The Quest for Profit and the Invisible Hand

The Quest for Profit and the Invisible Hand

The Central Role of Economic Profit 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 Vs. Economic Profit 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

Implicit 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.

Example 1 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

Example 1 Accounting Profit $400, 000(TR) - $250, 000 (explicit costs) = $150, 000 Slide 6

Example 1 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

The Difference Between Accounting Profit and Economic Profit Total revenue Explicit costs Accounting profit opportunity cost of resources supplied by owners of firm Economic profit Slide 8

Distinctions Between Accounting and Economic Profits Why are the distinctions important? Only economic profit serve the following economic functions: Rationing function Allocative function Slide 9

Example 2 Should Pudge Buffet stay in the farming business? He is a corn farmer with payments for land 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

Revenue, Costs, and Profit Summary for Pudge 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

Example 2 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

Example 3 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

New Revenue, Costs, and Profit Summary for Pudge 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

Functions of Price 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

Functions of 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

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. Slide 18

Economic Profit in the Short Run in the Corn Market MC S ATC 2. 00 D 65 Quantity (millions of bushels/year) Price ($/bushel) Economic profit = $104, 000/yr Price 2. 00 1. 20 130 Quantity (1000 s of bushels/year) Market price of $2/bushel produces economic profits Slide 19

The Effect of Entry on Price and Economic Profit S MC S’ ATC 2. 00 1. 50 D 65 95 Quantity (millions of bushels/year) Price ($/bushel) Economic profit = $50, 400/yr 2. 00 1. 50 Price 1. 08 120 130 Quantity (1000 s of bushels/year) Economic profits attract firms, reducing prices and profits Slide 20

Equilibrium when Entry Ceases MC S 1. 00 Price ($/bushel) ATC Price 1. 00 D 115 Quantity (millions of bushels/year) 90 Quantity (1000 s of bushels/year) Entry of firms continues until all firms earn zero economic profit Slide 21

A Short-Run Economic Loss in the Corn Market MC ATC S 0. 75 D 60 Quantity (millions of bushels/year) Price ($/bushel) Economic loss = $21, 000/year 1. 05 0. 75 Price 70 90 Quantity (1000 s of bushels/year) Prices below minimum ATC results in economic losses. Slide 22

Equilibrium when Exit Ceases S’ S 1. 00 0. 75 D 40 60 Quantity (millions of bushels/year) Price ($/bushel) MC 1. 00 0. 75 ATC Price 90 Quantity (1000 s of bushels/year) The departure of firms from the industry increases the market price Slide 23

Long Run Equilibrium 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

No Cash on the Table 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

Long-Run Equilibrium in a Corn Market with Constant Long-Run Average Cost MC LMC =LAC =1. 00 S D Quantity (millions of bushels/year) Price ($/bushel) ATC 1. 00 Price 90 Quantity (1000 s of bushels/year) Similar ATC curves allow the industry to supply any output at a price equal to minimum ATC. Slide 26

Long Run Equilibrium and Market Efficiency 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

Example 4 Long hair and physical fitness become popular these days, what happens to the supply-demand to hair stylists and aerobics instructors? Slide 28

Initial Equilibrium in the Markets for Haircuts ATCH S 15 Price ($/haircut) MCH D 50 Haircuts/day QH Haircuts/day Slide 29

Initial Equilibrium in the Markets for Aerobics Classes ATCA S 10 Price ($/class) MCA D 20 Classes/day QA Classes/day Slide 30

The Short-Run Effect of Demand Shifts in Two Markets 15 12 D’ 350 500 Haircuts/day D S 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

Economic Profit and Loss in the Short Run 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

Example 4: Long Run Equilibrium 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

The Importance of Free Entry and Exit 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 Rent Versus Economic Profit Economic profits attract resources that push economic profits toward zero. Slide 35

Economic Rent Versus Economic Profit 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

Example: Economic Rent 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 100 th restaurant employs a talented chef and customers are willing to pay 50% more for their meals Slide 37

Example: Economic Rent Assume TR at the each of the 99 restaurants is $300, 000, which yields a normal profit TR at the 100 th restaurant is $450, 000 (50% more) Slide 38

Example: Economic Rent Assume A talented chef Earns $180, 000 = $30, 000 + $150, 000 Reservation price = $30, 000 Economic rent = $150, 000 That the 100 th restaurant earns a normal profit Slide 39

Food for Thought Question Why not pay the chef less and increase the economic profit for the restaurant? Slide 40

Key Concept: Economic Rent Opportunities for private gain seldom remain unexploited for very long Slide 41

Economic Rent on Human Capital 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 Mc. Donald is happy to hire Yao for US$20, 000. What is Yao’s economic rent of playing basketball?

Economic Rent on Human Capital 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?

Food for Thought 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?

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