1. The Quest for Profit and
The Invisible Hand

2. Adam Smith Self-interest moves the economy
Consumers seek to maximize utility from purchases
Firms seek to maximize profit from production
It serves society’s interest
It is due to profit opportunities
With it, the entrepreneur “intends only his own gain,” he is “led by an invisible hand to promote an end which was no part of his intentions

3. Adam Smith Self interest = “greed”?
With it, the entrepreneur and consumer “intends only his own gain,” yet she is “led by an invisible hand to promote an end which was no part of her intentions

4. Invisible Hand Invisible Hand Theory
The actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources
I.E., markets are efficient

5. Equilibrium
When markets reach equilibrium there is no more “cash on the table”
It says that all opportunities for gain are exhausted
It implies that the prices of resources privately owned will tend to reflect their economic value
It implies those making profits are first to act on profit making opportunities

6. Markets and Social Optimum
Market equilibrium does not mean the resulting allocation of resources is the best one viewed from society’s perspective
Smart for one, dumb for all
For example, some market activities that produce profits for some may produce pollution (externalities) for many

7. Functions of Price Rationing function of price
Prices distribute scarce goods to those consumers who value them most highly
Allocative function of price
Prices direct resources away from overcrowded markets and toward markets that are underserved

8. Functions of Price
Where price is relative to average total costs of production (ATC) will determine firm profits and serve to allocate firm resources.
P > ATC => positive profits
P < ATC => negative profits
Changes in price may therefore reallocate resources.

9. 2 Types of Costs and 2 Types of Profit
Explicit Costs
Actual payments made to factors of production and other suppliers
Implicit Costs
All the opportunity costs of the resources supplied by the firm’s owners
Eg: opportunity cost of owner’s time
Eg: opportunity cost of owner-invested funds

10. Three Types of Profit Accounting Profit Economic Profit Normal Profit
Total Revenue – Explicit Costs
Economic Profit
Total Revenue – Explicit Costs – Implicit Costs
Normal Profit
The difference between accounting profit and economic profit
The opportunity cost of the resources
How much accounting profit is needed for econ profit to be exactly = 0?
Economic Loss
An economic profit less than zero

11. Figure 8.1 The Difference Between Accounting Profit and Economic Profit

12. The Difference Between Accounting Profit and Economic Profit
Revenue – Acct Costs = Acct Profit
Revenue – Econ Costs = Econ Profit
Revenue – Explicit Costs = Acct Profit
Revenue – (Explicit + Implicit costs) = Econ Profit
Acct Profit – Implicit Costs = Econ Profit
If Acct Profit exactly = Implicit Costs => Econ Profit = 0, and the firm is said to be earning a “normal profit”

13. Econ vs. Acct Profits
True or False: Economic profits are always less than or equal to accounting profits.
 TRUE
If some implicit costs exist  economic cost > accounting cost
 Economic profit < accounting profit
(ie: we are subtracting more costs from the same revenue)

14. To Farm or Not To Farm? Pudge Buffet sells corn
his revenues are $22,000/yr
he pays $10,000/yr in explicit costs
he could earn $11,000 at another job he likes equally well (implicit costs)
Pudge’s economic profit is
$22,000 - $10,000 - $11,000 = $1,000
Earning more than a normal profit

15. Example:
After graduation from the CSB with a degree in economics, you face the following job choice:
Option 1: IBM in RTP Salary = $50K/year
Option 2: Suntan shop in Key Largo Salary = $15K/year
If you choose option 2, you have to drain your $10,000 savings to start the business. Assume that you could have earned 10% on that money.

16. Example continued Suppose you choose option 2… 1st year analysis:
Revenue = $50,000 Costs of inventory = $8,000
Labor expenses = $15,000
Rent = $12,000
acounting economic
- inventory - inventory
- rent - rent
- wages for worker - wages for worker
- opp cost of Labor ($50k)
- opp cost of funds = $1000
 the normal rate of return on capital.

17. Example continued Accounting profit = 50 – 8 – 15 – 12 = 15
Economic profit
= 50 – 8 – 15 – 12 – 50 – 1 = -36
Earning less than a normal profit
How much is a normal profit for this firm?
Should this firm exit this industry in the long-run?

18. Market Forces and Economic Profit
Positive Economic Profit means the firm (owner) is more than covering opp costs
Doing better than the next best alternative
Price must be higher than ATC
Firms enter this industry
Supply increases
Price falls
Profits fall

19. Market Forces and Economic Profit
Negative Economic Profit means the firm (owner) is not covering opp costs
Doing worst than the next best alternative
Price must be below ATC
Firms exit this industry
Supply decreases
Price rises
Losses fall
Zero profit tendency of competitive markets

20. Fig. 8.2 The Effect of Economic Profit on Entry

21. Fig. 8.3 The Effect of Economic Losses on Exit

22. Free Entry and Exit
The implications of The Invisible Hand Theory depend critically on freedom of firms to enter and exit
Barrier to entry
Any force that prevents firms from entering a new market
Economic (e.g., large scale cost advantages, resource ownership)
Legal, (e.g., copyright laws, patents)
Natural (e.g., product compatibility)
Allows price to be higher than the opportunity costs of production

23. The Invisible Hand Operates
Even in regulated markets, resources flow in response to profit and loss signals
Misunderstanding the logic of the invisible hand can lead to inefficient government regulation and programs

24. Economic Rent Economic Rent
Part of the payment for a factor of production that exceeds the owner’s reservation price
Reservation price: The price below which the owner would not supply the factor
Economic rent accrues to inputs that cannot be replicated easily

25. Cost-Saving Innovations
Firms that develop and introduce cost-saving innovations
Reap economic profits in the short run
Supply curves shift right
Prices fall
Firms that do not use the new technology will earn economic losses
Competition assures that the cost savings is passed along to consumers