11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 8: Ch. 8: The Quest for Profit and the Invisible Hand

22

Three Types of ProfitThree Types of Profit

Accounting Profit = total revenue – explicit Accounting Profit = total revenue – explicit costs (payments for factors of production)costs (payments for factors of production)

Economic Profit = total revenue – explicit Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of costs – implicit costs (opportunity cost of the resources supplied by the firm’s the resources supplied by the firm’s owners)owners)

Normal Profit = accounting profit – Normal Profit = accounting profit – economic profit = opportunity cost of economic profit = opportunity cost of owners’ owners’

33

Calculating ProfitCalculating Profit

Suppose a firm has the following: Suppose a firm has the following: Total Revenue (Total Revenue (TR)TR) = $400,000 = $400,000Explicit costs (salaries) = $250,000/yrExplicit costs (salaries) = $250,000/yrMachinery and other equipment with a resale Machinery and other equipment with a resale

value of $1 millionvalue of $1 million

44

ProfitsProfits

Accounting Profit Accounting Profit $400,000($400,000(TRTR) - $250,000 (explicit costs) = $150,000) - $250,000 (explicit costs) = $150,000

To calculate economic profits, assumeTo calculate economic profits, assume Annual interest on savings = 10%Annual interest on savings = 10%

[Then the $1 million spent on equipment could have earned [Then the $1 million spent on equipment could have earned $100,000/yr had it been invested]$100,000/yr had it been invested]

Economic ProfitEconomic Profit $400,000 ($400,000 (TRTR) - $250,000 (explicit cost) - $100,000 (implicit ) - $250,000 (explicit cost) - $100,000 (implicit

cost) = $50,000cost) = $50,000

Normal ProfitNormal Profit Accounting Profit ($150,000/yr) – Economic Profit Accounting Profit ($150,000/yr) – Economic Profit

($50,000/yr) = $100,000/yr($50,000/yr) = $100,000/yr

55

The Difference BetweenThe Difference BetweenAccounting Profit and Economic ProfitAccounting Profit and Economic Profit

Totalrevenue

Explicitcosts

Accountingprofit

Normal profit = opportunity cost ofresources supplied

by owners of firm

Economicprofit

Explicitcosts

66

Should Buffet stay in the farming?Should Buffet stay in the farming?

He supplies only his labor which he values He supplies only his labor which he values equally to managing a retail store for equally to managing a retail store for $11,000/yr$11,000/yr

He is a corn farmer with payments for land He is a corn farmer with payments for land and equipment = $10,000/yrand equipment = $10,000/yr

Except for pay, he is indifferent between Except for pay, he is indifferent between the farm or the storethe farm or the store

Corn sells at a constant price and Corn sells at a constant price and TRTR = = $22,000$22,000

77

Revenue, Costs, and ProfitRevenue, Costs, and Profit

Total Explicit Implicit Accounting Economic Normalrevenue costs costs profit profit profit

22,000 10,000 11,000 12,000 1,000 11,000

88

Should Pudge stay in farming?Should Pudge stay in farming?

What would Pudge’s economic profit be if What would Pudge’s economic profit be if TR =TR = $20,000 $20,000Economic profitEconomic profit

TR TR (20,000) – explicit (10,000) and implicit costs (20,000) – explicit (10,000) and implicit costs (11,000) = -$1,000(11,000) = -$1,000

99

If Pudge owned his own land, If Pudge owned his own land, should he stay in farming?should he stay in farming?

Pudge inherits the landPudge inherits the landThe land can be rented for $6,000/yrThe land can be rented for $6,000/yr

Total Explicit Implicit Accounting Economic Normalrevenue costs costs profit profit profit($/year) ($/year) ($/year) ($/year) ($/year) ($/year)

20,000 4,000 17,000 16,000 -1,000 17,000

20,000 4,000 17,000 16,000 -1,000 17,000

1010

ReviewReview

Accounting Profit = Accounting Profit = TRTR – explicit costs – explicit costsEconomic Profit = Economic Profit = TR – TR – explicit and implicit explicit and implicit

costscostsEconomic Profit = 0 when accounting Economic Profit = 0 when accounting

profit = normal profitprofit = normal profitTo remain in business in the long run, To remain in business in the long run,

economic profits must be greater than or economic profits must be greater than or equal to 0 (zero).equal to 0 (zero).

1111

The Invisible Hand TheoryThe Invisible Hand Theory

The The rationing function of pricerationing function of price To distribute scarce goods to those To distribute scarce goods to those

consumers who value them most highlyconsumers who value them most highlyThe The allocative function of priceallocative function of price

To direct resources away from overcrowded To direct resources away from overcrowded markets and toward markets that are markets and toward markets that are underservedunderserved

1212

Profits and Losses Would EnsureProfits and Losses Would Ensure

That supplies within a market would be That supplies within a market would be distributed efficiently (rationing function)distributed efficiently (rationing function)

Resources would be allocated across Resources would be allocated across markets to produce the most efficient markets to produce the most efficient possible mix of goods and services possible mix of goods and services (allocative function)(allocative function)

1313

Responses to Profits and LossesResponses to Profits and Losses

Markets with firms earning economic Markets with firms earning economic profits will attract resources.profits will attract resources.

Markets where firms are experiencing Markets where firms are experiencing economic losses tend to lose resources.economic losses tend to lose resources.

1414

1.20

Economic profit= $104,000/yr

Market price of $2/bushel produces economic profits

2.00 Price2.00

Economic Profit in the Economic Profit in the Short Run in the Corn MarketShort Run in the Corn Market

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

S

D

65Quantity (1000s of

bushels/year)

Pri

ce (

$/b

ush

el)

MC

130

ATC

1515

1.50

Economic profit= $50,400/yr

1.50 Price

12095

The Effect of Entry onThe Effect of Entry onPrice and Economic ProfitPrice and Economic Profit

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

S

D

65Quantity (1000s of

bushels/year)

Pri

ce (

$/b

ush

el)

Economic profits attract firms, reducing prices and profits

2.00 2.00

MC

130

ATCS’

1616

Equilibrium when Entry CeasesEquilibrium when Entry Ceases

S

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

D

1.00

Quantity (1000s of bushels/year)

Pri

ce (

$/b

ush

el)

Price

90115

Entry of firms continues until all firms earn a normal profit

MCATC

1.00

1717

1.05

Economic loss= $21,000/year

Prices below minimum ATC results in economic losses.

A Short-Run Economic A Short-Run Economic Loss in the Corn MarketLoss in the Corn Market

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

Quantity (1000s of bushels/year)

Pri

ce (

$/b

ush

el)

70

0.75Price

90

ATC

0.75

MC

S

D

60

1818

Equilibrium when Exit CeasesEquilibrium when Exit Ceases

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

0.75

Quantity (1000s of bushels/year)

Pri

ce (

$/b

ush

el)

90

0.750.75

90

ATC

0.75

MC

40

S’

Price1.00 1.00

The departure of firms from the industry increases the market price

S

D

60

1919

The Invisible Hand TheoryThe Invisible Hand Theory

In the long-run, in a competitive market, In the long-run, in a competitive market, all firms will tend to earn zero economic all firms will tend to earn zero economic profits.profits.

Zero economic profits are the Zero economic profits are the consequence of price movements caused consequence of price movements caused by the entry and exit of firms trying to by the entry and exit of firms trying to maximize economic profits.maximize economic profits.

2020

Long-Run Equilibrium in a Corn Long-Run Equilibrium in a Corn Market with Constant Long-Run Average CostMarket with Constant Long-Run Average Cost

Quantity (millions of bushels/year)

Pri

ce (

$/b

ush

el)

Quantity (1000s of bushels/year)

Pri

ce (

$/b

ush

el)

=1.00D

S=LACLMC

Price

MC

90

ATC

1.00

Similar ATC curves allow the industry to supplyany output at a price equal to minimum ATC.

2121

The Invisible Hand TheoryThe Invisible Hand Theory

The market outcome is efficient in the The market outcome is efficient in the long run.long run.P = MCP = MC If output is increased: If output is increased: MC > MB.MC > MB. If output is reduced: If output is reduced: MC < MBMC < MB

The market is fair.The market is fair.The price the buyers pay is no higher than The price the buyers pay is no higher than

the cost incurred by sellers.the cost incurred by sellers.The cost includes a normal profit.The cost includes a normal profit.

2222

The Invisible Hand TheoryThe Invisible Hand Theory

What happens in a city with “too many” What happens in a city with “too many” hair stylists and “too few” aerobics hair stylists and “too few” aerobics instructors?instructors?

Responses to the change in demand for Responses to the change in demand for stylists and aerobics instructorsstylists and aerobics instructorsEconomic loss for stylists will Economic loss for stylists will

Reduce the supply of stylistsReduce the supply of stylistsIncrease the price until zero economic profits occurIncrease the price until zero economic profits occur

2323

Initial EquilibriumInitial Equilibriumin the Markets for Haircutsin the Markets for Haircuts

Haircuts/day

Pri

ce (

$/h

airc

ut)

Haircuts/day

D

MCH

QH

ATCH

15

S

50

Pri

ce (

$/h

airc

ut)

2424

Initial Equilibrium in the Initial Equilibrium in the Markets for Aerobics ClassesMarkets for Aerobics Classes

Classes/day

Pri

ce (

$/cl

ass)

Classes/day

QA

D

MCA

ATCA

10

S

20

Pri

ce (

$/cl

ass)

2525

The Short-Run Effect of The Short-Run Effect of Demand Shifts in Two MarketsDemand Shifts in Two Markets

Haircuts/day

Pri

ce (

$/h

airc

ut)

Classes/day

Pri

ce (

$/cl

ass)

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’

12D’

300

2626

Economic Profit and Economic Profit and Loss in the Short RunLoss in the Short Run

Haircuts/day

MCH

QH

ATCH

Pri

ce (

$/h

airc

ut)

Classes/day

MCA

QA

ATCA

Pri

ce (

$/cl

ass)

Q’H

15.50

12

Q’A

15

11

Economicloss

Economicprofit

The decrease in demand for haircuts causes economic losseswhile the increase in demand for classes creates economic profits

2727

The Importance of Free The Importance of Free Entry and ExitEntry and Exit

Free entry and exit must exist for the Free entry and exit must exist for the allocative function of price to operateallocative function of price to operate

Barriers to entry can be caused by legal Barriers to entry can be caused by legal constraints and unique market constraints and unique market characteristicscharacteristics

Economic profits attract resources that Economic profits attract resources that push economic profits toward zero.push economic profits toward zero.

2828

Economic RentEconomic RentVersus Economic ProfitVersus Economic Profit

Economic RentEconomic RentThat part of a payment for a factor of That part of a payment for a factor of

production that exceeds the owner’s production that exceeds the owner’s reservation pricereservation price

Market forces will not push economic rent Market forces will not push economic rent to zero because inputs cannot be to zero because inputs cannot be replicated easilyreplicated easily

2929

Economic RentEconomic RentVersus Economic ProfitVersus Economic Profit

AssumeAssumeA community with 100 restaurantsA community with 100 restaurants99 restaurants employ chefs with normal 99 restaurants employ chefs with normal

ability for $30,000/yr (the same amount ability for $30,000/yr (the same amount they could earn elsewhere)they could earn elsewhere)

The 100The 100thth restaurant employs a talented restaurant employs a talented chef and customers are willing to pay 50% chef and customers are willing to pay 50% more for their mealsmore for their meals

3030

Economic RentEconomic RentVersus Economic ProfitVersus Economic Profit

TRTR at the each of the 99 restaurants is at the each of the 99 restaurants is $300,000, which yields a normal profit$300,000, which yields a normal profit

TR TR at the 100at the 100thth restaurant is $450,000 (50% restaurant is $450,000 (50% more)more)

A talented chefA talented chef Earns $180,000 = $30,000 + $150,000Earns $180,000 = $30,000 + $150,000 Reservation price = $30,000Reservation price = $30,000 Economic rent = $150,000Economic rent = $150,000

The100The100thth restaurant earns a normal profit restaurant earns a normal profit

3131

QuestionQuestion Why not pay the chef less and increase the Why not pay the chef less and increase the

economic profit for the restaurant?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?

3232

The Invisible Hand in ActionThe Invisible Hand in Action

The Invisible Hand and Cost-Saving The Invisible Hand and Cost-Saving InnovationsInnovations In a competitive marketIn a competitive market

Firms are price takersFirms are price takersP = MCP = MCZero economic profits exist in the long runZero economic profits exist in the long run

QuestionQuestionWhy do these firms have an incentive to Why do these firms have an incentive to

introduce cost-saving innovations?introduce cost-saving innovations?

3333

The Invisible Hand in ActionThe Invisible Hand in Action

40 companies transport oil from the Middle East 40 companies transport oil from the Middle East to the U.S.to the U.S. The cost/trip, including normal profit, is $500,000The cost/trip, including normal profit, is $500,000 One company uses a new propeller that saves One company uses a new propeller that saves

$20,000/trip$20,000/trip

Short RunShort Run No impact on priceNo impact on price Economic profits for the company will increase Economic profits for the company will increase

$20,000/trip$20,000/trip

3434

The Invisible Hand in ActionThe Invisible Hand in Action

Long RunLong RunOther companies use the propellerOther companies use the propellerMarket supply increases and the price fallsMarket supply increases and the price fallsZero economic profits after all firms have Zero economic profits after all firms have

adopted the new propelleradopted the new propellerAny firm without the new propeller would Any firm without the new propeller would

have an economic loss of $20,000/triphave an economic loss of $20,000/trip

3535

NYC Taxi MedallionsNYC Taxi Medallions

Annual cost of operating the cabs = $40,000Annual cost of operating the cabs = $40,000 TRTR/year = $60,000/year = $60,000 Annual interest on savings = 6%Annual interest on savings = 6% If the medallion is free, economic profit = If the medallion is free, economic profit =

$20,000/year$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 $100,000If the medallion is $100,000 Forego $6,000 in interestForego $6,000 in interest Earn $20,000Earn $20,000

3636

How much would you pay How much would you pay for a medallion?for a medallion?

$333,333$333,333Forego $20,000 in interestForego $20,000 in interestEarn $20,000Earn $20,000Zero economic profitZero economic profit

3737

Why did major commercial airlines install Why did major commercial airlines install piano bars on the upper decks of Boeing piano bars on the upper decks of Boeing

747s in the 1970s?747s in the 1970s?

Regulated prices generated economic profitsRegulated prices generated economic profits With regulated fares, competition could not drive With regulated fares, competition could not drive

down pricedown price Airlines added more flights on each route until Airlines added more flights on each route until

economic profit equaled zero.economic profit equaled zero. Airlines engaged in “quality wars”: a piano bar, Airlines engaged in “quality wars”: a piano bar,

gourmet meals, etc.gourmet meals, etc. Intrastate carriers found price competition more Intrastate carriers found price competition more

efficientefficient

3838

Present Value of a Permanent Present Value of a Permanent Annual PaymentAnnual Payment

How much money would we have to put in How much money would we have to put in a bank to generate annual interest a bank to generate annual interest earnings of earnings of M M dollars?dollars?

AssumeAssumeAnnual interest rate (Annual interest rate (rr) = 4% or .04) = 4% or .04

Present Value (Present Value (PVPV) x .04/yr = $20,000/yr) x .04/yr = $20,000/yrPV =PV = M/rM/rPV =PV = $20,000/.04 = $500,000 $20,000/.04 = $500,000

3939

Invisible Hand in Antipoverty ProgramsInvisible Hand in Antipoverty Programs

How will an irrigation project affect the incomes How will an irrigation project affect the incomes of poor farmers?of poor farmers?

An unskilled worker has two job choicesAn unskilled worker has two job choices Textile worker for $8,000/yrTextile worker for $8,000/yr Renting land to grow riceRenting land to grow rice

Rent = $5,000/yrRent = $5,000/yr Non-labor cost = $3,000/yrNon-labor cost = $3,000/yr TR TR = $16,000/yr= $16,000/yr Net income = $8,000/yrNet income = $8,000/yr

A state funded irrigation program will double output A state funded irrigation program will double output and not change the market price.and not change the market price.

4040

Impact of the Irrigation ProgramImpact of the Irrigation Program

TR TR will increase to $32,000will increase to $32,000 Income will increase to $24,000Income will increase to $24,000The demand for land will increase and the The demand for land will increase and the

rent on the land will rise to $21,000rent on the land will rise to $21,000The land owners gain, not the farmersThe land owners gain, not the farmers

4141

Stock MarketStock Market

How much will a share of stock sell for?How much will a share of stock sell for?Accounting profit = $1 millionAccounting profit = $1 million1,000 shares of stock1,000 shares of stockAnnual interest rate = 5%Annual interest rate = 5%Each share pays $1,000/year ($1 Each share pays $1,000/year ($1

million/1,000)million/1,000)At 5% a $20,000 savings account pays At 5% a $20,000 savings account pays

$1,000$1,000The stock price = $20,000The stock price = $20,000

4242

Present Value of Future Present Value of Future Costs and BenefitsCosts and Benefits

Earnings received in the future are less valuable Earnings received in the future are less valuable than earnings today.than earnings today.

The time value of moneyThe time value of money Money deposited today will grow in value over timeMoney deposited today will grow in value over time

ExampleExample Deposit $100 @ Deposit $100 @ r r = 10% or 0.10= 10% or 0.10 After 1 yearAfter 1 year

$100(1.10) = $110$100(1.10) = $110

After 2 yearsAfter 2 years $100(1.10)(1.10) = $100(1.10)$100(1.10)(1.10) = $100(1.10)22 = $121 = $121

4343

Present ValuePresent ValuePVPV deposited today @ deposited today @ rr will generate: will generate:

PVPV(1 + (1 + rr) after 1 year) after 1 yearPVPV(1 + (1 + rr))22 after 2 years after 2 years

ExampleExampleWhat is the value of a company today if it will What is the value of a company today if it will

earn its only accounting profit of $14,400 in earn its only accounting profit of $14,400 in two years?two years?PV PV of $14,400(of $14,400(MM) = ) = PVPV(1 + (1 + rr))2 2 or or

21

40014

)r(

)M(,PV

$10,000

201

400142

).(

)M(,PV

4444

Present ValuePresent Value

If $10,000 is deposited today at 20%, it will If $10,000 is deposited today at 20%, it will equal ($10,000)(1.20)equal ($10,000)(1.20)22 = $14,400 in two = $14,400 in two years.years.

The value of the company today is The value of the company today is $10,000 at 20% interest rate.$10,000 at 20% interest rate.

4545

Calculating Present ValueCalculating Present Value

T)r(

)M(PV

1

Stock MarketFuture profits are not certain.There is a market for information that can indicate future profits.This information influences stock prices.

4646

Efficient Market HypothesisEfficient Market Hypothesis

The current price of a stock reflects all The current price of a stock reflects all relevant information about its current and relevant information about its current and future earnings prospects.future earnings prospects.

Can you increase your profit in the stock Can you increase your profit in the stock market by using information from the mass market by using information from the mass media?media?

Do stocks in well-managed companies Do stocks in well-managed companies perform better than those in poorly perform better than those in poorly managed companies?managed companies?

4747

The Distinction Between and The Distinction Between and Equilibrium and a Social OptimumEquilibrium and a Social Optimum

The market equilibrium does not imply The market equilibrium does not imply that the resulting allocation is necessarily that the resulting allocation is necessarily best from the point of view of society as a best from the point of view of society as a whole. whole. The smart for one, dumb for all principleThe smart for one, dumb for all principle

Equilibrium will not be socially optimal Equilibrium will not be socially optimal when the cost and benefits for the when the cost and benefits for the individuals differ from society as a whole.individuals differ from society as a whole.