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Chapter 8: The Invisible Hand in Action

Accounting Profit. Most common profit ideaAccounting profit = total revenue explicit costsExplicit costs are payments firms make to purchaseResources (labor, land, etc.) and Products from other firmsEasy to computeEasy to compare across firms. Economic Profit. Economic profit is the differen

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Chapter 8: The Invisible Hand in Action

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    1. Chapter 8: The Invisible Hand in Action Learning Objectives: Define and explain the differences between accounting and economic profit. Show how economic profit and economic loss affect the allocation of resources across industries. Explain the difference between economic profit and economic rent. Use the theory of the invisible hand to analyze events in everyday life. Understand and explain the relationship between a market equilibrium and a social optimum.

    2. Accounting Profit Most common profit idea Accounting profit = total revenue – explicit costs Explicit costs are payments firms make to purchase Resources (labor, land, etc.) and Products from other firms Easy to compute Easy to compare across firms

    3. Three Kinds of Profit

    4. Two Functions of Price Rationing function of price distributes scarce goods to the consumers who value them most highly Allocative function of price directs resources away from overcrowded markets to markets that are underserved Invisible Hand Theory is that actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resource Articulated by Adam Smith in eighteenth century

    5. Response to Economic Profits Markets with excess profits attract resources

    6. Shrinking Economic Profits Supply increases

    7. Market Equilibrium Zero economic profits

    8. Economic Losses Resources leave

    9. Market Equilibrium No economic losses

    10. Constant-Cost Industry In the long run, corn costs $1/bu regardless of the size of the industry

    11. Short-Run Adjustments

    12. Short-Run Adjustments

    13. Free Entry and Exit Barrier to entry: any force that prevents firms from entering a new industry Free entry and exit is required for the Invisible Hand to work

    14. Present Value

    15. Invisible Hand and Socially Optimal Outcome Markets work best when Buyers' marginal benefits = sellers' marginal costs AND Society's marginal benefits = society's marginal costs Individual spending to improve a stock price forecast may benefit the individual Some other individual loses Return to society of the investment is less than the benefit

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