The Quest for Profit
and the Invisible Hand
MB
MC
MB MC

The Central Role
of Economic Profit
According to Adam Smith
People are motivated by self-interest.
 The goal of profit maximization will serve
society’s collective interest.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 2
MB MC

The Central Role
of Economic Profit
Three Types of Profit

Accounting Profit = total revenue – explicit
costs (payments for factors of production)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 3
MB MC

The Central Role
of Economic Profit
Three Types of Profit

Economic Profit = total revenue – explicit
costs – implicit costs (opportunity cost of
the resources supplied by the firm’s
owners)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 4
MB MC

The Central Role
of Economic Profit
Three Types of Profit

Normal Profit = accounting profit –
economic profit
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 5
MB MC

The Central Role
of Economic Profit
Calculating Profit

Suppose a firm has the following:
 TR
[Total Revenue] = $400,000
 Explicit costs (salaries) = $250,000/yr
 Machinery and other equipment with a resale
value of $1 million
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 6
MB MC

The Central Role
of Economic Profit
Calculating Profit

Accounting Profit
 $400,000(TR)
- $250,000 (explicit costs) =
$150,000
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 7
MB MC

The Central Role
of Economic Profit
Calculating Profit

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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 8
MB MC

The Central Role
of Economic Profit
Calculating Profit

Normal Profit
Profit ($150,000/yr) – Economic Profit
($50,000/yr) = $100,000/yr
 Accounting
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 9
MB MC
The Difference Between
Accounting Profit and Economic Profit
Total
revenue
Explicit
costs
Explicit
costs
Accounting
profit
Normal profit =
opportunity cost of
resources supplied
by owners of firm
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Economic
profit
Slide 10
MB MC

The Central Role
of Economic Profit
A Review
Accounting Profit = TR – explicit costs
 Economic Profit = TR – explicit and
implicit costs
 Economic Profit = 0 when accounting
profit = normal profit
 To remain in business in the long run,
economic profits must be greater than or
equal to 0 (zero).

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 17
MB MC
The Invisible Hand Theory

Two Functions of Price

The rationing function of price
 To
distribute scarce goods to those consumers
who value them most highly
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 18
MB MC
The Invisible Hand Theory

Two Functions of Price

The allocative function of price
 To
direct resources away from overcrowded
markets and toward markets that are
underserved
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 19
MB MC
The Invisible Hand Theory

Profits and Losses Would Ensure
That supplies within a market would be
distributed efficiently (rationing function)
 Resources would be allocated across
markets to produce the most efficient
possible mix of goods and services
(allocative function)

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 20
MB MC
The Invisible Hand Theory

Responses to Profits and Losses
Markets with firms earning economic
profits will attract resources.
 Markets where firms are experiencing
economic losses tend to lose resources.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 21
MB MC
Economic Profit in the
Short Run in the Corn Market
MC
S
ATC
2.00
D
65
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic profit
= $104,000/yr
Price
2.00
1.20
130
Quantity (1000s of
bushels/year)
Market price of $2/bushel produces economic profits
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 22
MB MC
The Effect of Entry on
Price and Economic Profit
S
S’
MC
ATC
2.00
1.50
D
65 95
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic profit
= $50,400/yr
2.00
1.50
Price
120 130
Quantity (1000s of
bushels/year)
Economic profits attract firms, reducing prices and profits
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 23
MB MC
Equilibrium when Entry Ceases
MC
S
1.00
Price ($/bushel)
Price ($/bushel)
ATC
Price
1.00
D
115
Quantity (millions of
bushels/year)
90
Quantity (1000s of
bushels/year)
Entry of firms continues until all firms earn a normal profit
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 24
MB MC
A Short-Run Economic
Loss in the Corn Market
MC
S
0.75
D
60
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
Economic loss
= $21,000/year
1.05
0.75
Price
70 90
Quantity (1000s of
bushels/year)
Prices below minimum ATC results in economic losses.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 25
ATC
MB MC
Equilibrium when Exit Ceases
S’
S
1.00
0.75
D
40 60
Quantity (millions of
bushels/year)
Price ($/bushel)
Price ($/bushel)
MC
1.00
0.75
ATC
Price
90
Quantity (1000s of
bushels/year)
The departure of firms from the industry increases the market price
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 26
MB MC
The Invisible Hand Theory

Observations

In the long-run, in a competitive market, all
firms will tend to earn zero economic
profits.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 27
MB MC
The Invisible Hand Theory

Observations

Zero economic profits are the
consequence of price movements caused
by the entry and exit of firms trying to
maximize economic profits.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 28
MB MC
The Invisible Hand Theory

Two Attractive Features

The market outcome is efficient in the long
run.
P
= MC
 If output is increased: MC > MB.
 If output is reduced: MC < MB.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 8: The Quest for Profit and the Invisible Hand
Slide 31
End of
Chapter
MB
MC