1. Chapter 8: The Invisible Hand in Action
In a free market, individuals act in their own interests
Utility maximization
Profit maximization
So, how, in a free market, are limited resources allocated efficiently?

2. Accounting Profit vs. Economic Profit
Accounting profit = total revenue – explicit costs
Explicit costs are payments firms make to purchase
Resources (labor, land, etc.) and
Products from other firms
Economic profit = total revenue – explicit costs – implicit costs
Also called excess profit
Implicit costs are the opportunity cost of the resources supplied by the firm's owners
Normal profit = accounting profit - economic profit

3. Three Kinds of Profit Total Revenue Explicit Costs Explicit Costs
Total Revenue = Explicit Costs + Accounting Profit
Explicit
Costs
Explicit
Costs
Accounting
Profit
Economic Profit = Accounting Profit – Normal Profit
Normal Profit
Economic
Profit

4. Economic Profits Guide Decisions
Pudge Buffet's decision: keep farming or quit?
Farming
Explicit farm costs are $10,000
Total revenue is $22,000
Alternative job
Earn $11,000 per year working retail
Calculate accounting and economic profits of farming
Accounting Profit
Economic Profit
Normal Profit
$12,000
$1,000
$11,000

5. Economic Profits Guide Decisions
What changes if Pudge inherits the land?
His explicit costs decrease by the rent of the land ($6000)
Now he could choose to rent out the land for $6000
Total Revenue
Explicit Costs
Implicit Costs
$22,000
$4,000
$17,000
Accounting Profit
Economic Profit
Normal Profit
$18,000
$1,000
$17,000
Pudge should stick with farming

6. Two Functions of Price
Rationing function of price distributes scarce goods to the consumers who value them most highly
Allocative function of price directs resources away from overcrowded markets to markets that are underserved
Invisible Hand Theory is that actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resource
Articulated by Adam Smith in eighteenth century

7. Response to Economic Profits
Markets with excess profits attract resources P 2
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
1.20
Typical Corn Farm
Quantity (M of bushels/year) S D 65
Corn Industry
Economic Profit

8. Shrinking Economic Profits
Supply increases P
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
Typical Corn Farm 2
Quantity (M of bushels/year) S D 65
Corn Industry
Economic Profit S'
1.50 95
120

9. Market Equilibrium Zero economic profits P
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
Typical Corn Farm 2
Quantity (M of bushels/year) S D 65
Corn Industry S'
1.50
115 1
S" 90

10. Economic Losses Resources leave 1.05 Quantity (M of bushels/year)
Quantity (000s of bushels/year) 70
0.75 P 90
ATC MC S D 60
Price $/bu

11. Market Equilibrium No economic losses Quantity (M of bushels/year)
Quantity (000s of bushels/year) 70
0.75 P 90
ATC MC S D 60
Price $/bu 1 S' 40

12. The Ubiquitous Power of the Invisible Hand
Haircut market vs. aerobics market
Price ($/haircut)
Haircuts/day
Classes/day
Price ($/class) S D
500 15
200 10
350 D' 12
300
Haircut Market
Aerobics Market

13. The Ubiquitous Power of the Invisible Hand
The invisible hand and the cost-saving innovations
The invisible hand and the integrated labor market of the European Union
The invisible hand and the stock market