Types of profit The invisible hand

1. Types of profitThe invisible hand Today: Some fundamental ideas that are important to every economist

2. Applications of supply and demand • Today, we will continue to apply what we have learned about supply and demand • We will also introduce various ideas about profits and see another way to reach market equilibrium

3. Assumptions for today’s lecture • Property rights • Free entry and exit • Many potential sellers • Many potential buyers

4. Questions of the day • Why are TV repair shops harder to find? • Why has Las Vegas added many expensive hotels on its famous strip?

5. Answer • The invisible hand • We will see how much profit is “enough” for firms to stay in business • When profits exceed this, other firms will enter • When profits are lower than this, firms will leave

6. Today • We will compare different types of profits • We will find the point where marginal benefit of consumption equals the marginal cost of production • This will give us the efficient outcome

7. Business and profit • Each business has revenues and costs • The difference between these is profit • Profits that you typically hear about are what are called “accounting profits” • These profits do not account for opportunity costs

8. From total revenue to profits • Total revenue = Explicit costs + Accounting Profit = Explicit costs + Normal Profit + Economic Profit • Normal profit is an implicit cost • Defined as the “the opportunity cost of the resources supplied by a firm’s owners” (p. 219)

9. Example: Jill • Jill the plumber • She could either run a home business or work next door at AAA Plumbing at $30 per hour • Either way: • 40 hours / week • 50 weeks / year

10. Jill’s potential home business • If she works at home, she assumes that her annual revenues and costs will be as follows • Total revenue: $200,000 • Explicit costs: $160,000

11. What should Jill do? • Jill should run a home business if her economic profit is positive • Economic profit is total revenue minus all costs (including opportunity cost of not working) • Economic profit = $200,000 – ($160,000 + $60,000) = – $20,000

12. Jill’s Conclusion • Jill should work at AAA plumbing, since her economic profit of working at home is negative • Notice that the accounting profit is positive if Jill opens her business, but she can earn more as a plumber

13. Next: Long-run equilibrium • Remember that a firm’s short-run equilibrium will occur when MB (which is price in this case) equals MC • Exception: Shut-down condition • Now we will see how we get long-run equilibrium • Notice in the long run there are no fixed costs

14. For this discussion • Assume that costs include implicit costs • Thus, we are calculating economic profit • Equilibrium occurs when economic profit is zero

15. Example: Start at supply SPositive profits, since P > ATC Market supply Firm supply

16. What happens when economic profits are positive? • New firms enter the industry • Supply shifts to the right • Market price decreases • Market quantity increases

17. What else happens?

18. What happens to the firm from the price drop? • Each firm produces less, since some units produced are no longer profitable • Profits fall, since each unit produced has lower profit than before • Economic profits are often driven to zero in the long run • ATC is minimized when long-run profits are zero if each producer has the same ATC curve

19. Prediction: Supply continues to shift until economic profits are 0

20. Why do we predict a zero profit in the long run? • If economic profits are positive in a market, some firms will be able to make more economic profits in this market than in other markets • If economic profits are negative in a market, some firms already producing in this market can make more economic profit producing another good

21. Back to our questions • Why are TV repair shops harder to find? • Why has Las Vegas added many expensive hotels on its famous strip?

22. Why are TV repair shops harder to find? • When televisions were first produced, it was a major purchase • When the TV broke, fixing it was usually a much lower cost than replacing it

23. Why are TV repair shops harder to find? • Today, some flat screen TVs will cost you less than a dinner for 2 at an expensive restaurant • Example: $140 for a 20” flat-screen at Target (checked 1/15/08) • Repairing a TV today may cost more than replacing it

24. Why are TV repair shops harder to find? • As the price of TVs (relative to yearly income) falls, fewer people will have their TVs repaired when it breaks • Fewer repairs  Lower economic profit • Whenever economic profit becomes negative, some firms will not renew their leases

25. Las Vegas Mega resorts • In recent years, many large hotels have opened on the Las Vegas strip • Bellagio • Mandalay Bay • Wynn Las Vegas • MGM Grand • New York/New York

26. Why all of the new hotels? • Las Vegas is not only a gambling hotspot, but also has become an entertainment destination • Shopping for any budget is available on the strip • Some dining choices are world class Pinot Brasserie at the Venetian 

27. Example: Caesars Palace • Billion dollar expansion announced July 2007 • Shopping and entertainment options • The Forum Shops • Bette Midler • Elton John • Jerry Seinfeld

28. Some Las Vegas facts • From USA Today, 2/14/07 • 38.9 million visitors in 2006 • 137,600 hotel rooms (expected to grow to 171,000 by 2010) • Hotel occupancy of 89.7% • Hotel inventory stayed about the same in 2006 • Average room price increased by 16% in 2006

29. What happened? • In 2006, the Stardust closed to make way for a new resort, Echelon Place • The Boardwalk also closed to make way for new projects • Off-strip hotels of (arguably) comparable quality opened in 2006 • Increased demand for hotel rooms and short-run decrease in supply forced prices to go up by 16% in Las Vegas

30. What is happening in Las Vegas? • Short-run positive economic profits are currently likely in Las Vegas • Once new resorts open, economic profits will likely converge toward zero • Depending on demand, prices for hotel rooms may decline when new hotels open

31. Summary • Without government intervention, free entry and exit can lead to a long run of zero economic profit • Opportunity cost is important in calculating economic profit