1 Introductory Microeconomics The Quest for Profit and the Invisible Hand.

1

Introductory Microeconomics

The Quest for Profit and the Invisible Hand

2

Example 8.1.

For the supply and demand curves shown, suppose a tax of $6/lb is levied on sellers. What share of the burden of this tax be borne by buyers? By sellers?

Price ($/lb)

Quantity(millions of lb/month)

D

S

0 12

18

6

18

3

Example 8.1.

The equilibrium price, including the tax, will rise from $6/lb to $10/lb.

Price ($/lb)


D

S

0

S + 6

128

18

1064

18

Sellers receive $4/lb (net of the tax), $2 less than before. So the sellers’ share of the tax is (6-4)/6 = 1/3.

Buyers pay $10/lb (including the tax), $4 higher than before. So the buyers’ share of the tax is (10-6)/6 = 2/3. (as seen by the

buyers)

4

Example 8.2.

How would your answers to Example 8.1 have been different if the tax had been collected from buyers instead of sellers?

5

Example 8.2.

At a quantity of 8 million lb/month, the buyer is willing to pay $10/lb. With a tax of $6/lb, the most he would be willing to pay the seller, net of the tax, is only $4/lb. So the demand curve as seen by the sellers is the original demand curve shifted down by $6/lb.Price ($/lb)


D

0 128

18

1064

18

12 Demand with $6/lb tax

6

Example 8.2.

Price ($/lb)


D

S

0 128

18

1064

18

12

So, as before, the buyer pays $10/lb and the seller receives $4/lb in equilibrium. As before the buyers’ share of the tax is 2/3 and the sellers’ share is 1/3.

7

Example 8.3.

If the supply curve is completely elastic, what share of a tax of $1/lb is borne by buyers? By sellers?Price ($/lb)


D

0 21

3

2

1

3

S

To get an answer for this question, do we need to consider the two possibilities?

1. Tax collected from the buyers2. Tax collected from the sellers

8

Example 8.3.

For this empirically most relevant case, the tax is borne entirely by buyers.

Price ($/lb)


D

S+ 1

0 21

3

2

1

3

S

When supply is perfectly elastic, taxing sellers “because they can afford the tax more easily than buyers” makes no economic sense at all.

The burden of a tax falls where it can, not where it is placed.

9

Different Types of Profit

Profit = Total revenue - Total cost

Accounting profit = Total revenue - Explicit costs

Economic profit = Total revenue - All costs (implicit and explicit)

Normal profit = the opportunity cost of the resources owned by the firm

10

Different Types of Profit

Total RevenueExplicit costs

Accounting profit

Explicit costs

Economic profit

Normal profitOpportunity cost of resources supplied by owners of firm

11

Example 8.4.

Cullen Buffet runs a miniature golf course in Odessa, Texas.

12

Example 8.4.

He rents the course and equipment from a large recreational supply company, for which he pays a monthly fee of $1000.

He supplies his own labor, and considers the job of running the golf course just as attractive as his only other employment opportunity, working in a grocery store at a salary of $800/mo.

Monthly revenue from ticket sales is $2000/mo.

What at is Cullen's accounting profit? His economic profit?

13

Example 8.4.

He rents the course and equipment from a large recreational supply company, for which he pays a monthly fee of $1000.

He supplies his own labor, and considers the job of running the golf course just as attractive as his only other employment opportunity, working in a grocery store at a salary of $800/mo.

Monthly revenue from ticket sales is $2000/mo.What at is Cullen's accounting profit? His economic profit?Accounting profit = $2000 - $1000 = $1000/mo.

Economic profit = $2000 - $1000 - $800 = $200/mo.

14

Example 8.5.

Now suppose Cullen learns that his Uncle Warren has died and left him this parcel of land in New York City.

59th Street

58th Street

Fifth AveSixth Ave

15

Example 8.5.

The land has been cleared, and Cullen discovers that a construction company is willing to install and maintain a miniature golf course on it for a payment of $4000/month.

A market survey reveals that he would collect $16,000/month in revenue by operating a miniature golf course there.

The cost of living in New York is the same as in Odessa.

If Cullen opens a golf course on the Manhattan site, what will be his accounting profit?

Accounting profit = $16,000 - $4000 = $12,000/mo

16

Example 8.6.

Suppose Cullen's land would sell for $100,000,000 in today's real estate market, and suppose that the interest rate is 1%/month.

What is Cullen’s economic profit from running the Manhattan golf course?

Should he relocate to Manhattan?

17

Example 8.6.

1. The opportunity cost of devoting the land to a miniature golf course is the interest that Cullen could have earned from the money he could have gotten from selling the land:

(0.01)x($100,000,000) = $1,000,000/mo.

2. The opportunity cost of his time is $200/mo (economic profit he could have earned).

So his monthly economic profit in Manhattan is$16,000 - $4000 - $200 - $1,000,000 = -$978,200 < 0.

So Cullen should stay in Odessa.

18

Example 8.6.


(0.01)x($100,000,000) = $1,000,000/mo.

2. The opportunity cost of his time is $800/mo (the amount he could have earned at the grocery).

So his monthly economic profit in Manhattan is$16,000 - $4000 - $800 - $1,000,000 = -$978,800 < 0.


19

Example 8.6.


(0.01)x($100,000,000) = $1,000,000/mo.

2. The opportunity cost of his time is $800/mo (the amount he could have earned at the grocery) + $200/mo (economic profit he could have earned).

So his monthly economic profit in Manhattan is$16,000 - $4000 - $800 - $200 - $1,000,000 = -$979,000 < 0.


20

Competition tends to drive economic profit down to zero

When a firm is making positive economic profit, it is earning more than the cost of all the resources required to produce the goods it sells.

This means that another firm could produce the same goods and in the process increase its owners' wealth.

Entry by new firms will cause price to fall until economic profit is driven down to zero.

21

Competition tends to drive economic profit down to zero

Likewise, an industry in which firms are earning negative economic profit is one in which firms are failing to cover all the costs of the resources they use.

If this situation is expected to persist, some firms will go out of business.

Exit will continue until price rises to cover all resource costs.

So in long-run equilibrium in a competitive industry, firms will earn zero economic profit.

22

Example 8.7. (Rent)

Normal agricultural land yields 50 bushels of corn per acre each year.

Corn sells for $1/bushel, and a farmer can farm 500 acres with an equivalent amount of physical and psychological effort as is demanded by a factory job, which pays $10,000/yr and is the only other job available.

If labor and land are the only farm costs, how much will normal agricultural land rent for?

23

Example 8.7. (Rent)

Normal agricultural land yields 50 bushels of corn per acre each year.

Corn sells for $1/bushel, and a farmer can farm 500 acres with an equivalent amount of physical and psychological effort as is demanded by a factory job, which pays $10,000/yr and is the only other job available.

If labor and land are the only farm costs, how much will normal agricultural land rent for?

Total revenue from farming = $25,000/yrTotal costs = $10,000 + 500x(land rent per acre)Economic profit = 0 implies rent for 500 acres = $15,000/yr implies rent = $30 per acre.

24

Example 8.8. (Rent)

Suppose there is one 500 acre plot that yields twice as much corn as the normal farmland that rents for $30 per acre.

How much will this plot rent for?

25

Example 8.8. (Rent)

How much will this plot rent for?Total revenue = 100(500) = $50,000/yrTotal cost = $10,000 + land rentEconomic profit = TR – TC

= $50,000/yr - $10,000/yr – land rent

Farmers will bid for the fertile patch until it is no longer possible to earn positive economic profit from farming it.

Economic Profit = 0 implies land rent = $40,000, or $80 per acre

26

Example 8.9.

Imagine yourself a member of the California state legislature. You have been asked by the governor to vote for a bill whose purpose is to alleviate poverty among farm workers in a rural county.

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Example 8.9.

Farm workers in that county rent their farmland from landowners and are allowed to keep the proceeds from the sale of the crops they grow.

Because of limited rainfall, their crops are usually meager, resulting in very low incomes for the average worker.

The bill under consideration would authorize public funds to construct an irrigation system that would double the crop yields on the land in the county.

Will this bill achieve its desired purpose of raising farmers' incomes?

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Example 8.9.

Limited rainfall Irrigation system

The bill under consideration would authorize public funds to construct an irrigation system that would double the crop yields on the land in the county.

29

Example 8.9.


With the introduction of the irrigation project grain yields are now twice as high as before, so total revenues will double.

If the land rent remained at its original level, a farm worker would then earn more than he could by working in a factory.

30

Example 8.9.


What the supporters of the bill have failed to recognize is that land rents will not remain the same.

Both factory workers and farmers would bid vigorously for farm parcels, and the rental price of farmland will continue to rise until it reaches a level that equalizes the incomes of farmers and factory workers.

The beneficiaries of the state supported irrigation project would be not the impoverished farm workers but the owners of the land.

31

Example 8.9.


The beneficiaries of the state supported irrigation project would be not the impoverished farm workers but the owners of the land.

These owners already have high incomes.

Why should tax dollars be spent to increase their incomes further?

32

Example 8.10.

Suppose one firm is like all others except that it employs an extraordinarily efficient manager.

This manager is so efficient that the firm earns $500,000 of economic profit each year.

The firm operates in an industry in which the economic profit of other firms hovers very close to zero.If this manager received the same salary as all other managers, the firm that employed her would have much lower costs than all other firms in the industry.

Is this a stable outcome?

33

Example 8.10.

There would be a strong incentive for some other firm to bid this manager away by offering her a higher salary.

Suppose a new firm offered her $300,000 more than her current annual salary and she accepted.

That new firm would then earn an economic profit of $200,000/year.

That's not as good as an economic profit of $500,000/year. But it's $200,000/year better than the normal profit her original employer will earn without her.


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Example 8.10.

Still other firms would have an incentive to offer even more for this manager.

Theory tells us that the bidding should continue until the cost savings for which she is responsible are entirely incorporated into her salary.

If her salary is $500,000/year higher than the salary of an ordinary manager, her employer will earn zero economic profit.

Once her salary is bid up to that level, the firm that hires her will no longer enjoy a cost advantage over the other firms in the industry.


35

Example 8.11.

The owner of the team that wins the NBA Championship receives additional television revenues of $40 million.

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Example 8.11.

Whichever team hires Shaquille O’Neal wins the Championship.

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Example 8.11.

There is free agency and teams can bid openly for any player's services.

By how much will O’Neal's salary exceed the salaries of other players?

Suppose O’Neal received only a $39 million salary premium from his current team.

Some other team could increase its wealth by bidding O’Neal away with a higher salary.

Only when O’Neal's salary premium is $40 million will there be no further tendency for bidding.

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Example 8.12.

Ford has sued GM for $1 billion for infringement on Ford's patent on a revolutionary new engine technology.

GM has a reasonable claim that it developed an equivalent technology independently.

versus

39

Example 8.12.

The legal issues are complex, and experts regard the case as too close to call.

Whichever side hires the better lawyer is sure to win.

40

Example 8.12.

Smith and Jones are the best two patent lawyers in the world.

Both are outstanding but Jones is ever so slightly better.

Smith Jones

What are the equilibrium fees for Smith and Jones in this case?

41

Example 8.12.

Fees aside, whichever side hires Jones will be $1 billion better off than if it hadn't hired Jones.

So in equilibrium Jones's fee will be $1 billion, Smith's zero.

What are the equilibrium fees for Smith and Jones in this case?

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Although competition drives economic profit to zero, economic rent can persist indefinitely.

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The function of price

1. The rationing function of price: to distribute scarce goods to those consumers who value them most highly.

2. The allocative function of price: to direct resources away from overcrowded markets and toward markets that are underserved.

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Price -- Adam Smith’s Invisible Hand

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Carrot and stick

The carrot of economic profit and the stick of economic loss are the only forces necessary to assure not only that

1. existing supplies in any market will be allocated efficiently,

but also that

2. resources will be allocated across markets to produce the most efficient possible mix of goods and services.

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Zero economic profit in long run

Consider an industry in which the current market price enables firms to earn a positive economic profit.

ATC

$/bushel

1000s of bushels/yr

4.00

MC

2.50

100

PriceEconomic profit= $150,000/yr

$/bushel

millions of bushels/yr

4.00

50

S

D

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Economic profit in short and long run

ATC

$/bushel

1000s of bushels/yr

4.00

MC

3.00

100

Price

Economic profit= $68,000/yr

85

2.20

$/bushel


4.00

50

S

D

3.00

68

S’

Price falls, making each firm’s economic profit smaller than before.

The existence of positive economic profits attracts new firms, shifting supply outward

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ATC

$/bushel

1000s of bushels/yr

4.00

MC

3.00

100

Price

Economic profit= $68,000/yr

85

2.20

$/bushel


4.00

50

S

D

3.00

68

S’

As long as price remains above the minimum value of ATC, profits lure new entrants. Supply continues to shift out until …. .

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Supply continues to shift out until price falls to min ATC. At that point economic profit is zero and there is no further incentive to enter.

ATC

$/bushel

1000s of bushels/yr

MC

Price

$/bushel


85

D

2.00

65

S*

2.00

50


What if the firms are originally earning economic losses?

ATC

$/bushel

1000s of bushels/yr

1.70

MC

2.10

60

Economic loss= -$24,000/yr

$/bushel


1.70

75

S

D

51


Supply continues to shift inward until price rises to min ATC.

ATC

$/bushel

1000s of bushels/yr

MC

2.00

70

$/bushel


2.00

72S D

S’

52

Example 8.13. Present Value and the Time Value of Money

Suppose the annual interest rate on bank deposits is 10 percent. If you deposit $100 on January 1 of this year, how much will it be worth by January 1 of next year?

$100 (1.10) = $110.

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Present value

For any given interest rate, the present value of a sum of money that you will receive at a specific time in the future is the amount of money you would have to put in the bank today at that interest rate in order to have exactly the required sum on the future date.

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Example 8.14.

If the annual interest rate is 10 percent, what is the present value of $110 to be received one year from now?

As we saw in the previous example, $100 deposited today at 10 percent interest will be worth $110 a year from now.

So the present value of $110 a year from now is $100.

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Example 8.15.

If the annual interest rate is 5 percent, what is the present value of $52.50 a year from now?

Let PV = the present value of $52.50 to be received in 1 year.

PV (1.05) = $52.50. So PV = $52.50/ 1.05 = $50.

If you put $50 in the bank today at 5 percent interest, in a year's time you will have $52.50.

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Present value

More generally, when the interest rate (expressed as a proportion) is r, the present value of $M one year from now is given by

PV = M/(1+r).

57

Example 8.16.

When the annual interest rate is 10 percent, what is the present value of a payment of $121 to be received 2 years from now?

Put $100 in the bank today at 10 percent interest.

After one year: $100(1.1) = $110

After two years: $110 (1.10) = $100 (1.1)2 = $121

That is, PV = 121/(1.1)2 = $100

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Present value

More generally, if annual interest rate is r, present value of M dollars delivered T years from now

PV = M/(1 + r)T

59

Time value of money

The time value of money exists because money can be used to purchase real assets that generate increased output over time.

For example, a 12 foot tree 6 years from now is equivalent to a 5 foot tree right now.

61

Compound interest

Present value in reverse: the miracle of compound interest

$1000 deposited at 7 percent interest by Ben Franklin in late 1700s = $3 trillion today

$1000 deposited at 7 percent interest in 1945= $64,000 today

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The miracle of compound interest

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

20 25 30 35 40 45 50 55 60 65

Age

Sav

ing

s b

alan

ce

.

(t

ho

usa

nd

s) Saving rate = 0

Saving rate = 5%

Saving rate = 10%

Saving rate = 20%

Assume annual income of 100000.

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Example 8.17.

Jones can enter a business whose revenues and costs occur through time as follows:

Revenue Costs

Now 0 $300

1 year hence 0 0

2 year hence $363 0

3 year & more 0 0

Present value of economic profit = present value of revenue - present value of costs= 363/(1.1)2 - 300= 300 - 300 = 0.

64

Example 8.18.

Should Jones enter this business if the interest rate is 12 percent?

Revenue Costs

Now 0 $300

1 year hence 0 0

2 year hence $363 0

3 year & more 0 0

Enter only if PV of economic profit > 0.

At 12 percent, PV of revenue = 363/(1.12)2 = 289.38PV of economic profit = 289.38 - 300 = -$10.62 < 0, so don't enter.

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Example 8.19.

Should Jones enter this business if the interest rate is 8 percent?

Revenue Costs

Now 0 $300

1 year hence 0 0

2 year hence $363 0

3 year & more 0 0

PV of revenue = 363/(1.08)2 = 311.21

PV of economic profit = $311.21 - $300 = $11.21> 0,so Jones should enter.

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Interest rate and investment

Almost all investment projects require that costs be incurred in the short run in order that benefits accrue in the long run.

The higher the interest rate, the lower is the present value of benefits received in the future.

So as a general rule, an investment project is less likely to be worthwhile when interest rates are high than when interest rates are low.

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Interest rate and investment

Why does the Fed lower interest rates during a recession?

Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve of the United States from 1987 to 2006

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve of the United States since February 1, 2006

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Stocks

A stock is an ownership claim to the present value of the accounting profits in a company.

If you own 100 of a company's 1000 shares outstanding, you own one-tenth of the present value of the company's earnings.

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Buying a stock involves risk

April 15, 1912

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Example 8.20.

A company's accounting profits are $100,000 per year. If the annual interest rate is 10 percent, what is the

present value of this firm's accounting profit?

PV = $100,000/(1.1) + $100,000/(1.1)2 + $100,000/(1.1)3 + ....

= $100,000/(1.1) [1 + 1/1.1 + 1/(1.1)2 + 1/(1.1)3 + .... ]= $100,000/(1.1) [1/(1-1/1.1)] = $100,000/(1.1) [1.1/0.1]= $1,000,000

(If you put $1,000,000 in the bank at 10 percent, you would generate a flow of earnings of $100,000/yr)

Note on infinite geometric sum: 1 + x + x2 + x3 +…. = 1/(1-x)

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Example 8.21.

If this company has 1000 shares of stock outstanding, how much will each one sell for?

$1,000,000/1000 = $1,000/share

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Example 8.22.

Suppose accounting profit from the firm in the preceding example were to double. How would the value of its stock price change?

PV of profit = $2,000,000

Price per share = $2,000,000/1000 = $2000/share

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The Efficient Markets Hypothesis

At any moment, the market price of a firm’s stock reflects all relevant available information about the present value of the firm’s current and future accounting profits.

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The Efficient Markets Hypothesis

Suppose the efficient markets hypothesis were false.

For example, suppose Genentech’s current share price is $100 when it comes up with a cancer cure that will double its accounting profit from now on.

What would happen if the firm’s stock price failed to adjust right away to $200?

Someone with no talent, no luck, and no willingness to work hard could get rich just by buying shares of Genentech.

75

Example 8.23.

The Ace Investment Advisory Group has put together a special stock fund that includes only shares of monopolies that earn profits at least 50 percent higher than the overall industrial average.

If you invest in this fund, do you expect to do better than if you had invested in non-monopolies?If investing in monopolies yielded a higher payoff,

the prices in their stocks would be bid up until the return was brought into balance with the return on stock in other companies.

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Is investing in Microsoft a good bet?

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Is investing in Microsoft a good bet?

March, 2000

$39.75

March, 2005

$24.91

78

Example 8.24.

Consider a perpetual bond that pays $120/yr to its owner (a perpetual bond entitles the bearer to the same annual payment forever).

By how much would the price of this bond rise if the interest rate fell from 10 percent to 5 percent?

The price at 10 percent is $120/0.10=$1200.

At 5 percent the price will be $120/0.05=$2400.

So the rise in price is $1200.

79

Example 8.25. Price Supports as a Device for Saving Family Farms

Family farms tend to have higher costs than large corporate farms.

As more and more family farms give way to corporate farms, lower costs lead to lower prices, which result in economic losses for family farms.

To ease the plight of the family farmer, Congress has passed legislation that pegs prices of farm products higher than market-clearing levels.

Will this policy help tenant farmers in the long run?

80


When the price of farm products rises, farms that were earning zero economic profit will now earn positive economic profit.

The lure of positive profit causes others to bid for agricultural land, which causes land prices to rise.

The long-run effect of agricultural price supports was thus to drive up the rent for farmland, which does nothing to assure the survival of tenant farmers.

81


We are not sure how we can benefit from the price support.

A much more direct and efficient way to aid family farmers would be to reduce their income taxes.

In the case of more extreme need, farmers could be given outright cash grants.

82

Example 8.26.

A trucker gets $5000 for driving a trailer full of cargo from New York to San Francisco, a trip that takes him one week.

The rent for his rig is $3000/wk and he spends $1000 on gas.

Meals and other expenses come to another $500/wk.

His alternative employment is to work as a local deliveryman at a salary of $500/wk, a task he finds equally attractive as trucking.

What is this trucker's economic profit?

83

Example 8.26.

A trucker gets $5000 for driving a trailer full of cargo from New York to San Francisco, a trip that takes him one week.

The rent for his rig is $3000/wk and he spends $1000 on gas. Meals and other expenses come to another $500/wk. His alternative employment is to work as a local deliveryman at a

salary of $500/wk, a task he finds equally attractive as trucking.

What is this trucker's economic profit?

Total revenue = $5000Total cost = $3000 + $1000 + $500 + $500 =

$5000Economic profit = $5000 - $5000 = 0

84

Example 8.27.

Now suppose the trucker from the previous example installs an airfoil on the roof of the cab of his rig, resulting in a fuel savings of 25 percent.

If the airfoil rents for $50/wk, what is the trucker's new economic profit?

1970 1985

85

Example 8.27.

If the airfoil rents for $50/wk, what is the trucker's new economic profit?

Total revenue = $5000/wk, the same as before.

Total cost = $5000 - $250 + $50 = $4800

So economic profit = $5000 - $4800 = $200.

86

Example 8.28.

Suppose all truckers but one have installed the airfoil described in the preceding example.

What will be the economic profit of the lone holdout?

As more and more truckers install the airfoils, costs go down and this places downward pressure on trucking prices.

By the time all truckers have installed the airfoils, trucking rates will have fallen by the full $200 in net cost savings made possible by the airfoil.

Thus the lone trucker without an airfoil will suffer an economic loss of $200/wk.

87

Example 8.28.

Moral: Early adopters of cost-saving innovations tend to earn positive economic profits.

Late adopters tend to earn negative economic profits.

88

Example 8.29.

On April 24, 2003, the Commissioner for Transport (HKSAR), Mr Robert Footman, announced a scheme to relax general stopping restrictions for taxis to provide immediate relief to the trade under the difficult operating environment with the outbreak of atypical pneumonia.

To whom does the scheme benefit? Drivers or owners of taxi operating licenses?

89

Example 8.29.

In Hong Kong it is easy to become a taxi driver. Thus, in a recession, the supply of drivers is essentially perfectly elastic, possibly with the best alternative of unemployment benefits as the reservation wage.

The relaxation of road restrictions for taxis is supposed to increase the demand for taxis and hence revenue.

When the revenue is higher, more people will try to enter the trade of taxi drivers, bidding up the rental rate of taxis.

Higher rental rate leads to higher taxi operating license premium.

Thus, the relaxation benefits the taxi operating license owner (who are relatively rich) but not the taxi drivers (who are relatively poor).

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End

1 Introductory Microeconomics The Quest for Profit and the Invisible Hand.

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