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Econ 201 Lecture 16
The
rationing function of price:
to distribute scarce goods to those consumers who value them most highly.
The
allocative function of price:
to direct resources away from overcrowded markets and toward markets that are
underserved.
According to Adam Smith’s invisible hand theory, the carrot of economic profit and the stick of economic loss were the only
forces necessary to assure not only that existing supplies in any market would be allocated efficiently, but also that resources
would be allocated across markets to produce the most efficient possible mix of goods and services.
Consider a wheat market in which the current price generates $150,000/yr of economic profit per farm:
ATC
$/bushel
1000s of bushels/yr
4.00
MC
2.50
100
Price
Economic profit
=$150,000/yr
$/bushel
millions of bushels/yr
4.00
50
S
D
The existence of positive economic profits attracts new firms, shifting supply outward.
Price falls, making each firm’s
economic profit smaller than before.
ATC
$/bushel
1000s of bushels/yr
4.00
MC
3.00
100
Price
Economic profit
= $68,000/yr
$/bushel
millions of bushels/yr
4.00
85
50
S
D
3.00
2.20
68
S’
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.
ATC
$/bushel
1000s of bushels/yr
MC
Price
$/bushel
millions of bushels/yr
85
D
2.00
65
S*
2.00
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Present Value and the Time Value of Money
Example 16.1.
Suppose the annual interest rate on bank deposits is 10 percent.
If you deposit $100 on January 1 of this
year, how much will it be worth by January 1 of next year?
$100 (1.10) =
$110.
For any given interest rate, the present value of a sum of money that you will receive at a specific time in the future is the
amount of money you would have to put in the bank today at that interest rate in order to have exactly the required sum on
the future date.
Example 16.2
If the annual interest rate in 10 percent, what is the present value of $110 to be received one year from now?
As we saw in the previous example, $100 deposited today at 10 percent interest will be worth $110 a year from now.
So the
present value of $110 a year from now is $100.
Example 16.3
. If the annual interest rate is 5 percent, what is the present value of $52.50 a year from now?
Let PV = the present value of $52.50 to be received in 1 year.
PV (1.05) = $52.50,
so PV = $52.50/ 1.05 = $50.
If you put $50 in the bank today at 5 percent interest, in a year's time you will have $52.50.
More generally, when the interest rate (expressed as a proportion) is r, the present value of $M one year from now is given
by
PV
=
M/(1+r).
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 Spring '08
 Staff
 Macroeconomics

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