and the Invisible Hand.
11
Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007
Ch. 8: Ch. 8: The Quest for Profit and the Invisible Hand
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Three Types of ProfitThree Types of Profit
Accounting Profit = total revenue – explicit Accounting Profit = total revenue – explicit costs (payments for factors of production)costs (payments for factors of production)
Economic Profit = total revenue – explicit Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of costs – implicit costs (opportunity cost of the resources supplied by the firm’s the resources supplied by the firm’s owners)owners)
Normal Profit = accounting profit – Normal Profit = accounting profit – economic profit = opportunity cost of economic profit = opportunity cost of owners’ owners’
33
Calculating ProfitCalculating Profit
Suppose a firm has the following: Suppose a firm has the following: Total Revenue (Total Revenue (TR)TR) = $400,000 = $400,000Explicit costs (salaries) = $250,000/yrExplicit costs (salaries) = $250,000/yrMachinery and other equipment with a resale Machinery and other equipment with a resale
value of $1 millionvalue of $1 million
44
ProfitsProfits
Accounting Profit Accounting Profit $400,000($400,000(TRTR) - $250,000 (explicit costs) = $150,000) - $250,000 (explicit costs) = $150,000
To calculate economic profits, assumeTo calculate economic profits, assume Annual interest on savings = 10%Annual interest on savings = 10%
[Then the $1 million spent on equipment could have earned [Then the $1 million spent on equipment could have earned $100,000/yr had it been invested]$100,000/yr had it been invested]
Economic ProfitEconomic Profit $400,000 ($400,000 (TRTR) - $250,000 (explicit cost) - $100,000 (implicit ) - $250,000 (explicit cost) - $100,000 (implicit
cost) = $50,000cost) = $50,000
Normal ProfitNormal Profit Accounting Profit ($150,000/yr) – Economic Profit Accounting Profit ($150,000/yr) – Economic Profit
($50,000/yr) = $100,000/yr($50,000/yr) = $100,000/yr
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The Difference BetweenThe Difference BetweenAccounting Profit and Economic ProfitAccounting Profit and Economic Profit
Totalrevenue
Explicitcosts
Accountingprofit
Normal profit = opportunity cost ofresources supplied
by owners of firm
Economicprofit
Explicitcosts
66
Should Buffet stay in the farming?Should Buffet stay in the farming?
He supplies only his labor which he values He supplies only his labor which he values equally to managing a retail store for equally to managing a retail store for $11,000/yr$11,000/yr
He is a corn farmer with payments for land He is a corn farmer with payments for land and equipment = $10,000/yrand equipment = $10,000/yr
Except for pay, he is indifferent between Except for pay, he is indifferent between the farm or the storethe farm or the store
Corn sells at a constant price and Corn sells at a constant price and TRTR = = $22,000$22,000
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Revenue, Costs, and ProfitRevenue, Costs, and Profit
Total Explicit Implicit Accounting Economic Normalrevenue costs costs profit profit profit
22,000 10,000 11,000 12,000 1,000 11,000
88
Should Pudge stay in farming?Should Pudge stay in farming?
What would Pudge’s economic profit be if What would Pudge’s economic profit be if TR =TR = $20,000 $20,000Economic profitEconomic profit
TR TR (20,000) – explicit (10,000) and implicit costs (20,000) – explicit (10,000) and implicit costs (11,000) = -$1,000(11,000) = -$1,000
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If Pudge owned his own land, If Pudge owned his own land, should he stay in farming?should he stay in farming?
Pudge inherits the landPudge inherits the landThe land can be rented for $6,000/yrThe land can be rented for $6,000/yr
Total Explicit Implicit Accounting Economic Normalrevenue costs costs profit profit profit($/year) ($/year) ($/year) ($/year) ($/year) ($/year)
20,000 4,000 17,000 16,000 -1,000 17,000
20,000 4,000 17,000 16,000 -1,000 17,000
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ReviewReview
Accounting Profit = Accounting Profit = TRTR – explicit costs – explicit costsEconomic Profit = Economic Profit = TR – TR – explicit and implicit explicit and implicit
costscostsEconomic Profit = 0 when accounting Economic Profit = 0 when accounting
profit = normal profitprofit = normal profitTo remain in business in the long run, To remain in business in the long run,
economic profits must be greater than or economic profits must be greater than or equal to 0 (zero).equal to 0 (zero).
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The Invisible Hand TheoryThe Invisible Hand Theory
The The rationing function of pricerationing function of price To distribute scarce goods to those To distribute scarce goods to those
consumers who value them most highlyconsumers who value them most highlyThe The allocative function of priceallocative function of price
To direct resources away from overcrowded To direct resources away from overcrowded markets and toward markets that are markets and toward markets that are underservedunderserved
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Profits and Losses Would EnsureProfits and Losses Would Ensure
That supplies within a market would be That supplies within a market would be distributed efficiently (rationing function)distributed efficiently (rationing function)
Resources would be allocated across Resources would be allocated across markets to produce the most efficient markets to produce the most efficient possible mix of goods and services possible mix of goods and services (allocative function)(allocative function)
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Responses to Profits and LossesResponses to Profits and Losses
Markets with firms earning economic Markets with firms earning economic profits will attract resources.profits will attract resources.
Markets where firms are experiencing Markets where firms are experiencing economic losses tend to lose resources.economic losses tend to lose resources.
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1.20
Economic profit= $104,000/yr
Market price of $2/bushel produces economic profits
2.00 Price2.00
Economic Profit in the Economic Profit in the Short Run in the Corn MarketShort Run in the Corn Market
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
S
D
65Quantity (1000s of
bushels/year)
Pri
ce (
$/b
ush
el)
MC
130
ATC
1515
1.50
Economic profit= $50,400/yr
1.50 Price
12095
The Effect of Entry onThe Effect of Entry onPrice and Economic ProfitPrice and Economic Profit
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
S
D
65Quantity (1000s of
bushels/year)
Pri
ce (
$/b
ush
el)
Economic profits attract firms, reducing prices and profits
2.00 2.00
MC
130
ATCS’
1616
Equilibrium when Entry CeasesEquilibrium when Entry Ceases
S
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
D
1.00
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
Price
90115
Entry of firms continues until all firms earn a normal profit
MCATC
1.00
1717
1.05
Economic loss= $21,000/year
Prices below minimum ATC results in economic losses.
A Short-Run Economic A Short-Run Economic Loss in the Corn MarketLoss in the Corn Market
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
70
0.75Price
90
ATC
0.75
MC
S
D
60
1818
Equilibrium when Exit CeasesEquilibrium when Exit Ceases
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
0.75
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
90
0.750.75
90
ATC
0.75
MC
40
S’
Price1.00 1.00
The departure of firms from the industry increases the market price
S
D
60
1919
The Invisible Hand TheoryThe Invisible Hand Theory
In the long-run, in a competitive market, In the long-run, in a competitive market, all firms will tend to earn zero economic all firms will tend to earn zero economic profits.profits.
Zero economic profits are the Zero economic profits are the consequence of price movements caused consequence of price movements caused by the entry and exit of firms trying to by the entry and exit of firms trying to maximize economic profits.maximize economic profits.
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Long-Run Equilibrium in a Corn Long-Run Equilibrium in a Corn Market with Constant Long-Run Average CostMarket with Constant Long-Run Average Cost
Quantity (millions of bushels/year)
Pri
ce (
$/b
ush
el)
Quantity (1000s of bushels/year)
Pri
ce (
$/b
ush
el)
=1.00D
S=LACLMC
Price
MC
90
ATC
1.00
Similar ATC curves allow the industry to supplyany output at a price equal to minimum ATC.
2121
The Invisible Hand TheoryThe Invisible Hand Theory
The market outcome is efficient in the The market outcome is efficient in the long run.long run.P = MCP = MC If output is increased: If output is increased: MC > MB.MC > MB. If output is reduced: If output is reduced: MC < MBMC < MB
The market is fair.The market is fair.The price the buyers pay is no higher than The price the buyers pay is no higher than
the cost incurred by sellers.the cost incurred by sellers.The cost includes a normal profit.The cost includes a normal profit.
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The Invisible Hand TheoryThe Invisible Hand Theory
What happens in a city with “too many” What happens in a city with “too many” hair stylists and “too few” aerobics hair stylists and “too few” aerobics instructors?instructors?
Responses to the change in demand for Responses to the change in demand for stylists and aerobics instructorsstylists and aerobics instructorsEconomic loss for stylists will Economic loss for stylists will
Reduce the supply of stylistsReduce the supply of stylistsIncrease the price until zero economic profits occurIncrease the price until zero economic profits occur
2323
Initial EquilibriumInitial Equilibriumin the Markets for Haircutsin the Markets for Haircuts
Haircuts/day
Pri
ce (
$/h
airc
ut)
Haircuts/day
D
MCH
QH
ATCH
15
S
50
Pri
ce (
$/h
airc
ut)
2424
Initial Equilibrium in the Initial Equilibrium in the Markets for Aerobics ClassesMarkets for Aerobics Classes
Classes/day
Pri
ce (
$/cl
ass)
Classes/day
QA
D
MCA
ATCA
10
S
20
Pri
ce (
$/cl
ass)
2525
The Short-Run Effect of The Short-Run Effect of Demand Shifts in Two MarketsDemand Shifts in Two Markets
Haircuts/day
Pri
ce (
$/h
airc
ut)
Classes/day
Pri
ce (
$/cl
ass)
S
D
500
15
200
10
D
S
Assume: Long hair and physical fitness become popular.Price of haircuts fall the price of aerobics classes rise.
350
15
D’
12D’
300
2626
Economic Profit and Economic Profit and Loss in the Short RunLoss in the Short Run
Haircuts/day
MCH
QH
ATCH
Pri
ce (
$/h
airc
ut)
Classes/day
MCA
QA
ATCA
Pri
ce (
$/cl
ass)
Q’H
15.50
12
Q’A
15
11
Economicloss
Economicprofit
The decrease in demand for haircuts causes economic losseswhile the increase in demand for classes creates economic profits
2727
The Importance of Free The Importance of Free Entry and ExitEntry and Exit
Free entry and exit must exist for the Free entry and exit must exist for the allocative function of price to operateallocative function of price to operate
Barriers to entry can be caused by legal Barriers to entry can be caused by legal constraints and unique market constraints and unique market characteristicscharacteristics
Economic profits attract resources that Economic profits attract resources that push economic profits toward zero.push economic profits toward zero.
2828
Economic RentEconomic RentVersus Economic ProfitVersus Economic Profit
Economic RentEconomic RentThat part of a payment for a factor of That part of a payment for a factor of
production that exceeds the owner’s production that exceeds the owner’s reservation pricereservation price
Market forces will not push economic rent Market forces will not push economic rent to zero because inputs cannot be to zero because inputs cannot be replicated easilyreplicated easily
2929
Economic RentEconomic RentVersus Economic ProfitVersus Economic Profit
AssumeAssumeA community with 100 restaurantsA community with 100 restaurants99 restaurants employ chefs with normal 99 restaurants employ chefs with normal
ability for $30,000/yr (the same amount ability for $30,000/yr (the same amount they could earn elsewhere)they could earn elsewhere)
The 100The 100thth restaurant employs a talented restaurant employs a talented chef and customers are willing to pay 50% chef and customers are willing to pay 50% more for their mealsmore for their meals
3030
Economic RentEconomic RentVersus Economic ProfitVersus Economic Profit
TRTR at the each of the 99 restaurants is at the each of the 99 restaurants is $300,000, which yields a normal profit$300,000, which yields a normal profit
TR TR at the 100at the 100thth restaurant is $450,000 (50% restaurant is $450,000 (50% more)more)
A talented chefA talented chef Earns $180,000 = $30,000 + $150,000Earns $180,000 = $30,000 + $150,000 Reservation price = $30,000Reservation price = $30,000 Economic rent = $150,000Economic rent = $150,000
The100The100thth restaurant earns a normal profit restaurant earns a normal profit
3131
QuestionQuestion Why not pay the chef less and increase the Why not pay the chef less and increase the
economic profit for the restaurant?economic profit for the restaurant?Key Concept
Opportunities for private gain seldom remain unexploited for very long
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?
3232
The Invisible Hand in ActionThe Invisible Hand in Action
The Invisible Hand and Cost-Saving The Invisible Hand and Cost-Saving InnovationsInnovations In a competitive marketIn a competitive market
Firms are price takersFirms are price takersP = MCP = MCZero economic profits exist in the long runZero economic profits exist in the long run
QuestionQuestionWhy do these firms have an incentive to Why do these firms have an incentive to
introduce cost-saving innovations?introduce cost-saving innovations?
3333
The Invisible Hand in ActionThe Invisible Hand in Action
40 companies transport oil from the Middle East 40 companies transport oil from the Middle East to the U.S.to the U.S. The cost/trip, including normal profit, is $500,000The cost/trip, including normal profit, is $500,000 One company uses a new propeller that saves One company uses a new propeller that saves
$20,000/trip$20,000/trip
Short RunShort Run No impact on priceNo impact on price Economic profits for the company will increase Economic profits for the company will increase
$20,000/trip$20,000/trip
3434
The Invisible Hand in ActionThe Invisible Hand in Action
Long RunLong RunOther companies use the propellerOther companies use the propellerMarket supply increases and the price fallsMarket supply increases and the price fallsZero economic profits after all firms have Zero economic profits after all firms have
adopted the new propelleradopted the new propellerAny firm without the new propeller would Any firm without the new propeller would
have an economic loss of $20,000/triphave an economic loss of $20,000/trip
3535
NYC Taxi MedallionsNYC Taxi Medallions
Annual cost of operating the cabs = $40,000Annual cost of operating the cabs = $40,000 TRTR/year = $60,000/year = $60,000 Annual interest on savings = 6%Annual interest on savings = 6% If the medallion is free, economic profit = If the medallion is free, economic profit =
$20,000/year$20,000/year The economic profit will attract entry into the taxi market.The economic profit will attract entry into the taxi market.
If the medallion is $100,000If the medallion is $100,000 Forego $6,000 in interestForego $6,000 in interest Earn $20,000Earn $20,000
3636
How much would you pay How much would you pay for a medallion?for a medallion?
$333,333$333,333Forego $20,000 in interestForego $20,000 in interestEarn $20,000Earn $20,000Zero economic profitZero economic profit
3737
Why did major commercial airlines install Why did major commercial airlines install piano bars on the upper decks of Boeing piano bars on the upper decks of Boeing
747s in the 1970s?747s in the 1970s?
Regulated prices generated economic profitsRegulated prices generated economic profits With regulated fares, competition could not drive With regulated fares, competition could not drive
down pricedown price Airlines added more flights on each route until Airlines added more flights on each route until
economic profit equaled zero.economic profit equaled zero. Airlines engaged in “quality wars”: a piano bar, Airlines engaged in “quality wars”: a piano bar,
gourmet meals, etc.gourmet meals, etc. Intrastate carriers found price competition more Intrastate carriers found price competition more
efficientefficient
3838
Present Value of a Permanent Present Value of a Permanent Annual PaymentAnnual Payment
How much money would we have to put in How much money would we have to put in a bank to generate annual interest a bank to generate annual interest earnings of earnings of M M dollars?dollars?
AssumeAssumeAnnual interest rate (Annual interest rate (rr) = 4% or .04) = 4% or .04
Present Value (Present Value (PVPV) x .04/yr = $20,000/yr) x .04/yr = $20,000/yrPV =PV = M/rM/rPV =PV = $20,000/.04 = $500,000 $20,000/.04 = $500,000
3939
Invisible Hand in Antipoverty ProgramsInvisible Hand in Antipoverty Programs
How will an irrigation project affect the incomes How will an irrigation project affect the incomes of poor farmers?of poor farmers?
An unskilled worker has two job choicesAn unskilled worker has two job choices Textile worker for $8,000/yrTextile worker for $8,000/yr Renting land to grow riceRenting land to grow rice
Rent = $5,000/yrRent = $5,000/yr Non-labor cost = $3,000/yrNon-labor cost = $3,000/yr TR TR = $16,000/yr= $16,000/yr Net income = $8,000/yrNet income = $8,000/yr
A state funded irrigation program will double output A state funded irrigation program will double output and not change the market price.and not change the market price.
4040
Impact of the Irrigation ProgramImpact of the Irrigation Program
TR TR will increase to $32,000will increase to $32,000 Income will increase to $24,000Income will increase to $24,000The demand for land will increase and the The demand for land will increase and the
rent on the land will rise to $21,000rent on the land will rise to $21,000The land owners gain, not the farmersThe land owners gain, not the farmers
4141
Stock MarketStock Market
How much will a share of stock sell for?How much will a share of stock sell for?Accounting profit = $1 millionAccounting profit = $1 million1,000 shares of stock1,000 shares of stockAnnual interest rate = 5%Annual interest rate = 5%Each share pays $1,000/year ($1 Each share pays $1,000/year ($1
million/1,000)million/1,000)At 5% a $20,000 savings account pays At 5% a $20,000 savings account pays
$1,000$1,000The stock price = $20,000The stock price = $20,000
4242
Present Value of Future Present Value of Future Costs and BenefitsCosts and Benefits
Earnings received in the future are less valuable Earnings received in the future are less valuable than earnings today.than earnings today.
The time value of moneyThe time value of money Money deposited today will grow in value over timeMoney deposited today will grow in value over time
ExampleExample Deposit $100 @ Deposit $100 @ r r = 10% or 0.10= 10% or 0.10 After 1 yearAfter 1 year
$100(1.10) = $110$100(1.10) = $110
After 2 yearsAfter 2 years $100(1.10)(1.10) = $100(1.10)$100(1.10)(1.10) = $100(1.10)22 = $121 = $121
4343
Present ValuePresent ValuePVPV deposited today @ deposited today @ rr will generate: will generate:
PVPV(1 + (1 + rr) after 1 year) after 1 yearPVPV(1 + (1 + rr))22 after 2 years after 2 years
ExampleExampleWhat is the value of a company today if it will What is the value of a company today if it will
earn its only accounting profit of $14,400 in earn its only accounting profit of $14,400 in two years?two years?PV PV of $14,400(of $14,400(MM) = ) = PVPV(1 + (1 + rr))2 2 or or
21
40014
)r(
)M(,PV
$10,000
201
400142
).(
)M(,PV
4444
Present ValuePresent Value
If $10,000 is deposited today at 20%, it will If $10,000 is deposited today at 20%, it will equal ($10,000)(1.20)equal ($10,000)(1.20)22 = $14,400 in two = $14,400 in two years.years.
The value of the company today is The value of the company today is $10,000 at 20% interest rate.$10,000 at 20% interest rate.
4545
Calculating Present ValueCalculating Present Value
T)r(
)M(PV
1
Stock MarketFuture profits are not certain.There is a market for information that can indicate future profits.This information influences stock prices.
4646
Efficient Market HypothesisEfficient Market Hypothesis
The current price of a stock reflects all The current price of a stock reflects all relevant information about its current and relevant information about its current and future earnings prospects.future earnings prospects.
Can you increase your profit in the stock Can you increase your profit in the stock market by using information from the mass market by using information from the mass media?media?
Do stocks in well-managed companies Do stocks in well-managed companies perform better than those in poorly perform better than those in poorly managed companies?managed companies?
4747
The Distinction Between and The Distinction Between and Equilibrium and a Social OptimumEquilibrium and a Social Optimum
The market equilibrium does not imply The market equilibrium does not imply that the resulting allocation is necessarily that the resulting allocation is necessarily best from the point of view of society as a best from the point of view of society as a whole. whole. The smart for one, dumb for all principleThe smart for one, dumb for all principle
Equilibrium will not be socially optimal Equilibrium will not be socially optimal when the cost and benefits for the when the cost and benefits for the individuals differ from society as a whole.individuals differ from society as a whole.