Chapter 7 Efficiency, Exchange, and the Invisible Hand in Action
Adam Smith: We address ourselves not to their humanity, but to their self-love, and never talk to them
of our necessities, but of their advantage.
The Central Role of Economic Profit
Three Types of Profit
Explicit Costs: Actual payments the firm makes to factors of production and suppliers
Accounting Profit: Total Revenue Explicit Costs
Implicit Costs: Opportunity costs of all resources supplied by firm
Economic profit, or excess: Total revenue explicit costs implicit costs
Normal profit: Opportunity cost of the resources, Accounting profit Economic profit
Firm to remain in business in the long run, Economic profit >= 0
The Invisible Hand Theory
Two Functions of Price
Ration function of price: Distribute scare goods among potential claimants, those who value
product most
Allocative function of price: Direct productive resources to different sectors of economy
-resources leave market in which price cannot cover cost of production
-resources enter those in which price exceeds the cost of production
Invisible hand theory: Adam Smiths theory that actions of independent, self-interested buyers
and sellers will often result in most efficient allocation of resources
Responses to Profits and Losses
Firm to remain in business in long run = cover both explicit and implicit costs
-normal profit: cost of doing business
-firm earns no more than normal profit, manages to recover the opportunity cost of resources
invested in firm
-firm makes positive economic profit earns more than opportunity cost
Market forces cause Zero Economic Profit
-when economic profit > 0, more suppliers enter
+Supply curve shifts to the right, Price falls
+Economic profit drops to 0, price at where MC= ATC
-when economic profit <0, more suppliers leave
+Supply curve shifts to the left, Equilibrium Price increases
+Economic profit rises to 0, price at where MC=ATC
-assumption that firms can freely enter or leave industry
-consequences of invisible hand theory
+market outcome is efficient in long run
+long-run competitive equilibrium is fair market outcome, buyers pay = cost of suppliers
(normal profit)
The Importance of Free Entry and Exit
Allocative function of price relies on free entry and exit
-barriers to entry: inhibits from market entry
Economic Rent vs. Economic Profit
Economic Rent: Part of the payment for factor of production that exceeds owners reservation price, the
price below which the owner would not supply the factor
-landowners reservation price for land = $100, farmer pays $1000, economic rent = $900
Competition pushes economic profit to 0, no effect on economic rent
-restaurant with very good chef
+all economic rent goes to the chef, other restaurants will bid until chef receives all the
economic rent
+100 restaurants, 99 normal chefs (each $30000) and 1 superb chef (makes diners pay 50%
more for meals)
+99 restaurants (each earn $300000, equal to normal profit), 1 restaurant receives $450000
+Superb chef earns $180000, economic profit for hiring restaurant = $0
The Invisible Hand in Action
At Supermarket and on the Freeway: People are driven towards faster lanes, thus in the long run all
lanes move the same speed
The Invisible Hand and Cost-Saving Innovations
-Firm is passive actor in the marketplace
+Effects of cost-saving innovations for economic profit in short run and long run
-Short Run: some companies gain excess economic profit
-Long Run: all companies earn 0 economic profit
The Distinction between an Equilibrium and Social Optimum
Equilibrium, No-Cash-On-the-Table Principle: market reaches equilibrium, no further opportunities
for gain are available
-Three ways to earn big payoff
+work especially hard
+have unusual skill, talent, or training
+be lucky
-relates to the Individual
Smart for One, Dumb for All
-Adam Smith: individual pursuit of self-interest often promotes broader interests of society [not
always this case]
+exception: stock market analyst models when one individual benefit more than benefit of
society as a whole
Market Equilibrium and Efficiency
Not all markets guarantee fair income distribution, therefore government intervention
-efficient, Pareto efficiency: If price and quantity take anything other their equilibrium values, a
transaction that will make at least some people better off without harming others can always be found.
-vertical interpretation of supply and demand curve: equilibrium price can be efficient
-assumption: perfectly competitive market, marginal cost curves include all cost of production
(externalities), demand curve covers all externalities (e.g. benefit of shrubs to neighbors)
Efficiency Is Not the Only Goal
Efficiency is based on predetermined attributes of buyers and sellers: incomes, taste, knowledge, etc.
-Inequality of income distributions equilibrium in market for milk is efficient taking peoples
incomes as given
Why Efficiency Should Be the First Goal
-Market in equilibrium: no additional opportunities for gain remain available to buyers or sellers
+No Cash On the Table Principle pushes towards equilibrium
+not socially optimal when costs or benefits to individuals differ from society
-Market in equilibrium is efficient, or Pareto efficient: no reallocation without harm to some people
-Total economic surplus maximized at equilibrium price
The Cost of Preventing Price Adjustments
Price Ceilings
See Page 201 and 202
-by setting ceiling to price lower than equilibrium price, total economic surplus is reduced by
triangular area
-producer surplus falls and consumer surplus stays the same
-loss in total economic surplus = loss in producer surplus
+Flaws: Assuming that products will end in consumers who value product most
-Varying reservations prices might lead to products sold to those valuing it less
than others
-Buyers incur costly actions to get product due to shortage (wasting time [time =
money] by going early)
Alternative: Pay the poor with income transfers to heat their homes
-less costly than imposed price controls
-price control reduces the size of the pie, income transfers maintain size of pie
Price Subsidies
Bread: Original = $2, 4000000 loaves where supply curve is perfectly elastic
-Total economic surplus = consumer surplus = $8000000/2 = $4000000
Bread: Subsidized (to increase quantity) = $1, 6000000 loaves, where supply curve is perfectly elastic
-Total economic surplus = consumer surplus = $9000000
-Need to account for subsidy = tax of $6000000, results to reduction of economic surplus by
$1000000
Alternate Interpretation: Original Price and Quantity = Maximized total economic surplus, price =
marginal cost
-as quantity increases, marginal cost of $2 is constant, but worth to buyers decreases
-triangular area under original supply curve and demand curve, bound by new price =
change in total economic surplus
