Chapter 7

Efficiency, Exchange, and the Invisible

Hand in Action

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 Learning Objectives
1. Define and explain the differences between accounting
profit, economic profit, and normal profit.
2. Explain the invisible hand theory and show how
economic profit and economic loss affect the allocation
of resources across industries.
3. Explain why economic profit, unlike economic rent,
tends toward zero in the long run.
4. Identify whether the market equilibrium is socially
efficient and why no opportunities for gain remain open
for individuals when a market is in equilibrium.
5. Calculate total economic surplus and explain how it is
affected by policies that prevent markets from reaching
equilibrium. 2
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 The Invisible Hand
• Individuals act in their own interests
– Aggregate outcome is collective well-being
• Profit motive
– Produces highly valued goods and
services
– Allocates resources to their highest value
use

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 Accounting Profit
Accounting profit =

Total revenue –
Explicit costs
– Explicit costs are payments firms make to purchase
• Resources (labor, land, etc.) and
• Products from other firms
• Easy to compute
• Easy to compare across firms

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 Economic Profit
Economic profit =
Total revenue – Explicit costs – Implicit costs
– Also called excess profits
• Implicit costs are the opportunity costs of the
resources supplied by the firm's owners
• Normal profit is the difference between
accounting profit and economic profit
– Normal profits keep the resources in their current
use

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 Three Kinds of Profit
Total Revenue = Explicit costs + Accounting profit

Total
Revenue Explicit
Costs
Explicit
Costs
Accounting
Profit

Economic Profit = Accounting Profit – Normal Profit Economic Profit

Normal
Normal Profit Economic
Profit Profit
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 Example: Economic Profit Guides
Decisions
• Pudge Buffet's decision: continue farming or
quit?
– Quit farming and earn $11,000 per year working retail
– Explicit farm costs are $10,000
– Total revenue is $22,000

Accounting Economic Normal

Profit Profit Profit
$12,000 $1,000 $11,000
– Pudge should stick with farming
• His economic profit is positive

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 Example: Economic Profit Guides
Decisions: A Change in Revenue
• Pudge Buffet's decision: continue farming or
quit?
– Quit farming and earn $11,000 per year working retail
– Explicit farm costs are $10,000
– Total revenue is $20,000

Accounting Economic Normal

Profit Profit Profit
$10,000 -$1,000 $11,000
– Pudge should quit
• His economic profit is negative

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 Example: Owned Inputs
• Rent for the farmland is $6,000 of the $10,000 in
explicit costs
– What changes if Pudge inherits the land?
• His rent payments become an implicit cost
Total Revenue Explicit Costs Implicit Costs

$20,000 $4,000 $17,000

Accounting Economic
Normal Profit
Profit Profit
$16,000 -$1,000 $17,000

• Pudge should quit farming

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 Two Functions of Price
• Rationing function of price distributes scarce
goods to the consumers who value them most
highly
• Allocative function of price directs resources
away from overcrowded markets to markets that
are underserved
• Invisible hand theory states that the actions of
independent, self-interested buyers and sellers
will often result in the most efficient allocation of
resources
– Adam Smith

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 Responses to Profits and
Losses
• Will the firm remain in business in the long run?
– If it covers ALL of its costs
• Firms that earn normal profit recover only their
opportunity cost
• Firms that earn positive economic profit recover more
than their opportunity cost
• Markets in which firms are earning economic profit will
attract resources
• Markets in which firms are suffering economic losses will
lose resources

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 Response to Economic Profits
• Markets with excess profits attract resources
Corn Industry Typical Corn Farm
Price Price
S
$/bu $/bu MC ATC
Economic
Profit

2 2 P

1.20
D

65 130
Quantity (M of bushels/year) Quantity (1,000s of bushels/year)
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 Shrinking Economic Profits
• Supply increases
Corn Industry Typical Corn Farm
Price Price
S
$/bu $/bu MC ATC
S'

Economic
Profit
2
1.50 P

65 95 120 130
Quantity (M of bushels/year) Quantity (1,000s of bushels/year)
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 Market Equilibrium
• Zero economic profits
Corn Industry Typical Corn Farm
Price Price
S
$/bu $/bu MC ATC
S'
S"

2
1.50
1 P
D

65 115 90 130
Quantity (M of bushels/year) Quantity (1,000s of bushels/year)
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 Economic Losses
• Resources leave
Price Corn Industry Price Typical Corn Farm
MC ATC
$/bu $/bu

1.05
0.75 0.75 P
D
60 70 90
Quantity (M of bushels/year) Quantity (1,000s of bushels/year)
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 Market Equilibrium
• No economic losses

Price Price
MC ATC
$/bu $/bu

S'
S

1 P
0.75
D
40 60 70 90
Quantity (M of bushels/year) Quantity (1,000s of bushels/year)
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 Constant-Cost Industry
• In the long run, corn costs $1 per bushel regardless of
the size of the industry

Price Price
$/bu $/bu MC ATC

S P
1.00
D

Quantity (M of bushels/year) Quantity (1,000s of bushels/year)

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 Example: Movement Toward
Equilibrium
• Imagine haircut and Pilates markets are in
equilibrium (long run) and then demand for haircuts
drops, and demand for exercise increases
• All markets are in equilibrium when
– Demand for haircuts decreases
– Demand for exercise increases
• Price of haircuts goes down; hairstylists have losses
• Price of aerobics classes go up; instructors have
excess profits
• Eventually the long-run prices of haircuts and
Pilates classes return to long-run equilibrium
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 Short-Run Adjustments

Haircut Market Pilates Market

Price ($/haircut)

Price ($/class)
S
15
15
D'
12 10
D
D' D

350 500 200 300

Haircuts/day Classes/day

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 Short-Run Adjustments

Typical Hair Salon ATCH Typical Pilates Studio ATC

A
MCH
Economic MCA
Economic
profit
loss

Price ($/class)
Price ($/haircut)

15
15.5
11
12

Q'H QH QA Q'A

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 Free Entry and Exit
• Barrier to entry: any force that
prevents firms from entering a new
industry
– Legal constraints
– Practical factors
• Free entry and exit is required for the
invisible hand to hold

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 Economic Rent
• Economic profits tend toward zero, yet people
get rich
• Economic rent is the portion of a payment to a
factor of production that exceeds the owner's
reservation price
– People who love their work
– Non-reproducible input
• The case of the talented chef
– Unique talent for cooking
– In equilibrium, pay the chef the increase in revenue
from her talent
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 Invisible Hand in the
Supermarket
• No-Cash-on-the-Table Principle refers
also to any other opportunity to achieve
a more desirable outcome
– short check-out lines get longer…quickly
• Start in the shortest line
– Observe the pace of all lines
• Missing price in your line
• Complaining customer next to you
– Decide whether to switch
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 Invisible Hand and Cost-
Saving Innovations
• Competitive firms are price takers
– Cost management required
• Innovation lowers cost for one firm
– Profits increase by amount of cost savings
– Information is freely available
• Industry costs decrease
• Equilibrium price decreases by amount
of cost savings
– No excess profit
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 Example: Shipping
Innovation
• 40 companies compete in transoceanic
shipping
– Cost per trip is $500,000
• One firm innovates to save $20,000 in fuel per
trip
– Short-run economic profit
• Over time, competitors copy the innovation
– Industry costs decrease by $20,000
– Equilibrium price decreases by $20,000
• In the long run, no firm earns economic profit
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 Market Equilibrium and Big
Payoffs
• Equilibrium leaves no further opportunities
for mutually beneficial exchange for
individuals to gain
– Market prices of resources will reflect their private
economic values to the people who own them
• Exploiting opportunities moves the market towards
equilibrium
• Three ways to earn a big payoff:
1. Work exceptionally hard
2. Have some unique skill or talent
3. Be lucky
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 Invisible Hand and Socially
Optimal Outcome
• Markets work best when
– Buyers' marginal benefits = sellers' marginal costs
AND
– Society's marginal benefits = society's marginal
costs
• Individual spending to improve a stock price
forecast may benefit the individual
– Some other individual loses
– Return to society of the investment is less than
the benefit

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 Market Equilibrium and
Efficiency
• Economic efficiency exists when no
change could be made to benefit one
party without harming the other
– Sometimes called Pareto efficiency
– Different from engineering efficiency
– Equilibrium price and quantity are efficient
– Prices above or below equilibrium are not

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 Price Below Equilibrium
• Suppose milk is $1 per gallon

S
2.50

2.00
Price ($/gallon)

1.50

1.00

0.50
D
1 2 3 4 5
Quantity (1,000s of gallons/day)

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 Price Below Equilibrium
• A buyer offers $1.25
• There’s a seller who would happily take that price!
S
2.50

2.00
Price ($/gallon)

1.50
1.25
1.00

0.50
D
1 2 3 4 5
Quantity (1,000s of gallons/day)
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Price above Equilibrium

S
2.50
2.00
Price ($/gallon)

1.75
1.50
Only equilibrium
price is efficient
1.00

0.50
D
1 2 3 4 5
Quantity (1,000s of gallons/day)

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 Efficiency Conditions

Perfectly No Costs or
Competitive Benefits
Markets Shifted

Market
Efficiency

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 Trade-Offs
Efficiency Equity

Basic Needs

Maximum
Total Surplus Fairness

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 The Cost of Preventing Price
Adjustments
• Price ceilings
– A maximum allowable price, specified by
law
• Price subsidies
– Meant to assist low-income consumers,
governmental funding of “essential” goods
and services

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Example: Heating Oil Market
2.00
1.80
S
1.60 Consumer surplus = $900/day
1.40
Price ($/gallon)

1.20
Producer surplus = $900/day
1.00
.80

D
1 2 3 4 5 8
Quantity (1,000s of gallons/day)
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Price Ceiling on Heating Oil
2.00 Consumer surplus = $900/ day
1.80 S
1.60
Price ($/gallon)

1.40 Lost surplus = $800/ day

1.20
1.00
0.80 Producer surplus = $100/ day

D
1 2 3 4 5 8
Quantity (1,000s of gallons/day)
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 Surplus Lost to a Price Ceiling
• $800 underestimates surplus loss
– Consumers place different values on
heating oil
• If a person with a lower reservation price gets
the oil, there is additional surplus lost
• Shortages increase non-market costs
– Waiting in line
– Side payments

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Alternative Heating Oil Policy
Surplus with Surplus with Income
Price Controls Transfers Only

R
R

P
P

R = high income
P = low income
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 Example: Price Subsidy for Bread

• Imported bread costs $2

– Perfectly elastic supply
• Government program to subsidize
bread
– Government imports bread for $2
– Government sells bread for $1
– Results
• More bread
• Less efficiency

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Price Subsidies for Bread
Price
($/loaf)
$4.00 Consumer Surplus = $4 M/month

$3.00

$2.00 S
Consumer Surplus = $9 M/month
$1.00
S with subsidy
D
2 4 6 8
Quantity (millions of loaves/month)
BUT…
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 The Cost of the Subsidy
• The bread subsidy appears to increase
consumer surplus from $4 million to $9
million
• BUT …
– The government loses $1 on every loaf
• Imports 6 million loaves for $2 per loaf
– Government losses are $6 million
• The net benefit of the subsidy program
– Consumer surplus – government losses
– Net benefit = $3 million
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Price Subsidies for Bread
Price
($/loaf) Consumer Surplus
$4.00
Total Surplus Lost
$3.00 = $1 M/month

$2.00 S
Government Losses
$1.00
S with subsidy
D
2 4 6 8
Quantity (millions of loaves/month)

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 Invisible Hand in Action
Economic Invisible
Efficiency Hand
Resource
Allocation
Profits
Market
Equilibrium
Economic
Examples Rents

Price Ceilings

Subsidies
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