MBMC The Quest for Profit and the Invisible Hand.

MB MC

The Quest for Profit and the Invisible Hand

MB MC

Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Chapter 8: The Quest for Profit and the Invisible Hand Slide 2

The Central Roleof Economic Profit

According to mainstream economists People are rational and motivated by self-interest.

“homogenous globules of desire” But empirical research shows this assumption rarely

holds (e.g. behavioral economics) “Sales Are Colossal, Shares Are Soaring. All Amazon Is

Missing Is a Profit”

The goal of profit maximization will serve society’s collective interest.

but only in perfect markets and only if we believe that maximizing monetary value is

in society’s collective interest and the underlying distribution of wealth and resources is desirable.m

MB MC



Three Types of Profit: 1

Accounting Profit = total revenue – explicit costs (actual payments made to factors of production)e.g. money a farmer gets for selling his

milk, minus wages to hired hand, interest on loan for purchase of new tractor, costs of fuel, etc.

What is left out here?

MB MC




Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners) E.g. also subtract money farmer could have made

working elsewhere, money he could have made renting his land to someone else, etc.

Payments to factors of production (explicit and implicit) Payment to labor (human capital) = wage to land (natural capital) = rent (unearned income) to capitalists (finance and machinery/built capital)

= interest

MB MC




Normal Profit = accounting profit – economic profit= fair payment to implicit costs

i.e. normal profit occurs when all factors of production, owned and unowned, earn their expected returnsE.g. Farmer earns as much farming as he

would working elsewhere and renting his land to a neighbor.

MB MC




Calculating ProfitSuppose a firm has the following:

TR [Total Revenue] = $400,000Explicit costs (salaries) = $250,000/yrMachinery and other equipment with a resale

value of $1 million (implicit cost = returns to capital = interest, i.e. the amount of money he would earn by investing the $1 million elsewhere)

MB MC




Calculating ProfitAccounting Profit

$400,000(TR) - $250,000 (explicit costs) = $150,000

MB MC




Calculating ProfitTo calculate economic profits, assume

Annual interest on typical investment = 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

i.e. profits above and beyond a fair return to the factors of production

MB MC




Calculating ProfitNormal Profit

Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr

Normal profit is a fair return on the factors of production you own, in this case the $1 million in capital

MB MC



The Difference BetweenAccounting Profit and Economic Profit

Totalrevenue

Explicitcosts

Accountingprofit

Normal profit = opportunity cost ofresources supplied

by owners of firm

Economicprofit

Explicitcosts

MB MC



Why are the distinctions important?

ExampleShould a Vermont farmer stay in the farming

business?He should stay as long as he can pay for all

his hired factors of production (e.g. hired workers, rented machinery), makes as high a return on his labor as he would working elsewhere, and makes as much on his land as he would if he rented it, or else sold it and invested the profits.

MB MC


You are a small business owner who owns the land and capital required for your business. You bring in $500,000 per year in revenue, and pay out $250,000 per year for the labor and raw materials you require.

Practice at home:

MB MC


The difference between your total revenue and the $250,000 you pay for factors of production represents:A. Implicit costsB. Economic profitsC. Normal profitsD. Accounting profitsE. Explicit costs

MB MC


The potential return on your land, capital and labor, if allocated towards the best alternative activity, represents:A. Implicit costsB. Economic profitsC. Normal profitsD. Accounting profitsE. Explicit costs

MB MC


The different between your accounting profits and the potential return on your land, capital and labor represent:A. Implicit costsB. Economic profitsC. Normal profitsD. Accounting profitsE. Explicit costs

MB MC




A ReviewAccounting Profit = TR – explicit costs, Economic Profit = TR – explicit and

implicit costs Normal profit = a fair return on the factors

of production; economic profits = 0To remain in business in the long run,

economic profits must be greater than or equal to 0 (zero) i.e. P>=min ATC.

MB MC



Two Functions of Price: 1

The rationing function of price To distribute scarce goods to those

consumers who value them most highlyBUT as economists determine value, you

can only value something if you have money.

Amerindians in the Amazon do not value the forest

Poor people do not value life saving medicine, e.g. eflornithine

There is no role for ethical, moral or social values

MB MC



Two Functions of Price

The allocative function of priceTo direct resources away from

overcrowded markets and toward markets that are underserved

BUT, from the economists perspective, markets in life saving medicines for poor people are overcrowded, while markets for facial hair loss formulas for rich people are underserved.

MB MC



MB MC



The Invisible Hand Theory

Resources are allocated across firms to produce the most efficient (i.e. profitable) possible mix of goods and services (allocative function) Inputs will go to those producers who can pay the most for

them (i.e. who can create the highest valued products from them)

Goods and services are efficiently (i.e. maximizing monetary value) allocated across consumers (rationing function) Outputs will go to those consumers who value them the

most (i.e. who can pay the most)

Markets balance possibility with desirability

MB MC



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.

Shifts in demand will raise or lower prices, hence profits, leading to entry or exit of firms, returning prices to their ‘fair’ level

GRAPHS ON BOARD

MB MC


This graph depicts a situation in which:A.Economic profits will allocate more resources to this industryB.Economic losses will lead firms to leave this industryC.An industry in which firms are earning normal profitsD.An industry in which firms are making short run lossesE.An industry in which firms are making long run losses

MB MC



Economic Profit in the Short Run in the Corn Market

Market Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

S

D

65Firm Quantity (1000s of

bushels/year)

Pri

ce (

$/b

ush

el)

2.40

Market price of $4/bushel produces economic profits

4.00 Price4.00

MC

130

ATC

MB MC



3.00

Economic profit declines as price falls

3.00 Price

12095

The Effect of Entry onPrice and Economic Profit

Market Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

S

D

65Firm Quantity (1000s of

bushels/year)

Pri

ce (

$/b

ush

el)

Economic profits attract firms, reducing prices and profits

4.00 4.00

MC

130

ATCS’

MB MC



Equilibrium when Entry Ceases

S

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

D

2.00

Quantity (1000s of bushels/year)

Pri

ce (

$/b

ush

el)

Price

90115

Entry of firms continues until all firms earn a normal profit

MCATC

2.00

MB MC



2.10

Economic loss= $21,000/year

Prices below minimum ATC results in economic losses.

A Short-Run Economic Loss in the Corn Market


Pri

ce (

$/b

ush

el)


Pri

ce (

$/b

ush

el)

70

1.50Price

90

ATC

1.50

MC

S

D

60

MB MC



Equilibrium when Exit Ceases


Pri

ce (

$/b

ush

el)

1.50


Pri

ce (

$/b

ush

el)

90

1.50

90

ATCMC

40

S’

Price2.00 2.00

The departure of firms from the industry increases the market price

S

D

60

MB MC



Efficiency & community development

How does the cost structure of Wall-mart compare with the little store on Church street?

What happens when a Wall-mart comes to town?

MB MC



Communities, again

What happens when all other stores close?

Does this serve society’s collective interest?

MB MC



The Invisible Hand Theory

In the long-run, in a competitive market, all firms will tend to earn zero economic profits. Consumer gets the good as cheaply as possible But remember, normal profits cover all the costs of

production Zero economic profits are the consequence of

price movements caused by the entry and exit of firms trying to maximize economic profits.

MB MC



Long-Run Equilibrium in a Corn Market with Constant Long-Run Average Cost


Pri

ce (

$/b

ush

el)


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.

Is this realistic? What factors of production are fixed in th long run?

MB MC



Two Attractive Features

The market outcome is efficient in the long run.P = MC= min ATC

The market is fair.The price the buyers pay is no higher than

the cost incurred by sellers.The cost includes a normal profit.Normal profits include payments to all

factors of production, including a CEO making 100 million a year.

MB MC



The Invisible Hand in Action

The Invisible Hand and Cost-Saving InnovationsIn a competitive market

Firms are price takersP = MCZero economic profits exist in the long run

QuestionWhy do these firms have an incentive to

introduce cost-saving innovations?

MB MC



Free Entry and Exit

Free entry and exit must exist for the allocative function of price to operate Barriers to entry can be caused by legal

constraints and unique market characteristics Patents and copyrights

Medicine prices in US and Canada Textbook prices in US and Europe

Compatibility between products Firm size Quotas

MB MC



Economic RentVersus Economic Profit

Economic RentThat part of a payment for a factor of

production that exceeds the owner’s reservation price

Think about land, fossil fuels, etc.Market forces will not push economic rent

to zero because inputs cannot be replicated easily

But taxes can push it to zero

MB MC




An absentee landowner rents farmland to a corn farmer for $30,000 yr.

Farmer generates an income (TR-explicit costs) of $30,000 yr (normal profit)

A new government subsidy for ethanol increases revenue from the farmland by $30,000 year

What happens to the rent, the farmer’s income, and the price of the land?

MB MC




An absentee landowner rents farmland to a corn farmer for $30,000 yr.

Famer generates an income of $30,000 yr (normal profit)

The government raises taxes on the land by $30,000 year

What happens to the rent, the farmer’s income, and the price of the land?

MB MC


Landowner cannot pass on tax

30K

60K

excess supplytax?

taxdemand

MB MC




The Invisible Hand in Antipoverty Programs, e.g. the green revolutionHow will an irrigation project affect the

incomes of poor farmers who rent land?

MB MC




AssumeAn unskilled worker has two job choices

Textile workerRenting land to grow rice

A state funded irrigation program doubles output without changing the market price.

What happens to income of landless?

What happens to price of land? Who benefits?

MBMC The Quest for Profit and the Invisible Hand.

Documents

Transcript of MBMC The Quest for Profit and the Invisible Hand.