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The Invisible Hand

Ch. 7

The Invisible Hand Theory


The Invisible Hand Theory
Adam Smiths theory that the actions of independent selfinterested buyers and sellers will often result in the most
efficient allocation of resources

According to Adam Smith


People are motivated by self-interest
Under certain conditions (perfect competition, no external
costs and benefits etc.), the goal of profit/utility maximization
will serve societys collective interest

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The Invisible Hand Theory


It is not from the benevolence of the butcher, the brewer, or the
baker that we expect our dinner, but from their regard to their
own self-interest. We address ourselves not to their humanity but
to their self-love, and never talk to them of our own necessities,
but of their advantages
(Adam Smith, An Inquiry into the Nature and Causes of the
Wealth of Nations, 1776)
In this lecture we analyze the long run implications of the
invisible hand under perfect competition
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Accounting, Economic and Normal


Profit

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Explicit and Implicit Costs


Explicit costs
The actual payments a firm makes to its factors of
production and other suppliers

Implicit costs
The opportunity costs of the resources supplied by the
firms owners

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Accounting Vs. Economic Profit


Accounting profit
total revenue minus explicit costs

Economic profit
total revenue minus explicit costs minus implicit costs

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Accounting Profit
Example: a construction firm
Assume
Total Revenue (TR) = 400,000/yr
Explicit costs (salaries + intermediate goods) =
250,000/yr
Machinery and other equipment with a resale value of 1
million (supplied by the owner of the firm)
Job opportunity for the firm owner: 45,000/yr

Accounting Profit
TR explicit cost
400,000 - 250,000 = 150,000
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Economic Profit
Now calculate the opportunity cost of the
resources supplied by the firm (i.e. implicit costs)
One implicit cost is the job opportunity of the
firm owner: 45,000
Moreover,
If annual interest on savings = 10%
the 1 million spent on equipment could have earned
100,000/yr, had it been invested (i.e. implicit cost)

Economic profit
TR explicit cost implicit cost
400,000 - 250,000 - 100,000 45,000= 5,000/ yr
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Normal Profit
Normal Profit = Accounting Profit Economic Profit
= implicit costs
Accounting Profit
Economic Profit

150,000/yr
5,000/yr -

Normal Profit

145,000/yr

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Accounting, Economic and Normal Profit

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The Central Role of Economic Profit


In the following we are going to explain the meaning
of a null economic profit (and thus of an accounting
profit being equal to normal profit)
We will show that zero economic profit, far from
implying troubled firms exiting from the market, is
actually the standard state of affairs in a perfectly
competitive market in the long-run
In fact, null economic profit does not imply that workers
are not paid, capital is under-remunerated etc.,
It actually implies all factors of production are paid exactly
their perfectly competitive prices
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Economic Profits in the Long-run in


Perfectly Competitive Markets

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Competitive equilibrium in the short run


Example: Short-run economic profit in the cement market

Market price of 2/tonne produces economic profits


Economic profits = (2 - 1.20)130 tonnes/yr = 104,000/yr
Is this a stable situation?
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Market entry

Economic profits attract firms (supply shifts outwards), reducing


prices and economic profits
Is this a stable situation?
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Competitive equilibrium in the long run


As long as price remains above the minimum
value of ATC, profits lure new entrants.
Supply continues to shift out until price falls to
min ATC
At that point economic profit is zero and there is
no further incentive to enter
Accounting profit = normal profit

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Competitive equilibrium in the long run


Equilibrium when entry stops

Entry of firms continues until all firms earn an economic profit


of zero.
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Competition tends to drive economic


profit down to zero
When a firm is making positive economic profit,
it is earning more than the cost of all the
resources required to produce the goods it
sells.
This means that another firm could produce the
same goods and, in the process, increase its
owners' wealth.
Entry by new firms will cause price to fall until
economic profit is driven down to zero.
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Equilibrium in the short run


Short-run economic loss in the cement market

Prices below ATC (but above AVC) results in economic losses


Economic Loss = (0.75 - 1.05)70 tonnes/yr = 21,000/year
Is this a stable situation?
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Market exit and long run equilibrium


Equilibrium when exit stops

The exit of firms from the industry shifts supply inwards.


The market price increases (loss=0)
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Competition tends to drive economic


profit down to zero
An industry in which firms are earning negative economic
profit is one in which firms are failing to cover all the
costs of the resources they use.
If this situation is expected to persist, some firms will go
out of business.
Exit will continue until price rises to cover all resource
costs.
So again, in the long-run equilibrium of a competitive
industry, firms will earn zero economic profit
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The Invisible Hand Theory


In a competitive market, all firms will tend to earn zero
economic profits in the long run
This is the consequence of the price movements caused by
entry and exit of firms trying to maximize economic profits
Markets with firms earning economic profits will attract firms
Markets where firms are experiencing economic losses tend
to lose firms

The equilibrium principle (no-cash-on-the-table) predicts


that, when rational economic agents face an opportunity
for gain, they are quick to exploit it.
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Example: hair stylists Vs. aerobics instructors


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

Both markets are initially


in their long run
equilibrium
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Example: hair stylists Vs. aerobics instructors


Short-run demand shifts
Assume:
Long hair and physical fitness become popular
Demand for haircuts falls and demand for aerobics classes rises

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Example: hair stylists Vs. aerobics instructors


Short-run economic profit and loss

The decrease in demand for haircuts causes economic loss (a)


The increase in demand for classes creates economic profit (b)
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Example: hair stylists Vs. aerobics instructors


Responses to the change in demand for hair stylists
and aerobics instructors
Economic loss for hair 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 instructors
Decrease the price until zero economic profits occur

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Free entry and exit


Free entry and exit must exist for the invisible hand
to operate.
An entry barrier is any force that prevents firms
from entering a new market.
Entry barriers can be caused by legal constraints and
unique market characteristics.

Exit barriers are frequently caused by political


responses to declining demand or rising costs.
For instance, the government might decide to keep
alive economic activities that otherwise would be
shut down
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Economic Profit Vs. Economic Rent

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Economic Profit Vs. Economic Rent


Economic rent
that part of a payment for a production factor that exceeds the
owners reservation price

Economic profit is also given by the payment that


exceeds the sellers reservation price
Crucial difference:
Positive economic profits attract resources that push them to
zero in the long run
Economic rent cannot be pushed to zero because it is associated
to special inputs which cannot be replicated easily
Examples of non-reproducible inputs: land, exhaustible
resources, talent etc.
These inputs can be paid well above their own reservation
price!
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How is the amount of the economic rent


determined?
Example: a talented
basketball player
Suppose that the owner of
the team that wins the NBA
Championship receives
additional television
revenues of $40 million.

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How is the amount of the economic rent


determined?
For several years,
whichever team
hired Shaquille
ONeal won the
Championship

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How
is the amount
of basketball
the economic
rent
Example:
a talented
player
determined?
There is free agency and teams can bid openly for any player's
services.
By how much will ONeal's salary exceed the salaries of other
players?

Suppose ONeal received only a $39 million salary premium


from his current team
Some other team could increase its wealth by bidding ONeal
away with a higher salary
Only when ONeal's salary premium is $40 million will there
be no further tendency for bidding
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Economic Profit Vs. Economic Rent


Thus, economic rent is the difference between
the market price for normal players and that
for the talented player
The rent, which is determined by the market, is
entirely appropriated by Oneal as some sort of
reward for his talent
Although competition drives economic profit to
zero, economic rent can persist indefinitely
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Economic Profit Vs. Economic Rent


The size of the economic rent that your talent
enjoys, however, also depends on how big the
demand is for your talent

Who of them earns more? Why?


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Short run Vs. Long run


Perfect competition looks like an extremely boring situation
firms produce the same good with the same techniques
their profits tend to zero in the long run and nothing ever
happens that changes this state of the world

Indeed, perfect competition is not static at all


firms operate diverse strategies to raise their economic profits
in the short run (such as introducing innovations to their
products)

It is true that, in the long run, competition erodes economic


profits
But the long run equilibrium must be interpreted as a
configuration towards which the system tends to converge
over time but that it never reaches:
in the long run we are all dead (J. M. Keynes)
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Innovations and Perfect Competition

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Cost-saving innovations
Why do firms have an incentive to introduce
innovations?
How do innovations affect economic profit in the
short run?
And in the long run?
Let us consider an example with a cost-saving
innovation
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The trucker example

A trucker gets 5000 for driving a trailer full of cargo from Rome
to Moscow, a trip that takes him one week.

The rent for his rig is 3000/wk and he spends 1000 on gas.

Meals and other expenses come to another 500/wk.

His alternative employment is to work as a local deliveryman at


a salary of 500/wk, a task he finds equally attractive as
trucking

What is this trucker's economic profit?


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The trucker example


Total revenue = 5000
Total cost = 3000 + 1000 + 500 + 500 =
5000
Economic profit = 5000 - 5000 = 0

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The trucker example


Now suppose the trucker from the previous
example installs an airfoil on the roof of the cab
of his rig, resulting in a fuel savings of 25
percent

1970

1985
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The trucker example


If the airfoil rents for 50/wk, what is the
trucker's new economic profit?
Total revenue = 5000/wk, the same as before.
Total cost = 3000 + 750 + 500 + 500 + 50 =
4800

So economic profit = 5000 - 4800 = 200


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The trucker example


This trucker makes positive profits to the
extent that nobody else installs the airfoil
Is this a stable situation?
The no cash on the table principle suggests us
that more and more truckers install the
airfoils
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The trucker example


As more and more truckers install the airfoils,
the cost of the service goes down and this
places downward pressure on trucking prices
By the time all truckers have installed the
airfoils, trucking rates will have fallen by the full
200 in net cost savings made possible by the
airfoil (from 5000 to 4800)

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Profits and Economic Progress


Two key points
1. There exists an incentive to innovate:

2.

The benefits associated with innovation tend to diffuse across the


society

Early adopters of cost-saving innovations tend to earn temporary


positive economic profits

The adoption of an innovation by the innovative firm forces all


other competitors to do the same if they want to remain in the
market
The innovator might be led by pure self-interest (gaining temporary
positive profits)
Still, this purely selfish behavior is the main engine of economic
progress, and hence it greatly contributes to the welfare of society as
a whole

The invisible hand theory!


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