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chapter8 - The Quest for Profit and the Invisible Hand 1...

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1 The Quest for Profit and the Invisible Hand
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According to Adam Smith People are motivated by self-interest. The goal of profit maximization will serve  society’s collective interest. Slide 2
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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) Slide 3
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Costs incur without explicit money involved E.g., use your own garage for storage  Forego the opportunity to rent out your garage , the  opportunity cost is the lost income from renting the  garage out.
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Suppose a firm has the following:  Total Revenue ( TR)  = $400,000 Explicit costs (salaries) = $250,000/yr Machinery and other equipment with a  resale value of $1 million Slide 5
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Accounting Profit  $400,000( TR ) - $250,000 (explicit costs)  = $150,000 Slide 6
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To calculate economic profits, assume Annual interest on savings = 10%    [Then the $1 million spent on equipment  could have earned $100,000/yr had it  been invested] Economic Profit $400,000 ( TR ) - $250,000 (explicit cost) -  $100,000 (implicit cost) = $50,000 Slide 7
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Slide 8 Total revenue Explicit costs Accounting profit opportunity cost of resources supplied by owners of firm Economic profit Explicit costs
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Why are the distinctions important? Only economic profit serve the  following economic functions: Rationing function Allocative function Slide 9
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Should Pudge Buffet stay in the farming business? He is a corn farmer with payments for land and  equipment = $10,000/yr He supplies only his labor which he values equally  to managing a retail store for $11,000/yr Except for pay, he is indifferent between the farm  or the store Corn sells at a constant price and  TR  = $22,000 Slide 10
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Slide 11 Total Explicit Implicit Accounting Economic revenue costs costs profit profit ($/year) ($/year) ($/year) ($/year) ($/year) 22,000 10,000 11,000 12,000 1,000
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What would Pudge’s economic profit be if  TR =   $20,000 Economic profit TR  (20,000) – explicit (10,000) and implicit  costs (11,000) = -$1,000 Question Should Pudge stay in farming?
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