MB MC

The Quest for Profit

and the Invisible Hand

MB

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MC

MB MC

The Central Role

of Economic Profit

According to Adam Smith

People

are motivated by self-interest.

The goal of profit maximization will serve
societys collective interest.

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8: The Quest for Profit and the Invisible Hand

Slide 2

MB MC

The Central Role

of Economic Profit

Three Types of Profit

Accounting

Profit = total revenue explicit

costs (payments for factors of production)

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8: The Quest for Profit and the Invisible Hand

Slide 3

MB MC

The Central Role

of Economic Profit

Three Types of Profit

Economic

Profit = total revenue explicit

costs implicit costs (opportunity cost of
the resources supplied by the firms
owners)

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8: The Quest for Profit and the Invisible Hand

Slide 4

MB MC

The Central Role

of Economic Profit

Three Types of Profit

Normal

Profit = accounting profit

economic profit

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8: The Quest for Profit and the Invisible Hand

Slide 5

MB MC

The Central Role

of Economic Profit

Calculating Profit
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

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8: The Quest for Profit and the Invisible Hand

Slide 6

MB MC

The Central Role

of Economic Profit

Calculating Profit
Accounting

Profit

$400,000(TR)

- $250,000 (explicit costs) =

$150,000

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8: The Quest for Profit and the Invisible Hand

Slide 7

MB MC

The Central Role

of Economic Profit

Calculating Profit
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

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8: The Quest for Profit and the Invisible Hand

Slide 8

MB MC

The Central Role

of Economic Profit

Calculating Profit
Normal

Profit

Accounting

Profit ($150,000/yr) Economic Profit

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

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8: The Quest for Profit and the Invisible Hand

Slide 9

MB MC

The Difference Between

Accounting Profit and Economic Profit

Total
revenue

Explicit
costs

Explicit
costs

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

Economic
profit

Slide 10

MB MC

The Central Role

of Economic Profit

Why are the distinctions important?

Example
Should

Pudge Buffet stay in the farming

business?

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8: The Quest for Profit and the Invisible Hand

Slide 11

MB MC

The Central Role

of Economic Profit

Why are the distinctions important?

Assumptions
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

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8: The Quest for Profit and the Invisible Hand

Slide 12

MB MC

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)

22,000

10,000

11,000

12,000

1,000

11,000

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8: The Quest for Profit and the Invisible Hand

Slide 13

MB MC

The Central Role

of Economic Profit

What would Pudges 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?

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8: The Quest for Profit and the Invisible Hand

Slide 14

The Central Role

of Economic Profit

MB MC

Example
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

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8: The Quest for Profit and the Invisible Hand

Slide 15

MB MC

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

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8: The Quest for Profit and the Invisible Hand

Slide 16

MB MC

The Central Role

of Economic Profit

A Review
Accounting

Profit = TR explicit costs

Economic Profit = TR explicit and
implicit costs
Economic Profit = 0 when accounting
profit = normal profit
To remain in business in the long run,
economic profits must be greater than or
equal to 0 (zero).
Copyright c 2007 by The McGraw-HillChapter
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8: The Quest for Profit and the Invisible Hand

Slide 17

MB MC

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

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8: The Quest for Profit and the Invisible Hand

Slide 18

MB MC

The Invisible Hand Theory

Two Functions of Price

The

allocative function of price

To

direct resources away from overcrowded

markets and toward markets that are
underserved

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8: The Quest for Profit and the Invisible Hand

Slide 19

MB MC

Ilustration Invisible Hand

Free
drink!!
$7

$6
1

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8: The Quest for Profit and the Invisible Hand

Slide 20

MB MC

Video

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8: The Quest for Profit and the Invisible Hand

Slide 21