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Unformatted text preview: Chapter 8 The quest for pro t and the invisible hand 11 June 2011 1. Explain why the following statements are true or false. (a) The economic maxim: There's no cash on the table. That means there are never any unexploited economic opportunities. Answer: False. This statement is kind of tricky. It is wrong that there are never any unexploited economic opportunity. In the short run, there are normal unexploited economic opportunities to be drawn from so new entries are attracted by a positive economic pro t However, as the number of suppliers grows in the long run, the market price will be driven down and all the participating rms will eventually earn a zero economic pro t. (b) Firms in competitive environments making no accounting pro t when the market is in long-run equilib- rium. Answer: False. Firms in competitive environments make a positive accounting pro t in the long-run equilibrium so that it can be used to cover the implicit cost of resources used in the production. However, rms in competitive environments make no economic pro t in the long-run equilibrium. (c) Firms that can introduce cost-saving innovations can make an economic pro t in the short run. Answer: True. In the short run, market price of a good has not yet been adjusted, but rms experience a reduction in production cost due to the innovations, and thus they enjoy a higher economic pro t. The success of this rm (positive economic pro t) will encourage other rms to adopt similar innovation. When positive economic pro t due to innovation is seen in the short run, new rms may enter the industry, raising supply, lowering the equilibrium price. This process continues until the price is lowered to the level at which no rm will earn any positive pro t. In short, the market supply curve will shift to the right due to the replication of innovation and the increasing number of suppliers in the market. The market price will be driven down until the economic pro t gets down to zero in the long run. If a rm refuses to adopt the innovation, the rm will su er from an economic loss. 2. Explain why new software rms that give away their software products at a short-run economic loss are nonetheless able to sell their stock at positive prices. Answer: The share price of a rm is determined by the discounted present value of future pro t stream. P t = D t + D t +1 1 + r + D t +2 (1 + r ) 2 + D t +3 (1 + r ) 3 + ... = D t + 1 1 + r P t +1 1 Thus, P t can be positive even if D t is negative as long as the future pro ts D t +1 1+ r + D t +2 (1+ r ) 2 + D t +3 (1+ r ) 3 + ... are big enough. A rm may use a give-away as a way to establish market share. Once people are used to the software, they will be willing to pay for the product....
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