Profit and the Invisible Hand

Two Types of Cost

When calculating profit, all costs must be taken into account:

• Explicit cost: the opportunity costs of resources that the firm uses that are supplied from outside the firm, i.e. actual payments made for production
• Implicit cost: the value of the best opportunity forgone by the firm when it uses resources supplied by the firms owners, e.g. time

Three Types of Profit

• Economic profit: total revenue minus ALL costs
• Accounting profit: total revenue minus explicit cost ONLY
• Normal profit: when economic profit is zero, i.e. equal to implicit cost Economic Profit = Total Revenue - (Explicit Costs +Implicit Costs)

              Accounting Profit = Total Revenue - Explicit Costs

Assuming that all firms are profit maximising firms, then to stay in the market firms need to make

AT LEAST a normal profit

The Invisible Hand Theory

The invisible hand theory states that the independent, selfish actions of buyers and sellers for their own gains in a free market, will result in the socially optimal allocation of resources. It describes the self-regulating nature of the marketplace where price has two underlying functions:

• Rationing function: to distribute scarce goods to those consumers who value them most
• Allocative function: to distribute resources away from overcrowded markets towards markets that is underserved.

How the Invisible Hand Works in Long Run

Consider the short-run market for apples where firms are currently earning an economic profit, i.e. their revenue exceeds all costs. We make these assumptions:

• The cost of inputs required to enter the apple market, g. land and labour, are constant
• Anyone is free to enter the apple market
• All apple grower face the same costs, i.e. ATC curves are identical for everyone Initially, apple growers make an economic profit as the price is above ATC. Their demand and supply, MC and ATC curves are:

The existence of economic profit entices others to enter the apple market. This causes the supply to increase, so equilibrium price decreases and thus each producer makes less economic profit.

As long as economic profit exists in the apple market, price will continue to fall until it is at the minimum value of ATC. At this point, there is NO more economic profit.

However, if the initial price was below the ATC due to demand curve being lower than the previous case, then producers make an economic loss:

If this low demand persists, apple growers will keep leaving the market. Eventually, this will push prices back up to the minimum value of ATC for a normal profit, thus no need to quit anymore

In conclusion, for firms in a competitive market that pose no barriers to entry or exit, all firms will tend to earn zero economic profit (normal profit) in the long run. This also reflects the “no cash on table” principle, as people always exploit opportunities for gains, in this case either by entering for the profits or leaving the market to pursue profits elsewhere

Long Run Supply Curve

At the point of zero economic profit, i.e. minimum value of ATC, the production of apple can be reduced or expanded indefinitely in the long run. This means that the supply is perfectly elastic, i.e. horizontal. At this price, the market is in long run equilibrium.

Two main features of perfectly competitive long-run market equilibrium:

• Market outcome is efficient. At $1/kg, the marginal benefit of every apple sold ($1) is exactly equal to the marginal cost of producing it ($1). Thus there is no Pareto efficient transaction possible.
• Goods are produced at lowest cost possible. Since buyers pay no more than the total cost of production, all resources of supplied by owner earn equal to their opportunity cost.

Economic Profit vs. Economic Rent

Although the invisible hand eventually leads to zero economic profit, many people have become incredibly rich. This is due to barriers to entry, forces that prevent firms from entering a new market, which leads to economic rent. Economic rent is the part of the payment for a factor of production that EXCEEDS the owner’s reservation price, it is a similar concept to producer surplus

• Economic profit is driven to zero by competition in the long run
• Economic rent can persist in the long run

If the elasticity of supply is:

• Perfectly elastic: then supplier’s entire income is all opportunity cost and no economic rent
• Perfectly inelastic: all supplier’s income is economic rent

E.g. if a landowner is willing to lease his land to farmers for $1000 a year and a farmer pays $1500 a year for it. What is the landowner’s economic rent and why does it persist in the long run? Economic rent = $1500 - $1000 = $500

This economic rent does not disappear because of barriers to entry, i.e. fixed amount of land

The Invisible Hand and Cost-Saving Innovations

A perfectly competitive firm is a price taker with no influence over market price and eventually earns a normal profit. However, there is still incentive to develop cost-saving innovations. This is because costs saving innovations earn an economic profit in the short run for that firm, since the decrease in that firm’s costs has no impact on market price. Other producers eventually adopt these innovations and again drive economic profit to zero. At that point, any firm that did NOT adopt the new strategy would suffer a loss.