1. 1 Frank & Bernanke 3 rd edition, 2007 Ch. 8: Ch. 8: The Quest for Profit and the Invisible Hand

2. 2 Three Types of Profit Accounting Profit = total revenue – explicit costs (payments for factors of production) Accounting Profit = total revenue – explicit costs (payments for factors of production) Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners) Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners) Normal Profit = accounting profit – economic profit = opportunity cost of owners’ Normal Profit = accounting profit – economic profit = opportunity cost of owners’

3. 3 Calculating Profit Suppose a firm has the following: Suppose a firm has the following: Total Revenue (TR) = $400,000 Total Revenue (TR) = $400,000 Explicit costs (salaries) = $250,000/yr Explicit costs (salaries) = $250,000/yr Machinery and other equipment with a resale value of $1 million Machinery and other equipment with a resale value of $1 million

4. 4 Profits Accounting Profit Accounting Profit $400,000(TR) - $250,000 (explicit costs) = $150,000 $400,000(TR) - $250,000 (explicit costs) = $150,000 To calculate economic profits, assume To calculate economic profits, assume Annual interest on savings = 10% Annual interest on savings = 10% [Then the $1 million spent on equipment could have earned $100,000/yr had it been invested] [Then the $1 million spent on equipment could have earned $100,000/yr had it been invested] Economic Profit Economic Profit $400,000 (TR) - $250,000 (explicit cost) - $100,000 (implicit cost) = $50,000 $400,000 (TR) - $250,000 (explicit cost) - $100,000 (implicit cost) = $50,000 Normal Profit Normal Profit Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr Accounting Profit ($150,000/yr) – Economic Profit ($50,000/yr) = $100,000/yr

5. 5 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

6. 6 Should Buffet stay in the farming? He supplies only his labor which he values equally to managing a retail store for $11,000/yr He supplies only his labor which he values equally to managing a retail store for $11,000/yr He is a corn farmer with payments for land and equipment = $10,000/yr He is a corn farmer with payments for land and equipment = $10,000/yr Except for pay, he is indifferent between the farm or the store Except for pay, he is indifferent between the farm or the store Corn sells at a constant price and TR = $22,000 Corn sells at a constant price and TR = $22,000

7. 7 Revenue, Costs, and Profit Total ExplicitImplicit Accounting EconomicNormal revenue costs costs profit profitprofit 22,00010,000 11,000 12,000 1,000 11,000

8. 8 Should Pudge stay in farming? What would Pudge’s economic profit be if TR = $20,000 What would Pudge’s economic profit be if TR = $20,000 Economic profit Economic profit TR (20,000) – explicit (10,000) and implicit costs (11,000) = -$1,000 TR (20,000) – explicit (10,000) and implicit costs (11,000) = -$1,000

9. 9 If Pudge owned his own land, should he stay in farming? Pudge inherits the land Pudge inherits the land The land can be rented for $6,000/yr The land can be rented for $6,000/yr TotalExplicitImplicitAccountingEconomicNormal revenuecostscostsprofitprofitprofit ($/year)($/year)($/year)($/year)($/year)($/year) 20,0004,00017,00016,000-1,00017,000

10. 10 Review Accounting Profit = TR – explicit costs Accounting Profit = TR – explicit costs Economic Profit = TR – explicit and implicit costs Economic Profit = TR – explicit and implicit costs Economic Profit = 0 when accounting profit = normal profit 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). To remain in business in the long run, economic profits must be greater than or equal to 0 (zero).

11. 11 The Invisible Hand Theory The rationing function of price The rationing function of price To distribute scarce goods to those consumers who value them most highly To distribute scarce goods to those consumers who value them most highly The allocative function of price The allocative function of price To direct resources away from overcrowded markets and toward markets that are underserved To direct resources away from overcrowded markets and toward markets that are underserved

12. 12 Profits and Losses Would Ensure That supplies within a market would be distributed efficiently (rationing function) 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) Resources would be allocated across markets to produce the most efficient possible mix of goods and services (allocative function)

13. 13 Responses to Profits and Losses Markets with firms earning economic profits will attract resources. Markets with firms earning economic profits will attract resources. Markets where firms are experiencing economic losses tend to lose resources. Markets where firms are experiencing economic losses tend to lose resources.

14. 14 1.20 Economic profit = $104,000/yr Market price of $2/bushel produces economic profits 2.00 Price 2.00 Economic Profit in the Short Run in the Corn Market Quantity (millions of bushels/year) Price ($/bushel) S D 65 Quantity (1000s of bushels/year) Price ($/bushel) MC 130 ATC

15. 15 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’

16. 16 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

17. 17 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

18. 18 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

19. 19 The Invisible Hand Theory In the long-run, in a competitive market, all firms will tend to earn zero economic profits. 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 maximize economic profits. Zero economic profits are the consequence of price movements caused by the entry and exit of firms trying to maximize economic profits.

20. 20 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.

21. 21 The Invisible Hand Theory The market outcome is efficient in the long run. The market outcome is efficient in the long run. P = MC P = MC If output is increased: MC > MB. If output is increased: MC > MB. If output is reduced: MC < MB If output is reduced: MC < MB The market is fair. The market is fair. The price the buyers pay is no higher than the cost incurred by sellers. The price the buyers pay is no higher than the cost incurred by sellers. The cost includes a normal profit. The cost includes a normal profit.

22. 22 The Invisible Hand Theory What happens in a city with “too many” hair stylists and “too few” aerobics instructors? What happens in a city with “too many” hair stylists and “too few” aerobics instructors? Responses to the change in demand for stylists and aerobics instructors Responses to the change in demand for stylists and aerobics instructors Economic loss for stylists will Economic loss for stylists will Reduce the supply of stylists Reduce the supply of stylists Increase the price until zero economic profits occur Increase the price until zero economic profits occur

23. 23 Initial Equilibrium in the Markets for Haircuts Haircuts/day Price ($/haircut) Haircuts/day D MC H QHQH ATC H 15 S 50 Price ($/haircut)

24. 24 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)

25. 25 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

26. 26 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

27. 27 The Importance of Free Entry and Exit Free entry and exit must exist for the allocative function of price to operate Free entry and exit must exist for the allocative function of price to operate Barriers to entry can be caused by legal constraints and unique market characteristics Barriers to entry can be caused by legal constraints and unique market characteristics Economic profits attract resources that push economic profits toward zero. Economic profits attract resources that push economic profits toward zero.

28. 28 Economic Rent Versus Economic Profit Economic Rent Economic Rent That part of a payment for a factor of production that exceeds the owner’s reservation price 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 Market forces will not push economic rent to zero because inputs cannot be replicated easily

29. 29 Economic Rent Versus Economic Profit Assume Assume A community with 100 restaurants A community with 100 restaurants 99 restaurants employ chefs with normal ability for $30,000/yr (the same amount they could earn elsewhere) 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 The 100 th restaurant employs a talented chef and customers are willing to pay 50% more for their meals

30. 30 Economic Rent Versus Economic Profit TR at the each of the 99 restaurants is $300,000, which yields a normal profit 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) TR at the 100 th restaurant is $450,000 (50% more) A talented chef A talented chef Earns $180,000 = $30,000 + $150,000 Earns $180,000 = $30,000 + $150,000 Reservation price = $30,000 Reservation price = $30,000 Economic rent = $150,000 Economic rent = $150,000 The100 th restaurant earns a normal profit The100 th restaurant earns a normal profit

31. 31 Question Why not pay the chef less and increase the economic profit for the restaurant? Why not pay the chef less and increase the economic profit for the restaurant? Key Concept Opportunities for private gain seldom remain unexploited for very long 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?

32. 32 The Invisible Hand in Action The Invisible Hand and Cost-Saving Innovations The Invisible Hand and Cost-Saving Innovations In a competitive market In a competitive market Firms are price takers Firms are price takers P = MC P = MC Zero economic profits exist in the long run Zero economic profits exist in the long run Question Question Why do these firms have an incentive to introduce cost-saving innovations? Why do these firms have an incentive to introduce cost-saving innovations?

33. 33 The Invisible Hand in Action 40 companies transport oil from the Middle East to the U.S. 40 companies transport oil from the Middle East to the U.S. The cost/trip, including normal profit, is $500,000 The cost/trip, including normal profit, is $500,000 One company uses a new propeller that saves $20,000/trip One company uses a new propeller that saves $20,000/trip Short Run Short Run No impact on price No impact on price Economic profits for the company will increase $20,000/trip Economic profits for the company will increase $20,000/trip

34. 34 The Invisible Hand in Action Long Run Long Run Other companies use the propeller Other companies use the propeller Market supply increases and the price falls Market supply increases and the price falls Zero economic profits after all firms have adopted the new propeller 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 Any firm without the new propeller would have an economic loss of $20,000/trip

35. 35 NYC Taxi Medallions Annual cost of operating the cabs = $40,000 Annual cost of operating the cabs = $40,000 TR/year = $60,000 TR/year = $60,000 Annual interest on savings = 6% Annual interest on savings = 6% If the medallion is free, economic profit = $20,000/year If the medallion is free, economic profit = $20,000/year The economic profit will attract entry into the taxi market. The economic profit will attract entry into the taxi market. If the medallion is $100,000 If the medallion is $100,000 Forego $6,000 in interest Forego $6,000 in interest Earn $20,000 Earn $20,000

36. 36 How much would you pay for a medallion? $333,333 $333,333 Forego $20,000 in interest Forego $20,000 in interest Earn $20,000 Earn $20,000 Zero economic profit Zero economic profit

37. 37 Why did major commercial airlines install piano bars on the upper decks of Boeing 747s in the 1970s? Regulated prices generated economic profits Regulated prices generated economic profits With regulated fares, competition could not drive down price With regulated fares, competition could not drive down price Airlines added more flights on each route until economic profit equaled zero. Airlines added more flights on each route until economic profit equaled zero. Airlines engaged in “quality wars”: a piano bar, gourmet meals, etc. Airlines engaged in “quality wars”: a piano bar, gourmet meals, etc. Intrastate carriers found price competition more efficient Intrastate carriers found price competition more efficient

38. 38 Present Value of a Permanent Annual Payment How much money would we have to put in a bank to generate annual interest earnings of M dollars? How much money would we have to put in a bank to generate annual interest earnings of M dollars? Assume Assume Annual interest rate (r) = 4% or.04 Annual interest rate (r) = 4% or.04 Present Value (PV) x.04/yr = $20,000/yr Present Value (PV) x.04/yr = $20,000/yr PV = M/r PV = M/r PV = $20,000/.04 = $500,000 PV = $20,000/.04 = $500,000

39. 39 Invisible Hand in Antipoverty Programs How will an irrigation project affect the incomes of poor farmers? How will an irrigation project affect the incomes of poor farmers? An unskilled worker has two job choices An unskilled worker has two job choices Textile worker for $8,000/yr Textile worker for $8,000/yr Renting land to grow rice Renting land to grow rice Rent = $5,000/yr Rent = $5,000/yr Non-labor cost = $3,000/yr Non-labor cost = $3,000/yr TR = $16,000/yr TR = $16,000/yr Net income = $8,000/yr Net income = $8,000/yr A state funded irrigation program will double output and not change the market price. A state funded irrigation program will double output and not change the market price.

40. 40 Impact of the Irrigation Program TR will increase to $32,000 TR will increase to $32,000 Income will increase to $24,000 Income will increase to $24,000 The demand for land will increase and the rent on the land will rise to $21,000 The demand for land will increase and the rent on the land will rise to $21,000 The land owners gain, not the farmers The land owners gain, not the farmers

41. 41 Stock Market How much will a share of stock sell for? How much will a share of stock sell for? Accounting profit = $1 million Accounting profit = $1 million 1,000 shares of stock 1,000 shares of stock Annual interest rate = 5% Annual interest rate = 5% Each share pays $1,000/year ($1 million/1,000) Each share pays $1,000/year ($1 million/1,000) At 5% a $20,000 savings account pays $1,000 At 5% a $20,000 savings account pays $1,000 The stock price = $20,000 The stock price = $20,000

42. 42 Present Value of Future Costs and Benefits Earnings received in the future are less valuable than earnings today. Earnings received in the future are less valuable than earnings today. The time value of money The time value of money Money deposited today will grow in value over time Money deposited today will grow in value over time Example Example Deposit $100 @ r = 10% or 0.10 Deposit $100 @ r = 10% or 0.10 After 1 year After 1 year $100(1.10) = $110 $100(1.10) = $110 After 2 years After 2 years $100(1.10)(1.10) = $100(1.10) 2 = $121 $100(1.10)(1.10) = $100(1.10) 2 = $121

43. 43 Present Value PV deposited today @ r will generate: PV deposited today @ r will generate: PV(1 + r) after 1 year PV(1 + r) after 1 year PV(1 + r) 2 after 2 years PV(1 + r) 2 after 2 years Example Example What is the value of a company today if it will earn its only accounting profit of $14,400 in two years? 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 PV of $14,400(M) = PV(1 + r) 2 or

44. 44 Present Value If $10,000 is deposited today at 20%, it will equal ($10,000)(1.20) 2 = $14,400 in two years. 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. The value of the company today is $10,000 at 20% interest rate.

45. 45 Calculating Present Value Stock Market Future profits are not certain. There is a market for information that can indicate future profits. This information influences stock prices.

46. 46 Efficient Market Hypothesis The current price of a stock reflects all relevant information about its current and future earnings prospects. The current price of a stock reflects all relevant information about its current and future earnings prospects. Can you increase your profit in the stock market by using information from the mass media? 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? Do stocks in well-managed companies perform better than those in poorly managed companies?

47. 47 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 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 The smart for one, dumb for all principle Equilibrium will not be socially optimal when the cost and benefits for the individuals differ from society as a whole. Equilibrium will not be socially optimal when the cost and benefits for the individuals differ from society as a whole.