Types of profit The invisible hand Today: Some fundamental ideas that are important to every economist

Applications of supply and demand Today, we will continue to apply what we have learned about supply and demand We will also introduce various ideas about profits and see another way to reach market equilibrium

Assumptions for today’s lecture Property rights Free entry and exit Many potential sellers Many potential buyers

Questions of the day Why are TV repair shops harder to find? Why has Las Vegas added many expensive hotels on its famous strip?

Answer The invisible hand We will see how much profit is “enough” for firms to stay in business When profits exceed this, other firms will enter When profits are lower than this, firms will leave

Today We will compare different types of profits We will find the point where marginal benefit of consumption equals the marginal cost of production This will give us the efficient outcome

Business and profit Each business has revenues and costs The difference between these is profit Profits that you typically hear about are what are called “accounting profits” These profits do not account for opportunity costs

From total revenue to profits Total revenue = Explicit costs + Accounting Profit = Explicit costs + Normal Profit + Economic Profit Normal profit is an implicit cost Defined as the “the opportunity cost of the resources supplied by a firm’s owners” (p. 219)

Example: Jill Jill the plumber She could either run a home business or work next door at AAA Plumbing at $30 per hour Either way: 40 hours / week 50 weeks / year

Jill’s potential home business If she works at home, she assumes that her annual revenues and costs will be as follows Total revenue: $200,000 Explicit costs: $160,000

What should Jill do? Jill should run a home business if her economic profit is positive Economic profit is total revenue minus all costs (including opportunity cost of not working) Economic profit = $200,000 – ($160,000 + $60,000) = – $20,000

Jill’s Conclusion Jill should work at AAA plumbing, since her economic profit of working at home is negative Notice that the accounting profit is positive if Jill opens her business, but she can earn more as a plumber

Next: Long-run equilibrium Remember that a firm’s short-run equilibrium will occur when MB (which is price in this case) equals MC Exception: Shut-down condition Now we will see how we get long-run equilibrium Notice in the long run there are no fixed costs

For this discussion Assume that costs include implicit costs Thus, we are calculating economic profit Equilibrium occurs when economic profit is zero

Example: Start at supply S Positive profits, since P > ATC Market supplyFirm supply

What happens when economic profits are positive? New firms enter the industry Supply shifts to the right Market price decreases Market quantity increases

What else happens?

What happens to the firm from the price drop? Each firm produces less, since some units produced are no longer profitable Profits fall, since each unit produced has lower profit than before Economic profits are often driven to zero in the long run ATC is minimized when long-run profits are zero if each producer has the same ATC curve

Prediction: Supply continues to shift until economic profits are 0

Why do we predict a zero profit in the long run? If economic profits are positive in a market, some firms will be able to make more economic profits in this market than in other markets If economic profits are negative in a market, some firms already producing in this market can make more economic profit producing another good

Back to our questions Why are TV repair shops harder to find? Why has Las Vegas added many expensive hotels on its famous strip?

Why are TV repair shops harder to find? When televisions were first produced, it was a major purchase When the TV broke, fixing it was usually a much lower cost than replacing it

Why are TV repair shops harder to find? Today, some flat screen TVs will cost you less than a dinner for 2 at an expensive restaurant Example: $140 for a 20” flat-screen at Target (checked 1/15/08) Repairing a TV today may cost more than replacing it

Why are TV repair shops harder to find? As the price of TVs (relative to yearly income) falls, fewer people will have their TVs repaired when it breaks Fewer repairs  Lower economic profit Whenever economic profit becomes negative, some firms will not renew their leases

Las Vegas Mega resorts In recent years, many large hotels have opened on the Las Vegas strip Bellagio Mandalay Bay Wynn Las Vegas MGM Grand New York/New York

Why all of the new hotels? Las Vegas is not only a gambling hotspot, but also has become an entertainment destination Shopping for any budget is available on the strip Some dining choices are world class Pinot Brasserie at the Venetian 

Example: Caesars Palace Billion dollar expansion announced July 2007 Shopping and entertainment options The Forum Shops Bette Midler Elton John Jerry Seinfeld

Some Las Vegas facts From USA Today, 2/14/ million visitors in ,600 hotel rooms (expected to grow to 171,000 by 2010) Hotel occupancy of 89.7% Hotel inventory stayed about the same in 2006 Average room price increased by 16% in 2006

What happened? In 2006, the Stardust closed to make way for a new resort, Echelon Place The Boardwalk also closed to make way for new projects Off-strip hotels of (arguably) comparable quality opened in 2006 Increased demand for hotel rooms and short- run decrease in supply forced prices to go up by 16% in Las Vegas

What is happening in Las Vegas? Short-run positive economic profits are currently likely in Las Vegas Once new resorts open, economic profits will likely converge toward zero Depending on demand, prices for hotel rooms may decline when new hotels open

Summary Without government intervention, free entry and exit can lead to a long run of zero economic profit Opportunity cost is important in calculating economic profit