Chapter 9

The quest for profit and the invisible hand

9.1 The central role of economic profit

Three types of profit
- Explicit costs – the opportunity cost of resources that the firm uses that are supplied
from outside the firm. Explicit costs are calculated as the actual payments the firm
makes to its factors of production and other suppliers.
- Implicit costs – the value of the best opportunity forgone by the firm when it uses
resources supplied by the firm’s owners.
- Economic profit – the difference between a firm’s total revenue and the sum of its
explicit and implicit costs.
Ø Economic profit = total revenue – (explicit cost +implicit cost)
- Accounting profit – the difference between a firm’s total revenue and its explicit costs.
Ø Accounting profit = total revenue – explicit costs
- Normal profit – the level of accounting profit that a firm earns when economic profit is 0.
It is equal to the opportunity cost of the resources supplied to a business by its owners.
Ø Is the implicit cost. The return they could have brought the owner when put to
their best alternative use.
- When a firm earns a normal profit (0 economic profit), the resources that are owned by
the firm’s owners are earning a return exactly equal to their opportunity cost.
Ø I.e. total revenue=total cost
- If a firm’s accounting profit exceed its normal profit, it signals that the owner of the firm
is earning a return on his resources that exceeds their opportunity cost.
Ø Positive economic profit.
- When a firm’s accounting profit falls short of normal profit, the resource is yielding a
return below their opportunity cost.
Ø Economic loss.
- Economic loss – an economic profit that is less than 0.
- Owning land does not increase economic profit. The cost moves from explicit cost to
implicit cost, i.e. opportunity cost.

9.2 The invisible hand theory

The two functions of price
- Two major functions;
Ø Rationing function of price
Ø Allocative function of price
- Rationing function of price – to distribute scarce goods to those consumers who value
them most highly.
- Allocative function of price – to direct resources away from overcrowded markets and
towards markets that are underserved.
- Invisible hand theory – Adam Smith’s theory that the actions of self-interested buyers
and sellers, all acting independently, will often result in the social optimal allocation of
resources.

How firms respond to profits and losses

- If a firm was to remain in business long term, it must cover both explicit and implicit cost.
Ø Since normal profit is equal to implicit cost, the owner has only managed to recover
the opportunity cost of the resources invested in the firm.
- Markets in which firms are earning an economic profit tend to attract additional
resources, whereas markets in which firms are experiencing economic losses tend to lose
resources.
- ATC at any output level is the sum of all opportunity costs divided by output.
- The existence of positive economic profit means that producers in that market are
earning more than their opportunity cost of growing apples.
- This will lead to a large number of producers entering the market, hence shifting supply
to right, causing the market equilibrium price to fall.
Ø Entry will continue until price falls all the way to the minimum value of ATC.
Ø Once price reaches the minimum value of ATC curve, profit-maximising rule results
in a quantity for which price and ATC are the same.
o At that time economic profit is 0.
- If the demand curve results in economic loss, firms will leave the industry, shifting supply
to left, resulting in higher price.
Ø Exit will continue until price rises to minimum ATC.
o At that point economic profit is 0.
- This ensures that in the long run all firms in the industry will tend to earn zero economic
profit.
- Firm’s goal is not to earn zero profit, rather, it is a consequence of the price movements
associated with entry and exit.

Long-run supply in a competitive market

- Long run market supply curve is perfectly elastic or horizontal at the price corresponding
to the minimum point on the short-run ATC curve.
- Since long run marginal cost (LMC) is constant, so is the long run average cost (LAC).
- Long run equilibrium occurs in a competitive market where P=MC=ATC (at min of ATC).
- Two attractive features of perfectly competitive long-run market equilibrium;
Ø The market outcome is efficient. The value of the last unit sold is the long-run
marginal cost of producing it. There is no cash left on the table.
Ø Goods are produced at the lowest cost possible given the technology existing at the
time. Level of output corresponding to the minimum point on their ATC.
- We assume that;
Ø Long-term adjustment process in the market consist exclusive of the entry and exit
of firms that use a single standardized production method.
 Ø The apple growers are able to buy additional apple-growing inputs at fixed costs.

The invisible hand at work

- Strength of the invisible hand is to ensure that productive resources are attracted into
industries where economic profits are positive, and that they leave declining industries
where firms make economic losses.
- In the short run, when demand shifts left, there will be an economic loss.
- In the short run, when demand shifts right, there will be an economic profit.

The importance of free entry and exit

- The invisible hand works effectively because firms can enter and exit markets at will.
- Free entry is a characteristic of perfectly competitive market.
- Barrier to entry – any force that prevents firms from entering a new market.
Ø Copyright law – allows a generating of economic profit for publisher.
Ø Practical constraints such as Microsoft’s software.
Ø Barriers to exist becomes barriers to entry.

9.3 Economic rent versus economic profit

- Economic rent – that part of the payment for a factor of production that exceeds the
owner’s reservation price.
Ø Can be seen as economic profit, the difference between what someone is paid (the
business’ total revenue) and the reservation price for remaining in the business
(sum of all costs, explicit and implicit).
- Whilst economic profit is driven towards zero, economic rent may persist for extended
periods, but only in the case of factors with special talents that cannot easily by
duplicated.

9.4 The invisible hand in action

The invisible hand and cost-saving innovations
- Perfectly competitive firms are price-takers; they take the market price of the product as
given and then produce that quantity of output for which marginal cost equals that price.
- When fruit growers develop cost saving innovations, any firms that did not adopt the
new system will suffer an economic loss.

The invisible hand and government regulation

- Government carries out irrigation project.
Ø But it will increase the wealth of land owners but will have no long-run effect on
the incomes of tenant farmers.
The invisible hand in the stock market
- Share – a claim to a portion of a company’s current and future accounting profits.
- Present value – the amount of money we would need to invest today at a given interest
rate in order to generate a given amount of money at a specified date in the future.

-
Ø r= interest rate
Ø M= payment
Ø PV= present value

The efficient market hypothesis

- Efficient market hypothesis – the theory that the current price of shares in a company
reflects all relevant information about its current and future earnings prospects.
- In practice,
Ø New information often takes time to interpret
Ø Different investors may have different beliefs about exactly what it means
Ø Early information may signal an impending change that is far from certain
- The usual pattern for information to emerge is in bits and pieces, and for share prices to
adjust in small increments as each new bit of information emerges.
- Understanding the way in which self-interested people respond to cash left on the table
in a market will improve an economic naturalist’s ability to critically analyse government
policy by better anticipating its consequences.

9.5 “Smart for one, dumb for the group” revisited

- The “no cash on the table” principle/maxim does not mean that there never are any
unexploited opportunities, but that there are none when the market is in long-run
equilibrium.
- When a market is in equilibrium, it only implies that no additional opportunities are
available to individuals.
- Equilibrium will not be socially optimal when the costs or benefits to individual
participants in the market differ from those experienced by the society as a whole.