Econ 201 Lecture 16
The rationing function of price: to distribute scarce goods to those consumers who value them most highly.
The allocative function of price: to direct resources away from overcrowded markets and toward markets that are
underserved.
According to Adam Smith’s invisible hand theory, the carrot of economic profit and the stick of economic loss were the only
forces necessary to assure not only that existing supplies in any market would be allocated efficiently, but also that resources
would be allocated across markets to produce the most efficient possible mix of goods and services.
Consider a wheat market in which the current price generates $150,000/yr of economic profit per farm:
S
$/bushel
MC
$/bushel
ATC
4.00
4.00
Price
Economic profit
= $150,000/yr
2.50
D
50
millions of bushels/yr
100
1000s of bushels/yr
The existence of positive economic profits attracts new firms, shifting supply outward. Price falls, making each firm’s
economic profit smaller than before.
$/bushel
S
$/bushel
S’
Economic profit
= $68,000/yr
4.00
4.00
3.00
3.00
2.20
MC
ATC
Price
D
50
68
85 100
1000s of bushels/yr
millions of bushels/yr
As long as price remains above the minimum value of ATC, profits lure new entrants. 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*
Price
2.00
2.00
D
85
millions of bushels/yr
65
1000s of bushels/yr
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Present Value and the Time Value of Money
Example 16.1. 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.
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.
Example 16.2 If the annual interest rate in 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.
Example 16.3. 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.
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).
Example 16.4. 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?
PV = 121/(1.1)2 = $100
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
Example 16.5. Jones can enter a business whose revenues and costs occur through time as follows.
now
1 year hence
2 years hence
3 years & more
Revenues
0
0
$363
0
Costs
$300
0
0
0
If Jones enters this business and the interest rate is 10 percent per year, what is the present value of his economic profit?
Present value of economic profit
= present value of revenue - present value of costs
= 363/(1.1)2 - 300
= 300 - 300 = 0.
Example 16.6. Should Jones enter this business if the interest rate is 12 percent?
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.
Example 16.7. Should Jones enter if the interest rate is 8 percent?
PV of revenue = 363/(1.08)2 = 311.21
PV of economic profit = $311.21 - $300 = $11.21> 0,
so Jones should enter.
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.
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Stock Prices
A stock is an ownership claim to the accounting profits in a company. If you own 100 of a company's 1000 shares
outstanding, you own one-tenth of the company's earnings.
Example 16.8. 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 + ....
= $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)
Example 16.9. If this company has 1000 shares of stock outstanding, how much will each one sell for?
$1,000,000/1000 = $1,000/share
Example 16.10. 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
An Application of the Invisible Hand: The Efficient Markets Hypothesis
Economists are strongly united in their belief that the stock market is efficient. By this we mean that the price of a
stock embodies all available information that is relevant to its current and future earnings prospects. To illustrate, consider a
hypothetical example involving Genentech, a relatively young, highly successful genetic engineering company. Suppose that
on the strength of its earnings prospects, the current value of a share of Genentech is $1000. Now suppose that one of
Genentech's researchers suddenly stumbles onto a miracle cure for cancer. The discovery is simple and easy to patent. The
company is certain to win government approval for its discovery, at which point its revenues will soar dramatically. But
because of bureaucratic red tape, the approval process never takes less than three years. You read in Newsweek about
Genentech's discovery, and decide to buy stock in the company. Is this a shrewd move on your part?
The answer is almost certainly no, but not because the company does not have the rosy future that has been forecast
for it. The difficulty, according to the efficient markets hypothesis, is that the value of the new discovery will be almost
instantaneously bid into the market price of its stock.
By the time you hear about it, the rise in price for which it is
responsible will have long since occurred.
Critics of the efficient markets hypothesis often object that it refers to a frictionless ideal world. In the real world,
they argue, it may take considerable time for new information to disseminate, and so its effect on stock prices may be gradual
and protracted. Thus, they conclude, if the news of the Genentech discovery is only a few weeks old, there will still be
plenty of room for stock prices to keep growing on the strength of it.
This view is almost certainly wrong. The difficulty is a confusion that arises because new information often comes
not in the very sure form assumed in the example, but in highly uncertain form. In practice it would be much more common,
for example, for the market to learn at first only that a Genentech researcher had a promising lead on a cure for cancer. This
more limited information would justify a much smaller boost in the company's stock price, which would then be followed by
further increases if the development continued to show promise. But it would be followed by a plunge in stock prices if the
development were to fizzle. In either event, however, the full value of the information at hand would be reflected in the
stock price of the moment. But because information about new profit opportunities usually emerges gradually, many
observers erroneously conclude that the market's response to the new information is also gradual.
Unlike the conditions in our hypothetical example, in the real world it is usually hard to quantify exactly what
information becomes available at specific times. Moreover, there is almost always latitude for differences in interpretation of
any given piece of information. For these reasons, it is extremely difficult to verify the efficient markets hypothesis
empirically. Nonetheless, most economists believe that it is correct. If the hypothesis is impossible to verify directly, what
accounts for the strength of economists' commitment to it?
The answer is that the alternative hypothesis-- namely that stock prices don't embody all the available information-leads to conclusions that we find so difficult to accept. To illustrate, consider our cancer cure example again, and suppose
the market did not immediately bid up the price of the stock to reflect the higher future profits implied by the new discovery.
Then you or I could simply pick up the phone and instruct our stockbrokers to buy as many shares in Genentech as we could
afford. We could then sit back and wait for the market to bid up our shares to their full market value, reaping a substantial
gain in the process.
The one belief that economists hold more deeply than any other is that the only way to reap such gains is by some
combination of talent, hard work, and luck. But if we deny the efficient markets hypothesis, there can be examples like this
one in which there is cash just sitting on the table for the taking. We need no talent; we needn't do any hard work; and
because the information is certain, we don't even need to be lucky. We just call our brokers and wait for the money to roll in.
There is an ample supply of people who would be delighted to earn their livings in this painless way. That it seems generally
impossible to do so is all the confirmation most economists need for the efficient markets hypothesis.
Example 16.11. The Ace Investment Advisory Group has put together a special stock fund that includes only shares of
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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.
Example 16.12. 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.
More Applications of Invisible Hand Theory
Price Supports as a Device for Saving Family Farms
Example 16.13. 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?
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.
A much more direct and efficient way to aid family farmers would be to reduce their income taxes; or in the case of
more extreme need, to give them outright cash grants.
The Adoption of Cost-Saving Innovations
Perfectly competitive firms can do nothing to alter the market price, but they can often take steps to reduce their costs.
Example 16.14. 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
Example 16.15 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
Total revenue = $5000/wk, the same as before.
So economic profit = $5000 - $4800 = $200.
1985
Total cost = $5000 - $250 + $50 = $4800
Example 16.16. 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 save one 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.
Moral: Early adopters of cost-saving innovations tend to earn positive economic profits. Late adopters tend to earn negative
economic profits.