The Quest for Profit and
The Invisible Hand
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Adam Smith
Self-interest moves the economy
Consumers seek to maximize utility from
purchases
Firms seek to maximize profit from
production
It serves society’s interest
It is due to profit opportunities
With it, the entrepreneur “intends only his
own gain,” he is “led by an invisible hand
to promote an end which was no part of
his intentions
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Adam Smith
Self interest = “greed”?
With it, the entrepreneur and
consumer “intends only his own
gain,” yet she is “led by an invisible
hand to promote an end which was
no part of her intentions
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Invisible Hand
Invisible Hand Theory
The actions of independent, self-interested
buyers and sellers will often result in the
most efficient allocation of resources
I.E., markets are efficient
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Equilibrium
When markets reach equilibrium there
is no more “cash on the table”
It says that all opportunities for gain are
exhausted
It implies that the prices of resources
privately owned will tend to reflect their
economic value
It implies those making profits are first to
act on profit making opportunities
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Markets and
Social Optimum
Market equilibrium does not mean the
resulting allocation of resources is the
best one viewed from society’s
perspective
Smart for one, dumb for all
For example, some market activities that
produce profits for some may produce
pollution (externalities) for many
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Functions of Price
Rationing function of price
Prices distribute scarce goods to those
consumers who value them most highly
Allocative function of price
Prices direct resources away from
overcrowded markets and toward markets
that are underserved
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Functions of Price
Where price is relative to average total
costs of production (ATC) will
determine firm profits and serve to
allocate firm resources.
P > ATC => positive profits
P < ATC => negative profits
Changes in price may therefore
reallocate resources.
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2 Types of Costs and 2 Types of
Profit
Explicit Costs
Actual payments made to factors of
production and other suppliers
Implicit Costs
All the opportunity costs of the resources
supplied by the firm’s owners
Eg: opportunity cost of owner’s time
Eg: opportunity cost of owner-invested funds
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Three Types of Profit
Accounting Profit
 Total Revenue – Explicit Costs
Economic Profit
 Total Revenue – Explicit Costs – Implicit Costs
Normal Profit
The difference between accounting profit and
economic profit
The opportunity cost of the resources
How much accounting profit is needed for econ
profit to be exactly = 0?
Economic Loss
An economic profit less than zero
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Figure 8.1
The Difference Between Accounting
Profit and Economic Profit
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The Difference Between
Accounting Profit and Economic
Profit
Revenue – Acct Costs = Acct Profit
Revenue – Econ Costs = Econ Profit
 Revenue – Explicit Costs = Acct Profit
 Revenue – (Explicit + Implicit costs) = Econ Profit
 Acct Profit – Implicit Costs = Econ Profit
 If Acct Profit exactly = Implicit Costs => Econ Profit = 0,
and the firm is said to be earning a “normal profit”
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Econ vs. Acct Profits
True or False: Economic profits are always
less than or equal to accounting profits.
 TRUE
If some implicit costs exist  economic cost >
accounting cost
 Economic profit < accounting profit
(ie: we are subtracting more costs from the
same revenue)
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To Farm or Not To Farm?
Pudge Buffet sells corn
his revenues are $22,000/yr
he pays $10,000/yr in explicit costs
he could earn $11,000 at another job he
likes equally well (implicit costs)
Pudge’s economic profit is
$22,000 - $10,000 - $11,000 = $1,000
Earning more than a normal profit
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Example:
After graduation from the CSB with a degree
in economics, you face the following job
choice:
Option 1:
IBM in RTP
Salary = $50K/year
Option 2:
Suntan shop in Key Largo
Salary = $15K/year
If you choose option 2, you have to drain
your $10,000 savings to start the business.
Assume that you could have earned 10% on
that money.
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Example continued
 Suppose you choose option 2…
1st year analysis:
Revenue = $50,000
Costs of inventory = $8,000
Labor expenses = $15,000
Rent = $12,000
 acounting
- inventory
- rent
- wages for worker
economic
- inventory
- rent
- wages for worker
- opp cost of Labor ($50k)
- opp cost of funds = $1000
 the normal rate of return on
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capital.
Example continued
Accounting profit
= 50 – 8 – 15 – 12 = 15
Economic profit
= 50 – 8 – 15 – 12 – 50 – 1 = -36
Earning less than a normal profit
How much is a normal profit for this firm?
Should this firm exit this industry in the longrun?
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Market Forces and
Economic Profit
Positive Economic Profit means the firm
(owner) is more than covering opp costs
Doing better than the next best alternative
Price must be higher than ATC
Firms enter this industry
Supply increases
Price falls
Profits fall
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Market Forces and Economic
Profit
Negative Economic Profit means the firm
(owner) is not covering opp costs
Doing worst than the next best alternative
Price must be below ATC
Firms exit this industry
Supply decreases
Price rises
Losses fall
Zero profit tendency of competitive markets
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Fig. 8.2
The Effect of Economic Profit on Entry
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Fig. 8.3
The Effect of Economic Losses on Exit
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Free Entry and Exit
The implications of The Invisible Hand
Theory depend critically on freedom of firms
to enter and exit
Barrier to entry
Any force that prevents firms from entering a
new market
Economic (e.g., large scale cost advantages, resource
ownership)
Legal, (e.g., copyright laws, patents)
Natural (e.g., product compatibility)
Allows price to be higher than the opportunity
costs of production
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The Invisible Hand Operates
Even in regulated markets, resources
flow in response to profit and loss
signals
Misunderstanding the logic of the
invisible hand can lead to inefficient
government regulation and programs
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Economic Rent
Economic Rent
Part of the payment for a factor of
production that exceeds the owner’s
reservation price
Reservation price: The price below which
the owner would not supply the factor
Economic rent accrues to inputs that
cannot be replicated easily
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Cost-Saving Innovations
Firms that develop and introduce costsaving innovations
 Reap economic profits in the short run
Supply curves shift right
Prices fall
Firms that do not use the new technology will
earn economic losses
Competition assures that the cost
savings is passed along to consumers
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