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The Quest for Profit and the Invisible Hand
According to Adam SmithPeople are motivated by self-
interest.The goal of profit maximization will
serve society’s collective interest.
Slide 2
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)
Slide 3
Costs incur without explicit money involved
E.g., use your own garage for storage
Forego the opportunity to rent out your garage , the opportunity cost is the lost income from renting the garage out.
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
Slide 5
Accounting Profit $400,000(TR) - $250,000 (explicit costs) = $150,000
Slide 6
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
Slide 7
Slide 8
Totalrevenue
Explicitcosts
Accountingprofit
opportunity cost ofresources supplied
by owners of firm
Economicprofit
Explicitcosts
Why are the distinctions important?
Only economic profit serve the following economic functions:Rationing functionAllocative function
Slide 9
Should Pudge Buffet stay in the farming business?
He is a corn farmer with payments for land and equipment = $10,000/yr
He supplies only his labor which he values equally to managing a retail store for $11,000/yr
Except for pay, he is indifferent between the farm or the store
Corn sells at a constant price and TR = $22,000
Slide 10
Slide 11
Total Explicit Implicit Accounting Economicrevenue costs costs profit profit($/year) ($/year) ($/year) ($/year) ($/year)
22,000 10,000 11,000 12,000 1,000
What would Pudge’s economic profit be if TR = $20,000 Economic profit
TR (20,000) – explicit (10,000) and implicit costs (11,000) = -$1,000
Question Should Pudge stay in farming?
Slide 12
If Pudge owned his own land, should he stay in farming?Assume
Pudge inherits the land The land can be rented for $6,000/yr
Slide 13
Slide 14
Total Explicit Implicit Accounting Economicrevenue costs costs profit profit($/year) ($/year) ($/year) ($/year) ($/year)
20,000 4,000 17,000 16,000 -1,000
A Review Accounting Profit = TR – explicit costs Economic Profit = TR – explicit costs –
implicit costs Economic Profit = 0 when accounting
profit = implicit costs To remain in business in the long run,
economic profits must be greater than or equal to 0 (zero).
Slide 15
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
Slide 16
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)
Slide 17
Markets with firms earning economic profits will attract resources.
Markets where firms are experiencing economic losses tend to lose resources.
Slide 18
1.20
Economic profit= $104,000/yr
Market price of $2/bushel produces economic profits
2.00 Price2.00
Slide 19
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
1.08
1.50
Economic profit= $50,400/yr
1.50 Price
12095
Slide 20
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’
Slide 21
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 zero economic profit
MCATC
1.00
1.05
Economic loss= $21,000/year
Prices below minimum ATC results in economic losses.
Slide 22
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
Slide 23
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
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.
Slide 24
The equilibrium principle (no cash on the table) predicts, when people confront an opportunity for gain they are almost always quick to exploit it.
Slide 25
Slide 26
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.
The market outcome is efficient in the long run.
P = MC If output is increased: MC > MB. If output is reduced: MC < MB.
Slide 27
Long hair and physical fitness become popular these days, what happens to the supply-demand to hair stylists and aerobics instructors?
Slide 28
Slide 29
Haircuts/day
Pri
ce (
$/h
airc
ut)
Haircuts/day
D
MCH
QH
ATCH
15
S
50
Pri
ce (
$/h
airc
ut)
Slide 30
Classes/day
Pri
ce (
$/cl
ass)
Classes/day
QA
D
MCA
ATCA
10
S
20
Pri
ce (
$/cl
ass)
Slide 31
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
Slide 32
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
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 Economic profit for aerobics instructors will
Increase the supply of aerobics instructors Reduce the price until zero economic
profits occur
Slide 33
Free entry and exit must exist for the allocative function of price to operate.
A barrier to exit can become a barrier to entry
Yet, barriers to entry can be caused by legal and political constraints as well as unique market characteristics
Slide 34
Economic profits attract resources that push economic profits toward zero.
Slide 35
Economic RentThat 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
Slide 36
How much rent will a talented chef get?
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
Slide 37
Assume 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)
Slide 38
Assume A talented chef
Earns $180,000 = $30,000 + $150,000
Reservation price = $30,000 Economic rent = $150,000
That the100th restaurant earns a normal profit
Slide 39
QuestionWhy not pay the chef less and
increase the economic profit for the restaurant?
Slide 40
Opportunities for private gain seldom remain unexploited for very long
Slide 41
Suppose Yao Ming, a star player for the Houston Rockets, can either play basketball or fry hamburger. In fact, he is equally happy and capable of doing either job.
In the 2005 season, Yao made US$4.4 million for playing basketball, while McDonald is happy to hire Yao for US$20,000.
What is Yao’s economic rent of playing basketball?
If the US federal government dramatically increases personal income tax rate for super-star athletes like Yao, are basketball fans going to bear the tax burden?
It is argued that pharmaceutical companies earns exorbitant amount of profits from their patents. Some politicians argue to impose a tax on such patents. The pharmaceutical companies argue that taxation on patented drugs will lower research and development expenditures. Do you agree with this statement?
End
