Transcript Document

The Quest for Profit and the
Invisible Hand
1

According to Adam Smith
 People are motivated by self-interest.
 The goal of profit maximization will
serve society’s collective interest.
Slide 2


Accounting Profit = total revenue –
explicit costs (payments for factors of
production)
Economic Profit = total revenue – explicit
costs – implicit costs (opportunity cost of
the resources supplied by the firm’s
owners)
Slide 3

Costs incur without explicit money involved

E.g., use your own garage for storage

Forego the opportunity to rent out your garage
, the opportunity cost is the lost income from
renting the garage out.

Suppose a firm has the following:
 Total Revenue (TR) = $400,000
 Explicit costs (salaries) = $250,000/yr
 Machinery and other equipment with
a resale value of $1 million
Slide 5

Accounting Profit
 $400,000(TR) - $250,000 (explicit costs)
= $150,000
Slide 6

To calculate economic profits, assume
 Annual interest on savings = 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
Slide 7
Total
revenue
Explicit
costs
Explicit
costs
Accounting
profit
opportunity cost of
resources supplied
by owners of firm
Economic
profit
Slide 8


Why are the distinctions important?
Only economic profit serve the
following economic functions:
Rationing function
 Allocative function

Slide 9





Should Pudge Buffet stay in the farming
business?
He is a corn farmer with payments for land
and equipment = $10,000/yr
He supplies only his labor which he values
equally to managing a retail store for
$11,000/yr
Except for pay, he is indifferent between the
farm or the store
Corn sells at a constant price and TR = $22,000
Slide 10
Total
revenue
($/year)
Explicit
costs
($/year)
Implicit
costs
($/year)
Accounting
profit
($/year)
Economic
profit
($/year)
22,000
10,000
11,000
12,000
1,000
Slide 11


What would Pudge’s economic profit be if
TR = $20,000
 Economic profit
 TR (20,000) – explicit (10,000) and
implicit costs (11,000) = -$1,000
Question
 Should Pudge stay in farming?
Slide 12

If Pudge owned his own land, should he
stay in farming?

Assume
 Pudge inherits the land
 The land can be rented for
$6,000/yr
Slide 13
Total
revenue
($/year)
Explicit
costs
($/year)
Implicit
costs
($/year)
Accounting
profit
($/year)
Economic
profit
($/year)
20,000
4,000
17,000
16,000
-1,000
Slide 14

A Review
 Accounting Profit = TR – explicit costs
 Economic Profit = TR – explicit costs –
implicit costs
 Economic Profit = 0 when accounting
profit = implicit costs
 To remain in business in the long run,
economic profits must be greater than or
equal to 0 (zero).
Slide 15

The rationing function of price
 To distribute scarce goods to those
consumers who value them most
highly

The allocative function of price
 To direct resources away from
overcrowded markets and toward
markets that are underserved
Slide 16

Profits and Losses Would Ensure

That supplies within a market would be
distributed efficiently (rationing function)

Resources would be allocated across markets
to produce the most efficient possible mix of
goods and services (allocative function)
Slide 17


Markets with firms earning economic
profits will attract resources.
Markets where firms are experiencing
economic losses tend to lose resources.
Slide 18
MC
S
ATC
2.00
D
65
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic profit
= $104,000/yr
Price
2.00
1.20
130
Quantity (1000s of
bushels/year)
Market price of $2/bushel produces economic profits
Slide 19
S
S’
MC
ATC
2.00
1.50
D
65 95
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic profit
= $50,400/yr
2.00
1.50
Price
1.08
120 130
Quantity (1000s of
bushels/year)
Economic profits attract firms, reducing prices and profits
Slide 20
MC
S
1.00
Price ($/bushel)
Price ($/bushel)
ATC
Price
1.00
D
115
Quantity (millions of
bushels/year)
90
Quantity (1000s of
bushels/year)
Entry of firms continues until all firms earn zero economic profit
Slide 21
MC
ATC
S
0.75
D
60
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic loss
= $21,000/year
1.05
0.75
Price
70 90
Quantity (1000s of
bushels/year)
Prices below minimum ATC results in economic losses.
Slide 22
S’
S
1.00
0.75
D
40 60
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
MC
1.00
0.75
ATC
Price
90
Quantity (1000s of
bushels/year)
The departure of firms from the industry increases the market price
Slide 23


In the long-run, in a competitive market,
all firms will tend to earn zero economic
profits.
Zero economic profits are the
consequence of price movements caused
by the entry and exit of firms trying to
maximize economic profits.
Slide 24

The equilibrium principle (no cash on the
table) predicts, when people confront an
opportunity for gain they are almost
always quick to exploit it.
Slide 25
MC
LMC
=LAC
=1.00
S
D
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
ATC
1.00
Price
90
Quantity (1000s of
bushels/year)
Similar ATC curves allow the industry to supply
any output at a price equal to minimum ATC.
Slide 26

The market outcome is efficient in the
long run.
 P = MC
 If output is increased: MC > MB.
 If output is reduced: MC < MB.
Slide 27

Long hair and physical fitness become
popular these days, what happens to the
supply-demand to hair stylists and
aerobics instructors?
Slide 28
ATCH
S
15
Price ($/haircut)
Price ($/haircut)
MCH
D
50
Haircuts/day
QH
Haircuts/day
Slide 29
ATCA
S
10
Price ($/class)
Price ($/class)
MCA
D
20
Classes/day
QA
Classes/day
Slide 30
S
15
12
D’
350 500
Haircuts/day
D
Price ($/class)
Price ($/haircut)
S
15
D’
10
D
200
Classes/day
300
Assume: Long hair and physical fitness become popular.
Price of haircuts fall the price of aerobics classes rise.
Slide 31
ATCH
ATCA
Economic
loss
Economic
profit
Price ($/class)
Price ($/haircut)
MCH
15.50
12
Q’H QH
Haircuts/day
MCA
15
11
QA Q’A
Classes/day
The decrease in demand for haircuts causes economic losses
while the increase in demand for classes creates economic profits
Slide 32

Responses to the change in demand for stylists
and aerobics instructors
 Economic loss for stylists will
 Reduce the supply of stylists
 Increase the price until zero economic
profits occur
 Economic profit for aerobics instructors will
 Increase the supply of aerobics instructors
 Reduce the price until zero economic
profits occur
Slide 33



Free entry and exit must exist for the
allocative function of price to operate.
A barrier to exit can become a barrier to
entry
Yet, barriers to entry can be caused by
legal and political constraints as well as
unique market characteristics
Slide 34

Economic profits attract resources that
push economic profits toward zero.
Slide 35

Economic Rent
That part of a payment for a factor of
production that exceeds the owner’s
reservation price
 Market forces will not push economic
rent to zero because inputs cannot be
replicated easily

Slide 36


How much rent will a talented chef get?
Assume
 A community with 100 restaurants
 99 restaurants employ chefs with normal
ability for $30,000/yr (the same amount they
could earn elsewhere)
 The 100th restaurant employs a talented chef
and customers are willing to pay 50% more
for their meals
Slide 37

Assume
 TR at the each of the 99 restaurants is
$300,000, which yields a normal profit
 TR at the 100th restaurant is $450,000 (50%
more)
Slide 38

Assume
 A talented chef
 Earns $180,000 = $30,000 + $150,000
 Reservation price = $30,000
 Economic rent = $150,000
 That the100th restaurant earns a normal profit
Slide 39

Question

Why not pay the chef less and increase
the economic profit for the restaurant?
Slide 40

Opportunities for private gain seldom
remain unexploited for very long
Slide 41



Suppose Yao Ming, a star player for the
Houston Rockets, can either play basketball or
fry hamburger. In fact, he is equally happy and
capable of doing either job.
In the 2005 season, Yao made US$4.4 million
for playing basketball, while McDonald is
happy to hire Yao for US$20,000.
What is Yao’s economic rent of playing
basketball?

If the US federal government dramatically
increases personal income tax rate for superstar athletes like Yao, are basketball fans going
to bear the tax burden?

It is argued that pharmaceutical companies
earns exorbitant amount of profits from their
patents. Some politicians argue to impose a tax
on such patents. The pharmaceutical
companies argue that taxation on patented
drugs will lower research and development
expenditures. Do you agree with this
statement?
End