08 the Invisible Hand in Action

8/10/2019 08 the Invisible Hand in Action

1/52

MB MC

The Invisible Hand In

Action


2/52

MB MC

Copyright c 2007 by The McGraw-HillCopanies! Inc" All rights reserved"

Chapter #$ %lasticity &lide 2

'earning (b)ectives

1.

Accounting, Economic and Normal Profit.2. Allocation of resources through economic profit

and economic loss the example of perfectcompetition.

3. Difference beteen economic profit and economicrent

!. "n#isible hand$ applications in e#er%da% life

&. 'ar(et e)uilibrium #ersus social optimum.


3/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide /

The Invisible Hand

"n this chapter e ill stud% the natureof forces that guide the in#isible hand.

Adam *mith+s #ision as thatPeople are moti#ated b% selfinterest.

-he goal of profit maximiation /underman% conditions0 ser#e societ%+s collecti#e

interest.


4/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide #

Three Types o .roit

Accounting Profit total re#enue explicit costs /pa%mentsfor factors of production0

Economic Profit total re#enue explicit costs implicitcosts /opportunit% cost of the resources supplied b% the

firm+s oners0 Normal Profit accounting profit economic profit "mplicit

costs

"f economic profit, normal profitaccounting profit

"f economic profit then Normal Profit Acc Profit.

4ence, positi#e economic profits are called supernormalprofits


5/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide

Three 1inds o .roit

Totalreven,e

%plicit

costs

Acco,ntingproit

3oral proit 4opport,nity cost oreso,rces s,pplied

by owners o ir

%conoicproit

%plicit

costs


6/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide 5

Calc,lating .roits

*uppose a firm has the folloing$

TR 5!,6 Explicit costs /salaries0 52&,7%r

'achiner% and other e)uipment ith a resale #alue of 51million

Annual interest on sa#ings 18 /implies that the 51 millionspent on e)uipment could ha#e earned 51,7%r had itbeen in#ested06 this is the implicit /opportunit%0 cost

Accounting Profit $ 5!, 52&, 51&,

Economic Profit$ 5!, 52&, 51, /implicitcost0 5&,

Normal Profit Accounting Profit /51&,7%r0 EconomicProfit /5&,7%r0 51,7%r 9:


7/52

MB MC



6hy Are The istinctions Iportant8

-o ma(e correct decisions. Example*hould 'r. A sta% in farming or should he manage

a retail store;

Assumptions4e is a corn farmer ith pa%ments for land and

e)uipment /5


8/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide *

9even,e! Costs! and .roit &,ary

Total %plicit Iplicit Acco,nting %conoic 3oralreven,e costs costs proit proit proit:;>!000

20!000 >0!000 >>!000 >0!000 ->!000 >>!000

> 2 / # 5

"f ->522,, 'r. A is better off farming than as a storemanager. "f -> falls to 52,, economic profit is 51,hich means he can ma(e 51 more as a store managerthan in farming. *o he should manage the store.


9/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide ?

6hy Are The istinctions Iportant8

-o remain in business in the long run, 'r. Aould need an economic profit or .

?% a turn of fate, the oner of the land

ma(es a gift of it to 'r. A. -he land can alsobe rented to other farmers for 5


10/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >0

3ew 9even,e! Costs! and.roit &,ary or .,dge

Total %plicit Iplicit Acco,nting %conoic 3oralreven,e costs costs proit proit proit:;


11/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >>

The Invisible Hand Theory

-o @unctions of Price-he rationing function of price

-o distribute scarce goods to thoseconsumers ho #alue them most highl%.

-he allocative function of price

-o direct resources aa% from o#ercrodedmar(ets /here P is too lo to co#er 9:0 and

toard mar(ets that are underser#ed. ?oth these functions of price underlie Adam *mith+s

theor% of the "n#isible hand.


12/52

MB MC



The Invisible Hand 6or@ing as a9esponse to .roits and 'osses

>esponses to Profits and osses'ar(ets ith firms earning economic

profits ill attract resources.

'ar(ets here firms are experiencingeconomic losses tend to lose resources.

>ecall, normal profit is Bust a cost of doing

business. Chen economic profit , %ou areonl% earning normal profit.


13/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >/

>"20

%conoic proit4 ;>0#!000


14/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >#

>"0*

>"0

%conoic proit4 ;0!#00"0 .rice

>20?

The %ect o %ntry on.rice and %conoic .roit

+,antity :illions ob,shels


15/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >

%,ilibri, when %ntry Ceases

S

+,antity :illions ob,shels


16/52

MB MC



>"0

%conoic loss4 ;2>!000


17/52

MB MC



%,ilibri, when %it Ceases

+,antity :illions ob,shels"00 >"00

The depart,re o irs ro the ind,stry increases the ar@et price

S

D

50


18/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >*

'ong 9,n .erectly Copetitive%,ilibri,

"n the longrun, in a competiti#e mar(et, allfirms ill tend to earn ero economic profits.

ero economic profits are the conse)uence of price

mo#ements caused b% the entr% and exit of firmstr%ing to maximie economic profits.

-he e)uilibrium principle /no cash on the table0predicts, hen people confront an opportunit% for

gain the% are almost ala%s )uic( to exploit it.


19/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide >?


-o Attracti#e @eatures-he mar(et outcome is efficient /sociall% optimal0

P = MC /the #alue to bu%ers of the last unit of thegood sold exactl% e)uals the marginal opportunit% cost

to societ% of producing one extra unit of the good0.

-he mar(et is, in a sense, fair.-he price the bu%ers pa% is no higher than the cost

incurred b% sellers.

-he cost includes a normal profit.


20/52

MB MC



'ong 9,n Ind,stry &,pply C,rve

4o ould the long run industr% suppl% cur#e loo(under perfect competition;

Assume that all firms ha#e identical coststructures in the short run. *o all long run

adBustments are made exclusi#el% b% entr% andexit of identical firms using an identicalstandardied production method.


21/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide 2>

'ong 9,n Ind,stry &,pply C,rve

:onsider an initial e)uilibrium at min A-:. *upposedemand rises. Each firm ill produce more and earnpositi#e economic profits in the short run.

Ne firms ill enter the mar(et. *hort run industr% suppl%

cur#e ill shift to the right until prices come don to minA-:.

-he long run industr% e)uilibrium ill settle at Pmin A-:ith the number of firms being higher.

-herefore, the long run industr% suppl% cur#e is a horiontalstraight line at minimum A-:. All long run adBustments aredone through the number of firms in the industr% /under theassumption of identical firms ith identical cost structure0.


22/52

MB MC



The Invisible Hand$ %aple

*uppose that the mar(et for haircuts andaerobics classes are currentl% at their longrun e)uilibria.

*uppose then that long hair becomesfashionable hile citiens become morefitness conscious.

*o, compared to the initial long rune)uilibrium, demand for haircuts ill fall andthat for aerobics ill rise.


23/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide 2/

Initial %,ilibri,in the Mar@et or Hairc,ts

Hairc,ts


24/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide 2#

Initial %,ilibri, in theMar@et or Aerobics Classes

Classes


25/52

MB MC



The &hort-9,n %ect oeand &hits in Two Mar@ets

Hairc,ts


26/52

MB MC



%conoic .roit and'oss in the &hort 9,n

Hairc,ts


27/52

MB MC




>esponses to the change in demand forst%lists and aerobics instructorsEconomic loss for st%lists ill

>educe the suppl% of st%lists

"ncrease the price until ero economic profits occur

Economic profit for aerobics instructors ill"ncrease the suppl% of aerobics classes

>educe the price until ero economic profits occur

Th I t % t d


28/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide 2*

The Iportance o ree %ntry and%it

@ree entr% and exit must exist for the allocati#efunction of price to operate

?arriers to entr% can be caused b% legal constraints/patents, cop%rights, etc0 and uni)ue mar(etcharacteristics /netor(ing externalities andproduct compatibilit% in the softare industr%0

A barrier to exit can become a barrier to entr%

/airline industr% regulation made it impossible forairlines to lea#e unprofitable routes and so airlinesere unilling to enter these mar(ets0


29/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide 2?

%conoic 9ent vs" %conoic .roit

Economic profits attract resources that pusheconomic profits toard ero, in competiti#emar(ets.

Economic >ent-hat part of a pa%ment for a factor of production

that exceeds the oner+s reser#ation price

'ar(et forces ill not push economic rent toero because inputs cannot be replicated easil%.


30/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide /0

%conoic 9ent$ %aple

4o much rent ill a talented chef get;AssumeA communit% ith 1 restaurants

restaurants emplo% chefs ith normal abilit%for 53,7%r /the same amount the% could earnelsehere0

-he 1threstaurant emplo%s a talented chefand customers are illing to pa% &8 more fortheir meals


31/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide />

%conoic 9entDers,s %conoic .roit

AssumeTRat the each of the restaurants is53,, hich %ields a normal profit

TR at the 1threstaurant is 5!&, /&8

more0-he talented chef

Earns 51F, 53, = 51&,

>eser#ation price 53,Economic rent 51&,

-he1threstaurant earns a normal profit


32/52

MB MC



%conoic 9entDers,s %conoic .roit

Ch% not pa% the chef less and increase theeconomic profit for the restaurant;9ther restaurants ill bid him aa%.

*a%, restaurant 1 gi#es the chef 5!, andma(es economic profit of 511,. >estaurant2 ill ant to pa% slightl% more than 5!, andta(e the chef. -he process ill continue until

economic profit is dri#en to ero. 9pportunities for pri#ate gain seldom remain

unexploited for #er% long

MB MC


33/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide //

The Invisible Hand in Action

Economic NaturalistCh% do supermar(et lines tend to be

roughl% the same length;

Ch% do all lanes on a croded, multilanefreea% mo#e at about the same speed;

MB MC Invisible Hand and Cost &aving


34/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide /#

Invisible Hand and Cost &avingInnovation

Ch% do firms ha#e an incenti#e to introducecostsa#ing inno#ations; 4o do costsa#ing inno#ations affect economic profit inthe short run; "n the long run;

Assume! companies transport oil from the middle east

to the G.*.

-he cost7trip, including normal profit, is 5&,

9ne compan% disco#ers the use of a nepropeller that sa#es 52,7trip

MB MC Invisible Hand and Cost &aving


35/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide /

Invisible Hand and Cost &avingInnovation

*hort >un

No impact on price6 A-: and ': ill shift don6Economic profits for the compan% ill increase b%52,7trip

ong >un9ther companies ill introduce the propeller

A-: and ': for all firms ill shift don6 mar(et

suppl% ill shift to the right and price ill fallero economic profits after all firms ha#e adopted

the ne propeller6 prices loer for the consumer

MB MC


36/52

MB MC



.resent isco,nted Dal,e

:alculating the Present Discounted Halue of@uture :osts and ?enefits-he time #alue of mone%

"s the concept that a gi#en dollar amount toda% ise)ui#alent to a larger dollar amount in the futurebecause of interest earnings.

-herefore, earnings recei#ed in the future are

less #aluable than earnings toda%.*imilarl%, costs incurred in the future are lesscostl% toda%.

MB MC


37/52

MB MC




Deposit 51 I r 18 or .1After 1 %ear

51/1.10 511

-herefore, the PDH of 511 a %ear from nois 51.

After 2 %ears

51/1.10/1.10 51/1.102 5121

-herefore, the PDH of 5121, to %ears fromno is 51.

MB MC


38/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide /*


Jenerall%PDVof a pa%ment Mto be recei#ed - %ears

from no at interest rate r, is$

Chat is the #alue of a compan% toda% if it illearn its onl% accounting profit of 51!,! in to%ears, gi#en r 28;51!,!7/1 = .202 51,

Tr

MPV)1( +

=

MB MC Invisible Hand in 9eg,lated


39/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide /?

Invisible Hand in 9eg,latedMar@ets

Ch% do Ne Kor( :it% taxicab medallions sell formore than 53,;

*uppose

Annual cost of operating the cabs /includingdepreciation and all opportunit% costs0 5!,

TR7%ear 5


40/52

MB MC


Chapter *$ The +,est or .roit and the Invisible Hand &lide #0


4ad the medallion been free, the cab dri#er+s economicprofit ould be 52,. -his economic profit ould attractentr% into the taxi mar(et.

"t ould re)uire an%one to (eep 5333,333 in the ban( at


41/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide #>


Ch% did maBor commercial airlines installpiano bars on the upper dec(s of ?oeing!s in the 1s;Gntil late 1F airlines ere regulated b% the

federal agenc% :A? /:i#il Aeronautics ?oard0.

>egulated prices on popular routes ere ellabo#e free mar(et e)uilibrium #alues, thus

generating economic profits hich ere thensupposed to pa% for ser#ice on sparsel% tra#eledroutes.

MB MC Invisible Hand in 9eg,lated


42/52




Cith regulated fares, competition could not dri#edon prices

*o airlines competed for passengers b% pro#idingnon monetar% incenti#es li(e adding more flights,

piano bars, fanc% food, etc. Airlines added more flights on each route until

economic profits ere dri#en to ero.

"ntrastate /ithin state li(e *an Diego to *an@rancisco0 carriers /not regulated b% :A?0 foundpassengers sacrificed amenities for loer prices.

MB MC Invisible Hand in Anti .overty


43/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide #/

Invisible Hand in Anti-.overty.rogras

4o ill an irrigation proBect affect the incomes of poorfarmers;

Assume$ An uns(illed or(er has to Bob choices

Cor( as a -extile or(er for 5F,7%r, or,

>ent land to gro riceo >ent 5&,7%r

o Nonlabor cost 53,7%r

o TR 51


44/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide ##

Invisible Hand in Anti-.overty.rogras

Chat ill be the impact of the irrigationprogram on incomes of tenant farmers;TR ill increase to 51


45/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide #

The Invisible Hand and the &toc@Mar@et

9ne of the most competiti#e mar(ets is themar(et for stoc(s and bonds on Call *treet.

:alculating the #alue of a share of stoc(

A share of stoc( in a compan% is a claim to ashare of the current and future accounting profitsof that compan%.

-he price of a share of stoc( depends on-he compan%+s current and expected future

accounting profits

-he mar(et interest rate, as the next example shos

MB MC The Invisible Hand and the &toc@


46/52




AssumeAccounting profit 51 million1, shares of stoc(

Annual interest rate &8

Price7shareEach share pa%s 51,7%ear /51 million71,0

At &8 a 52, sa#ings account pa%s 51,7%r-herefore, the stoc( price 52,

MB MC The Invisible Hand and the &toc@


47/52




@uture profits are not certain.

*o, current price of a share of stoc( dependson in#estors+ estimates about future profits.

-hese estimates incorporate informationabout current profits, prospects for thecompan%+s industr%, state of the econom%,

demographic trends, etc.As this information changes, so does the

price of a share of stoc(.

MB MC

Th %i i @ H h i


48/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide #*

The %icient ar@ets Hypothesis

-he Efficient 'ar(et 4%pothesis isessentiall% a nocashonthetableh%pothesis.

Ne information is reflected in the currentprice of a stoc( ith amaing speed andaccurac%.

-he current price of a stoc( reflects allrele#ant information about its current andfuture earnings prospects.

MB MC

%i i t M @ t H th i


49/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide #?

%icient Mar@ets Hypothesis

Chat do %ou thin(;:an %ou increase %our profit in the stoc( mar(etb% using information from the mass media;

Do stoc(s in ellmanaged companies perform

better than those in poorl% managed companies;Jood management is better than bad management,

but the surplus is captured b% those that pro#ide thatbetter management and not the stoc(holders.

MB MC

Th i ti ti B t


50/52



The istinction Between an%,ilibri, and a &ocial (pti,

-he e)uilibrium /nocashonthetable0 principlemeans that there are no unexploited opportunitiesin mar(ets that are in e)uilibrium.

-he mar(et e)uilibrium does not impl% that the

resulting allocation is necessaril% best from thepoint of #ie of societ% as a hole.

-he smart for one, dumb for all principle

E)uilibrium ill not be sociall% optimal hen thecost and benefits for the indi#iduals differ fromsociet% as a hole.

MB MC

The istinction Bet een an


51/52


Chapter *$ The +,est or .roit and the Invisible Hand &lide >

The istinction Between an%,ilibri, and a &ocial (pti,

Are there Otoo man% smart people or(ing ascorporate earnings forecasters;

-he anal%st ith the best forecasting model ill earna indfall b% bu%ing stoc(s hose prices are about to

rise. Ji#en the speed of response of stoc( prices to ne

information, the second best forecasting model,hoe#er good, is of no use.

*o a rat race to number one place is rational from apri#ate perspecti#e but not necessaril% from a socialpoint of #ie.


52/52

MB MC

%nd o

Chapter

Documents

08 the Invisible Hand in Action