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The Invisible Hand In

Action

MB

MC

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Learning Objectives

1.

Accounting, Economic and Normal Profit.

2.

Allocation of resources through economic profit


and economic loss the example of perfect
competition.

3.

Difference between economic profit and economic


rent

4.

Invisible hand: applications in everyday life

5.

Market equilibrium versus social optimum.

Copyright c 2007 by The McGraw-Hill


Companies, Inc. All rights reserved.

Chapter 4: Elasticity

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The Invisible Hand

In this chapter we will study the nature


of forces that guide the invisible hand.
Adam Smiths vision was that
People

are motivated by self-interest.


The goal of profit maximization (under
many conditions) serve societys collective
interest.

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Chapter 8: The Quest for Profit and the Invisible Hand

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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
firms owners)

Normal Profit = accounting profit economic profit = Implicit


costs

If economic profit=0, normal profit=accounting profit

If economic profit>0 then Normal Profit > Acc Profit.

Hence, positive economic profits are called super-normal


profits

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Chapter 8: The Quest for Profit and the Invisible Hand

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Three Kinds of Profit

Total
revenue

Explicit
costs

Explicit
costs

Accounting
profit
Normal profit =
opportunity cost of
resources supplied
by owners of firm
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Chapter 8: The Quest for Profit and the Invisible Hand

Economic
profit

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Calculating Profits

Suppose a firm has the following:

TR = $400,000; Explicit costs (salaries) = $250,000/yr

Machinery and other equipment with a resale value of $1


million

Annual interest on savings = 10% (implies that the $1 million


spent on equipment could have earned $100,000/yr had it
been invested); this is the implicit (opportunity) cost

Accounting Profit : $400,000 - $250,000 = $150,000

Economic Profit: $400,000 - $250,000 - $100,000 (implicit


cost) = $50,000

Normal Profit = Accounting Profit ($150,000/yr) Economic


Profit ($50,000/yr) = $100,000/yr = OC

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Chapter 8: The Quest for Profit and the Invisible Hand

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Why Are The Distinctions Important?

To make correct decisions. Example


Should

Mr. A stay in farming or should he manage


a retail store?
Assumptions
He

is a corn farmer with payments for land and


equipment ($6,000 + $4,000) = $10,000/yr
As a store manager he would have received a salary of
$11,000/yr. As a farmer he supplies his own labor on
the land.
Except for pay, he is indifferent between the farm or the
store
Corn sells at a constant price and TR = $22,000
Copyright c 2007 by The McGraw-Hill
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Chapter 8: The Quest for Profit and the Invisible Hand

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Revenue, Costs, and Profit Summary

Total
revenue
($/year)

Explicit
costs
($/year)

Implicit
costs
($/year)

Accounting
profit
($/year)

Economic
profit
($/year)

Normal
profit
($/year)

22,000

10,000

11,000

12,000

1,000

11,000

20,000

10,000

11,000

-1,000

11,000

10,000

If TR=$22,000, Mr. A is better off farming than as a store


manager. If TR falls to $20,000, economic profit is -$1,000
which means he can make $1000 more as a store manager
than in farming. So he should manage the store.

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Chapter 8: The Quest for Profit and the Invisible Hand

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Why Are The Distinctions Important?

To remain in business in the long run, Mr. A


would need an economic profit > or = 0.

By a turn of fate, the owner of the land


makes a gift of it to Mr. A. The land can also
be rented to other farmers for $6,000/yr.

If TR=$20,000, should Mr. A stay in farming?

Copyright c 2007 by The McGraw-Hill


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Chapter 8: The Quest for Profit and the Invisible Hand

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New Revenue, Costs, and


Profit Summary for Pudge

Total
revenue
($/year)

Explicit
costs
($/year)

Implicit
costs
($/year)

Accounting
profit
($/year)

Economic
profit
($/year)

Normal
profit
($/year)

20,000

4,000

17,000

16,000

-1,000

17,000

Mr. A is clearly wealthier as an owner than as a renter.


However he is still making $1,000 less than his next best
alternative (managing the store). In the long run, if things
dont change, he will want to be store manager.

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Chapter 8: The Quest for Profit and the Invisible Hand

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The Invisible Hand Theory

Two Functions of Price


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 (where P is too low to cover OC) and
toward markets that are underserved.

Both these functions of price underlie Adam Smiths


theory of the Invisible hand.

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Chapter 8: The Quest for Profit and the Invisible Hand

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The Invisible Hand Working as a


Response to Profits and Losses

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.

Recall, normal profit is just a cost of doing


business. When economic profit =0, you are
only earning normal profit.

Copyright c 2007 by The McGraw-Hill


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Chapter 8: The Quest for Profit and the Invisible Hand

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Economic Profit in the


Short Run in the Corn Market
MC

ATC

2.00

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


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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 13

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The Effect of Entry on


Price and Economic Profit
S

MC

ATC

2.00
1.50

65 95
Quantity (millions of
bushels/year)

Price ($/bushel)

Price ($/bushel)

Economic profit
= $50,400/yr

2.00
1.50

Price

1.08

120 130
Quantity (1000s of
bushels/year)

Economic profits attract firms, reducing prices and profits


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Chapter 8: The Quest for Profit and the Invisible Hand

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Equilibrium when Entry Ceases


MC

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


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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 15

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A Short-Run Economic
Loss in the Corn Market
MC

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.


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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 16

ATC

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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
Copyright c 2007 by The McGraw-Hill
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Chapter 8: The Quest for Profit and the Invisible Hand

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Long Run Perfectly Competitive


Equilibrium

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.

The equilibrium principle (no cash on the table)


predicts, when people confront an opportunity for
gain they are almost always quick to exploit it.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 18

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The Invisible Hand Theory

Two Attractive Features


The

market outcome is efficient (socially optimal)

= MC (the value to buyers of the last unit of the


good sold exactly equals the marginal opportunity cost
to society of producing one extra unit of the good).

The

market is, in a sense, fair.

The

price the buyers pay is no higher than the cost


incurred by sellers.
The cost includes a normal profit.

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Chapter 8: The Quest for Profit and the Invisible Hand

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Long Run Industry Supply Curve

How would the long run industry supply curve look


under perfect competition?
Assume that all firms have identical cost
structures in the short run. So all long run
adjustments are made exclusively by entry and
exit of identical firms using an identical
standardized production method.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 20

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Long Run Industry Supply Curve

Consider an initial equilibrium at min ATC. Suppose


demand rises. Each firm will produce more and earn
positive economic profits in the short run.

New firms will enter the market. Short run industry supply
curve will shift to the right until prices come down to min
ATC.

The long run industry equilibrium will settle at P=min ATC


with the number of firms being higher.

Therefore, the long run industry supply curve is a horizontal


straight line at minimum ATC. All long run adjustments are
done through the number of firms in the industry (under the
assumption of identical firms with identical cost structure).

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 21

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The Invisible Hand: Example

Suppose that the market for haircuts and


aerobics classes are currently at their long
run equilibria.

Suppose then that long hair becomes


fashionable while citizens become more
fitness conscious.

So, compared to the initial long run


equilibrium, demand for haircuts will fall and
that for aerobics will rise.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 22

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Initial Equilibrium
in the Market for Haircuts
ATCH

S
15

Price ($/haircut)

Price ($/haircut)

MCH

D
50
Haircuts/day

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QH
Haircuts/day

Chapter 8: The Quest for Profit and the Invisible Hand

Slide 23

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Initial Equilibrium in the


Market for Aerobics Classes

ATCA

S
10

Price ($/class)

Price ($/class)

MCA

D
20
Classes/day

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QA
Classes/day

Chapter 8: The Quest for Profit and the Invisible Hand

Slide 24

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The Short-Run Effect of


Demand Shifts in Two Markets

15
12

Price ($/class)

Price ($/haircut)

S
15

D
10

350 500
Haircuts/day

D
200
Classes/day

300

Assume: Long hair and physical fitness become popular.


Price of haircuts fall the price of aerobics classes rise.
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 25

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Economic Profit and


Loss in the Short Run
ATCH

ATCA

Economic
loss

Economic
profit
Price ($/class)

Price ($/haircut)

MCH

15.50
12

MCA

15
11

QH QH
Haircuts/day

QA QA
Classes/day

The decrease in demand for haircuts causes economic losses


while the increase in demand for classes creates economic profits
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 26

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The Invisible Hand Theory

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 classes


Reduce the price until zero economic profits occur

Copyright c 2007 by The McGraw-Hill


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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 27

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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


(patents, copyrights, etc) and unique market
characteristics (networking externalities and
product compatibility in the software industry)

A barrier to exit can become a barrier to entry


(airline industry regulation made it impossible for
airlines to leave unprofitable routes and so airlines
were unwilling to enter these markets)

Copyright c 2007 by The McGraw-Hill


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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 28

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Economic Rent vs. Economic Profit

Economic profits attract resources that push


economic profits toward zero, in competitive
markets.

Economic Rent
That

part of a payment for a factor of production


that exceeds the owners reservation price
Market forces will not push economic rent to
zero because inputs cannot be replicated easily.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 29

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Economic Rent: Example

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
Copyright c 2007 by The McGraw-Hill
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 30

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Economic Rent
Versus Economic Profit
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)
The talented chef
Earns

$180,000 = $30,000 + $150,000


Reservation price = $30,000
Economic rent = $150,000
The100th
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restaurant earns a normal profit


Chapter 8: The Quest for Profit and the Invisible Hand

Slide 31

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Economic Rent
Versus Economic Profit
Why not pay the chef less and increase the
economic profit for the restaurant?
Other

restaurants will bid him away.


Say, restaurant 1 gives the chef $40,000 and
makes economic profit of $110,000. Restaurant
2 will want to pay slightly more than $40,000 and
take the chef. The process will continue until
economic profit is driven to zero.

Opportunities for private gain seldom remain


unexploited for very long

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 32

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The Invisible Hand in Action

Economic Naturalist
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?

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 33

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Invisible Hand and Cost Saving


Innovation

Why do firms have an incentive to introduce


cost-saving innovations? How do costsaving innovations affect economic profit in
the short run? In the long run?

Assume
40

companies transport oil from the middle east


to the U.S.
The cost/trip, including normal profit, is $500,000
One company discovers the use of a new
propeller that saves $20,000/trip
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 34

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Invisible Hand and Cost Saving


Innovation

Short Run
No impact on price; ATC and MC will shift down;
Economic profits for the company will increase by
$20,000/trip

Long Run
Other companies will introduce the propeller
ATC and MC for all firms will shift down; market
supply will shift to the right and price will fall
Zero economic profits after all firms have adopted
the new propeller; prices lower for the consumer

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 35

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Present Discounted Value

Calculating the Present Discounted Value of


Future Costs and Benefits
The

time value of money

Is

the concept that a given dollar amount today is


equivalent to a larger dollar amount in the future
because of interest earnings.

Therefore,

earnings received in the future are


less valuable than earnings today.
Similarly, costs incurred in the future are less
costly today.
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 36

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Present Discounted Value

Deposit $100 @ r = 10% or 0.10


After 1 year
$100(1.10) = $110
Therefore, the PDV of $110 a year from now
is $100.

After 2 years
$100(1.10)(1.10) = $100(1.10)2 = $121
Therefore, the PDV of $121, two years from
now is $100.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 37

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Present Discounted Value

Generally
PDV

of a payment M to be received T years


from now at interest rate r, is:

M
PV
(1 r )T
What

is the value of a company today if it will


earn its only accounting profit of $14,400 in two
years, given r = 20%?
$14,400/(1

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+ 0.2)2 = $10,000

Chapter 8: The Quest for Profit and the Invisible Hand

Slide 38

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Invisible Hand in Regulated


Markets

Why do New York City taxicab medallions sell for


more than $300,000?
Suppose
Annual cost of operating the cabs (including
depreciation and all opportunity costs) =
$40,000
TR/year = $60,000

If annual interest on savings = 6%, what should the


equilibrium price of a medallion be?

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 39

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Invisible Hand in Regulated


Markets

Had the medallion been free, the cab drivers economic


profit would be $20,000. This economic profit would attract
entry into the taxi market.

It would require anyone to keep $333,333 in the bank at 6%


to earn $20,000 in annual interest earning. [PV=M/r;
Present Value, PV x Interest Rate, r = Interest Earning, M].
So in equilibrium a person will be willing to pay $333,333
(=20,000 divided by 0.06) for a taxi medallion.

Economic profit = 0 because your accounting profit is


$20,000 and opportunity cost (foregone interest earning
equals $20,000).

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 40

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Invisible Hand in Regulated


Markets

Why did major commercial airlines install


piano bars on the upper decks of Boeing
747s in the 1970s?
Until

late 1978 airlines were regulated by the


federal agency CAB (Civil Aeronautics Board).
Regulated prices on popular routes were well
above free market equilibrium values, thus
generating economic profits which were then
supposed to pay for service on sparsely traveled
routes.
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 41

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Invisible Hand in Regulated


Markets

With regulated fares, competition could not drive


down prices

So airlines competed for passengers by providing


non monetary incentives like adding more flights,
piano bars, fancy food, etc.

Airlines added more flights on each route until


economic profits were driven to zero.

Intrastate (within state like San Diego to San


Francisco) carriers (not regulated by CAB) found
passengers sacrificed amenities for lower prices.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 42

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Invisible Hand in Anti-Poverty


Programs

How will an irrigation project affect the incomes of poor


farmers?

Assume: An unskilled worker has two job choices


Work as a Textile worker for $8,000/yr, or,
Rent land to grow rice
o Rent = $5,000/yr
o Non-labor cost = $3,000/yr
o TR = $16,000/yr
o Accounting Profit = $16,000 8,000 = $8,000/yr,
same as textile workers; Economic Profit = 0.

The state funds an irrigation program that doubles output


but does not change the market price.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 43

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Invisible Hand in Anti-Poverty


Programs

What will be the impact of the irrigation


program on incomes of tenant farmers?
TR

will increase to $16,000 x 2 = $32,000


Accounting Profit = $32,000 8,000 = $24,000
Economic Profit = $24,000 8,000 = $16,000
So now there is cash-on-the-table in farming
Supply of land is fixed. Demand for land will increase to
eat up the entire additional $16,000 of eco profit. New
increased rent on land = $5,000 + $16,000 = $21,000
The land owners gain, not the tenant farmers

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 44

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The Invisible Hand and the Stock


Market

One of the most competitive markets is the


market for stocks and bonds on Wall Street.

Calculating the value of a share of stock


A share

of stock in a company is a claim to a


share of the current and future accounting profits
of that company.
The price of a share of stock depends on
The

companys current and expected future


accounting profits
The market interest rate, as the next example shows
Copyright c 2007 by The McGraw-Hill
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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 45

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The Invisible Hand and the Stock


Market

Assume
Accounting

profit = $1 million
1,000 shares of stock
Annual interest rate = 5%

Price/share
Each

share pays $1,000/year ($1 million/1,000)


At 5% a $20,000 savings account pays $1,000/yr
Therefore, the stock price = $20,000

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 46

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The Invisible Hand and the Stock


Market

Future profits are not certain.

So, current price of a share of stock depends


on investors estimates about future profits.

These estimates incorporate information


about current profits, prospects for the
companys industry, state of the economy,
demographic trends, etc.

As this information changes, so does the


price of a share of stock.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 47

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The Efficient markets Hypothesis

The Efficient Market Hypothesis is


essentially a no-cash-on-the-table
hypothesis.

New information is reflected in the current


price of a stock with amazing speed and
accuracy.

The current price of a stock reflects all


relevant information about its current and
future earnings prospects.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 48

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Efficient Markets Hypothesis

What do you think?


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?
Good

management is better than bad management,


but the surplus is captured by those that provide that
better management and not the stockholders.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 49

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The Distinction Between an


Equilibrium and a Social Optimum
The equilibrium (no-cash-on-the-table) principle
means that there are no unexploited opportunities
in markets that are in equilibrium.

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.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 50

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The Distinction Between an


Equilibrium and a Social Optimum

Are there too many smart people working as


corporate earnings forecasters?

The analyst with the best forecasting model will earn


a windfall by buying stocks whose prices are about to
rise.

Given the speed of response of stock prices to new


information, the second best forecasting model,
however good, is of no use.

So a rat race to number one place is rational from a


private perspective but not necessarily from a social
point of view.

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Chapter 8: The Quest for Profit and the Invisible Hand

Slide 51

End of
Chapter
MB

MC

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