Unformatted text preview: Economic Profit = Revenue - Explicit Cost - Implicit cost Accounting Profit - Economic Profit = Implicit Costs = Normal Profit Chapter Chapter 8 The Invisible Hand “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard of their own interest. We address ourselves not to their humanity but their self-love, and never talk to them of our necessities, but of their advantage.”
– Individuals act in their own interests – Aggregate outcome is collective well-being It is as if “the entrepreneur is led by an invisible hand to promote an end which was no part of his intention.” The The Invisible Hand
• Profit motive
– Produces highly valued goods and services – Allocates resources to their highest value use Accounting Profit
• Accounting profit = total revenue – explicit costs
– Explicit costs: actual payments firms make to purchase factors of production. – Most common profit idea
• Objective • Easy to compute • Easy to compare across firms Economic Economic Profit
• Economic profit = total revenue - explicit costs - implicit costs
= accounting profit - Implicit costs • Implicit costs: the opportunity cost of the resources supplied by the firm's owners • Normal profit: the difference between accounting profit and economic profit. Three Kinds of Profit
Accounting Profit = Total Revenue - Explicit Costs Economic Profit = Accounting Profit – Normal Profit Total Revenue Explicit Costs Explicit Costs Economic Profit If accounting profit is 0: 1) owner is not supplying any resources to his business 2) economic profit is negative Accounting profit normal profit (implicit costs) Economic Economic Profits Guide Decisions
• You own a small restaurant. The restaurant has an annual sales revenue of $200,000. The costs of food ingredients, utility, rent, chefs and waitresses amount to $120,000 in total. Should you stay in this business?
Accounting Profit = 200,000 - 120,000 = 80,000 Implicit cost= 160,000 (working as financial analyst) Economic profit= 80,000 - 160,000 = -80,000<0 (2) Implicit cost = 50,000 ( Secretary) economic profit = 80,000- 50,000= 30,000>0 The Role of Economic Profit
• In the short run, firms may be stuck making an economic loss (their economic profit may be negative) • In the long run, firms can enter or exit the market.
– Firms EXIT whenever they incur an economic loss. – Firms ENTER whenever they can make an economic profit. perfectly competitive market Economic Profit Entry Entry
Price S positive economic profit
MC S' Cost p* P=P*
D C* C*lr q*lr
q* (explicit + implicit) P=P*lr Q* Q (market) Q (firm) Exit Economic Loss
lr = longrun
Price negative economic profit
MC S' Cost ATC P*lr
p* D S c* C*lr P=P*lr P=P* Q* Q (market) q* q*lr Q (firm) P*lr = min(ATC)
#of firms in the industry in the long run = Q*lr / q*lr Summary: Summary: Long-run Outcome
• In the long run, economic profit is zero.
– Price = minimum of ATC – Long-run supply curve is horizontal. :P=P*lr = min(ATC) – What about accounting profit? positive, equal to normal profit • To achieve this outcome, we need:
– Free entry and exit in the market – Perfectly competitive market The The Invisible Hand Theory
• Invisible Hand Theory: actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resource. • The “invisible hand”:
– Lines at the grocery store – Stock prices Barriers Barriers to Entry
• Barrier to entry: any force that prevents firms from entering a new industry
– Legal constraints – Practical factors • When there are barriers to entry:
– Economic profit may be nonzero. – Will economic profit always be nonzero?
• No. Sometimes economic profit can be driven to zero not through a decrease in the price of the goods but through an increase in the costs of factors of production. Profit = Revenue - Cost Economic Economic Rent
• Economic rent: the portion of a payment to a factor of production that exceeds the owner's reservation price.
– People with special talents – Non-reproducible inputs Example: Example: Star Singer
• Suppose sales revenue from concert tickets will increase by $100,000 whenever John is singing. If he doesn’t become a singer, he can get a job that pays $50,000. How much will he be paid in equilibrium? How much of his pay is economic rent? How much economic profit will his band make? reservation price = $50,000 price = 50,000 + 100,000= 150,000 economic rent = 100,000 economic profit = 0 If salary, $130,000 , economic profit = $20,000 Example: Example: Star Yoga Instructor
• Rachel is a bank teller and makes $45,000 a year. She wants to quit her job and open a yoga studio. She finds out that a yoga studio can usually get 2,000 people to attend the classes in a year and the regular admission fee is $100 per person . It would cost her $53,000 a year to rent classrooms. All yoga teachers have the same opportunity cost of $50,000 a year. For the size of her yoga studio, she needs to hire two teachers. She also needs to use $10,000 of her savings to buy various equipment (the equipment can be used for 10 years) in the beginning. • What would be Rachel’s accounting profit in a year? • What would be her economic profit in a year? (interest rate is 10%) • What is the normal profit that Rachel earns in a year? • If there is a star yoga teacher, who can attract 600 more people to attend her classes than other teachers. If this yoga teacher has the same opportunity cost as the other teachers, what salary does Rachel need to offer to get this star teacher? • How much of this yoga teacher’s salary is economic rent? • What would be Rachel’s economic profit if she hires this yoga teacher? Accounting Profit = 2,000 x $100 = $53,000 - $50,000x2 - $10,000/10 = $46,000 Economic Profit = $46,000 -$45,000- $10,000 x 10% = 0 Normal Profit = $45,000 + $10,000 x 10% = $46,000 extra revenue from star teacher = 600 x $100 = $60,000 salary offered = 50,000 + 60,000= $110,000 Economic rent = $60,000 Economic profit = 0 Example: Example: Taxi Medallion
• Suppose total revenue from operating a cab is $60,000 per year. Total cost excluding the cost of the medallion is $40,000.
– What is the implicit cost of medallion per year?
Economic Profit = $60,000 - $40,000 Implicit cost of medallion = $20,000 – Suppose this will stay there forever. How much is a person willing to pay for the medallion? Assuming deposit into a savings account earning 6% interest rate.
20,000/0.06 = $333,333 present value of $20,000 a year forever Present Present Value
• How much are you willing to pay for an asset that makes a perpetual annual payment of $M? Is it infinite? • Time Value of Money: $1 today is worth more than $1 tomorrow. • Present Value of $M in T years: PV = M / (1 + r)T Present Present Value
• What is the present value of $100,000 in 5 years at an interest rate of 4%?
P= 100,000/( 1 + 0.04)^5 = $82,193 Present Value
• A perpetual annual payment of $M has a present value of ___________ at a given interest rate of M/r r. • Which of the following would you prefer at an interest rate of 5%: getting a lump sum of $100,000 today or getting $5000 per year forever?
PV= 5000/0.05= $100,000 Value Value of the Taxi Medallion
Interest rate (r) 0.06 0.04 0.01 Annual Payment (M) $20,000 $20,000 $20,000 Annual Payment (M) $10,000 $20,000 $30,000 Present Value (PV) $333,333
20,000/0.04 = 500,000 20,000/0.01= 2,00,000 Interest rate (r) 0.04 0.04 0.04 Present Value (PV)
10,000/0.04 = 250,000 20,000/0.04 = 500,000 30,000/0.04 = 750,000 ...
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