Topic 9 - The Quest for Profit and the Invisible Hand

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The Quest For Profit And The Invisible Hand

3 Types of Profit

[1] There are 3 types of profit in economics that need to be clearly distinguished.

  • Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
    • Explicit Costs are the costs of resources that the firm uses that are supplied from the outside the firm, i.e. payments made to factors of production & other suppliers e.g. wages
    • Implicit Costs – Value of the best opportunity forgone by the firm when it uses its own resources e.g. if you own land, the implicit costs is what you could rent it for.
  • Accounting Profit = Total Revenue – Explicit Costs
  • Normal Profit = The level of accounting profit that a firm earns when economic profit is zero, it is equal to the total implicit cost

Invisible Hand Theory

[2] The market system does two things:

  • Rationing Function of Price - ensuring those who value the goods the most get those goods
  • Allocative Function of Price - directs resources from overcrowded (less profitable) markets to markets that are under served.

Adam Smith (famous economist), argued that [3] markets channeled the selfish interests of buyers and sellers to promote the greatest good for society as the 'carrot' (or economic profit) and the 'stick' (or economic losses) ensure resources are allocated efficiently across markets


How Firms Respond to Profits And Losses

In the long run, for a firm to stay in business, it needs to at least earn an economic profit = 0 (a normal profit), otherwise it would go into another market as it could earn a higher return (if a firm earns less than 0 economic profit, implicit costs (opportunity cost) are higher than accounting profit which means it is foregoing a more lucrative business market or opportunity).


Hence, markets that earn an economic profit attract additional economic resources whilst markets that are experiencing economic losses tend to see a reduction in resources (businesses leave).

The examples below [4] [5] show this.

The Apple Market Enjoying An Economic Profit

9EP1.jpg

The Apple Market Suffering An Economic Profit

9EP2.jpg

If the poor market situations seems like it will persist, growers will start abandoning their businesses and move on to do other activities. This will continue until ATC = MC = Price.

In the long run, firms in a competitive market will tend to earn zero economic profit

Long Run Supply In A Competitive Market

  • In a perfectly competitive market, the firm's supply curve is simply its marginal cost curve.
  • Market Supply is perfectly elastic at the price corresponding to the minimum of the average total cost curve
    • E.g. Since there is free entry in and out of the market, if the price is higher than $1, more firms will enter increasing supply and decreasing the price. If the price is lower than $1 (the minimum of the average total cost curve), firms will exist reducing supply and increasing the price. Thus in the long run supply is perfectly elastic at $1 (since free exit/entry).

[6] [7]

9EP3.jpg

Attractive Features of Markets in Long Run Equilibrium (P=MC=ATC)

  1. The market outcome is efficient (marginal benefits = marginal costs)
  2. Goods are produced at the lowest possible costs given the level of technology. Buyers pay the costs of supplying, allowing 'suppliers' to earn a return equal to their opportunity cost

Economic Rent Vs. Economic Profit

[8]

  • Economic Rent - the part of the payment for a factor of production that exceeds the owner’s reservation price
    • note that the reservation price = implicit + explicit costs
  • With economic profit, competition pushes it towards zero, BUT not with economic rent as they have inputs that cannot be reproduced easily e.g. special skills/training
    • E.g. there is only so much land type and quality to be had (more cannot come onto the market)

Talented Chef Example please refer to the textbook for more guidance, this is a summary. [9]

  • Assumptions
    • 100 Restaurants, 99 ‘normal’ Chefs on $50,000 a year, one chef (because he is more skilled) is able to charge diners 50% more
      • 99 Chef’s Restaurants earn $300,000 a year with the Chef’s earning $50,000
      • Nick’s Restaurant earns $450,000 a year with the special Chef earning X
        • 99 Earn an accounting profit of $250,000 and an economic profit of 0. ($250,000 is the normal profit (implicit cost)).
        • Nicks restaurant earns $450,000, if he pays Nick $50,000, he has an economic profit of 150,000, however other firms will bid for nicks services until there is no economic profit i.e. when nick earns a further $150,000
          • Nick can earn $200,000, economic rent of $150,000 (since reservation price is 50,000)
  • Economic rent can persist for long periods but only when special talents that cannot be easily reproduced

The Invisible Hand And Cost Saving Innovations

Under the invisible hand, price takers in perfectly competitive markets still have an incentive to innovate. Hopefully this example illustrates this point. [10]

  • Suppose a tomato growers normal profit is $50,000
    • The grower develops an innovation that saves $5000
      • This will initially increase economic and accounting profit as 1 grower will not affect the market price.
        • However, as more growers adopt this technology, the supply curve shifts to the right leading to a lower equilibrium price and higher equilibrium quantity
          • Hence, in the long run economic profit will return to 0 to ensure cost savings are passed onto consumers, BUT the innovator will receive economic profits in the short run.

References

  1. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  2. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  3. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  4. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  5. Scott French, School of Economics, UNSW
  6. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  7. Scott French, School of Economics, UNSW
  8. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  9. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  10. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
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