Lecture 8 The Invisible Hand in Action2

The Invisible Hand
Ch. 7
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
Giordani - Principles of Economics

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
Accounting, Economic and Normal

Profit
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
Accounting Vs. Economic Profit

Accounting profit
total revenue minus explicit costs
Economic profit
total revenue minus explicit costs minus implicit costs
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
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
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
Accounting, Economic and Normal Profit
10
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
11
Economic Profits in the Long-run in

Perfectly Competitive Markets
12
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?
13
Market entry
Economic profits attract firms (supply shifts outwards), reducing

prices and economic profits
14
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
15
Competitive equilibrium in the long run

Equilibrium when entry stops
Entry of firms continues until all firms earn an economic profit

of zero.
16
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.
17
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
18
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)
19
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
20

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.
21
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
22

Short-run demand shifts
Assume:
Long hair and physical fitness become popular
Demand for haircuts falls and demand for aerobics classes rises
23

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)
24

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
25
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
26
Economic Profit Vs. Economic Rent
27

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!
28
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.
29
How is the amount of the economic rent

determined?
For several years,
whichever team
hired Shaquille
ONeal won the
Championship
30
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
31

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
32

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?

33
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)
34
Innovations and Perfect Competition
35
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
36
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?

37
The trucker example

Total revenue = 5000
Total cost = 3000 + 1000 + 500 + 500 =
5000
Economic profit = 5000 - 5000 = 0
38
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
39
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

40
The trucker example

This trucker makes positive profits to the
extent that nobody else installs the airfoil
The no cash on the table principle suggests us
that more and more truckers install the
airfoils
41
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)
42
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!

43

Lecture 8 The Invisible Hand in Action2

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The Invisible Hand

The Invisible Hand Theory

According to Adam Smith

Giordani - Principles of Economics

The Invisible Hand Theory

Accounting, Economic and Normal

Giordani - Principles of Economics

Explicit and Implicit Costs

Giordani - Principles of Economics

Accounting Vs. Economic Profit

Giordani - Principles of Economics

Giordani - Principles of Economics

Accounting, Economic and Normal Profit

Giordani - Principles of Economics

The Central Role of Economic Profit

Economic Profits in the Long-run in

Giordani - Principles of Economics

Competitive equilibrium in the short run

Market price of 2/tonne produces economic profits

Economic profits attract firms (supply shifts outwards), reducing

Competitive equilibrium in the long run

Giordani - Principles of Economics

Competitive equilibrium in the long run

Entry of firms continues until all firms earn an economic profit

Competition tends to drive economic

Equilibrium in the short run

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

Market exit and long run equilibrium

The exit of firms from the industry shifts supply inwards.

Competition tends to drive economic

The Invisible Hand Theory

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

Example: hair stylists Vs. aerobics instructors

Both markets are initially

Example: hair stylists Vs. aerobics instructors

Giordani - Principles of Economics

Example: hair stylists Vs. aerobics instructors

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

Example: hair stylists Vs. aerobics instructors

Economic profit for aerobics instructors will

Giordani - Principles of Economics

Free entry and exit

Exit barriers are frequently caused by political

Economic Profit Vs. Economic Rent

Giordani - Principles of Economics

Economic Profit Vs. Economic Rent

Economic profit is also given by the payment that

How is the amount of the economic rent

Giordani - Principles of Economics

How is the amount of the economic rent

Giordani - Principles of Economics

Suppose ONeal received only a $39 million salary premium

Economic Profit Vs. Economic Rent

Economic Profit Vs. Economic Rent

Who of them earns more? Why?

Short run Vs. Long run

Indeed, perfect competition is not static at all

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

Innovations and Perfect Competition

Giordani - Principles of Economics

The trucker example

Meals and other expenses come to another 500/wk.