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Lecture8_ - The Quest for Profit and the Invisible Hand...

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The Quest for Profit and the Invisible Hand LECTURE
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Slide 2 The Quest for Profit This chapter’s fundamental lesson: resources move into a profitable industry and they leave an unprofitable industry. Modern microeconomics assumes that the quest for profit is a driving force in all market-driven activity.
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Slide 3 Accounting Profit = total revenue – explicit costs (payments for factors of production). Economic Profit = total revenue – explicit costs – implicit costs (opportunity cost of the resources supplied by the firm’s owners). Normal Profit = accounting profit – economic profit = the opportunity cost of the resources owned by the firm. Different Types of Profit
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Slide 4 Economic profit is used by economists because it measures the incentive the owner of a firm has to stay in business versus doing something else. Economic profit is the critical issue: It indicates the gain or the advantage associated with taking an activity. Different Types of Profit
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Slide 5 Suppose Tom learns that his American Uncle Tim has died and left him a parcel of land in New York City. The Central Role of Economic Profit
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Slide 6 The land has been cleared, and Tom discovers that a construction company is willing to install and maintain a mini- golf course on it for a payment of $40,000/month. A market survey reveals that he would collect $160,000/month in revenue by operating a miniature golf course there. The Central Role of Economic Profit
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Slide 7 If Tom opens a golf course on Manhattan, what will be his accounting profit? What is Tom’s economic profit to open a golf course on Manhattan? The Central Role of Economic Profit Accounting profit = $160,000 - $40,000 = $120,000/mo
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Slide 8 Suppose Tom’s land would sell for $10,000,000 in today’s real estate market, and that the interest rate is 1%/month. By selling his land and simply putting his money in the bank, he could earn (0.01)x($10,000,000) = $100,000 per month without doing anything! The Central Role of Economic Profit
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Slide 9 Any alternative use of the money must return at least this $100,000 amount – and hopefully more. If mini golf profit<$100,000, put money in bank. If mini golf profit>$100,000, go ahead with plans. The $100,000 represents something like a “default profit” that economists call normal profit . The Central Role of Economic Profit
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Slide 10 Tom’s accounting (=operating) profit from running the Manhattan golf course is: $160,000 ( TR ) - $40,000 (explicit costs) = $120,000 per month Accounting profit > Normal profit, Hence Tom’s economic profit = $20,000. The Central Role of Economic Profit
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Slide 11 Revenue, Costs, and Profit Summary for Tom Total Explicit Implicit Accounting Economic revenue costs costs profit profit ($/month) ($/month) ($/month) ($/month) ($/month) 160,000 40,000 100,000 120,000 20,000 Implicit costs = the opportunity cost of devoting the land to a miniature golf course = the interest that Tom could have earned from the money he could have gotten from selling the land: (0.01)x($10,000,000) = $100,000/month.
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Slide 12 The Difference Between Accounting Profit and Economic Profit Total revenue Explicit costs
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