The Quest for Profit and
the Invisible Hand
Introductory Microeconomics
1
Example 8.1.
For the supply and demand curves shown, suppose a tax
of $6/lb is levied on sellers. What share of the burden of
this tax be borne by buyers? By sellers?
Price ($/lb)
18
S
6
D
0
Quantity
12 18 (millions of lb/month)
2
Example 8.1.
The equilibrium price, including the tax, will rise from
$6/lb to $10/lb.
Price ($/lb)
Buyers pay $10/lb (including the tax), $4
higher than before. So the buyers’ share
of the tax is (10-6)/6 = 2/3.
S + 6(as seen by the buyers)
18
10
6
4
0
S
D
Sellers receive $4/lb (net of the tax), $2
less than before. So the sellers’ share of
the tax is (6-4)/6 = 1/3.
Quantity
8 12 18 (millions of lb/month)
3
Example 8.2.
 How would your answers to Example 8.1 have been
different if the tax had been collected from buyers
instead of sellers?
4
Example 8.2.
At a quantity of 8 million lb/month, the buyer is willing to pay $10/lb.
With a tax of $6/lb, the most he would be willing to pay the seller, net
of the tax, is only $4/lb. So the demand curve as seen by the sellers
is the original demand curve shifted down by $6/lb.
Price ($/lb)
18
12
10
6
4
0
Demand with $6/lb tax
D
Quantity
8 12 18 (millions of lb/month)
5
Example 8.2.
Price ($/lb)
18
12
10
6
4
0
So, as before, the buyer pays $10/lb
and the seller receives $4/lb in
equilibrium.
As before the buyers’ share of the tax
is 2/3 and the sellers’ share is 1/3.
S
D
Quantity
8 12 18 (millions of lb/month)
6
Example 8.3.
If the supply curve is completely elastic, what share of a
tax of $1/lb is borne by buyers? By sellers?
Price ($/lb)
To get an answer for this question, do we need
to consider the two possibilities?
1. Tax collected from the buyers
2. Tax collected from the sellers
3
2
S
1
D
0
1
2
Quantity
3 (millions of lb/month)
7
Example 8.3.
For this empirically most relevant case, the tax is borne
entirely by buyers.
When supply is perfectly elastic,
taxing sellers “because they can
afford the tax more easily than
buyers” makes no economic
sense at all.
Price ($/lb)
3
S+ 1
2
The burden of a tax falls where
it can, not where it is placed.
S
1
D
0
1
2
Quantity
3 (millions of lb/month)
8
Different Types of Profit
 Profit = Total revenue - Total cost
 Accounting profit = Total revenue - Explicit costs
 Economic profit
= Total revenue - All costs (implicit and explicit)
 Normal profit
= the opportunity cost of the resources owned by the firm
9
Different Types of Profit
Normal profit
Accounting profit
Opportunity cost of
resources supplied by
owners of firm
Economic
profit
Total Revenue
Explicit costs
Explicit costs
10
Example 8.4.
Cullen Buffet runs a miniature golf course in Odessa,
Texas.
11
Example 8.4.
 He rents the course and equipment from a large
recreational supply company, for which he pays a
monthly fee of $1000.
 He supplies his own labor, and considers the job of
running the golf course just as attractive as his only
other employment opportunity, working in a grocery
store at a salary of $800/mo.
 Monthly revenue from ticket sales is $2000/mo.
What at is Cullen's accounting profit? His economic profit?
12
Example 8.4.
 He rents the course and equipment from a large recreational
supply company, for which he pays a monthly fee of $1000.
 He supplies his own labor, and considers the job of running the
golf course just as attractive as his only other employment
opportunity, working in a grocery store at a salary of $800/mo.
 Monthly revenue from ticket sales is $2000/mo.
What at is Cullen's accounting profit? His economic profit?
Accounting profit = $2000 - $1000 = $1000/mo.
Economic profit = $2000 - $1000 - $800 = $200/mo.
13
Example 8.5.
Now suppose Cullen learns that his Uncle Warren has
died and left him this parcel of land in New York City.
Sixth Ave
Fifth Ave
59th Street
58th Street
14
Example 8.5.
 The land has been cleared, and Cullen discovers that a
construction company is willing to install and maintain a
miniature golf course on it for a payment of
$4000/month.
 A market survey reveals that he would collect
$16,000/month in revenue by operating a miniature golf
course there.
 The cost of living in New York is the same as in Odessa.
 If Cullen opens a golf course on the Manhattan site,
what will be his accounting profit?
Accounting profit = $16,000 - $4000 = $12,000/mo
15
Example 8.6.
 Suppose Cullen's land would sell for $100,000,000 in
today's real estate market, and suppose that the
interest rate is 1%/month.
 What is Cullen’s economic profit from running the
Manhattan golf course?
Should he relocate to Manhattan?
16
Example 8.6.
1. The opportunity cost of devoting the land to a miniature golf
course is the interest that Cullen could have earned from the
money he could have gotten from selling the land:
(0.01)x($100,000,000) = $1,000,000/mo.
2. The opportunity cost of his time is $200/mo (economic profit he
could have earned).
So his monthly economic profit in Manhattan is
$16,000 - $4000 - $200 - $1,000,000 = -$978,200 < 0.
So Cullen should stay in Odessa.
17
Example 8.6.
1. The opportunity cost of devoting the land to a miniature golf
course is the interest that Cullen could have earned from the
money he could have gotten from selling the land:
(0.01)x($100,000,000) = $1,000,000/mo.
2. The opportunity cost of his time is $800/mo (the amount he could
have earned at the grocery).
So his monthly economic profit in Manhattan is
$16,000 - $4000 - $800 - $1,000,000 = -$978,800 < 0.
So Cullen should stay in Odessa.
18
Example 8.6.
1. The opportunity cost of devoting the land to a miniature golf
course is the interest that Cullen could have earned from the
money he could have gotten from selling the land:
(0.01)x($100,000,000) = $1,000,000/mo.
2. The opportunity cost of his time is $800/mo (the amount he could
have earned at the grocery) + $200/mo (economic profit he could
have earned).
So his monthly economic profit in Manhattan is
$16,000 - $4000 - $800 - $200 - $1,000,000 = -$979,000 < 0.
So Cullen should stay in Odessa.
19
Competition tends to drive economic profit
down to zero
 When a firm is making positive economic profit, it is earning more
than the cost of all the resources required to produce the goods it
sells.
 This means that another firm could produce the same goods and in
the process increase its owners' wealth.
 Entry by new firms will cause price to fall until economic profit is
driven down to zero.
20
Competition tends to drive economic profit
down to zero
 Likewise, an industry in which firms are earning negative economic
profit is one in which firms are failing to cover all the costs of the
resources they use.
 If this situation is expected to persist, some firms will go out of
business.
 Exit will continue until price rises to cover all resource costs.
 So in long-run equilibrium in a competitive industry, firms will earn
zero economic profit.
21
Example 8.7. (Rent)
 Normal agricultural land yields 50 bushels of corn per acre each
year.
 Corn sells for $1/bushel, and a farmer can farm 500 acres with an
equivalent amount of physical and psychological effort as is
demanded by a factory job, which pays $10,000/yr and is the only
other job available.
 If labor and land are the only farm costs, how much will normal
agricultural land rent for?
22
Example 8.7. (Rent)
 Normal agricultural land yields 50 bushels of corn per acre each
year.
 Corn sells for $1/bushel, and a farmer can farm 500 acres with an
equivalent amount of physical and psychological effort as is
demanded by a factory job, which pays $10,000/yr and is the only
other job available.
 If labor and land are the only farm costs, how much will normal
agricultural land rent for?
Total revenue from farming = $25,000/yr
Total costs = $10,000 + 500x(land rent per acre)
Economic profit = 0 implies rent for 500 acres = $15,000/yr
implies rent = $30 per acre.
23
Example 8.8. (Rent)
Suppose there is one 500 acre plot that yields twice as
much corn as the normal farmland that rents for $30 per
acre.
How much will this plot rent for?
24
Example 8.8. (Rent)
How much will this plot rent for?
Total revenue = 100(500) = $50,000/yr
Total cost = $10,000 + land rent
Economic profit = TR – TC
= $50,000/yr - $10,000/yr – land rent
Farmers will bid for the fertile patch until it is no longer possible to earn
positive economic profit from farming it.
Economic Profit = 0 implies land rent = $40,000, or $80 per acre
25
Example 8.9.
Imagine yourself a member of the California state
legislature. You have been asked by the governor to vote
for a bill whose purpose is to alleviate poverty among farm
workers in a rural county.
26
Example 8.9.
 Farm workers in that county rent their farmland from landowners
and are allowed to keep the proceeds from the sale of the crops
they grow.
 Because of limited rainfall, their crops are usually meager, resulting
in very low incomes for the average worker.
 The bill under consideration would authorize public funds to
construct an irrigation system that would double the crop yields on
the land in the county.
Will this bill achieve its desired purpose of
raising farmers' incomes?
27
Example 8.9.
The bill under consideration would authorize public funds
to construct an irrigation system that would double the
crop yields on the land in the county.
Limited rainfall
Irrigation system
28
Example 8.9.
Will this bill achieve its desired purpose of
raising farmers' incomes?
 With the introduction of the irrigation project grain
yields are now twice as high as before, so total
revenues will double.
 If the land rent remained at its original level, a farm
worker would then earn more than he could by working
in a factory.
29
Example 8.9.
Will this bill achieve its desired purpose of
raising farmers' incomes?
 What the supporters of the bill have failed to recognize
is that land rents will not remain the same.
 Both factory workers and farmers would bid vigorously
for farm parcels, and the rental price of farmland will
continue to rise until it reaches a level that equalizes
the incomes of farmers and factory workers.
 The beneficiaries of the state supported irrigation
project would be not the impoverished farm workers
but the owners of the land.
30
Example 8.9.
Will this bill achieve its desired purpose of
raising farmers' incomes?
 The beneficiaries of the state supported irrigation
project would be not the impoverished farm workers
but the owners of the land.
 These owners already have high incomes.
Why should tax dollars be spent to
increase their incomes further?
31
Example 8.10.
 Suppose one firm is like all others except that it
employs an extraordinarily efficient manager.
 This manager is so efficient that the firm earns
$500,000 of economic profit each year.
 The firm operates in an industry in which the economic
profit of other firms hovers very close to zero.
If this manager received the same salary as all other
managers, the firm that employed her would have
much lower costs than all other firms in the industry.
Is this a stable outcome?
32
Example 8.10.
Is this a stable outcome?
 There would be a strong incentive for some other firm
to bid this manager away by offering her a higher
salary.
 Suppose a new firm offered her $300,000 more than her
current annual salary and she accepted.
 That new firm would then earn an economic profit of
$200,000/year.
 That's not as good as an economic profit of
$500,000/year. But it's $200,000/year better than the
normal profit her original employer will earn without her.
33
Example 8.10.
Is this a stable outcome?
 Still other firms would have an incentive to offer even
more for this manager.
 Theory tells us that the bidding should continue until the
cost savings for which she is responsible are entirely
incorporated into her salary.
 If her salary is $500,000/year higher than the salary of
an ordinary manager, her employer will earn zero
economic profit.
 Once her salary is bid up to that level, the firm that
hires her will no longer enjoy a cost advantage over the
other firms in the industry.
34
Example 8.11.
 The owner of the team that wins the NBA
Championship receives additional television
revenues of $40 million.
35
Example 8.11.
 Whichever team
hires Shaquille
O’Neal wins the
Championship.
36
Example 8.11.
 There is free agency and teams can bid openly for any
player's services.
By how much will O’Neal's salary exceed
the salaries of other players?
 Suppose O’Neal received only a $39 million salary
premium from his current team.
 Some other team could increase its wealth by bidding
O’Neal away with a higher salary.
 Only when O’Neal's salary premium is $40 million will
there be no further tendency for bidding.
37
Example 8.12.
 Ford has sued GM for $1 billion for infringement on
Ford's patent on a revolutionary new engine
technology.
 GM has a reasonable claim that it developed an
equivalent technology independently.
versus
38
Example 8.12.
 The legal issues are complex, and experts regard the
case as too close to call.
 Whichever side hires the better lawyer is sure to win.
39
Example 8.12.
 Smith and Jones are
the best two patent
lawyers in the world.
 Both are outstanding
but Jones is ever so
slightly better.
Smith
Jones
What are the equilibrium fees for Smith and Jones in this case?
40
Example 8.12.
What are the equilibrium fees for Smith and Jones in this case?
 Fees aside, whichever side hires Jones will be $1 billion
better off than if it hadn't hired Jones.
 So in equilibrium Jones's fee will be $1 billion, Smith's
zero.
41
Although competition drives economic
profit to zero, economic rent can persist
indefinitely.
42
The function of price
1. The rationing function of price: to distribute scarce
goods to those consumers who value them most
highly.
2. The allocative function of price: to direct resources
away from overcrowded markets and toward markets
that are underserved.
43
Price -- Adam Smith’s Invisible Hand
44
Carrot and stick
 The carrot of economic profit and the stick of
economic loss are the only forces necessary to assure
not only that
1. existing supplies in any market will be allocated
efficiently,
but also that
2. resources will be allocated across markets to produce
the most efficient possible mix of goods and services.
45
Zero economic profit in long run
Consider an industry in which the current market price
enables firms to earn a positive economic profit.
$/bushel
S
MC
$/bushel
ATC
4.00
4.00
Economic profit
= $150,000/yr
Price
2.50
D
50
millions of bushels/yr
100
1000s of bushels/yr
46
Economic profit in short and long run
The existence of positive
economic profits attracts new
firms, shifting supply outward
$/bushel
S
S’
Price falls, making each
firm’s economic profit
smaller than before.
MC
$/bushel
ATC
Economic profit
= $68,000/yr
4.00
4.00
3.00
3.00
2.20
Price
D
50 68
millions of bushels/yr
85 100
1000s of bushels/yr
47
Economic profit in short and long run
As long as price remains above the minimum value of ATC,
profits lure new entrants. Supply continues to shift out until
…. .
$/bushel
S
S’
MC
$/bushel
ATC
Economic profit
= $68,000/yr
4.00
4.00
3.00
3.00
2.20
Price
D
50 68
millions of bushels/yr
85 100
1000s of bushels/yr
48
Economic profit in short and long run
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.
MC
$/bushel
$/bushel
ATC
S*
2.00
2.00
Price
D
85
millions of bushels/yr
65
1000s of bushels/yr
49
Economic profit in short and long run
What if the firms are originally earning economic losses?
$/bushel
$/bushel
Economic loss
= -$24,000/yr
S
1.70
MC
ATC
2.10
1.70
D
75
millions of bushels/yr
60
1000s of bushels/yr
50
Economic profit in short and long run
Supply continues to shift inward until price rises to min ATC.
$/bushel
$/bushel
MC
ATC
S’
2.00
2.00
S
D
72
millions of bushels/yr
70
1000s of bushels/yr
51
Example 8.13.
Present Value and the Time Value of Money
 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.
52
Present value
 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.
53
Example 8.14.
 If the annual interest rate is 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.
54
Example 8.15.
 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.
55
Present value
 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).
56
Example 8.16.
 When the annual interest rate is 10 percent, what is the
present value of a payment of $121 to be received 2
years from now?
Put $100 in the bank today at 10 percent interest.
After one year: $100(1.1) = $110
After two years: $110 (1.10) = $100 (1.1)2 = $121
That is, PV = 121/(1.1)2 = $100
57
Present value
 More generally, if annual interest rate is r, present value
of M dollars delivered T years from now
PV = M/(1 + r)T
58
Time value of money
 The time value of money exists because money can be
used to purchase real assets that generate increased
output over time.
 For example, a 12 foot tree 6 years from now is
equivalent to a 5 foot tree right now.
59
60
Compound interest
 Present value in reverse: the miracle of compound
interest
 $1000 deposited at 7 percent interest by Ben Franklin in
late 1700s = $3 trillion today
 $1000 deposited at 7 percent interest in 1945
= $64,000 today
61
The miracle of compound interest
Assume annual income of 100000.
.
8000
Savings balance
(thousands)
9000
7000
Saving rate = 0
6000
Saving rate = 5%
5000
Saving rate = 10%
4000
Saving rate = 20%
3000
2000
1000
0
20
25
30
35
40
45
Age
50
55
60
65
62
Example 8.17.
 Jones can enter a business whose revenues and costs occur
through time as follows:
Revenue
Costs
Now
0
$300
1 year hence
0
0
2 year hence
$363
0
0
0
3 year & more
Present value of economic profit
= present value of revenue - present value of costs
= 363/(1.1)2 - 300
= 300 - 300 = 0.
63
Example 8.18.
 Should Jones enter this business if the interest rate is
12 percent?
Revenue
Costs
Now
0
$300
1 year hence
0
0
2 year hence
$363
0
0
0
3 year & more
Enter only if PV of economic profit > 0.
At 12 percent, PV of revenue = 363/(1.12)2 = 289.38
PV of economic profit = 289.38 - 300 = -$10.62 < 0, so
don't enter.
64
Example 8.19.
 Should Jones enter this business if the interest rate is 8
percent?
Revenue
Costs
Now
0
$300
1 year hence
0
0
2 year hence
$363
0
0
0
3 year & more
PV of revenue = 363/(1.08)2 = 311.21
PV of economic profit = $311.21 - $300 = $11.21> 0,
so Jones should enter.
65
Interest rate and investment
 Almost all investment projects require that costs be
incurred in the short run in order that benefits accrue in
the long run.
 The higher the interest rate, the lower is the present
value of benefits received in the future.
 So as a general rule, an investment project is less likely
to be worthwhile when interest rates are high than
when interest rates are low.
66
Interest rate and investment
Why does the Fed lower interest rates during a recession?
Alan Greenspan,
Chairman of the Board
of Governors of the
Federal Reserve of the
United States from 1987
to 2006
Ben Bernanke,
Chairman of the Board
of Governors of the
Federal Reserve of the
United States since
February 1, 2006
67
Stocks
 A stock is an ownership claim to the present value of
the accounting profits in a company.
 If you own 100 of a company's 1000 shares
outstanding, you own one-tenth of the present value of
the company's earnings.
68
Buying a stock involves risk
April 15, 1912
69
Example 8.20.
 A company's accounting profits are $100,000 per year.
 If the annual interest rate is 10 percent, what is the present value
of this firm's accounting profit?
PV = $100,000/(1.1) + $100,000/(1.1)2 + $100,000/(1.1)3 + ....
= $100,000/(1.1) [1 + 1/1.1 + 1/(1.1)2 + 1/(1.1)3 + .... ]
= $100,000/(1.1) [1/(1-1/1.1)] = $100,000/(1.1) [1.1/0.1]
= $1,000,000
(If you put $1,000,000 in the bank at 10 percent, you would generate
a flow of earnings of $100,000/yr)
Note on infinite geometric sum: 1 + x + x2 + x3 +…. = 1/(1-x)
70
Example 8.21.
 If this company has 1000 shares of stock outstanding,
how much will each one sell for?
$1,000,000/1000 = $1,000/share
71
Example 8.22.
 Suppose accounting profit from the firm in the
preceding example were to double. How would the
value of its stock price change?
PV of profit = $2,000,000
Price per share = $2,000,000/1000 = $2000/share
72
The Efficient Markets Hypothesis
 At any moment, the market price of a firm’s stock
reflects all relevant available information about the
present value of the firm’s current and future
accounting profits.
73
The Efficient Markets Hypothesis
 Suppose the efficient markets hypothesis were false.
 For example, suppose Genentech’s current share price
is $100 when it comes up with a cancer cure that will
double its accounting profit from now on.
 What would happen if the firm’s stock price failed to
adjust right away to $200?
 Someone with no talent, no luck, and no willingness to
work hard could get rich just by buying shares of
Genentech.
74
Example 8.23.
 The Ace Investment Advisory Group has put together a
special stock fund that includes only shares of
monopolies that earn profits at least 50 percent higher
than the overall industrial average.
 If you invest in this fund, do you expect to do better
than if you had invested in non-monopolies?
If investing in monopolies yielded a higher payoff, the
prices in their stocks would be bid up until the return was
brought into balance with the return on stock in other
companies.
75
Is investing in Microsoft a good bet?
76
Is investing in Microsoft a good bet?
$39.75
$24.91
March, 2000
March, 2005
77
Example 8.24.
 Consider a perpetual bond that pays $120/yr to its
owner (a perpetual bond entitles the bearer to the
same annual payment forever).
 By how much would the price of this bond rise if the
interest rate fell from 10 percent to 5 percent?
The price at 10 percent is $120/0.10=$1200.
At 5 percent the price will be $120/0.05=$2400.
So the rise in price is $1200.
78
Example 8.25. Price Supports as a Device
for Saving Family Farms
 Family farms tend to have higher costs than large
corporate farms.
 As more and more family farms give way to corporate
farms, lower costs lead to lower prices, which result in
economic losses for family farms.
 To ease the plight of the family farmer, Congress has
passed legislation that pegs prices of farm products
higher than market-clearing levels.
Will this policy help tenant farmers in the long run?
79
Example 8.25. Price Supports as a Device
for Saving Family Farms
 When the price of farm products rises, farms that were
earning zero economic profit will now earn positive
economic profit.
 The lure of positive profit causes others to bid for
agricultural land, which causes land prices to rise.
 The long-run effect of agricultural price supports was
thus to drive up the rent for farmland, which does
nothing to assure the survival of tenant farmers.
80
Example 8.25. Price Supports as a Device
for Saving Family Farms
We are not sure how
we can benefit from the
price support.
 A much more direct and
efficient way to aid family
farmers would be to
reduce their income taxes.
 In the case of more
extreme need, farmers
could be given outright
cash grants.
81
Example 8.26.
 A trucker gets $5000 for driving a trailer full of cargo
from New York to San Francisco, a trip that takes him
one week.
 The rent for his rig is $3000/wk and he spends $1000
on gas.
 Meals and other expenses come to another $500/wk.
 His alternative employment is to work as a local
deliveryman at a salary of $500/wk, a task he finds
equally attractive as trucking.
What is this trucker's economic profit?
82
Example 8.26.
 A trucker gets $5000 for driving a trailer full of cargo from New York to
San Francisco, a trip that takes him one week.
 The rent for his rig is $3000/wk and he spends $1000 on gas.
 Meals and other expenses come to another $500/wk.
 His alternative employment is to work as a local deliveryman at a salary of
$500/wk, a task he finds equally attractive as trucking.
What is this trucker's economic profit?
Total revenue = $5000
Total cost = $3000 + $1000 + $500 + $500 = $5000
Economic profit = $5000 - $5000 = 0
83
Example 8.27.
 Now suppose the trucker from the previous example
installs an airfoil on the roof of the cab of his rig,
resulting in a fuel savings of 25 percent.
If the airfoil rents for $50/wk,
what is the trucker's new economic profit?
1970
1985
84
Example 8.27.
If the airfoil rents for $50/wk,
what is the trucker's new economic profit?
Total revenue = $5000/wk, the same as before.
Total cost = $5000 - $250 + $50 = $4800
So economic profit = $5000 - $4800 = $200.
85
Example 8.28.
 Suppose all truckers but one have installed the airfoil described in
the preceding example.
What will be the economic profit of the lone holdout?
 As more and more truckers install the airfoils, costs go down and
this places downward pressure on trucking prices.
 By the time all truckers have installed the airfoils, trucking rates will
have fallen by the full $200 in net cost savings made possible by the
airfoil.
 Thus the lone trucker without an airfoil will suffer an economic loss
of $200/wk.
86
Example 8.28.
Moral: Early adopters of cost-saving innovations tend
to earn positive economic profits.
Late adopters tend to earn negative economic profits.
87
Example 8.29.
 On April 24, 2003, the Commissioner for Transport
(HKSAR), Mr Robert Footman, announced a scheme to
relax general stopping restrictions for taxis to provide
immediate relief to the trade under the difficult
operating environment with the outbreak of atypical
pneumonia.
 To whom does the scheme benefit? Drivers or owners
of taxi operating licenses?
88
Example 8.29.
 In Hong Kong it is easy to become a taxi driver. Thus, in a
recession, the supply of drivers is essentially perfectly elastic,
possibly with the best alternative of unemployment benefits as the
reservation wage.
 The relaxation of road restrictions for taxis is supposed to increase
the demand for taxis and hence revenue.
 When the revenue is higher, more people will try to enter the trade
of taxi drivers, bidding up the rental rate of taxis.
 Higher rental rate leads to higher taxi operating license premium.
 Thus, the relaxation benefits the taxi operating license owner (who
are relatively rich) but not the taxi drivers (who are relatively poor).
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End
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