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The Invisible Hand In
Action
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Chapter #$ %lasticity &lide 2
'earning (b)ectives
1.
Accounting, Economic and Normal Profit.2. Allocation of resources through economic profit
and economic loss the example of perfectcompetition.
3. Difference beteen economic profit and economicrent
!. "n#isible hand$ applications in e#er%da% life
&. 'ar(et e)uilibrium #ersus social optimum.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /
The Invisible Hand
"n this chapter e ill stud% the natureof forces that guide the in#isible hand.
Adam *mith+s #ision as thatPeople are moti#ated b% selfinterest.
-he goal of profit maximiation /underman% conditions0 ser#e societ%+s collecti#e
interest.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #
Three Types o .roit
Accounting Profit total re#enue explicit costs /pa%mentsfor factors of production0
Economic Profit total re#enue explicit costs implicitcosts /opportunit% cost of the resources supplied b% the
firm+s oners0 Normal Profit accounting profit economic profit "mplicit
costs
"f economic profit, normal profitaccounting profit
"f economic profit then Normal Profit Acc Profit.
4ence, positi#e economic profits are called supernormalprofits
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Chapter *$ The +,est or .roit and the Invisible Hand &lide
Three 1inds o .roit
Totalreven,e
%plicit
costs
Acco,ntingproit
3oral proit 4opport,nity cost oreso,rces s,pplied
by owners o ir
%conoicproit
%plicit
costs
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 5
Calc,lating .roits
*uppose a firm has the folloing$
TR 5!,6 Explicit costs /salaries0 52&,7%r
'achiner% and other e)uipment ith a resale #alue of 51million
Annual interest on sa#ings 18 /implies that the 51 millionspent on e)uipment could ha#e earned 51,7%r had itbeen in#ested06 this is the implicit /opportunit%0 cost
Accounting Profit $ 5!, 52&, 51&,
Economic Profit$ 5!, 52&, 51, /implicitcost0 5&,
Normal Profit Accounting Profit /51&,7%r0 EconomicProfit /5&,7%r0 51,7%r 9:
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 7
6hy Are The istinctions Iportant8
-o ma(e correct decisions. Example*hould 'r. A sta% in farming or should he manage
a retail store;
Assumptions4e is a corn farmer ith pa%ments for land and
e)uipment /5
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Chapter *$ The +,est or .roit and the Invisible Hand &lide *
9even,e! Costs! and .roit &,ary
Total %plicit Iplicit Acco,nting %conoic 3oralreven,e costs costs proit proit proit:;>!000
20!000 >0!000 >>!000 >0!000 ->!000 >>!000
> 2 / # 5
"f ->522,, 'r. A is better off farming than as a storemanager. "f -> falls to 52,, economic profit is 51,hich means he can ma(e 51 more as a store managerthan in farming. *o he should manage the store.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide ?
6hy Are The istinctions Iportant8
-o remain in business in the long run, 'r. Aould need an economic profit or .
?% a turn of fate, the oner of the land
ma(es a gift of it to 'r. A. -he land can alsobe rented to other farmers for 5
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >0
3ew 9even,e! Costs! and.roit &,ary or .,dge
Total %plicit Iplicit Acco,nting %conoic 3oralreven,e costs costs proit proit proit:;
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >>
The Invisible Hand Theory
-o @unctions of Price-he rationing function of price
-o distribute scarce goods to thoseconsumers ho #alue them most highl%.
-he allocative function of price
-o direct resources aa% from o#ercrodedmar(ets /here P is too lo to co#er 9:0 and
toard mar(ets that are underser#ed. ?oth these functions of price underlie Adam *mith+s
theor% of the "n#isible hand.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >2
The Invisible Hand 6or@ing as a9esponse to .roits and 'osses
>esponses to Profits and osses'ar(ets ith firms earning economic
profits ill attract resources.
'ar(ets here firms are experiencingeconomic losses tend to lose resources.
>ecall, normal profit is Bust a cost of doing
business. Chen economic profit , %ou areonl% earning normal profit.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >/
>"20
%conoic proit4 ;>0#!000
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >#
>"0*
>"0
%conoic proit4 ;0!#00"0 .rice
>20?
The %ect o %ntry on.rice and %conoic .roit
+,antity :illions ob,shels
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >
%,ilibri, when %ntry Ceases
S
+,antity :illions ob,shels
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >5
>"0
%conoic loss4 ;2>!000
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >7
%,ilibri, when %it Ceases
+,antity :illions ob,shels"00 >"00
The depart,re o irs ro the ind,stry increases the ar@et price
S
D
50
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >*
'ong 9,n .erectly Copetitive%,ilibri,
"n the longrun, in a competiti#e mar(et, allfirms ill tend to earn ero economic profits.
ero economic profits are the conse)uence of price
mo#ements caused b% the entr% and exit of firmstr%ing to maximie economic profits.
-he e)uilibrium principle /no cash on the table0predicts, hen people confront an opportunit% for
gain the% are almost ala%s )uic( to exploit it.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >?
The Invisible Hand Theory
-o Attracti#e @eatures-he mar(et outcome is efficient /sociall% optimal0
P = MC /the #alue to bu%ers of the last unit of thegood sold exactl% e)uals the marginal opportunit% cost
to societ% of producing one extra unit of the good0.
-he mar(et is, in a sense, fair.-he price the bu%ers pa% is no higher than the cost
incurred b% sellers.
-he cost includes a normal profit.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 20
'ong 9,n Ind,stry &,pply C,rve
4o ould the long run industr% suppl% cur#e loo(under perfect competition;
Assume that all firms ha#e identical coststructures in the short run. *o all long run
adBustments are made exclusi#el% b% entr% andexit of identical firms using an identicalstandardied production method.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 2>
'ong 9,n Ind,stry &,pply C,rve
:onsider an initial e)uilibrium at min A-:. *upposedemand rises. Each firm ill produce more and earnpositi#e economic profits in the short run.
Ne firms ill enter the mar(et. *hort run industr% suppl%
cur#e ill shift to the right until prices come don to minA-:.
-he long run industr% e)uilibrium ill settle at Pmin A-:ith the number of firms being higher.
-herefore, the long run industr% suppl% cur#e is a horiontalstraight line at minimum A-:. All long run adBustments aredone through the number of firms in the industr% /under theassumption of identical firms ith identical cost structure0.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 22
The Invisible Hand$ %aple
*uppose that the mar(et for haircuts andaerobics classes are currentl% at their longrun e)uilibria.
*uppose then that long hair becomesfashionable hile citiens become morefitness conscious.
*o, compared to the initial long rune)uilibrium, demand for haircuts ill fall andthat for aerobics ill rise.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 2/
Initial %,ilibri,in the Mar@et or Hairc,ts
Hairc,ts
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 2#
Initial %,ilibri, in theMar@et or Aerobics Classes
Classes
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 2
The &hort-9,n %ect oeand &hits in Two Mar@ets
Hairc,ts
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 25
%conoic .roit and'oss in the &hort 9,n
Hairc,ts
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 27
The Invisible Hand Theory
>esponses to the change in demand forst%lists and aerobics instructorsEconomic loss for st%lists ill
>educe the suppl% of st%lists
"ncrease the price until ero economic profits occur
Economic profit for aerobics instructors ill"ncrease the suppl% of aerobics classes
>educe the price until ero economic profits occur
Th I t % t d
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 2*
The Iportance o ree %ntry and%it
@ree entr% and exit must exist for the allocati#efunction of price to operate
?arriers to entr% can be caused b% legal constraints/patents, cop%rights, etc0 and uni)ue mar(etcharacteristics /netor(ing externalities andproduct compatibilit% in the softare industr%0
A barrier to exit can become a barrier to entr%
/airline industr% regulation made it impossible forairlines to lea#e unprofitable routes and so airlinesere unilling to enter these mar(ets0
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 2?
%conoic 9ent vs" %conoic .roit
Economic profits attract resources that pusheconomic profits toard ero, in competiti#emar(ets.
Economic >ent-hat part of a pa%ment for a factor of production
that exceeds the oner+s reser#ation price
'ar(et forces ill not push economic rent toero because inputs cannot be replicated easil%.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /0
%conoic 9ent$ %aple
4o much rent ill a talented chef get;AssumeA communit% ith 1 restaurants
restaurants emplo% chefs ith normal abilit%for 53,7%r /the same amount the% could earnelsehere0
-he 1threstaurant emplo%s a talented chefand customers are illing to pa% &8 more fortheir meals
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Chapter *$ The +,est or .roit and the Invisible Hand &lide />
%conoic 9entDers,s %conoic .roit
AssumeTRat the each of the restaurants is53,, hich %ields a normal profit
TR at the 1threstaurant is 5!&, /&8
more0-he talented chef
Earns 51F, 53, = 51&,
>eser#ation price 53,Economic rent 51&,
-he1threstaurant earns a normal profit
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /2
%conoic 9entDers,s %conoic .roit
Ch% not pa% the chef less and increase theeconomic profit for the restaurant;9ther restaurants ill bid him aa%.
*a%, restaurant 1 gi#es the chef 5!, andma(es economic profit of 511,. >estaurant2 ill ant to pa% slightl% more than 5!, andta(e the chef. -he process ill continue until
economic profit is dri#en to ero. 9pportunities for pri#ate gain seldom remain
unexploited for #er% long
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Chapter *$ The +,est or .roit and the Invisible Hand &lide //
The Invisible Hand in Action
Economic NaturalistCh% do supermar(et lines tend to be
roughl% the same length;
Ch% do all lanes on a croded, multilanefreea% mo#e at about the same speed;
MB MC Invisible Hand and Cost &aving
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /#
Invisible Hand and Cost &avingInnovation
Ch% do firms ha#e an incenti#e to introducecostsa#ing inno#ations; 4o do costsa#ing inno#ations affect economic profit inthe short run; "n the long run;
Assume! companies transport oil from the middle east
to the G.*.
-he cost7trip, including normal profit, is 5&,
9ne compan% disco#ers the use of a nepropeller that sa#es 52,7trip
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /
Invisible Hand and Cost &avingInnovation
*hort >un
No impact on price6 A-: and ': ill shift don6Economic profits for the compan% ill increase b%52,7trip
ong >un9ther companies ill introduce the propeller
A-: and ': for all firms ill shift don6 mar(et
suppl% ill shift to the right and price ill fallero economic profits after all firms ha#e adopted
the ne propeller6 prices loer for the consumer
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /5
.resent isco,nted Dal,e
:alculating the Present Discounted Halue of@uture :osts and ?enefits-he time #alue of mone%
"s the concept that a gi#en dollar amount toda% ise)ui#alent to a larger dollar amount in the futurebecause of interest earnings.
-herefore, earnings recei#ed in the future are
less #aluable than earnings toda%.*imilarl%, costs incurred in the future are lesscostl% toda%.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /7
.resent isco,nted Dal,e
Deposit 51 I r 18 or .1After 1 %ear
51/1.10 511
-herefore, the PDH of 511 a %ear from nois 51.
After 2 %ears
51/1.10/1.10 51/1.102 5121
-herefore, the PDH of 5121, to %ears fromno is 51.
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /*
.resent isco,nted Dal,e
Jenerall%PDVof a pa%ment Mto be recei#ed - %ears
from no at interest rate r, is$
Chat is the #alue of a compan% toda% if it illearn its onl% accounting profit of 51!,! in to%ears, gi#en r 28;51!,!7/1 = .202 51,
Tr
MPV)1( +
=
MB MC Invisible Hand in 9eg,lated
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Chapter *$ The +,est or .roit and the Invisible Hand &lide /?
Invisible Hand in 9eg,latedMar@ets
Ch% do Ne Kor( :it% taxicab medallions sell formore than 53,;
*uppose
Annual cost of operating the cabs /includingdepreciation and all opportunit% costs0 5!,
TR7%ear 5
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #0
Invisible Hand in 9eg,latedMar@ets
4ad the medallion been free, the cab dri#er+s economicprofit ould be 52,. -his economic profit ould attractentr% into the taxi mar(et.
"t ould re)uire an%one to (eep 5333,333 in the ban( at
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #>
Invisible Hand in 9eg,latedMar@ets
Ch% did maBor commercial airlines installpiano bars on the upper dec(s of ?oeing!s in the 1s;Gntil late 1F airlines ere regulated b% the
federal agenc% :A? /:i#il Aeronautics ?oard0.
>egulated prices on popular routes ere ellabo#e free mar(et e)uilibrium #alues, thus
generating economic profits hich ere thensupposed to pa% for ser#ice on sparsel% tra#eledroutes.
MB MC Invisible Hand in 9eg,lated
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #2
Invisible Hand in 9eg,latedMar@ets
Cith regulated fares, competition could not dri#edon prices
*o airlines competed for passengers b% pro#idingnon monetar% incenti#es li(e adding more flights,
piano bars, fanc% food, etc. Airlines added more flights on each route until
economic profits ere dri#en to ero.
"ntrastate /ithin state li(e *an Diego to *an@rancisco0 carriers /not regulated b% :A?0 foundpassengers sacrificed amenities for loer prices.
MB MC Invisible Hand in Anti .overty
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #/
Invisible Hand in Anti-.overty.rogras
4o ill an irrigation proBect affect the incomes of poorfarmers;
Assume$ An uns(illed or(er has to Bob choices
Cor( as a -extile or(er for 5F,7%r, or,
>ent land to gro riceo >ent 5&,7%r
o Nonlabor cost 53,7%r
o TR 51
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Chapter *$ The +,est or .roit and the Invisible Hand &lide ##
Invisible Hand in Anti-.overty.rogras
Chat ill be the impact of the irrigationprogram on incomes of tenant farmers;TR ill increase to 51
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #
The Invisible Hand and the &toc@Mar@et
9ne of the most competiti#e mar(ets is themar(et for stoc(s and bonds on Call *treet.
:alculating the #alue of a share of stoc(
A share of stoc( in a compan% is a claim to ashare of the current and future accounting profitsof that compan%.
-he price of a share of stoc( depends on-he compan%+s current and expected future
accounting profits
-he mar(et interest rate, as the next example shos
MB MC The Invisible Hand and the &toc@
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #5
The Invisible Hand and the &toc@Mar@et
AssumeAccounting profit 51 million1, shares of stoc(
Annual interest rate &8
Price7shareEach share pa%s 51,7%ear /51 million71,0
At &8 a 52, sa#ings account pa%s 51,7%r-herefore, the stoc( price 52,
MB MC The Invisible Hand and the &toc@
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #7
The Invisible Hand and the &toc@Mar@et
@uture profits are not certain.
*o, current price of a share of stoc( dependson in#estors+ estimates about future profits.
-hese estimates incorporate informationabout current profits, prospects for thecompan%+s industr%, state of the econom%,
demographic trends, etc.As this information changes, so does the
price of a share of stoc(.
MB MC
Th %i i @ H h i
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #*
The %icient ar@ets Hypothesis
-he Efficient 'ar(et 4%pothesis isessentiall% a nocashonthetableh%pothesis.
Ne information is reflected in the currentprice of a stoc( ith amaing speed andaccurac%.
-he current price of a stoc( reflects allrele#ant information about its current andfuture earnings prospects.
MB MC
%i i t M @ t H th i
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Chapter *$ The +,est or .roit and the Invisible Hand &lide #?
%icient Mar@ets Hypothesis
Chat do %ou thin(;:an %ou increase %our profit in the stoc( mar(etb% using information from the mass media;
Do stoc(s in ellmanaged companies perform
better than those in poorl% managed companies;Jood management is better than bad management,
but the surplus is captured b% those that pro#ide thatbetter management and not the stoc(holders.
MB MC
Th i ti ti B t
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Chapter *$ The +,est or .roit and the Invisible Hand &lide 0
The istinction Between an%,ilibri, and a &ocial (pti,
-he e)uilibrium /nocashonthetable0 principlemeans that there are no unexploited opportunitiesin mar(ets that are in e)uilibrium.
-he mar(et e)uilibrium does not impl% that the
resulting allocation is necessaril% best from thepoint of #ie of societ% as a hole.
-he smart for one, dumb for all principle
E)uilibrium ill not be sociall% optimal hen thecost and benefits for the indi#iduals differ fromsociet% as a hole.
MB MC
The istinction Bet een an
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Chapter *$ The +,est or .roit and the Invisible Hand &lide >
The istinction Between an%,ilibri, and a &ocial (pti,
Are there Otoo man% smart people or(ing ascorporate earnings forecasters;
-he anal%st ith the best forecasting model ill earna indfall b% bu%ing stoc(s hose prices are about to
rise. Ji#en the speed of response of stoc( prices to ne
information, the second best forecasting model,hoe#er good, is of no use.
*o a rat race to number one place is rational from apri#ate perspecti#e but not necessaril% from a socialpoint of #ie.
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%nd o
Chapter
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