Types of profitThe invisible hand

Today: Some fundamental ideas that are important to

every economist

Reminder Test 1 coming soon (February 9)

Make sure you have a Scantron and calculator that is allowed (see syllabus for more details)

Talk to me if you are not sure if your calculator is allowed for the test

Today is the last day to make a DSP request to me in order to guarantee a room

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

Assumptions for today’s lecture

Property rights Free entry and exit Many potential sellers Many potential buyers

Questions of the day

Why are TV repair shops harder to find?

Why has Las Vegas added many expensive hotels on its famous strip?

…before the recession hit

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

Today

We will compare different types of profits

Long-run equilibrium We will talk about why some

businesses expand, while other types of businesses disappear

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

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” (F/B, p. 175)

Example: Emma Emma 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

Emma’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

What should Emma do? Emma 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

Emma’s Conclusion

Emma should work at AAA plumbing, since her economic profit of working at home is negative

Notice that the accounting profit is positive if Emma opens her business, but she can earn more as a plumber

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

For this discussion

Assume that costs include implicit costs

Thus, we are calculating economic profit

Equilibrium occurs when economic profit is zero

Example: Start at supply S

Market supply Firm supply

Profits are positive here, since P > ATC

Market supply Firm supply

What happens when economic profits are positive?

New firms enter the industry Supply shifts to the right Market price decreases Market quantity increases

What else happens?

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

Prediction: Supply continues to shift until economic profits are 0

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

Back to our questions

Why are TV repair shops harder to find?

Why has Las Vegas added many expensive hotels on its famous strip?

…before the recession hit

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

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

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

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

Other hotels have expanded

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

Example: Caesars Palace

Billion dollar expansion announced July 2007

Shopping and entertainment options The Forum Shops Bette Midler Elton John Jerry Seinfeld

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

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

What is happening in Las Vegas?

Short-run positive economic profits were likely 1-2 years ago in Las Vegas

However, with the current economic downturn, hotels currently in business are having a hard time filling rooms Caesars Palace expansion slowed down

Example: What Echelon Place is supposed to look like when done

This is what it looks like in a recent picture

What has happened?

The economic downturn has slowed the pace of completion of the $4+ billion Echelon Place

Other hotels have drastically reduced their rates Rooms in Circus Circus under $30 per

night on select nights $159 rate available some nights at

Bellagio

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