Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-1 Chapter 9 The quest for profit and the invisible hand

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-2 The central role of economic profit According to Adam Smith –People are motivated by self-interest. –The goal of profit maximisation will serve society’s collective interest.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-3 The central role of economic profit (cont.) Three types of profit –Accounting profit: The difference between a firm’s total revenue and its explicit costs  Accounting profit = total revenue – explicit costs (payments for factors of production) –Economic profit: The difference between a firm’s total revenue and the sum of its explicit and implicit costs.  Economic profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners). –Normal profit: The difference between a business’s accounting profit and its economic profit. It is equal to the opportunity cost of the resources supplied to a business by its owners.  Normal profit = accounting profit – economic profit.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-4 The central role of economic profit (cont.) Calculating profit –Suppose a firm has the following:  TR [total revenue] = $  Explicit costs (salaries) = $ /year  Machinery and other equipment with a resale value of $1 million –Accounting profit  $ (TR) - $ (explicit costs) = $ –To calculate economic profits, assume  Annual interest on savings = 10% [Then the $1 million spent on equipment could have earned $ /year had it been invested.] –Economic profit  $ (TR) - $ (explicit cost) - $ (implicit cost) = $ –Normal profit  Accounting profit ($ /year) – Economic profit ($50 000/year) = $ /year

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-5 The three concepts of profit Total revenue Explicit costs Accounting profit Implicit costs Economic profit Explicit costs

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-6 The central role of economic profit Why are the distinctions important? –Example  Should Andy stay in the farming business?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-7 The central role of economic profit (cont.) Why are the distinctions important? –Assumptions  He is an apple grower with payments for land and equipment = $20 000/year.  He supplies only his labour which he values equally to managing a retail store for $30 000/year.  Except for pay, he is indifferent between the farm or the store.  Apples sell at a constant price and TR = $

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-8 The central role of economic profit (cont.) Why are the distinctions important? –Example  What is his accounting profit? His economic profit? His normal profit?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-9 Revenue, costs and profit summary for Andy’s apple orchard TotalExplicitImplicitAccountingEconomicNormal revenuecostscostsprofitprofitprofit ($/year)($/year)($/year)($/year)($/year)($/year)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-10 The central role of economic profit What would Andy’s economic profit be if TR = $ –Economic profit  TR (65 000) – explicit (20 000) and implicit costs (30 000) = -$ Question –Should Andy stay in farming?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-11 The central role of economic profit (cont.) Example –If Andy owned his own land, should he remain an orchardist? –Assume  Andy inherits the land.  The land can be rented for $6000/year.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-12 Revenue, costs and profit summary for Andy’s apple orchard TotalExplicitImplicitAccountingEconomicNormal revenuecostscostsprofitprofitprofit ($/year)($/year)($/year)($/year)($/year)($/year)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-13 The central role of economic profit Review –Economic profit = TR – explicit and implicit costs. –Accounting profit = TR – explicit costs. –Normal profit is the opportunity cost of the resources supplied by the owners of the firm.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-14 The central role of economic profit (cont.) Review –Economic profit = 0 when accounting profit is exactly equal to its normal profit. –To remain in business in the long run, economic profits must be greater than or equal to 0 (zero).

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-15 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. –The allocative function of price  To direct resources away from overcrowded markets and toward markets that are underserved.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-16 The invisible hand theory (cont.) 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).

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-17 The invisible hand theory (cont.) How firms respond to profits and losses –Markets with firms earning economic profits will attract resources. –Markets where firms are experiencing economic losses tend to lose resources.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-18 Economic profit in the short run in the apple market Quantity (millions of kg/year) Price ($/kg) S D 65 Quantity (1000s of kg/year) Price ($/kg) 1.20 Economic profit = $ /year Market price of $2/kg produces economic profits 2.00 Price 2.00 MC 130 ATC

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Economic profit = $50 400/year 1.50 Price The effect of entry of new growers on price and economic profit Quantity (millions of kg/year) Price ($/kg) S D 65 Quantity (1000s of kg/year) Price ($/kg) Economic profits attract firms, reducing prices and profits 2.00 MC 130 ATC S’

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-20 Equilibrium when entry of new growers ceases in the apple market S Quantity (millions of kg/year) Price ($/kg) D 1.00 Quantity (1000s of kg/year) Price ($/kg) Price Entry of firms continues until all firms earn a normal profit MC ATC 1.00

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Economic loss = $21 000/year Prices below minimum ATC result in economic losses. A short-run economic loss in the apple market Quantity (millions of kg/year) Price ($/kg) Quantity (1000s of kg/year) Price ($/kg) Price 90 ATC 0.75 MC S D 140

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-22 Equilibrium when cease exiting the apple market Quantity (millions of kg/year) Price ($/kg) Quantity (1000s of kg/year) Price ($/kg) ATC 0.75 MC 125 S’ Price 1.00 The departure of firms from the industry increases the market price S D

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-23 The invisible hand theory Observations –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 maximise economic profits. –The equilibrium principle (no cash on the table) predicts when people confront an opportunity for gain they are almost always quick to exploit it.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-24 The invisible hand theory (cont.) Long-run supply in a competitive market –Example  What is the long-run supply curve for apples?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-25 Long-run equilibrium in an apple market with constant long-run average cost Quantity (millions of kg/year) Price ($/kg) Quantity (1000s of kg/year) Price ($/kg) =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.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-26 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. –The market is fair.  The price the buyers pay is no higher than the cost incurred by sellers.  The cost includes a normal profit.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-27 The invisible hand at work Example –How has the invisible hand operated to make sure that we do not have ‘too many’ photo labs and ‘too few’ personal trainers?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-28 Initial equilibrium in the markets for film processing Film processed/day Price ($/film) Film processed/day D MC F QFQF ATC F 15 S 500 Price ($/film)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-29 Initial equilibrium in the markets for training sessions Training sessions/day Price ($/session) Training sessions/day QTQT D MC T ATC T 10 S 200 Price ($/session)

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-30 The short-run effect of demand shifts in two markets Films processed/day Price ($/film) Training sessions/day Price ($/session) S D D S D’ 12 D’ 300

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-31 Economic profit and loss in the short run Film processed/day MC F QFQF ATC F Price ($/film) Training sessions/day MC T QTQT ATC T Price ($/session) Q’ F Q’ T Economic loss Economic profit The decrease in demand for film processing causes economic losses, while the increase in demand for training session creates economic profits.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-32 The invisible hand theory Responses to the change in demand for film processing and personal trainers –Economic loss for photo labs will  Reduce the number of films processed.  Increase the price until zero economic profits occur. The importance of free entry and exit –Free entry and exit must exist for the allocative function of price to operate. –Forces that inhibit firms from entering new market are called barriers to entry. –Barriers to entry can be caused by legal constraints and unique market characteristics. –A barrier to exit can become a barrier to entry.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-33 Economic rent versus economic profit Important note –Economic profits attract resources that push economic profits toward zero. Economic rent –That part of the 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. Example –How much rent will a talented chef get?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-34 Economic rent versus economic profit (cont.) Assume –A community with 100 restaurants. –99 restaurants employ chefs with normal ability for $50 000/year (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. –TR at the each of the 99 restaurants is $ , which yields a normal profit. –TR at the 100th restaurant is $ (50% more).

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-35 Economic rent versus economic profit (cont.) Assume –A talented chef  Earns $ = $ $  Reservation price = $  Economic rent = $ –That the100th restaurant earns a normal profit. Question –Why not pay the chef less and increase the economic profit for the restaurant?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-36 The invisible hand in action Key concept –Opportunities for private gain seldom remain unexploited for very long. Thinking as an economist –Why do supermarket checkout queues all tend to be roughly the same length? The invisible hand in everyday life –The ‘no cash on the table’ principle provides opportunities to earn economic profits in cash and more desirable outcomes.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-37 The invisible hand in action (cont.) 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? Example –Why do tomato growers develop cost-saving innovations when the market is highly competitive and they know they will always earn a zero economic profit in the long run?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-38 The invisible hand in action (cont.) Assume –40 firms grow tomatoes for the fresh produce market using hydroponics in Victoria. –The value of a single grower’s annual crop, including a normal profit, is $ –The grower uses a fully automatic computer system to monitor and control irrigation that saves about $5000 a crop.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-39 The invisible hand in action (cont.) Short run –No impact on price. –Economic profits for the company will increase $5000 a crop. Long run –Other companies use the automatic computer system. –Market supply increases and the price falls. –Zero economic profits after all firms have adopted the new automatic computer system. –Any firm without a computer system would have an economic loss of $5000 a crop.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-40 The invisible hand in action (cont.) The invisible hand and government regulation –Economic profit and economic loss guide resource movements in regulated and unregulated markets.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-41 The invisible hand in action (cont.) Thinking as an economist –Why do taxi licences sell for between $ and $ in some Australian capital cities?  Assume Annual cost of operating the cabs = $ TR/year = $ Annual interest on savings = 8% –Will the owner of a licence earn an economic profit?  If the licence is free, economic profit = $20 000/year. –The economic profit will attract entry into the taxi market.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-42 The invisible hand in action (cont.) Thinking as an economist –How much would you pay for a taxi licence?  $ Forego $8000 in interest Earn $20 000

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-43 The invisible hand in action (cont.) Thinking as an economist –How much would you pay for a taxi licence?  $ Forego $ in interest Earn $ Zero economic profit Economic rent = $20 000

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-44 The invisible hand in action (cont.) The invisible hand in antipoverty programs –Example  How will an irrigation project affect the incomes of poor tenant farmers in a developing country?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-45 The invisible hand in action (cont.) Assume –An unskilled worker has two job choices  Textile worker for $8000 a year  Renting land to grow rice Rent = $5000 per year Non-labour cost = $3000 a year TR = $ a year Net income = $8000 a year  A state-funded irrigation program will double output and not change the market price.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-46 The invisible hand in action (cont.) Question –What will be the impact of the irrigation program?  TR will increase to $  Income will increase to $  The demand for land will increase and the rent on the land will rise to $  The landowners gain, not the farmers.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-47 The invisible hand in action (cont.) The invisible hand in the stock market –Calculating the value of a share of stock  The price of a share of stock depends on the company’s accounting profit the market interest rate.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-48 The invisible hand in action (cont.) The invisible hand in the stock market –Example  How much will a share of stock sell for? Assume –Accounting profit = $1 million –1000 shares of stock –Annual interest rate = 5%

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-49 The invisible hand in action (cont.) The invisible hand in the stock market –Question  How much will a share of stock sell for? Price/share –Each share pays $1000/year –($1 million/1000) –At 5%, a $ savings account pays $1000 –The stock price = $20 000

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-50 The invisible hand in action (cont.) 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.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-51 The invisible hand in action (cont.) 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.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-52 The invisible hand in action (cont.) Calculating the present value of future costs and benefits –Example  Deposit r = 10% or 0.10  After 1 year $100(1.10) = $110  After 2 years $100(1.10)(1.10) = $100(1.10)2 = $121

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-53 The invisible hand in action (cont.) Generally –PV deposited r will generate:  PV(1 + r) after 1 year  PV(1 + r)2 after 2 years.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-54 The invisible hand in action (cont.) Example –What is the value of a company today if it will earn an accounting profit of $ in two years?  PV of $14 400(M) = PV(1 + r)2 or

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-55 The invisible hand in action (cont.) Example –If r = 0.20, then

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-56 The invisible hand in action (cont.) Example –If $ is deposited today at 20%, it will equal ($10 000)(1.20)2 = $ in two years. –The value of the company today is $ at 20% interest rate.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-57 The invisible hand in action (cont.) Calculating present value

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-58 The invisible hand in action (cont.) 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. The efficient market hypothesis –The theory that the current price of shares in a company reflects all relevant information about its current and future earnings prospects.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-59 The invisible hand in action (cont.) 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?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-60 The invisible hand in action (cont.) Thinking as an economist –What do you think?  Why isn’t a share portfolio consisting of Australasia’s ‘best-managed companies’ necessarily a good investment?

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-61 ‘Smart for one, dumb for the group’ revisited The equilibrium (no cash on the table) principle means that there are no unexploited opportunities in markets that are in equilibrium.

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9-62 The distinction between an 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. Equilibrium will not be socially optimal when the cost and benefits for the individual differ from those for society as a whole.