1. MBMC The Quest for Profit and the Invisible Hand

2. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 2 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.

3. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 3 The Central Role of Economic Profit Three Types of Profit Accounting Profit = total revenue – explicit costs (payments for factors of production)

4. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 4 The Central Role of Economic Profit Three Types of Profit Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners)

5. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 5 The Central Role of Economic Profit Three Types of Profit Normal Profit = accounting profit – economic profit

6. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 6 The Central Role of Economic Profit Calculating Profit Suppose a firm has the following:  TR [Total Revenue] = $400,000  Explicit costs (salaries) = $250,000/yr  Machinery and other equipment with a resale value of $1 million

7. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 7 The Central Role of Economic Profit Calculating Profit Accounting Profit  $400,000(TR) - $250,000 (explicit costs) = $150,000

8. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 8 The Central Role of Economic Profit Calculating Profit 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

9. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 9 The Central Role of Economic Profit Calculating Profit Normal Profit  Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr

10. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 10 The Difference Between Accounting Profit and Economic Profit Total revenue Explicit costs Accounting profit Normal profit = opportunity cost of resources supplied by owners of firm Economic profit Explicit costs

11. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 11 The Central Role of Economic Profit Why are the distinctions important? Example  Should Pudge Buffet stay in the farming business?

12. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 12 The Central Role of Economic Profit Why are the distinctions important? Assumptions  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

13. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 13 Revenue, Costs, and Profit Summary for Pudge TotalExplicitImplicitAccountingEconomicNormal revenuecostscostsprofitprofitprofit ($/year)($/year)($/year)($/year)($/year)($/year) 22,00010,00011,00012,0001,00011,000

14. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 14 The Central Role of Economic Profit 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?

15. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 15 The Central Role of Economic Profit Example 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

16. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 16 New Revenue, Costs, and Profit Summary for Pudge TotalExplicitImplicitAccountingEconomicNormal revenuecostscostsprofitprofitprofit ($/year)($/year)($/year)($/year)($/year)($/year) 20,0004,00017,00016,000-1,00017,000

17. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 17 The Central Role of Economic Profit A Review Accounting Profit = TR – explicit costs Economic Profit = TR – explicit and implicit costs Economic Profit = 0 when accounting profit = normal profit To remain in business in the long run, economic profits must be greater than or equal to 0 (zero).

18. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 18 The Invisible Hand Theory Two Functions of Price The rationing function of price  To distribute scarce goods to those consumers who value them most highly

19. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 19 The Invisible Hand Theory Two Functions of Price The allocative function of price  To direct resources away from overcrowded markets and toward markets that are underserved

20. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 20 The Invisible Hand Theory 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)

21. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 21 The Invisible Hand Theory 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.

22. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 22 Economic Profit in the Short Run in the Corn Market Quantity (millions of bushels/year) Price ($/bushel) S D 65 Quantity (1000s of bushels/year) Price ($/bushel) 1.20 Economic profit = $104,000/yr Market price of $2/bushel produces economic profits 2.00 Price 2.00 MC 130 ATC

23. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 23 1.50 Economic profit = $50,400/yr 1.50 Price 120 95 The Effect of Entry on Price and Economic Profit Quantity (millions of bushels/year) Price ($/bushel) S D 65 Quantity (1000s of bushels/year) Price ($/bushel) Economic profits attract firms, reducing prices and profits 2.00 MC 130 ATC S’

24. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 24 Equilibrium when Entry Ceases S Quantity (millions of bushels/year) Price ($/bushel) D 1.00 Quantity (1000s of bushels/year) Price ($/bushel) Price 90 115 Entry of firms continues until all firms earn a normal profit MC ATC 1.00

25. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 25 1.05 Economic loss = $21,000/year Prices below minimum ATC results in economic losses. A Short-Run Economic Loss in the Corn Market Quantity (millions of bushels/year) Price ($/bushel) Quantity (1000s of bushels/year) Price ($/bushel) 70 0.75 Price 90 ATC 0.75 MC S D 60

26. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 26 Equilibrium when Exit Ceases Quantity (millions of bushels/year) Price ($/bushel) 0.75 Quantity (1000s of bushels/year) Price ($/bushel) 90 0.75 90 ATC 0.75 MC 40 S’ Price 1.00 The departure of firms from the industry increases the market price S D 60

27. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 27 The Invisible Hand Theory Observations In the long-run, in a competitive market, all firms will tend to earn zero economic profits.

28. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 28 The Invisible Hand Theory Observations Zero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits.

29. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 29 The Invisible Hand Theory Observations The equilibrium principle (no cash on the table) predicts, when people confront an opportunity for gain they are almost always quick to exploit it.

30. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 30 Long-Run Equilibrium in a Corn Market with Constant Long-Run Average Cost Quantity (millions of bushels/year) Price ($/bushel) Quantity (1000s of bushels/year) Price ($/bushel) =1.00 D S =LAC LMC Price MC 90 ATC 1.00 Similar ATC curves allow the industry to supply any output at a price equal to minimum ATC.

31. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 31 The Invisible Hand Theory Two Attractive Features The market outcome is efficient in the long run.  P = MC  If output is increased: MC > MB.  If output is reduced: MC < MB.

32. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 32 The Invisible Hand Theory Two Attractive Features The market is fair.  The price the buyers pay is no higher than the cost incurred by sellers.  The cost includes a normal profit.

33. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 33 The Invisible Hand Theory Example What happens in a city with “too many” hair stylists and “too few” aerobics instructors?

34. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 34 Initial Equilibrium in the Markets for Haircuts Haircuts/day Price ($/haircut) Haircuts/day D MC H QHQH ATC H 15 S 50 Price ($/haircut)

35. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 35 Initial Equilibrium in the Markets for Aerobics Classes Classes/day Price ($/class) Classes/day QAQA D MC A ATC A 10 S 20 Price ($/class)

36. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 36 The Short-Run Effect of Demand Shifts in Two Markets Haircuts/day Price ($/haircut) Classes/day Price ($/class) S D 500 15 200 10 D S Assume: Long hair and physical fitness become popular. Price of haircuts fall the price of aerobics classes rise. 350 15 D’ 12 D’ 300

37. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 37 Economic Profit and Loss in the Short Run Haircuts/day MC H QHQH ATC H Price ($/haircut) Classes/day MC A QAQA ATC A Price ($/class) Q’ H 15.50 12 Q’ A 15 11 Economic loss Economic profit The decrease in demand for haircuts causes economic losses while the increase in demand for classes creates economic profits

38. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 38 The Invisible Hand Theory 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

39. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 39 The Invisible Hand Theory The Importance of Free Entry and Exit Free entry and exit must exist for the allocative function of price to operate

40. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 40 The Invisible Hand Theory The Importance of Free Entry and Exit Barriers to entry can be caused by legal constraints and unique market characteristics

41. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 41 The Invisible Hand Theory The Importance of Free Entry and Exit A barrier to exit can become a barrier to entry

42. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 42 Economic Rent Versus Economic Profit Important Note Economic profits attract resources that push economic profits toward zero.

43. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 43 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

44. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 44 Economic Rent Versus Economic Profit Example How much rent will a talented chef get?

45. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 45 Economic Rent Versus Economic Profit 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

46. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 46 Economic Rent Versus Economic Profit 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)

47. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 47 Economic Rent Versus Economic Profit Assume A talented chef  Earns $180,000 = $30,000 + $150,000  Reservation price = $30,000  Economic rent = $150,000 That the100 th restaurant earns a normal profit

48. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 48 Economic Rent Versus Economic Profit Question Why not pay the chef less and increase the economic profit for the restaurant?

49. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 49 The Invisible Hand in Action Key Concept Opportunities for private gain seldom remain unexploited for very long

50. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 50 The Invisible Hand in Action Economic Naturalist Why do supermarket lines tend to be roughly the same length? Why do all lanes on a crowded, multilane freeway move at about the same speed?

51. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 51 The Invisible Hand in Action The Invisible Hand and Cost-Saving Innovations In a competitive market  Firms are price takers  P = MC  Zero economic profits exist in the long run Question Why do these firms have an incentive to introduce cost-saving innovations?

52. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 52 The Invisible Hand in Action Example How do cost-saving innovations affect economic profit in the short run? In the long run?

53. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 53 The Invisible Hand in Action Assume 40 companies transport oil from the middle east to the U.S. The cost/trip, including normal profit, is $500,000 One company uses a new propeller that saves $20,000/trip

54. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 54 The Invisible Hand in Action Short Run No impact on price Economic profits for the company will increase $20,000/trip

55. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 55 The Invisible Hand in Action Long Run Other companies use the propeller Market supply increases and the price falls Zero economic profits after all firms have adopted the new propeller Any firm without the new propeller would have an economic loss of $20,000/trip

56. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 56 The Invisible Hand in Action Economic Naturalist Why do New York City taxicab medallions sell for more than $250,000?  Assume oAnnual cost of operating the cabs = $40,000 oTR/year = $60,000 oAnnual interest on savings = 8%

57. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 57 The Invisible Hand in Action Economic Naturalist Will the medallion owner earn an economic profit?  If the medallion is free, economic profit = $20,000/year

58. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 58 The Invisible Hand in Action Economic Naturalist The economic profit will attract entry into the taxi market.

59. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 59 The Invisible Hand in Action Economic Naturalist How much would you pay for a medallion?  $100,000 oForego $8,000 in interest oEarn $20,000

60. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 60 The Invisible Hand in Action Economic Naturalist How much would you pay for a medallion?  $250,000 oForego $20,000 in interest oEarn $20,000 oZero economic profit oEconomic rent = $20,000

61. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 61 The Invisible Hand in Action Economic Naturalist Why did major commercial airlines install piano bars on the upper decks of Boeing 747s in the 1970s?

62. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 62 The Invisible Hand in Action Economic Naturalist Regulated prices generated economic profits With regulated fares, competition could not drive down price Airlines added more flights on each route until economic profit equaled zero.

63. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 63 The Invisible Hand in Action Economic Naturalist Airlines engaged in “quality wars”: a piano bar, gourmet meals, etc. Intrastate carriers found price competition more efficient

64. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 64 The Invisible Hand in Action The Invisible Hand in Antipoverty Programs Example  How will an irrigation project affect the incomes of poor farmers?

65. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 65 The Invisible Hand in Action Assume An unskilled worker has two job choices  Textile worker for $8,000/yr  Renting land to grow rice oRent = $5,000/yr oNon-labor cost = $3,000/yr oTR = $16,000/yr oNet income = $8,000/yr  A state funded irrigation program will double output and not change the market price.

66. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 66 The Invisible Hand in Action Question What will be the impact of the irrigation program?  TR will increase to $32,000  Income will increase to $24,000  The demand for land will increase and the rent on the land will rise to $21,000  The land owners gain, not the farmers

67. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 67 The Invisible Hand in Action The Invisible Hand in the Stock Market Calculating the value of a share of stock  The price of a share of stock depends on oThe company’s accounting profit oThe market interest rate

68. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 68 The Invisible Hand in Action The Invisible Hand in the Stock Market Example  How much will a share of stock sell for? Assume Accounting profit = $1 million 1,000 shares of stock Annual interest rate = 5%

69. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 69 The Invisible Hand in Action The Invisible Hand in the Stock Market Question  How much will a share of stock sell for? Price/share Each share pays $1,000/year ($1 million/1,000) At 5% a $20,000 savings account pays $1,000 The stock price = $20,000

70. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 70 The Invisible Hand in Action Calculating the Present Value of Future Costs and Benefits Earnings received in the future are less valuable than earnings today. The time value of money  Money deposited today will grow in value over time

71. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 71 The Invisible Hand in Action Calculating the Present Value of Future Costs and Benefits Present Value (PV)  The amount that must be deposited today, at a given interest rate (r), to generate a given balance (M) at a specified time (T) in the future.

72. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 72 The Invisible Hand in Action Calculating the Present Value of Future Costs and Benefits Example  Deposit $100 @ r = 10% or 0.10  After 1 year o$100(1.10) = $110  After 2 years o$100(1.10)(1.10) = $100(1.10) 2 = $121

73. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 73 The Invisible Hand in Action Generally PV deposited today @ r will generate:  PV(1 + r) after 1 year  PV(1 + r) 2 after 2 years

74. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 74 The Invisible Hand in Action Example What is the value of a company today if it will earn its only accounting profit of $14,400 in two years?  PV of $14,400(M) = PV(1 + r) 2 or

75. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 75 The Invisible Hand in Action Example If r = 0.20, then

76. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 76 The Invisible Hand in Action Example If $10,000 is deposited today at 20%, it will equal ($10,000)(1.20) 2 = $14,400 in two years. The value of the company today is $10,000 at 20% interest rate.

77. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 77 The Invisible Hand in Action Calculating Present Value

78. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 78 The Invisible Hand in Action The Invisible Hand in the Stock Market Future profits are not certain. There is a market for information that can indicate future profits. This information influences stock prices.

79. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 79 The Invisible Hand in Action The Efficient Market Hypothesis The current price of a stock reflects all relevant information about its current and future earnings prospects.

80. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 80 The Invisible Hand in Action What do you think? Can you increase your profit in the stock market by using information from the mass media? Do stocks in well-managed companies perform better than those in poorly managed companies?

81. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 81 The Distinction Between and Equilibrium and a Social Optimum The equilibrium (no-cash-on-the-table) principle means that there are no unexploited opportunities in markets that are in equilibrium.

82. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 82 The Distinction Between and Equilibrium and a Social Optimum The market equilibrium does not imply that the resulting allocation is necessarily best from the point of view of society as a whole. The smart for one, dumb for all principle

83. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 83 The Distinction Between and Equilibrium and a Social Optimum Equilibrium will not be socially optimal when the cost and benefits for the individuals differ from society as a whole.

84. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8: The Quest for Profit and the Invisible Hand Slide 84 The Distinction Between and Equilibrium and a Social Optimum Economic Naturalist What do you think?  Are there “too many” smart people working as corporate earnings forecasters?

85. MBMC End of Chapter End of Chapter