Chapter 7 - Efficiency, exchange, and the invisible hand in action. In chapter 6 our focus will shift to the seller’s side of the market, where our task will be to see why upward-sloping supply curves are a consequence of production decisions taken by firms whose goal is to maximize profit.
Efficiency, Exchange, and the Invisible Hand in Action Chapter McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved.71 Learning Objectives Define and explain the differences between accounting profit, economic profit, and normal profit Explain the Invisible Hand Theory and show how economic profit and economic loss affect the allocation of resources across industries Explain why economic profit, unlike economic rent, tends toward zero in the long run Identify whether the market equilibrium is socially efficient, and explain why no opportunities for gain remain open for individuals when a market is in equilibrium Calculate total economic surplus and explain how it is affected by policies that prevent the market from reaching equilibrium 72 Markets Are Dynamic • Every time you see one of these signs, you see the market dynamics at work: – – Store for Lease Going Out of Business Sale • – – – Everything Must Go Now Open Close-Out Model Under New Management 73 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 • LeBron James does not receive training as a baseball player 74 Accounting Profit • Most common profit idea 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 75 Economic Profit • Economic profit is the difference between a firm's total revenue and the sum of its explicit and 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 76 Three Kinds of Profit Total Revenue = Explicit Costs + Accounting Profit Total Revenue Explicit Costs Explicit Costs Accounting Profit Economic Profit = Accounting Profit – Normal Profit Normal Economic Profit Profit 77 Example: Economic Profit Guides Decisions • Kim Hyun-woo'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 Profit $12,000 – Economic Profit $1,000 Normal Profit $11,000 Kim should stick with farming 78 Example: Economic Profit Guides Decisions, A Change in Revenue • Kim Hyun-woo'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 Profit $10,000 – Kim should quit Economic Profit -$1,000 Normal Profit $11,000 79 Example: Owned Inputs • Rent for the farm land is $6,000 of the $10,000 in explicit costs – What changes if Kim inherits the land? • His rent payments become an implicit cost Total Revenue $20,000 Accounting Profit $16,000 • Explicit Costs Implicit Costs $4,000 Economic Profit -$1,000 Kim should quit farming $17,000 Normal Profit $17,000 710 Price Below Equilibrium Suppose milk is $1 per liter Price ($/liter) • S 2.5 2.0 1.5 1.0 0.5 D Quantity (1,000s of liters/day) 731 Price Below Equilibrium A buyer offers $1.25 S 2.50 Price ($/liter) • 2.00 1.50 1.25 1.00 0.50 D Quantity (1,000s of liters/day) 732 Price above Equilibrium S Price ($/liter) 2.50 2.00 1.75 1.50 Only equilibrium price is efficient 1.00 0.50 D Quantity (1,000s of liters/day) 733 Efficiency Conditions 734 Trade-Offs 735 The Cost of Preventing Price Adjustments • Price ceilings – • A maximum allowable price, specified by law Price subsidies – Meant to assist low-income consumers, governmental funding of “essential” goods and services 736 Example: Heating Oil Market Price ($/liter) 2.0 1.8 1.6 1.4 1.2 1.0 S Consumer surplus = $900/day Producer surplus = $900/day D Quantity (1,000s of liters/day) 737 Price Ceiling on Heating Oil 2.00 Consumer surplus = $900/ day S 1.80 Price ($/liter) 1.60 Lost surplus = $800/ day 1.40 1.20 1.00 Producer surplus = $100/ day 0.80 D Quantity (1,000s of liters/day) 738 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 739 Alternative Heating Oil Policy Surplus with Price Controls R P Surplus with Income Transfers Only R P R = high income P = low income 740 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 $1 Results • • More bread Less efficiency 741 Price Subsidies for Bread Price ($/loaf ) $4.00 Consumer Surplus = $4 M/month $3.00 S $2.00 Consumer Surplus = $9 M/month $1.00 D Quantity (millions of loaves/month) S with subsidy BUT… 742 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 million loaves for $2 per loaf Government losses are $6 million The net benefit of the subsidy program – – Consumer surplus – government losses Net benefit = $3 million 743 Price Subsidies for Bread Price ($/loaf) Consumer Surplus $4.00 $3.00 Total Surplus Lost = $1 M/month $2.00 S Government Losses $1.00 D S with subsidy Quantity (millions of loaves/month) 744 Invisible Hand in Action Economic Efficiency Market Equilibrium Invisible Hand Profits Examples Resource Allocation Economic Rents Price Ceilings Subsidies 745 ... Accounting Profit $16,000 • Explicit Costs Implicit Costs $4,000 Economic Profit -$ 1,000 Kim should quit farming $ 17, 000 Normal Profit $ 17, 000 7 10 Two Functions of Price • • • Rationing function of price... 0 .75 P 70 90 Quantity (000s of bushels/year) 7 16 Market Equilibrium • No economic losses Price Price $/bu $/bu S' 0 .75 MC ATC S P D 40 60 Quantity (M of bushels/year) 70 90 Quantity (000s of. .. Three Kinds of Profit Total Revenue = Explicit Costs + Accounting Profit Total Revenue Explicit Costs Explicit Costs Accounting Profit Economic Profit = Accounting Profit – Normal Profit Normal