Cyberlecture

This chapter introduces you to the concepts of economic, accounting and normal profits. It also looks at why perfectly competitive markets are efficient, and why easy entry to and exit from markets is important in perfect competition.

What is profit?
Accounting profit is total revenue less total explicit costs. Explicit costs are actual payments to factors of production.
      Economic profit is total revenue less total explicit and implicit costs. Implicit costs are the opportunity costs of the resources provided by the firm's owner.
      Normal profit is the difference between accounting profit and economic profit, and is equal to the implicit costs of production.

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Practice Activity 1 Try answering some questions about accounting and economic profit.

What role does economic profit play in the perfectly competitive market?
Firms are organizations that combine factors of production in order to produce some goods or services to sell. They can enter and exit perfectly competitive industries relatively easily.

If the firms in an industry make an economic profit, other firms will enter that industry to capture some of that profit.

• production of the industry's product will increase
• the price in the long run will fall until firms make only a normal profit

If the firms in an industry make an economic loss, some firms will exit that industry in order to pursue more profitable ventures.

• production of the industry's product will decrease
• the price in the long run will rise until firms make a normal profit

Economic profit or loss cannot persist in the long run.

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Economic Naturalist What are the new office buildings in my town on half full?

How does competition affect the size of firms?
Competition between firms in a market drives price down. As price falls, firms will be forced to vary their size to minimize their costs. Since different sized firms have different average costs, firms will tend, in the long run, to reach the same size – that size that minimizes their average costs.
      Long-run average cost shows the minimum average total cost achievable for every level of output using various amounts of inputs. (In the long run, all inputs are variable.)

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What is the long-run market supply curve?
The long-run market supply curve traces the points of equilibrium as the industry expands.

• if input prices remain the same, the price in the industry will not fall with expansion
• the long-run supply curve will be horizontal
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• if input prices rise as the industry expands, the price in the industry will also rise
• the long-run supply curve will slope up
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Why is the long-run average cost curve U-shaped?
The long-run average cost curve reflects economies of scale, constant returns to scale and diseconomies of scale.

• economies of scale – when the LAC curve slopes down as output increases
  • increasing all inputs results in a greater than proportionate increase in output
  • increased specialization of inputs
  • larger production runs allow use of more efficient capital equipment
• constant returns to scale – when the LAC curve is horizontal and output increases
  • there is no increasing return to increasing all inputs
  • twice the inputs will give twice the output
  • the smallest output in this range is the minimum efficient quantity of production
• diseconomies of scale – when the LAC curve slopes up as output increases
  • as production increases, more managers and supervisors are employed to organize the workers
  • managers don't add to output, but their salaries add to cost, increasing LAC
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Practice Activity 2 Try answering some questions about long run costs.

What is the invisible hand theory?
Adam Smith wrote of the invisible hand of the market place, guiding resources and final products to their most valued uses. The market price acts as the invisible hand.
      Market prices ration goods and services.

• the buyer who most wants a good or service will pay the most for it
• the price rations that good or service to its most valued use

Market prices also allocate resources.

• resources will leave an industry with a price too low to produce profits
• resources will migrate to industries with prices high enough to guarantee profits
• the price allocates resources to their highest valued uses
• firms must be able to enter and exit industries for this function to work efficiently

Why is free entry and exit important?
Free entry and exit are important to achieve an efficient allocation of resources. The most efficient allocation exists when economic profit is zero.
      Firms enter profitable industries and bid the price down until economic profit is zero. Firms exit unprofitable industries, causing the price to rise until economic profit is zero.
      Barriers to entry keep firms from entering industries.

• legal constraints keeping firms out
• patents and copyright laws
• product compatibility

Barriers to exit may exist, if a government forces an unprofitable firm to stay in business.
      Perfectly competitive firms have an incentive to find cost-saving innovations.

• at long-run equilibrium, economic profit is zero
• perfectly competitive firms cannot affect the price for their own product, but they can affect their costs
• using cost-saving innovations, a firm will make a temporary economic profit
  • once all firms adopt the innovation, market price will fall and economic profit will return to zero

What is economic rent?
Economic rent is that part of a payment to a factor of production that is over and above that factor's reservation price.

• a person may be willing to work for $100 per day, but is paid $150 per day
  • the person's economic rent is $150-$100 = $50 per day
  • the $100 is the person's opportunity cost of staying in that job

What are stocks and bonds?
A share of stock represents ownership in a firm. If a firm has issued 100 shares of stock, then each shareholder owns 1/100th of the firm, assuming each shareholder owns one share. The value of a share of stock is dependent on the expected value of the company and its expected profits.
      A bond represents ownership of a firm's debt. The firm sells bonds to raise money, and pays interest to the bondholder at some specified rate. A bondholder does not own any part of the firm.

To learn more about the stock market, visit the Toronto Stock Exchange at http://www.tse.com. You will find a pamphlet entitled Understanding the Stock Market that explains the basic workings of the TSE.

What is the present value of money?
The present value of money is how much a sum of money to be received in the future is worth today. Present value is calculated using the following formula:

PV =	MT    (1 + r)T

where
PV º present value
M_Tº the value of the sum of money to be received in the future
T º the number of years in the future
r º rate of interest earned on the initial deposit

This calculation tells you how much money must be deposited today (PV) into an interest-bearing instrument (r) for a period of time (T) to grow to a target amount (M_T).

• the higher the rate of interest, the smaller the present value
• the longer the time frame of deposit, the smaller the present value

You can access an online time value of money calculator at http://www.arachnoid.com/lutusp/finance_old.html. Use this calculator to find present value, future value, even how many loan payments are needed to retire a debt.

What is the efficient markets hypothesis?
The efficient markets hypothesis says that the current price of a share of stock incorporates all available information about the company's expected earnings.

• as new information emerges about a company's profitability, buyers and sellers of shares react
• changes in the stock's price are usually small because new information is usually small

What is the difference between equilibrium and social optimum?
When a market is in equilibrium, the gains from trade have been exhausted.

• individual firms can still make economic profits by finding cost-savings innovations
• individual consumers can still make gains by thorough research into the best deal in the market

The equilibrium outcome does not guarantee that the outcome is optimal for society. If production produces pollution, for example, then society is made worse off by the production.

Understanding Questions Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.