Lecture 8 the Invisible Hand in Action2

The Invisible Hand

Ch. 7

The Invisible Hand Theory


Adam Smiths theory that the actions of independent self-interested buyers and sellers will often result in the most efficient allocation of resources

According to Adam Smith

People are motivated by self-interest

Under certain conditions (perfect competition, no external costs and benefits etc.), the goal of profit/utility maximization will serve societys collective interest

Giordani - Principles of Economics 2


It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages

(Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776)

In this lecture we analyze the long run implications of the invisible hand under perfect competition


Accounting, Economic and Normal Profit


Explicit and Implicit Costs

Explicit costs The actual payments a firm makes to its factors of

production and other suppliers

Implicit costs The opportunity costs of the resources supplied by the

firms owners


Accounting Vs. Economic Profit

Accounting profit total revenue minus explicit costs

Economic profit total revenue minus explicit costs minus implicit costs


Accounting Profit

Example: a construction firm Assume Total Revenue (TR) = 400,000/yr

Explicit costs (salaries + intermediate goods) = 250,000/yr

Machinery and other equipment with a resale value of 1 million (supplied by the owner of the firm)

Job opportunity for the firm owner: 45,000/yr

Accounting Profit TR explicit cost

400,000 - 250,000 = 150,000


Now calculate the opportunity cost of the resources supplied by the firm (i.e. implicit costs)

One implicit cost is the job opportunity of the firm owner: 45,000

Moreover,

If annual interest on savings = 10%

the 1 million spent on equipment could have earned 100,000/yr, had it been invested (i.e. implicit cost)

Economic profit TR explicit cost implicit cost

400,000 - 250,000 - 100,000 45,000= 5,000/ yr

Economic Profit


Normal Profit

Normal Profit = Accounting Profit Economic Profit

= implicit costs

Accounting Profit 150,000/yr

Economic Profit 5,000/yr -

Normal Profit 145,000/yr


Accounting, Economic and Normal Profit


The Central Role of Economic Profit

In the following we are going to explain the meaning of a null economic profit (and thus of an accounting profit being equal to normal profit)

We will show that zero economic profit, far from implying troubled firms exiting from the market, is actually the standard state of affairs in a perfectly competitive market in the long-run In fact, null economic profit does not imply that workers

are not paid, capital is under-remunerated etc., It actually implies all factors of production are paid exactly

their perfectly competitive prices


Economic Profits in the Long-run in Perfectly Competitive Markets


Example: Short-run economic profit in the cement market

Market price of 2/tonne produces economic profits Economic profits = (2 - 1.20)130 tonnes/yr = 104,000/yr Is this a stable situation?

Competitive equilibrium in the short run


Economic profits attract firms (supply shifts outwards), reducing prices and economic profits Is this a stable situation?

Market entry


As long as price remains above the minimum

value of ATC, profits lure new entrants.

Supply continues to shift out until price falls to min ATC

At that point economic profit is zero and there is no further incentive to enter Accounting profit = normal profit

Competitive equilibrium in the long run


Entry of firms continues until all firms earn an economic profit of zero.

Equilibrium when entry stops


Competitive equilibrium in the long run

When a firm is making positive economic profit, it is earning more than the cost of all the resources required to produce the goods it sells.

This means that another firm could produce the same goods and, in the process, increase its owners' wealth.

Entry by new firms will cause price to fall until

economic profit is driven down to zero.

Competition tends to drive economic profit down to zero


Prices below ATC (but above AVC) results in economic losses Economic Loss = (0.75 - 1.05)70 tonnes/yr = 21,000/year Is this a stable situation?

Short-run economic loss in the cement market

Equilibrium in the short run


The exit of firms from the industry shifts supply inwards. The market price increases (loss=0)

Equilibrium when exit stops

Market exit and long run equilibrium


An industry in which firms are earning negative economic profit is one in which firms are failing to cover all the costs of the resources they use.

If this situation is expected to persist, some firms will go out of business.

Exit will continue until price rises to cover all resource costs.

So again, in the long-run equilibrium of a competitive industry, firms will earn zero economic profit

Competition tends to drive economic profit down to zero


In a competitive market, all firms will tend to earn zero economic profits in the long run

This is the consequence of the price movements caused by entry and exit of firms trying to maximize economic profits Markets with firms earning economic profits will attract firms Markets where firms are experiencing economic losses tend

to lose firms

The equilibrium principle (no-cash-on-the-table) predicts that, when rational economic agents face an opportunity for gain, they are quick to exploit it.



Example: hair stylists Vs. aerobics instructors


What happens in a city with too many hair stylists and too few aerobics instructors?

Both markets are initially in their long run equilibrium

Short-run demand shifts

Assume: Long hair and physical fitness become popular Demand for haircuts falls and demand for aerobics classes rises



Short-run economic profit and loss

The decrease in demand for haircuts causes economic loss (a) The increase in demand for classes creates economic profit (b)



Responses to the change in demand for hair stylists and aerobics instructors

Economic loss for hair stylists will Reduce the supply of stylists

Increase the price until zero economic profits occur

Economic profit for aerobics instructors will Increase the supply of instructors

Decrease the price until zero economic profits occur



Free entry and exit must exist for the invisible hand to operate.

An entry barrier is any force that prevents firms from entering a new market. Entry barriers can be caused by legal constraints and

unique market characteristics.

Exit barriers are frequently caused by political responses to declining demand or rising costs.

For instance, the government might decide to keep alive economic activities that otherwise would be shut down

Free entry and exit


Economic Profit Vs. Economic Rent


Economic rent that part of a payment for a production factor that exceeds the

owners reservation price

Economic profit is also given by the payment that exceeds the sellers reservation price

Crucial difference: Positive economic profits attract resources that push them to

zero in the long run

Economic rent cannot be pushed to zero because it is associated to special inputs which cannot be replicated easily

Examples of non-reproducible inputs: land, exhaustible resources, talent etc.

These inputs can be paid well above their own reservation price!



Example: a talented basketball player

Suppose that the owner of the team that wins the NBA Championship receives additional television revenues of $40 million.

How is the amount of the economic rent determined?


For several years, whichever team hired Shaquille ONeal won the Championship


How is the amount of the economic rent determined?

There is free agency and teams can bid openly for any player's services. By how much will ONeal's salary exceed the salaries of other players? Suppose ONeal received only a $39 million salary premium from his current team Some other team could increase its wealth by bidding ONeal away with a higher salary Only when ONeal's salary premium is $40 million will there be no further tendency for bidding


Example: a talented basketball player How is the amount of the economic rent determined?

Thus, economic rent is the difference between the market price for normal players and that for the talented player

The rent, which is determined by the market, is entirely appropriated by Oneal as some sort of reward for his talent

Although competition drives economic profit to zero, economic rent can persist indefinitely



The size of the economic rent that your talent enjoys, however, also depends on how big the demand is for your talent



Who of them earns more? Why?

Short run Vs. Long run

Perfect competition looks like an extremely boring situation firms produce the same good with the same techniques their profits tend to zero in the long run and nothing ever

happens that changes this state of the world

Indeed, perfect competition is not static at all firms operate diverse strategies to raise their economic profits

in the short run (such as introducing innovations to their products)

It is true that, in the long run, competition erodes economic profits

But the long run equilibrium must be interpreted as a configuration towards which the system tends to converge over time but that it never reaches: in the long run we are all dead (J. M. Keynes)


Innovations and Perfect Competition


Why do firms have an incentive to introduce innovations?

How do innovations affect economic profit in the short run?

And in the long run?

Let us consider an example with a cost-saving innovation

Cost-saving innovations


A trucker gets 5000 for driving a trailer full of cargo from Rome to Moscow, a trip that takes him one week.

The rent for his rig is 3000/wk and he spends 1000 on gas.

Meals and other expenses come to another 500/wk.

His alternative employment is to work as a local deliveryman at a salary of 500/wk, a task he finds equally attractive as trucking

What is this trucker's economic profit?

The trucker example


Total revenue = 5000

Total cost = 3000 + 1000 + 500 + 500 = 5000

Economic profit = 5000 - 5000 = 0

The trucker example


Now suppose the trucker from the previous example installs an airfoil on the roof of the cab of his rig, resulting in a fuel savings of 25 percent

1970 1985

The trucker example


If the airfoil rents for 50/wk, what is the trucker's new economic profit?

Total revenue = 5000/wk, the same as before.

Total cost = 3000 + 750 + 500 + 500 + 50 =

4800 So economic profit = 5000 - 4800 = 200

The trucker example


This trucker makes positive profits to the extent that nobody else installs the airfoil

Is this a stable situation?

The no cash on the table principle suggests us that more and more truckers install the airfoils

The trucker example


As more and more truckers install the airfoils, the cost of the service goes down and this places downward pressure on trucking prices

By the time all truckers have installed the airfoils, trucking rates will have fallen by the full 200 in net cost savings made possible by the airfoil (from 5000 to 4800)

The trucker example

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Two key points

1. There exists an incentive to innovate:

Early adopters of cost-saving innovations tend to earn temporary positive economic profits

2. The benefits associated with innovation tend to diffuse across the society

The adoption of an innovation by the innovative firm forces all other competitors to do the same if they want to remain in the market

The innovator might be led by pure self-interest (gaining temporary positive profits)

Still, this purely selfish behavior is the main engine of economic progress, and hence it greatly contributes to the welfare of society as a whole

The invisible hand theory!

Profits and Economic Progress


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Lecture 8 the Invisible Hand in Action2