Download Ch08 my ppt

Frank & Bernanke
rd
3 edition, 2007
Ch. 8: The Quest for Profit and
the Invisible Hand
1
Three Types of Profit
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)
 Normal Profit = accounting profit –
economic profit = opportunity cost of
owners’

2
Calculating Profit

Suppose a firm has the following:
Total Revenue (TR) = $400,000
 Explicit costs (salaries) = $250,000/yr
 Machinery and other equipment with a resale
value of $1 million

3
Profits

Accounting Profit


$400,000(TR) - $250,000 (explicit costs) = $150,000
To calculate economic profits, assume

Annual interest on savings = 10%
[Then the $1 million spent on equipment could have earned
$100,000/yr had it been invested]

Economic Profit


$400,000 (TR) - $250,000 (explicit cost) - $100,000 (implicit
cost) = $50,000
Normal Profit

Accounting Profit ($150,000/yr) – Economic Profit
($50,000/yr) = $100,000/yr
4
The Difference Between
Accounting Profit and Economic Profit
Total
revenue
Explicit
costs
Explicit
costs
Accounting
profit
Normal profit =
opportunity cost of
resources supplied
by owners of firm
Economic
profit
5
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 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
 Corn sells at a constant price and TR =
$22,000

6
Revenue, Costs, and Profit
Total
Explicit
revenue costs
Implicit
costs
22,000 10,000
11,000
Accounting
profit
12,000
Economic
profit
Normal
profit
1,000
11,000
7
Should Pudge stay in farming?

What would Pudge’s economic profit be if
TR = $20,000

Economic profit
(20,000) – explicit (10,000) and implicit costs
(11,000) = -$1,000
 TR
8
If Pudge owned his own land,
should he stay in farming?
Pudge inherits the land
 The land can be rented for $6,000/yr

20,000
Total
revenue
($/year)
20,000
4,000
Explicit
17,000
Implicit
costs
($/year)
costs
($/year)
4,000
17,000
16,000
Accounting -1,000
Economic 17,000
Normal
profit
($/year)
profit
($/year)
16,000
-1,000
profit
($/year)
17,000
9
Review
Accounting Profit = TR – explicit costs
 Economic Profit = TR – explicit and implicit
costs
 Economic Profit = 0 when accounting
profit = normal profit
 To remain in business in the long run,
economic profits must be greater than or
equal to 0 (zero).

10
The Invisible Hand Theory

The rationing function of price


To distribute scarce goods to those
consumers who value them most highly
The allocative function of price

To direct resources away from overcrowded
markets and toward markets that are
underserved
11
Profits and Losses Would Ensure
That supplies within a market would be
distributed efficiently (rationing function)
 Resources would be allocated across
markets to produce the most efficient
possible mix of goods and services
(allocative function)

12
Responses to Profits and Losses
Markets with firms earning economic
profits will attract resources.
 Markets where firms are experiencing
economic losses tend to lose resources.

13
Economic Profit in the
Short Run in the Corn Market
MC
S
ATC
2.00
D
65
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic profit
= $104,000/yr
Price
2.00
1.20
130
Quantity (1000s of
bushels/year)
Market price of $2/bushel produces economic profits
14
The Effect of Entry on
Price and Economic Profit
S
S’
MC
ATC
2.00
1.50
D
65 95
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic profit
= $50,400/yr
2.00
1.50
Price
120 130
Quantity (1000s of
bushels/year)
Economic profits attract firms, reducing prices and profits
15
Equilibrium when Entry Ceases
MC
S
1.00
Price ($/bushel)
Price ($/bushel)
ATC
Price
1.00
D
115
Quantity (millions of
bushels/year)
90
Quantity (1000s of
bushels/year)
Entry of firms continues until all firms earn a normal profit
16
A Short-Run Economic
Loss in the Corn Market
MC
ATC
S
0.75
D
60
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic loss
= $21,000/year
1.05
0.75
Price
70 90
Quantity (1000s of
bushels/year)
Prices below minimum ATC results in economic losses.
17
Equilibrium when Exit Ceases
S’
S
1.00
0.75
D
40 60
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
MC
1.00
0.75
ATC
Price
90
Quantity (1000s of
bushels/year)
The departure of firms from the industry increases the market price
18
The Invisible Hand Theory
In the long-run, in a competitive market,
all firms will tend to earn zero economic
profits.
 Zero economic profits are the
consequence of price movements caused
by the entry and exit of firms trying to
maximize economic profits.

19
Long-Run Equilibrium in a Corn
Market with Constant Long-Run Average Cost
MC
LMC
=LAC
=1.00
S
D
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
ATC
1.00
Price
90
Quantity (1000s of
bushels/year)
Similar ATC curves allow the industry to supply
any output at a price equal to minimum ATC.
20
The Invisible Hand Theory

The market outcome is efficient in the
long run.
P = MC
 If output is increased: MC > MB.
 If output is reduced: MC < MB


The market is fair.
The price the buyers pay is no higher than
the cost incurred by sellers.
 The cost includes a normal profit.

21
The Invisible Hand Theory
What happens in a city with “too many”
hair stylists and “too few” aerobics
instructors?
 Responses to the change in demand for
stylists and aerobics instructors


Economic loss for stylists will
 Reduce
the supply of stylists
 Increase the price until zero economic profits occur
22
Initial Equilibrium
in the Markets for Haircuts
ATCH
S
15
Price ($/haircut)
Price ($/haircut)
MCH
D
50
Haircuts/day
QH
Haircuts/day
23
Initial Equilibrium in the
Markets for Aerobics Classes
ATCA
S
10
Price ($/class)
Price ($/class)
MCA
D
20
Classes/day
QA
Classes/day
24
The Short-Run Effect of
Demand Shifts in Two Markets
S
15
12
D’
350 500
Haircuts/day
D
Price ($/class)
Price ($/haircut)
S
15
D’
10
D
200
Classes/day
300
Assume: Long hair and physical fitness become popular.
Price of haircuts fall the price of aerobics classes rise.
25
Economic Profit and
Loss in the Short Run
ATCH
ATCA
Economic
loss
Economic
profit
Price ($/class)
Price ($/haircut)
MCH
15.50
12
Q’H QH
Haircuts/day
MCA
15
11
QA Q’A
Classes/day
The decrease in demand for haircuts causes economic losses
while the increase in demand for classes creates economic profits
26
The Importance of
Free Entry and Exit
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
 Economic profits attract resources that
push economic profits toward zero.

27
Economic Rent
Versus Economic Profit

Economic Rent
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

28
Economic Rent
Versus Economic Profit

Assume
A community with 100 restaurants
 99 restaurants employ chefs with normal
ability for $30,000/yr (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

29
Economic Rent
Versus Economic Profit



TR at the each of the 99 restaurants is
$300,000, which yields a normal profit
TR at the 100th restaurant is $450,000 (50%
more)
A talented chef




Earns $180,000 = $30,000 + $150,000
Reservation price = $30,000
Economic rent = $150,000
The100th restaurant earns a normal profit
30
Question

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?
31
The Invisible Hand in Action

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?
32
The Invisible Hand in Action

40 companies transport oil from the Middle East
to the U.S.



The cost/trip, including normal profit, is $500,000
One company uses a new propeller that saves
$20,000/trip
Short Run


No impact on price
Economic profits for the company will increase
$20,000/trip
33
The Invisible Hand in Action

Long Run
Other companies use the propeller
 Market supply increases and the price falls
 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

34
NYC Taxi Medallions




Annual cost of operating the cabs = $40,000
TR/year = $60,000
Annual interest on savings = 6%
If the medallion is free, economic profit =
$20,000/year


The economic profit will attract entry into the taxi market.
If the medallion is $100,000


Forego $6,000 in interest
Earn $20,000
35
How much would you pay
for a medallion?

$333,333
Forego $20,000 in interest
 Earn $20,000
 Zero economic profit

36
Why did major commercial airlines install
piano bars on the upper decks of Boeing
747s in the 1970s?





Regulated prices generated economic profits
With regulated fares, competition could not drive
down price
Airlines added more flights on each route until
economic profit equaled zero.
Airlines engaged in “quality wars”: a piano bar,
gourmet meals, etc.
Intrastate carriers found price competition more
efficient
37
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?
 Assume


Annual interest rate (r) = 4% or .04
Present Value (PV) x .04/yr = $20,000/yr
 PV = M/r
 PV = $20,000/.04 = $500,000

38
Invisible Hand in Antipoverty Programs


How will an irrigation project affect the incomes
of poor farmers?
An unskilled worker has two job choices


Textile worker for $8,000/yr
Renting land to grow rice





Rent = $5,000/yr
Non-labor cost = $3,000/yr
TR = $16,000/yr
Net income = $8,000/yr
A state funded irrigation program will double output
and not change the market price.
39
Impact of the Irrigation Program
TR will increase to $32,000
 Income will increase to $24,000
 The demand for land will increase and the
rent on the land will rise to $21,000
 The land owners gain, not the farmers

40
Stock Market

How much will a share of stock sell for?
Accounting profit = $1 million
 1,000 shares of stock
 Annual interest rate = 5%
 Each share pays $1,000/year
($1
million/1,000)
 At 5% a $20,000 savings account pays
$1,000
 The stock price = $20,000

41
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
Example


Deposit $100 @ 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
42
Present Value

PV deposited today @ r will generate:
PV(1 + r) after 1 year
 PV(1 + r)2 after 2 years


Example

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
14,400( M )
PV 
2
(1 r )
14,400( M )
PV 
 $10,000
2
( 1  .20 )
43
Present Value
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.

44
Calculating Present Value
(M )
PV 
T
(1 r )
Stock Market
Future profits are not certain.
There is a market for information that
can indicate future profits.
This information influences stock
prices.
45
Efficient Market Hypothesis
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?
 Do stocks in well-managed companies
perform better than those in poorly
managed companies?

46
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 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.
47