Chapter 8: The Invisible Hand in Action
• In a free market, individuals act in their own
interests
– Utility maximization
– Profit maximization
• So, how, in a free market, are limited resources
allocated efficiently?
1
Accounting Profit vs. Economic Profit
• Accounting profit = total revenue – explicit costs
– Explicit costs are payments firms make to purchase
• Resources (labor, land, etc.) and
• Products from other firms
• Economic profit = total revenue – explicit costs –
implicit costs
– Also called excess profit
– Implicit costs are the opportunity cost of the resources
supplied by the firm's owners
– Normal profit = accounting profit - economic profit
2
Three Kinds of Profit
Total Revenue = Explicit Costs + Accounting Profit
Total
Revenue
Explicit
Costs
Explicit
Costs
Accounting
Profit
Economic
Profit = Accounting Profit – Normal Profit
Normal Economic
Profit
Profit
3
Economic Profits Guide Decisions
• Pudge Buffet's decision: keep farming or quit?
 Farming
– Explicit farm costs are $10,000
– Total revenue is $22,000
 Alternative job
 Earn $11,000 per year working retail
 Calculate accounting and economic profits of farming
Accounting Profit Economic Profit
$12,000
$1,000
Normal Profit
$11,000
4
Economic Profits Guide Decisions
What changes if Pudge inherits the land?
His explicit costs decrease by the rent of the land ($6000)
Now he could choose to rent out the land for $6000
Total Revenue
Explicit Costs
Implicit Costs
$22,000
$4,000
$17,000
Accounting Profit Economic Profit
$18,000
$1,000
Normal Profit
$17,000
Pudge should stick with farming
5
Two Functions of Price
• Rationing function of price distributes scarce goods to
the consumers who value them most highly
• Allocative function of price directs resources away
from overcrowded markets to markets that are
underserved
• Invisible Hand Theory is that actions of independent,
self-interested buyers and sellers will often result in the
most efficient allocation of resource
– Articulated by Adam Smith in eighteenth century
6
Response to Economic Profits
• Markets with excess profits attract resources
Price
$/bu
Corn Industry
S
Price
$/bu
Typical Corn Farm
MC
ATC
Economic
Profit
2
2
P
1.20
D
65
Quantity (M of bushels/year)
130
Quantity (000s of bushels/year)
7
Shrinking Economic Profits
 Supply increases
Price
$/bu
Corn Industry
S
S'
Price
$/bu
Typical Corn Farm
MC
ATC
Economic
Profit
2
P
1.50
D
65 95
Quantity (M of bushels/year)
120 130
Quantity (000s of bushels/year)
8
Market Equilibrium
 Zero economic profits
Price
$/bu
Corn Industry
Price
$/bu
S
S'
Typical Corn Farm
MC
ATC
S"
2
1.50
1
D
65
115
Quantity (M of bushels/year)
P
90 130
Quantity (000s of bushels/year)
9
Economic Losses
 Resources leave
Price
$/bu
Price
$/bu
MC
ATC
S
1.05
0.75
0.75
P
D
60
Quantity (M of bushels/year)
70 90
Quantity (000s of bushels/year)
10
Market Equilibrium
 No economic losses
Price
$/bu
Price
$/bu
MC
ATC
S'
S
P
1
0.75
D
40 60
Quantity (M of bushels/year)
70 90
Quantity (000s of bushels/year)
11
The Ubiquitous Power of the Invisible Hand
• Haircut market vs. aerobics market
S
Aerobics Market
Price ($/class)
Price ($/haircut)
Haircut Market
S
15
15
12
D
'
10
D'
350 500
Haircuts/day
D
D
200
300
Classes/day
12
The Ubiquitous Power of the Invisible Hand
• The invisible hand and the cost-saving
innovations
• The invisible hand and the integrated labor
market of the European Union
• The invisible hand and the stock market
13