CHAPTER 7
Early suppliers of more fuel-efficient cars were able to charge premium prices for them, but that ability faded as other suppliers adopted similar technologies.©Robert Churchill/E+/Getty Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Define and explain the differences between accounting profit, economic profit, and normal profit.
2. LO2Explain the invisible hand theory and show how economic profit and economic loss affect the allocation of resources across industries.
3. LO3Explain why economic profit, unlike economic rent, tends toward zero in the long run.
4. LO4Identify whether the market equilibrium is socially efficient and why no opportunities for gain remain open to individuals when a market is in equilibrium.
5. LO5Calculate total economic surplus and explain how it is affected by policies that prevent markets from reaching equilibrium.
The market for ethnic cuisine in Ithaca, New York, offered few choices in the 1970s: The city had one Japanese, two Greek, four Italian, and three Chinese restaurants. Today, some 40 years later and with essentially the same population, Ithaca has one Sri Lankan, three Indian, one French, one Spanish, six Thai, two Korean, two Vietnamese, four Mexican, three Greek, seven Italian, two Caribbean, two Japanese, one Ethiopian, one Turkish, and nine Chinese restaurants. In some of the city’s other markets, however, the range of available choices has narrowed. For example, several companies provided telephone answering services in 1972, but only one does so today.
Rare indeed is the marketplace in which the identities of the buyers and sellers remain static for extended periods. New businesses enter; established ones leave. There are more body-piercing studios in Ithaca now and fewer watch-repair shops; more marketing consultants and fewer intercity bus companies; and more appliances in stainless steel or black finishes, fewer in avocado or coppertone.
Driving these changes is the business owner’s quest for profit. Businesses migrate to industries and locations in which profit opportunities abound and desert those whose prospects appear bleak. In perhaps the most widely quoted passage from his landmark treatise, The Wealth of Nations, Adam Smith wrote,
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard of their own interest. We address ourselves not to their humanity, but to their self-love, and never talk to them of our necessities, but of their advantage.1
Incentive
Smith went on to argue that although the entrepreneur “intends only his own gain,” he is “led by an invisible hand to promote an end which was no part of his intention.” As Smith saw it, even though self-interest is the prime mover of economic activity, the end result is an allocation of goods and services that serves society’s collective interests remarkably well. If producers are offering “too much” of one product and “not enough” of another, profit opportunities stimulate entrepreneurs into action. All the while, the system exerts relentless pressure on producers to hold the price of each good close to its cost of production, and indeed to reduce that cost in any ways possible. The invisible hand, in short, is about all the good things that can happen because of the Incentive Principle.
Why do most American cities now have more tattoo parlors and fewer watch-repair shops than in 1972?
Our task in this chapter is to gain deeper insight into the nature of the forces that guide the invisible hand. What exactly does “profit” mean? How is it measured, and how does the quest for it serve society’s ends? And if competition holds price close to the cost of production, why do so many entrepreneurs become fabulously wealthy? We will also discuss cases in which misunderstanding of Smith’s theory results in costly errors, both in everyday decision making and in the realm of government policy.
THE CENTRAL ROLE OF ECONOMIC PROFIT
The economic theory of business behavior is built on the assumption that the firm’s goal is to maximize its profit. So we must be clear at the outset about what, exactly, profit means.
THREE TYPES OF PROFIT
The economist’s understanding of profit is different from the accountant’s, and the distinction between the two is important for understanding how the invisible hand works. Accountants define the annual profit of a business as the difference between the revenue it takes in and its explicit costs for the year, which are the actual payments the firm makes to its factors of production and other suppliers. Profit thus defined is called accounting profit.
Accounting profit = Total revenue − Explicit costs.
Accounting profit is the most familiar profit concept in everyday discourse. It is the one that companies use, for example, when they provide statements about their profits in press releases or annual reports.2
Economists, by contrast, define profit as the difference between the firm’s total revenue and not just its explicit costs, but also its implicit costs, which are the opportunity costs of all the resources supplied by the firm’s owners. Profit thus defined is called economic profit ( or excess profit).
Economic profit = Total revenue − Explicit costs − Implicit costs.
To illustrate the difference between accounting profit and economic profit, consider a firm with $400,000 in total annual revenue whose only explicit costs are workers’ salaries, totaling $250,000 per year. The owners of this firm have supplied machines and other capital equipment with a total resale value of $1 million. This firm’s accounting profit then is $150,000, or the difference between its total revenue of $400,000 per year and its explicit costs of $250,000 per year.
To calculate the firm’s economic profit, sometimes called its excess profit, we must first calculate the opportunity cost of the resources supplied by the firm’s owners. Suppose the current annual interest rate on savings accounts is 10 percent. Had owners not invested in capital equipment, they could have earned an additional $100,000 per year interest by depositing their $1 million in a savings account. So the firm’s economic profit is $400,000 per year − $250,000 per year − $100,000 per year = $50,000 per year.
Note that this economic profit is smaller than the accounting profit by exactly the amount of the firm’s implicit costs—the $100,000 per year opportunity cost of the resources supplied by the firm’s owners. This difference between a business’s accounting profit and its economic profit is called its normal profit. Normal profit is simply the opportunity cost of the resources supplied to a business by its owners.
Figure 7.1 illustrates the difference between accounting and economic profit. A firm’s total revenue is represented in Figure 7.1(a), while (b) and (c) show how this revenue is apportioned among the various cost and profit categories.
FIGURE 7.1 The Difference between Accounting Profit and Economic Profit.Accounting profit (b) is the difference between total revenue and explicit costs. Normal profit (c) is the opportunity cost of all resources supplied by a firm’s owners. Economic profit (c) is the difference between total revenue and all costs, explicit and implicit (also equal to the difference between accounting profit and normal profit).
The following examples illustrate why the distinction between accounting and economic profit is so important.
EXAMPLE 7.1Accounting versus Economic Profit, Part 1
Should Pudge Buffet stay in the farming business?
Pudge Buffet is a corn farmer who lives near Lincoln, Nebraska. His payments for land and equipment rental and for other supplies come to $10,000 per year. The only input he supplies is his own labor, and he considers farming just as attractive as his only other employment opportunity, managing a retail store at a salary of $11,000 per year. Apart from the matter of pay, Pudge is indifferent between farming and being a manager. Corn sells for a constant price per bushel in an international market too large to be affected by changes in one farmer’s corn production. Pudge’s revenue from corn sales is $22,000 per year. What is his accounting profit? His economic profit? His normal profit? Should he remain a corn farmer?
As shown in Table 7.1, Pudge’s accounting profit is $12,000 per year, the difference between his $22,000 annual revenue and his $10,000 yearly payment for land, equipment, and supplies. His economic profit is that amount less the opportunity cost of his labor. Since the latter is the $11,000 per year he could have earned as a store manager, he is making an economic profit of $1,000 per year. Finally, his normal profit is the $11,000 opportunity cost of the only resource he supplies, namely, his labor. Since Pudge likes the two jobs equally well, he will be better off by $1,000 per year if he remains in farming.
CONCEPT CHECK 7.1
In Example 7.1, how will Pudge’s economic profit change if his annual revenue from corn production is not $22,000, but $20,000? Should he continue to farm?
When revenue falls from $22,000 to $20,000, Pudge has an economic profit of −$1,000 per year. A negative economic profit is also called an economic loss. If Pudge expects to sustain an economic loss indefinitely, his best bet would be to abandon farming in favor of managing a retail store.
You might think that if Pudge could just save enough money to buy his own land and equipment, his best option would be to remain a farmer. But as the following example illustrates, that impression is based on a failure to perceive the difference between accounting profit and economic profit.
EXAMPLE 7.2Accounting versus Economic Profit, Part 2
Does owning one’s own land make a difference?
Let’s build on Example 7.1 and Concept Check 7.1. Suppose Pudge’s Uncle Warren, who owns the farmland Pudge has been renting, dies and leaves Pudge that parcel of land. If the land could be rented to some other farmer for $6,000 per year, should Pudge remain in farming?
As shown in Table 7.2, if Pudge continues to farm his own land, his accounting profit will be $16,000 per year, or $6,000 more than in Concept Check 7.1. But his economic profit will still be the same as before—that is, −$1,000 per year—because Pudge must deduct the $6,000 per year opportunity cost of farming his own land, even though he no longer must make an explicit payment to his uncle for it. The normal profit from owning and operating his farm will be $17,000 per year—the opportunity cost of the land and labor he provides. But since Pudge earns an accounting profit of only $16,000, he will again do better to abandon farming for the managerial job.
Pudge obviously would be wealthier as an owner than he was as a renter. But the question of whether to remain a farmer is answered the same way whether Pudge rents his farmland or owns it. He should stay in farming only if that is the option that yields the highest economic profit.
RECAP
THE CENTRAL ROLE OF ECONOMIC PROFIT
A firm’s accounting profit is the difference between its revenue and the sum of all explicit costs it incurs. Economic profit is the difference between the firm’s revenue and all costs it incurs—both explicit and implicit. Normal profit is the opportunity cost of the resources supplied by the owners of the firm. When a firm’s accounting profit is exactly equal to the opportunity cost of the inputs supplied by the firm’s owners, the firm’s economic profit is zero. For a firm to remain in business in the long run, it must earn an economic profit greater than or equal to zero.
THE INVISIBLE HAND THEORY
TWO FUNCTIONS OF PRICE
In the free enterprise system, market prices serve two important and distinct functions. The first, the rationing function of price, is to distribute scarce goods among potential claimants, ensuring that those who get them are the ones who value them most. Thus, if three people want the only antique clock for sale at an auction, the clock goes home with the person who bids the most for it. The second function, the allocative function of price, is to direct productive resources to different sectors of the economy. Resources leave markets in which price cannot cover the cost of production and enter those in which price exceeds the cost of production.
Both the allocative and rationing functions of price underlie Adam Smith’s celebrated theory of theinvisible hand of the market. Recall that Smith thought the market system channeled the selfish interests of individual buyers and sellers so as to promote the greatest good for society. The carrot of economic profit and the stick of economic loss, he argued, were often the only forces necessary to ensure that existing supplies in any market would be allocated efficiently and that resources would be allocated across markets to produce the most efficient possible mix of goods and services.
RESPONSES TO PROFITS AND LOSSES
To get a feel for how the invisible hand works, we begin by looking at how firms respond to economic profits and losses. If a firm is to remain in business in the long run, it must cover all its costs, both explicit and implicit. A firm’s normal profit is just a cost of doing business. Thus, the owner of a firm that earns no more than a normal profit has managed only to recover the opportunity cost of the resources invested in the firm. By contrast, the owner of a firm that makes a positive economic profit earns more than the opportunity cost of the invested resources; she earns a normal profit and then some.
Naturally, everyone would be delighted to earn more than a normal profit, and no one wants to earn less. The result is that those markets in which firms are earning an economic profit tend to attract additional resources, whereas markets in which firms are experiencing economic losses tend to lose resources.
To see how this happens, we’ll examine the workings of the market for corn, whose short-run supply and demand curves are shown in Figure 7.2(a). Figure 7.2(b) depicts the marginal and average total cost curves for a representative farm. The equilibrium price of $2 per bushel is determined by the supply–demand intersection in (a). The representative farm whose MC and ATC curves are shown in (b) then maximizes its profit by producing the quantity for which price equals marginal cost, 130,000 bushels of corn per year.
FIGURE 7.2 Economic Profit in the Short Run in the Corn Market.At an equilibrium price of $2 per bushel (a), the typical farm earns an economic profit of $104,000 per year (b).
Recall from Chapter 6, Perfectly Competitive Supply that average total cost at any output level is the sum of all costs, explicit and implicit, divided by output. The difference between price and ATC is thus equal to the average amount of economic profit earned per unit sold. In Figure 7.2(b), that difference is $0.80 per unit. With 130,000 bushels per year sold, the representative farm earns an economic profit of $104,000 per year.
The existence of positive economic profit in the corn market means that producers in that market are earning more than their opportunity cost of farming. For simplicity, we assume that the inputs required to enter the corn market—land, labor, equipment, and the like—are available at constant prices and that anyone is free to enter this market if he or she chooses. The key point is that because price exceeds the opportunity cost of the resources required to enter the market, others will want to enter. And as they add their corn production to the amount already on offer, supply shifts to the right, causing the market equilibrium price to fall, as shown in Figure 7.3(a). At the new price of $1.50 per bushel, the representative farm now earns much less economic profit than before, only $50,400 per year [Figure 7.3(b)].
FIGURE 7.3 The Effect of Entry on Price and Economic Profit.At the original price of $2 per bushel, existing farmers earned economic profit, prompting new farmers to enter. With entry, supply shifts right [from S to S′ in (a)] and equilibrium price falls, as does economic profit (b).
For simplicity, we assume that all farms employ the same standard production method, so that their ATC curves are identical. Entry will then continue until price falls all the way to the minimum value of ATC. (At any price higher than that, economic profit would still be positive, and entry would continue, driving price still lower.) Recall from Chapter 6, Perfectly Competitive Supply that the short-run marginal cost curve intersects the ATC curve at the minimum point of the ATC curve. This means that once price reaches the minimum value of ATC, the profit-maximizing rule of setting price equal to marginal cost results in a quantity for which price and ATC are the same. And when that happens, economic profit for the representative farm will be exactly zero, as shown in Figure 7.4(b).
FIGURE 7.4 Equilibrium When Entry Ceases.Further entry ceases once price falls to the minimum value of ATC. At that point, all firms earn a normal economic profit. Equivalently, each earns an economic profit of zero.
In the adjustment process just considered, the initial equilibrium price was above the minimum value of ATC, giving rise to positive economic profits. Suppose instead that the market demand curve for corn had intersected the short-run supply curve at a price below the minimum value of each firm’s ATC curve, as shown in Figure 7.5(a). As long as this price is above the minimum value of average variable cost,3 each farm will supply that quantity of corn for which price equals marginal cost, shown as 70,000 bushels per year in Figure 7.5(b). Note, however, that at that quantity, the farm’s average total cost is $1.05 per bushel, or $0.30 more than the price for which it sells each bushel. As shown in (b), the farm thus sustains an economic loss of $21,000 per year.
FIGURE 7.5 A Short-Run Economic Loss in the Corn Market.When price is below the minimum value of ATC (a), each farm sustains an economic loss (b).
If the demand curve that led to the low price and resulting economic losses in Figure 7.5 is expected to persist, farmers will begin to abandon farming for other activities that promise better returns. This means that the supply curve for corn will shift to the left, resulting in higher prices and smaller losses. Exit from corn farming will continue, in fact, until price has again risen to $1 per bushel, at which point there will be no incentive for further exit. Once again we see a stable equilibrium in which price is $1 per bushel, as shown in Figure 7.6.
FIGURE 7.6 Equilibrium When Exit Ceases.Further exit ceases once price rises to the minimum value of ATC. At that point, all firms earn a normal economic profit. Equivalently, each earns an economic profit of zero.
Given our simplifying assumptions that all corn farms employ a standardized production method and that inputs can be purchased in any quantities at fixed prices, the price of corn cannot remain above $1 per bushel (the minimum point on the ATC curve) in the long run. Any higher price would stimulate additional entry until price again fell to that level. Further, the price of corn cannot remain below $1 per bushel in the long run because any lower price would stimulate exit until the price of corn again rose to $1 per bushel.
The fact that firms are free to enter or leave an industry at any time ensures that, in the long run, all firms in the industry will tend to earn zero economic profit. Their goal is not to earn zero profit. Rather, the zero-profit tendency is a consequence of the price movements associated with entry and exit. As the Equilibrium Principle—also called the No-Cash-On-the-Table Principle (see Chapter 3, Supply and Demand)—predicts, when people confront an opportunity for gain, they are almost always quick to exploit it.
Equilibrium
What does the long-run supply curve look like in the corn market just discussed? This question is equivalent to asking, “What is the marginal cost of producing additional bushels of corn in the long run?” In general, adjustment in the long run may entail not just entry and exit of standardized firms, but also the ability of firms to alter the mix of capital equipment and other fixed inputs they employ. Explicit consideration of this additional step would complicate the analysis considerably but would not alter the basic logic of the simpler account we present here, which assumes that all firms operate with the same standard mix of fixed inputs in the short run. Under this assumption, the long-run adjustment process consists exclusively of the entry and exit of firms that use a single standardized production method.
The fact that a new firm could enter or leave this corn market at any time means that corn production can always be augmented or reduced in the long run at a cost of $1 per bushel. And this, in turn, means that the long-run supply curve of corn will be a horizontal line at a price equal to the minimum value of the ATC curve, $1 per bushel. Since the long-run marginal cost (LMC) of producing corn is constant, so is the long-run average cost (LAC) and it, too, is $1 per bushel, as shown in Figure 7.7(a). Figure 7.7(b) shows the MC and ATC curves of a representative corn farm. At a price of $1 per bushel, this corn market is said to be in long-run equilibrium. The representative farm produces 90,000 bushels of corn each year, the quantity for which price equals its marginal cost. And since price is exactly equal to ATC, this farm also earns an economic profit of zero.
FIGURE 7.7 Long-Run Equilibrium in a Corn Market with Constant Long-Run Average Cost.When each producer has the same ATC curve, the industry can supply as much or as little output as buyers wish to buy at a price equal to the minimum value of ATC (a). At that price, the representative producer (b) earns zero economic profit.
These observations call attention to two attractive features of the invisible hand theory. One is that the market outcome is efficient in the long run. Note, for example, that when the corn market is in long-run equilibrium, the value to buyers of the last unit of corn sold is $1 per bushel, which is exactly the same as the long-run marginal cost of producing it. Thus, there is no possible rearrangement of resources that would make some participants in this market better off without causing harm to some others. If farmers were to expand production, for example, the added costs incurred would exceed the added benefits; and if they were to contract production, the cost savings would be less than the benefits forgone.
A second attractive feature of long-run competitive equilibrium is the market outcome can be described as fair, in the sense that the price buyers must pay is no higher than the cost incurred by suppliers. That cost includes a normal profit, the opportunity cost of the resources supplied by owners of the firm.
We must emphasize that Smith’s invisible hand theory does not mean that market allocation of resources is optimal in every way. It simply means that markets are efficient in the limited technical sense discussed in the chapter on perfectly competitive supply. Thus, if the current allocation differs from the market equilibrium allocation, the invisible hand theory implies that we can reallocate resources in a way that makes some people better off without harming others.
The following example affords additional insight into how Smith’s invisible hand works in practice.
EXAMPLE 7.3Movement toward Equilibrium
What happens in a city with “too many” hair stylists and “too few” Pilates instructors?
At the initial equilibrium quantities and prices in the markets for haircuts and Pilates classes shown in Figure 7.8, all suppliers are currently earning zero economic profit. Now suppose that styles suddenly change in favor of longer hair and increased physical fitness. If the long-run marginal cost of altering current production levels is constant in both markets, describe how prices and quantities will change in each market, in both the short run and the long run. Are the new equilibrium quantities socially optimal?
FIGURE 7.8 Initial Equilibrium in the Markets for (a) Haircuts and (b) Pilates Classes.MCH and ATCH are the marginal cost and average total cost curves for a representative hair stylist, and MCA and ATCA are the marginal cost and average total cost curves for a representative Pilates instructor. Both markets are initially in long-run equilibrium, with sellers in each market earning zero economic profit.
The shift to longer hair styles means a leftward shift in the demand for haircuts, while the increased emphasis on physical fitness implies a rightward shift in the demand curve for Pilates classes, as seen in Figure 7.9. As a result of these demand shifts, the new short-run equilibrium prices change. For the sake of illustration, these new prices are shown as $12 per haircut and $15 per Pilates class.
FIGURE 7.9 The Short-Run Effect of Demand Shifts in Two Markets.(a) The decline in demand for haircuts causes the price of haircuts to fall from $15 to $12 in the short run. (b) The increase in demand for Pilates classes causes the price of classes to rise from $10 to $15 in the short run.
Because each producer was earning zero economic profit at the original equilibrium prices, hair stylists will experience economic losses and Pilates instructors will experience economic profits at the new prices, as seen in Figure 7.10.
FIGURE 7.10 Economic Profit and Loss in the Short Run.The assumed demand shifts result in an economic loss for the representative hair stylist (a) and an economic profit for the representative Pilates instructor (b).
Because the short-run equilibrium price of haircuts results in economic losses for hair stylists, some hair stylists will begin to leave that market in search of more favorable opportunities elsewhere. As a result, the short-run supply curve of haircuts will shift leftward, resulting in a higher equilibrium price. Exit of hair stylists will continue until the price of haircuts rises sufficiently to cover the long-run opportunity cost of providing them, which by assumption is $15.
By the same token, because the short-run equilibrium price of Pilates classes results in economic profits for instructors, outsiders will begin to enter that market, causing the short-run supply curve of classes to shift rightward. New instructors will continue to enter until the price of classes falls to the long-run opportunity cost of providing them. By assumption, that cost is $10. Once all adjustments have taken place, there will be fewer haircuts and more Pilates classes than before. But because marginal costs in both markets were assumed constant in the long run, the prices of the two goods will again be at their original levels.
It bears mention that those stylists who leave the hair-cutting market won’t necessarily be the same people who enter the Pilates teaching market. Indeed, given the sheer number of occupations a former hair stylist might choose to pursue, the likelihood of such a switch is low. Movements of resources will typically involve several indirect steps. Thus, a former hair stylist might become a secretary, and a former postal worker might become an Pilates instructor.
We also note that the invisible hand theory says nothing about how long these adjustments might take. In some markets, especially labor markets, the required movements might take months or even years. But if the supply and demand curves remain stable, the markets will eventually reach equilibrium prices and quantities. And the new prices and quantities will be socially optimal in the same sense as before. Because the value to buyers of the last unit sold will be the same as the marginal cost of producing it, no additional transactions will be possible that benefit some without harming others.
THE IMPORTANCE OF FREE ENTRY AND EXIT
The allocative function of price cannot operate unless firms can enter new markets and leave existing ones at will. If new firms could not enter a market in which existing firms were making a large economic profit, economic profit would not tend to fall to zero over time, and price would not tend to gravitate toward the marginal cost of production.
Forces that inhibit firms from entering new markets are called barriers to entry. In the book publishing market, for example, the publisher of a book enjoys copyright protection granted by the government. Copyright law forbids other publishers from producing and selling their own editions of protected works. This barrier allows the price of a popular book to remain significantly above its cost of production for an extended period, all the while generating an economic profit for its publisher. (A copyright provides no guarantee of a profit, and indeed most new books actually generate an economic loss for their publishers.)
Barriers to entry may result from practical as well as legal constraints. Some economists, for example, have argued that the compelling advantages of product compatibility have created barriers to entry in the computer software market. Since more than 85 percent of new desktop and laptop computers come with Microsoft’s Windows software already installed, rival companies have difficulty selling other operating systems that may prevent users from exchanging files with friends and colleagues. This fact, more than any other, explains Microsoft’s spectacular profit history. But the share of computers equipped with Windows has been steadily falling, leading may economists to predict that Microsoft’s profits will follow a similar trajectory.
No less important than the freedom to enter a market is the freedom to leave. When the airline industry was regulated by the federal government, air carriers were often required to serve specific markets, even though they were losing money in them. When firms discover that a market, once entered, is difficult or impossible to leave, they become reluctant to enter new markets. Barriers to exit thus become barriers to entry. Without reasonably free entry and exit, then, the implications of Adam Smith’s invisible hand theory cannot be expected to hold.
All things considered, producers enjoy a high degree of freedom of entry in most U.S. markets. Because free entry is one of the defining characteristics of perfectly competitive markets, unless otherwise stated, we’ll assume its existence.
RECAP
THE INVISIBLE HAND THEORY
In market economies, the allocative and rationing functions of prices guide resources to their most highly valued uses. Prices influence how much of each type of good gets produced (the allocative function). Firms enter industries in which prices are sufficiently high to sustain an economic profit and leave those in which low prices result in an economic loss. Prices also direct existing supplies of goods to the buyers who value them most (the rationing function).
Industries in which firms earn a positive economic profit tend to attract new firms, shifting industry supply to the right. Firms tend to leave industries in which they sustain an economic loss, shifting supply curves to the left. In each case, the supply movements continue until economic profit reaches zero. In long-run equilibrium, the value of the last unit produced to buyers is equal to its marginal cost of production, leaving no possibility for additional mutually beneficial transactions.
ECONOMIC RENT VERSUS ECONOMIC PROFIT
Microsoft co-founder Bill Gates is one of the wealthiest people on the planet, largely because the problem of compatibility prevents rival suppliers from competing effectively in the many software markets dominated by his company. Yet numerous people have become fabulously rich even in markets with no conspicuous barriers to entry. If market forces push economic profit toward zero, how can that happen?
The answer to this question hinges on the distinction between economic profit and economic rent. Most people think of rent as the payment they make to a landlord or the supplier of a dorm refrigerator, but the term economic rent has a different meaning. Economic rent is that portion of the payment for an input that is above the supplier’s reservation price for that input. Suppose, for example, that a landowner’s reservation price for an acre of land is $100 per year. That is, suppose he would be willing to lease it to a farmer as long as he received an annual payment of at least $100, but for less than that amount he would rather leave it fallow. If a farmer gives him an annual payment not of $100 but of $1,000, the landowner’s economic rent from that payment will be $900 per year.
Economic profit is like economic rent in that it, too, may be seen as the difference between what someone is paid (the business owner’s total revenue) and her reservation price for remaining in business (the sum of all her costs, explicit and implicit). But whereas competition pushes economic profit toward zero, it has no such effect on the economic rent for inputs that cannot be replicated easily. For example, although the lease payments for land may remain substantially above the landowner’s reservation price, year in and year out, new land cannot come onto the market to reduce or eliminate the economic rent through competition. There is, after all, only so much land to be had.
As the following example illustrates, economic rent can accrue to people as well as land.
EXAMPLE 7.4Economic Rent
How much economic rent will a talented chef get?
A community has 100 restaurants, 99 of which employ chefs of normal ability at a salary of $30,000 per year, the same as the amount they could earn in other occupations that are equally attractive to them. But the 100th restaurant has an unusually talented chef. Because of her reputation, diners are willing to pay 50 percent more for the meals she cooks than for those prepared by ordinary chefs. Owners of the 99 restaurants with ordinary chefs each collect $300,000 per year in revenue, which is just enough to ensure that each earns exactly a normal profit. If the talented chef’s opportunities outside the restaurant industry are the same as those of ordinary chefs, how much will she be paid by her employer at equilibrium? How much of her pay will be economic rent? How much economic profit will her employer earn?
Because diners are willing to pay 50 percent more for meals cooked by the talented chef, the owner who hires her will take in total receipts not of $300,000 per year but of $450,000. In the long run, competition should ensure that the talented chef’s total pay each year will be $180,000 per year, the sum of the $30,000 that ordinary chefs get and the $150,000 in extra revenues for which she is solely responsible. Since the talented chef’s reservation price is the amount she could earn outside the restaurant industry—by assumption, $30,000 per year, the same as for ordinary chefs—her economic rent is $150,000 per year. The economic profit of the owner who hires her will be exactly zero.
Since the talented chef’s opportunities outside the restaurant industry are no better than an ordinary chef’s, why is it necessary to pay the talented chef so much? Suppose her employer were to pay her only $60,000, which they both would consider a generous salary since it is twice what ordinary chefs earn. The employer would then earn an economic profit of $120,000 per year since his annual revenue would be $150,000 more than that of ordinary restaurants, but his costs would be only $30,000 more.
But this economic profit would create an opportunity for the owner of some other restaurant to bid the talented chef away. For example, if the owner of a competing restaurant were to hire the talented chef at a salary of $70,000, the chef would be $10,000 per year better off and the rival owner would earn an economic profit of $110,000 per year, rather than his current economic profit of zero. Furthermore, if the talented chef is the sole reason that a restaurant earns a positive economic profit, the bidding for that chef should continue as long as any economic profit remains. Some other owner will pay her $80,000, still another $90,000, and so on. Equilibrium will be reached only when the talented chef’s salary has been bid up to the point that no further economic profit remains—in our example, at an annual paycheck of $180,000.
This bidding process assumes, of course, that the reason for the chef’s superior performance is that she possesses some personal talent that cannot be copied. If instead it were the result of, say, training at a culinary institute in France, then her privileged position would erode over time, as other chefs sought similar training.
RECAP
ECONOMIC RENT VERSUS ECONOMIC PROFIT
Economic rent is the amount by which the payment to a factor of production exceeds the supplier’s reservation price. Unlike economic profit, which is driven toward zero by competition, economic rent may persist for extended periods, especially in the case of factors with special talents that cannot easily be duplicated.
THE INVISIBLE HAND IN ACTION
To help develop your intuition about how the invisible hand works, we will examine how it helps us gain insight into patterns we observe in a wide variety of different contexts. In each case, the key idea we want you to focus on is that opportunities for private gain seldom remain unexploited for very long. Perhaps more than any other, this idea encapsulates the essence of that distinctive mindset known as “thinking like an economist.”
Equilibrium
The Invisible Hand at the Supermarket and on the Freeway
As the following example illustrates, the No-Cash-on-the-Table Principle refers not just to opportunities to earn economic profits in cash, but also to any other opportunity to achieve a more desirable outcome.
Equilibrium
The Economic Naturalist 7.1
Why do supermarket checkout lines all tend to be roughly the same length?
Pay careful attention the next few times you go grocery shopping and you’ll notice that the lines at all the checkout stations tend to be roughly the same length. Suppose you saw one line that was significantly shorter than the others as you wheeled your cart toward the checkout area. Which line would you choose? The shorter one, of course; because most shoppers would do the same, the short line seldom remains shorter for long.
Why do you seldom see one supermarket checkout line that is substantially shorter than all the others?
CONCEPT CHECK 7.2
Use the No-Cash-on-the-Table Principle to explain why all lanes on a crowded, multilane freeway move at about the same speed.
The Invisible Hand and Cost-Saving Innovations
When economists speak of perfectly competitive firms, they have in mind businesses whose contribution to total market output is too small to have a perceptible impact on market price. As explained in Chapter 6, Perfectly Competitive Supply, such firms are often called price takers: they take the market price of their product as given and then produce that quantity of output for which marginal cost equals that price.
This characterization of the competitive firm gives the impression that the firm is essentially a passive actor in the marketplace. Yet for most firms, that is anything but the case. As the next example illustrates, even those firms that cannot hope to influence the market prices of their products have very powerful incentives to develop and introduce cost-saving innovations.
EXAMPLE 7.5The Impact of Cost-Saving Innovations on Economic Profit
How do cost-saving innovations affect economic profit in the short run? In the long run?
Forty merchant marine companies operate supertankers that carry oil from the Middle East to the United States. The cost per trip, including a normal profit, is $500,000. An engineer at one of these companies develops a more efficient propeller design that results in fuel savings of $20,000 per trip. How will this innovation affect the company’s accounting and economic profits? Will these changes persist in the long run?
In the short run, the reduction in a single firm’s costs will have no impact on the market price of transoceanic shipping services. The firm with the more efficient propeller will thus earn an econom*-ic profit of $20,000 per trip (since its total revenue will be the same as before, while its total cost will now be $20,000 per trip lower). As other firms learn about the new design, however, they will begin to adopt it, causing their individual supply curves to shift downward (since the marginal cost per trip at these firms will drop by $20,000). The shift in these individual supply curves will cause the market supply curve to shift, which in turn will result in a lower market price for shipping and a decline in economic profit at the firm where the innovation originated. When all firms have adopted the new, efficient design, the long-run supply curve for the industry will have shifted downward by $20,000 per trip and each company will again be earning only a normal profit. At that point, any firm that did not adopt the new propeller design would suffer an economic loss of $20,000 per trip.
T order to reap economic profit is one of the most powerful forces on the economic landscape. Its beauty, in terms of the invisible hand theory, is that competition among firms ensures that the resulting cost savings will be passed along to consumers in the long run.
THE DISTINCTION BETWEEN AN EQUILIBRIUM AND A SOCIAL OPTIMUM
Equilibrium
The Equilibrium, or No-Cash-on-the-Table, Principle tells us that when a market reaches equilibrium, no further opportunities for gain are available to individuals. This principle implies that the market prices of resources that people own will eventually reflect their economic value. (As we will see in later chapters, the same cannot be said of resources that are not owned by anyone, such as fish in international waters.)
The No-Cash-on-the-Table Principle is sometimes misunderstood to mean that there are never any valuable opportunities to exploit. For example, the story is told of two economists on their way to lunch when they spot what appears to be a $100 bill lying on the sidewalk. When the younger economist stoops to pick up the bill, his older colleague restrains him, saying, “That can’t be a $100 bill.” “Why not?” asks the younger colleague. “If it were, someone would have picked it up by now,” the older economist replies.
Equilibrium
The No-Cash-on-the-Table Principle means not that there never are any unexploited opportunities, but that there are none when the market is in equilibrium. Occasionally a $100 bill does lie on the sidewalk, and the person who first spots it and picks it up gains a windfall. Likewise, when a company’s earnings prospects improve, somebody must be the first to recognize the opportunity, and that person can make a lot of money by purchasing the stock quickly.
Still, the No-Cash-on-the-Table Principle is important. It tells us, in effect, that there are only three ways to earn a big payoff: to work especially hard; to have some unusual skill, talent, or training; or simply to be lucky. The person who finds a big bill on the sidewalk is lucky, as are many of the investors whose stocks perform better than average. Other investors whose stocks do well achieve their gains through hard work or special talent. For example, the legendary investor Warren Buffett, whose portfolio has grown in value at almost three times the stock market average for the last 40 years, spends long hours studying annual financial reports and has a remarkably keen eye for the telling detail. Thousands of others work just as hard yet fail to beat the market averages.
It is important to stress, however, that a market being in equilibrium implies only that no additional opportunities are available to individuals. It does not imply that the resulting allocation is necessarily best from the point of view of society as a whole.
SMART FOR ONE, DUMB FOR ALL
Adam Smith’s profound insight was that the individual pursuit of self-interest often promotes the broader interests of society. But unlike some of his modern disciples, Smith was under no illusion that this is always the case. Note, for example, Smith’s elaboration on his description of the entrepreneur led by the invisible hand “to promote an end which was no part of his intention”:
Nor is it always the worse for society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it. [Emphasis added.]4
Smith was well aware that the individual pursuit of self-interest often does not coincide with society’s interest. In the chapter on supply and demand we cited activities that generate environmental pollution as an example of conflicting economic interests, noting that behavior in those circumstances may be described as smart for one but dumb for all. As the following example suggests, extremely high levels of investment in earnings forecasts also can be smart for one, dumb for all.
The Economic Naturalist 7.2
Are there “too many” smart people working as corporate earnings forecasters?
Stock analysts use complex mathematical models to forecast corporate earnings. The more analysts invest in the development of these models, the more accurate the models become. Thus, the analyst whose model produces a reliable forecast sooner than others can reap a windfall by buying stocks whose prices are about to rise. Given the speed with which stock prices respond to new information, however, the results of even the second-fastest forecasting model may come too late to be of much use. Individual stock analysts thus face a powerful incentive to invest more and more money in their models, in the hope of generating the fastest forecast. Does this incentive result in the socially optimal level of investment in forecast models?
Beyond some point, increased speed of forecasting is of little benefit to society as a whole, whose interests suffer little when the price of a stock moves to its proper level a few hours more slowly. If all stock analysts spent less money on their forecasting models, someone’s model would still produce the winning forecast, and the resources that might otherwise be devoted to fine-tuning the models could be put to more valued uses. Yet if any one individual spends less, he can be sure the winning forecast will not be his.
The invisible hand went awry in the situation just described because the benefit of an investment to the individual who made it was larger than the benefit of that investment to society as a whole. In later chapters we will discuss a broad class of investments with this property. In general, the efficacy of the invisible hand depends on the extent to which the individual costs and benefits of actions taken in the marketplace coincide with the respective costs and benefits of those actions to society. These exceptions notwithstanding, some of the most powerful forces at work in competitive markets clearly promote society’s interests.
MARKET EQUILIBRIUM AND EFFICIENCY
Private markets cannot by themselves guarantee an income distribution that most people regard as fair. Nor can they ensure clean air, uncongested highways, or safe neighborhoods for all.
In virtually all successful societies, markets are supplemented by active political coordination in at least some instances. We will almost always achieve our goals more effectively if we know what tasks private markets can do well, and then allow them to perform those tasks. Unfortunately, the discovery that markets cannot solve every problem seems to have led some critics to conclude that markets cannot solve any problems. This misperception is a dangerous one because it has prompted attempts to prevent markets from doing even those tasks for which they are ideally suited.
We will explore why many tasks are best left to the market and the conditions under which unregulated markets generate the largest possible economic surplus. We also will discuss why attempts to interfere with market outcomes often lead to unintended and undesired consequences.
As noted in Chapter 3, Supply and Demand, the mere fact that markets coordinate the production of a large and complex list of goods and services is reason enough to marvel at them. But in the absence of pollution and other externalities like the ones discussed in the preceding section, economists make an even stronger claim—namely, that markets not only produce these goods, but also produce them as efficiently as possible.
The term efficient, as economists use it, has a narrow technical meaning. When we say that market equilibrium is efficient, we mean simply this: If price and quantity take anything other than their equilibrium values, a transaction that will make at least some people better off without harming others can always be found. This conception of efficiency is also known as Pareto efficiency, after Vilfredo Pareto, the nineteenth-century Italian economist who introduced it.
Why is market equilibrium efficient in this sense? The answer is that it is always possible to construct an exchange that helps some without harming others whenever a market is out of equilibrium. Suppose, for example, that the supply and demand curves for milk are as shown in Figure 7.11 and that the current price of milk is $1 per gallon. At that price, sellers offer only 2,000 gallons of milk a day. At that quantity, the marginal buyer values an extra gallon of milk at $2. This is the price that corresponds to 2,000 gallons a day on the demand curve, which represents what the marginal buyer is willing to pay for an additional gallon (another application of the vertical interpretation of the demand curve). We also know that the cost of producing an extra gallon of milk is only $1. This is the price that corresponds to 2,000 gallons a day on the supply curve, which equals marginal cost (another application of the vertical interpretation of the supply curve).
FIGURE 7.11 A Market in Which Price Is Below the Equilibrium Level.In this market, milk is currently selling for $1 per gallon, $0.50 below the equilibrium price of $1.50 per gallon.
Furthermore, a price of $1 per gallon leads to excess demand of 2,000 gallons per day, which means that many frustrated buyers cannot buy as much milk as they want at the going price. Now suppose a supplier sells an extra gallon of milk to the most eager of these buyers for $1.25, as in Figure 7.12. Since the extra gallon cost only $1 to produce, the seller is $0.25 better off than before. And since the most eager buyer values the extra gallon at $2, that buyer is $0.75 better off than before. In sum, the transaction creates an extra $1 of economic surplus out of thin air!
FIGURE 7.12 How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction.At a market price of $1 per gallon, the most intensely dissatisfied buyer is willing to pay $2 for an additional gallon, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra gallon, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.
Note that none of the other buyers or sellers is harmed by this transaction. Thus, milk selling for only $1 per gallon cannot be efficient. As the following Concept Check 7.3 illustrates, there was nothing special about the price of $1 per gallon. Indeed, if milk sells for any price below $1.50 per gallon (the market equilibrium price), we can design a similar transaction, which means that selling milk for any price less than $1.50 per gallon cannot be efficient.
CONCEPT CHECK 7.3
In Figure 7.11, suppose that milk initially sells for 50 cents per gallon. Describe a transaction that will create additional economic surplus for both buyer and seller without causing harm to anyone else.
Furthermore, it is always possible to describe a transaction that will create additional surplus for both buyer and seller whenever the price lies above the market equilibrium level. Suppose, for example, that the current price is $2 per gallon in the milk market shown in Figure 7.13. At that price, we have excess supply of 2,000 gallons per day. Suppose the most dissatisfied producer sells a gallon of milk for $1.75 to the buyer who values it most highly. This buyer, who would have been willing to pay $2, will be $0.25 better off than before. Likewise the producer, who would have been willing to sell milk for as little as $1 per gallon (the marginal cost of production at 2,000 gallons per day), will be $0.75 better off than before. As when the price was $1 per gallon, the new transaction creates $1 of additional economic surplus without harming any other buyer or seller. Since we could design a similar surplus-enhancing transaction at any price above the equilibrium level, selling milk for more than $1.50 per gallon cannot be efficient.
FIGURE 7.13 How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction.At a market price of $2 per gallon, dissatisfied sellers can produce an additional gallon of milk at a cost of only $1, which is $1 less than a buyer would be willing to pay for it. If the buyer pays the seller $1.75 for an extra gallon, the buyer gains an economic surplus of $0.25 and the seller gains an economic surplus of $0.75.
The vertical interpretations of the supply and demand curves thus make it clear why only the equilibrium price in a market can be efficient. When the price is either higher or lower than the equilibrium price, the quantity exchanged in the market will always be lower than the equilibrium quantity. If the price is below equilibrium, the quantity sold will be the amount that sellers offer. If the price is above equilibrium, the quantity sold will be the amount that buyers wish to buy. In either case, the vertical value on the demand curve at the quantity exchanged, which is the value of an extra unit to buyers, must be larger than the vertical value on the supply curve, which is the marginal cost of producing that unit.
So the market equilibrium price is the only price at which buyers and sellers cannot design a surplus-enhancing transaction. The market equilibrium price leads, in other words, to the largest possible total economic surplus. In this specific, limited sense, free markets are said to produce and distribute goods and services efficiently.
Actually, to claim that market equilibrium is always efficient even in this limited sense is an overstatement. The claim holds only if buyers and sellers are well informed, if markets are perfectly competitive, and if the demand and supply curves satisfy certain other restrictions. For example, market equilibrium will not be efficient if the individual marginal cost curves that add up to the market supply curve fail to include all relevant costs of producing the product. Thus, as we saw in Chapter 3, Supply and Demand, the true cost of expanding output will be higher than indicated by the market supply curve if production generates pollution that harms others. The equilibrium output will then be inefficiently large and the equilibrium price inefficiently low.
Likewise, market equilibrium will not be efficient if the individual demand curves that make up the market demand curve do not capture all the relevant benefits of buying additional units of the product. For instance, if a homeowner’s willingness to pay for ornamental shrubs is based only on the enjoyment she herself gains from them, and not on any benefits that may accrue to her neighbors, the market demand curve for shrubs will understate their value to the neighborhood. The equilibrium quantity of ornamental shrubs will be inefficiently small and the market price for shrubs will be inefficiently low.
We will take up such market imperfections in greater detail in later chapters. For now, we will confine our attention to perfectly competitive markets whose demand curves capture all relevant benefits and whose supply curves capture all relevant costs. For such goods, market equilibrium will always be efficient in the limited sense described earlier.
Efficiency Is Not the Only Goal
The fact that market equilibrium maximizes economic surplus is an attractive feature, to be sure. Bear in mind, however, that “efficient” does not mean the same thing as “good.” For example, the market for milk may be in equilibrium at a price of $1.50 per gallon, yet many poor families may be unable to afford milk for their children at that price. Still others may not even have a place for their children to sleep.
Efficiency is a concept that is based on predetermined attributes of buyers and sellers—their incomes, tastes, abilities, knowledge, and so on. Through the combined effects of individual cost-benefit decisions, these attributes give rise to the supply and demand curves for each good produced in an economy. If we are concerned about inequality in the distribution of attributes like income, we should not be surprised to discover that markets do not always yield outcomes we like.
Most of us could agree, for example, that the world would be a better one if all people had enough income to feed their families adequately. The claim that equilibrium in the market for milk is efficient means simply that taking people’s incomes as given, the resulting allocation of milk cannot be altered so as to help some people without at the same time harming others.
To this a critic of the market system might respond: So what? As such critics rightly point out, imposing costs on others may be justified if doing so will help those with sufficiently important unmet demands. For example, most people would prefer to fund homeless shelters with their tax dollars rather than let the homeless freeze to death. Arguing in these terms, American policymakers responded to rapid increases in the price of oil in the late 1970s by imposing price controls on home heating oil. Many of us might agree that if the alternative had been to take no action at all, price controls might have been justified in the name of social justice.
The economist’s concept of market efficiency makes clear that there must be a better alternative policy. Price controls on oil prevent the market from reaching equilibrium, and as we’ve seen, that means forgoing transactions that would benefit some people without harming others.
Why Efficiency Should Be the First Goal
Efficiency is important not because it is a desirable end in itself, but because it enables us to achieve all our other goals to the fullest possible extent. It is always possible to generate additional economic surplus when a market is out of equilibrium. To gain additional economic surplus is to gain more of the resources we need to do the things we want to do.
RECAP
EQUILIBRIUM, SOCIAL OPTIMUM, AND EFFICIENCY
· A market in equilibrium is one in which no additional opportunities for gain remain available to individual buyers or sellers. The No-Cash-on-the-Table Principle describes powerful forces that help push markets toward equilibrium. But even if all markets are in equilibrium, the resulting allocation of resources need not be socially optimal. Equilibrium will not be socially optimal when the costs or benefits to individual participants in the market differ from those experienced by society as a whole.
· A market in equilibrium is said to be efficient, or Pareto efficient, meaning that no reallocation is possible that will benefit some people without harming others.
· When a market is not in equilibrium—because price is either above the equilibrium level or below it—the quantity exchanged is always less than the equilibrium level. At such a quantity, a transaction can always be made in which both buyer and seller benefit from the exchange of an additional unit of output.
· Total economic surplus in a market is maximized when exchange occurs at the equilibrium price. But the fact that equilibrium is “efficient” in this sense does not mean that it is “good.” All markets can be in equilibrium, yet many people may lack sufficient income to buy even basic goods and services. Still, permitting markets to reach equilibrium is important because, when economic surplus is maximized, it is possible to pursue every goal more fully.
THE COST OF PREVENTING PRICE ADJUSTMENTS
PRICE CEILINGS
During 1979, an interruption in oil supplies from the Middle East caused the price of home heating oil to rise by more than 100 percent. Concern about the hardship this sudden price increase would impose on poor families in northern states led the government to impose a price ceiling in the market for home heating oil. This price ceiling prohibited sellers from charging more than a specified amount for heating oil.
The following example illustrates why imposing a price ceiling on heating oil, though well intended, was a bad idea.
EXAMPLE 7.6A Price Ceiling on Heating Oil
How much waste does a price ceiling on heating oil cause?
Suppose the demand and supply curves for home heating oil are as shown in Figure 7.14, in which the equilibrium price is $1.40 per gallon. Suppose that, at that price, many poor families cannot heat their homes adequately. Out of concern for the poor, legislators pass a law setting the maximum price at $1 per gallon. How much lost economic surplus does this policy cost society?
FIGURE 7.14 Economic Surplus in an Unregulated Market for Home Heating Oil.For the supply and demand curves shown, the equilibrium price of home heating oil is $1.40 per gallon and the equilibrium quantity is 3,000 gallons per day. Consumer surplus is the area of the upper shaded triangle ($900 per day). Producer surplus is the area of the lower shaded triangle (also $900 per day).
First, let’s calculate total economic surplus without price controls. If this market is not regulated, 3,000 gallons per day will be sold at a price of $1.40 per gallon. In Figure 7.14, the economic surplus received by buyers is the area of the upper shaded triangle. Since the height of this triangle is $0.60 per gallon and its base is 3,000 gallons per day, its area is equal to (1/2)(3,000 gallons/day)($0.60/gallon) = $900 per day. The economic surplus received by producers is the area of the lower shaded triangle. This triangle also has an area of $900 per day, so total economic surplus in this market will be $1,800 per day.
If the price of heating oil is prevented from rising above $1 per gallon, only 1,000 gallons per day will be sold and the total economic surplus will be reduced by the area of the lined triangle shown in Figure 7.15. Since the height of this triangle is $0.80 per gallon and its base is 2,000 gallons per day, its area is (1/2)(2,000 gallons/day) ($0.80/gallon) = $800 per day. Producer surplus falls from $900 per day in the unregulated market to the area of the lower shaded triangle, or (1/2)(1,000 gallons/day)($0.20/gallon) = $100 per day, which is a loss of $800 per day. Thus, the loss in total economic surplus is equal to the loss in producer surplus, which means that the new consumer surplus must be the same as the original consumer surplus. To verify this, note that consumer surplus with the price ceiling is the area of the upper shaded figure, which is again $900 per day. (Hint: To compute this area, first split the figure into a rectangle and a triangle.) By preventing the home heating oil market from reaching equilibrium, price controls waste $800 of producer surplus per day without creating any additional surplus for consumers!
FIGURE 7.15 The Waste Caused by Price Controls.By limiting output in the home heating oil market to 1,000 gallons per day, price controls cause a loss in economic surplus of $800 per day (area of the lined triangle).
CONCEPT CHECK 7.4
In Example 7.6, by how much would total economic surplus have been reduced if the price ceiling had been set not at $1 but at $1.20 per gallon?
For several reasons, the reduction in total economic surplus shown in Figure 7.15 is a conservative estimate of the waste caused by attempts to hold price below its equilibrium level. For one thing, the analysis assumes that each of the 1,000 gallons per day that are sold in this market will end up in the hands of the consumers who value them most—in the diagram, those whose reservation prices are above $1.80 per gallon. But since any buyer whose reservation price is above $1 per gallon will want to buy at the ceiling price, much of the oil actually sold is likely to go to buyers whose reservation prices are below $1.80. Suppose, for example, that a buyer whose reservation price was $1.50 per gallon made it into the line outside a heating oil supplier just ahead of a buyer whose reservation price was $1.90 per gallon. If each buyer had a 20-gallon tank to fill, and if the first buyer got the last of the day’s available oil, then total surplus would be smaller by $8 that day than if the oil had gone to the second buyer.
A second reason that the reduction in surplus shown in Figure 7.15 is likely to be an underestimate is that shortages typically prompt buyers to take costly actions to enhance their chances of being served. For example, if the heating oil distributor begins selling its available supplies at 6:00 a.m., many buyers may arrive several hours early to ensure a place near the front of the line. Yet when all buyers incur the cost of arriving earlier, no one gets any more oil than before.
Notwithstanding the fact that price ceilings reduce total economic surplus, their defenders might argue that controls are justified because they enable at least some low- income families to buy heating oil at affordable prices. Yes, but the same objective could have been accomplished in a much less costly way—namely, by giving the poor more income with which to buy heating oil.
It may seem natural to wonder whether the poor, who have limited political power, can really hope to receive income transfers that would enable them to heat their homes. On reflection, the answer to this question would seem to be yes, if the alternative is to impose price controls that would be even more costly than the income transfers. After all, the price ceiling as implemented ends up costing heating oil sellers $800 per day in lost economic surplus. So they ought to be willing to pay some amount less than $800 a day in additional taxes in order to escape the burden of controls. The additional tax revenue could finance income transfers that would be far more beneficial to the poor than price controls.
This point is so important, and so often misunderstood by voters and policymakers, that we will emphasize it by putting it another way. Think of the economic surplus from a market as a pie to be divided among the various market participants. Figure 7.16(a) represents the $1,000 per day of total economic surplus available to participants in the home heating oil market when the government limits the price of oil to $1 per gallon. We divided this pie into two slices, labeled R and P, to denote the surpluses received by rich and poor participants. Figure 7.16(b) represents the $1,800 per day of total economic surplus available when the price of home heating oil is free to reach its equilibrium level. This pie is divided among rich and poor participants in the same proportion as the pie in the left panel.
FIGURE 7.16 When the Pie Is Larger, Everyone Can Have a Bigger Slice.Any policy that reduces total economic surplus is a missed opportunity to make everyone better off.
The important point to notice is this: Because the pie on the right side is larger, both rich and poor participants in the home heating oil market can get a bigger slice of the pie than they would have had under price controls. Rather than tinker with the market price of oil, it is in everyone’s interest to simply transfer additional income to the poor.
Incentive
With the Incentive Principle in mind, supporters of price controls may object that income transfers to the poor might weaken people’s incentive to work, and thus might prove extremely costly in the long run. Difficult issues do indeed arise in the design of programs for transferring income to the poor—issues we will consider in some detail in later chapters. But for now, suffice it to say that ways exist to transfer income without undermining work incentives significantly. One such method is the Earned Income Tax Credit, a program that supplements the wages of low-income workers. Given such programs, transferring income to the poor will always be more efficient than trying to boost their living standard through price controls.
PRICE SUBSIDIES
Sometimes governments try to assist low-income consumers by subsidizing the prices of “essential” goods and services. France and Russia, for example, have taken this approach at various points by subsidizing the price of bread. As the following example illustrates, such subsidies are like price ceilings in that they reduce total economic surplus.
EXAMPLE 7.7The Impact of Subsidies on Economic Surplus
By how much do subsidies reduce total economic surplus in the market for bread?
A small island nation imports bread for its population at the world price of $2 per loaf. If the domestic demand curve for bread is as shown in Figure 7.17, by how much will total economic surplus decline in this market if the government provides a $1-per-loaf subsidy?
FIGURE 7.17 Economic Surplus in a Bread Market without Subsidy.For the demand curve shown, consumer surplus (area of the shaded triangle) is $4,000,000 per month. This amount is equal to total economic surplus in the domestic bread market since no bread is produced domestically.
With no subsidy, the equilibrium price of bread in this market would be the world price of $2 per loaf and the equilibrium quantity would be 4,000,000 loaves per month. The shaded triangle in Figure 7.17 represents consumer economic surplus for buyers in the domestic bread market. The height of this triangle is $2 per loaf, and its base is 4,000,000 loaves per month, so its area is equal to (1/2)(4,000,000 loaves/month)($2/loaf) = $4,000,000 per month. Because the country can import as much bread as it wishes at the world price of $2 per loaf, supply is perfectly elastic in this market. Because the marginal cost of each loaf of bread to sellers is exactly the same as the price buyers pay, producer surplus in this market is zero. So total economic surplus is exactly equal to consumer surplus, which, again, is $4,000,000 per month.
Now suppose that the government administers its $1 per loaf subsidy program by purchasing bread in the world market at $2 per loaf and reselling it in the domestic market for only $1 per loaf. At the new lower price, buyers will now consume not 4,000,000 loaves per month but 6,000,000. Consumer surplus for buyers in the bread market is now the area of the larger shaded triangle in Figure 7.18: (1/2)($3/loaf)(6,000,000 loaves/month) = $9,000,000 per month, or $5,000,000 per month more than before. The catch is that the subsidy wasn’t free. Its cost, which must be borne by taxpayers, is ($1/loaf)(6,000,000 loaves/month) = $6,000,000 per month. So even though consumer surplus in the bread market is larger than before, the net effect of the subsidy program is actually to reduce total economic surplus by $1,000,000 per month.
FIGURE 7.18 The Reduction in Economic Surplus from a Subsidy.Since the marginal cost of bread is $2 per loaf, total economic surplus is maximized at 4,000,000 loaves per month, the quantity for which the marginal buyer’s reservation price is equal to marginal cost. The reduction in economic surplus from consuming an additional 2,000,000 loaves per month is $1,000,000 per month, the area of the smaller shaded triangle.
Another way to see why the subsidy reduces total economic surplus by that amount is to note that total economic surplus is maximized at 4,000,000 loaves per month, the quantity for which the marginal buyer’s reservation price is equal to marginal cost, and that the subsidy induces additional consumption of 2,000,000 loaves per month. Each additional loaf has a marginal cost of $2 but is worth less than that to the buyer (as indicated by the fact that the vertical coordinate of the demand curve lies below $2 for consumption beyond 4,000,000). As consumption expands from 4,000,000 to 6,000,000 loaves per month, the cumulative difference between the marginal cost of bread and its value to buyers is the area of the smaller shaded triangle in Figure 7.18, which is $1,000,000 per month.
This reduction in economic surplus constitutes pure waste—no different, from the perspective of participants in this market, than if someone had siphoned that much cash out of their bank accounts each month and thrown it into a bonfire.
CONCEPT CHECK 7.5
How much total economic surplus would have been lost if the bread subsidy, as illustrated in Example 7.7, had been set at $0.50 per loaf instead of $1.00?
Compared to a bread subsidy, a much better policy would be to give low-income people some additional income and then let them buy bread on the open market. Subsidy advocates who complain that taxpayers would be unwilling to give low-income people income transfers must be asked to explain why people would be willing to tolerate subsidies, which are more costly than income transfers. Logically, if voters are willing to support subsidies, they should be even more eager to support income transfers to low-income persons.
This is not to say that the poor reap no benefit at all from bread subsidies. Because they get to buy bread at lower prices and because the subsidy program is financed by taxes collected primarily from middle- and upper-income families, poor families probably come out ahead on balance. The point is that for the same expense, we could do much more to help the poor. Their problem is that they have too little income. The simplest and best solution is not to try to peg the prices of the goods they and others buy below equilibrium levels, but rather to give them some additional money.
RECAP
THE COST OF PREVENTING PRICE ADJUSTMENTS
In an effort to increase economic welfare of disadvantaged customers, governments often implement policies that attempt to prevent markets from reaching equilibrium. Price ceilings and subsidies attempt to make housing and other basic goods more affordable to poor families.
SUMMARY
· Accounting profit is the difference between a firm’s revenue and its explicit expenses. It differs from economic profit, which is the difference between revenue and the sum of the firm’s explicit and implicit costs. Normal profit is the difference between accounting profit and economic profit. It is the opportunity cost of the resources supplied to a business by its owners. (LO1)
· The quest for economic profit is the invisible hand that drives resource allocation in market economies. Markets in which businesses earn an economic profit tend to attract additional resources, whereas markets in which businesses experience an economic loss tend to lose resources. If new firms enter a market with economic profits, that market’s supply curve shifts to the right, causing a reduction in the price of the product. Prices will continue to fall until economic profits are eliminated. By contrast, the departure of firms from markets with economic losses causes the supply curve in such markets to shift left, increasing the price of the product. Prices will continue to rise until economic losses are eliminated. In the long run, market forces drive economic profits and losses toward zero. (LO2, LO3)
· Economic rent is the portion of the payment for an input that exceeds the reservation price for that input. If a professional baseball player who is willing to play for as little as $100,000 per year is paid $15 million, he earns an economic rent of $14,900,000 per year. Whereas the invisible hand drives economic profit toward zero over the long run, economic rent can persist indefinitely because replicating the services of players like Steph Curry is impossible. Talented individuals who are responsible for the superior performance of a business will tend to capture the resulting financial gains as economic rents. (LO3)
· The benefit of an investment to an individual sometimes differs from its benefit to society as a whole. Such conflicting incentives may give rise to behavior that is smart for one but dumb for all. Despite such exceptions, the invisible hand of the market works remarkably well much of the time. One of the market system’s most important contributions to social well-being is the pressure it creates to adopt cost-saving innovations. Competition among firms ensures that the resulting cost savings get passed along to consumers in the long run. (LO4)
· When the supply and demand curves for a product capture all the relevant costs and benefits of producing that product, then market equilibrium for that product will be efficient. In such a market, if price and quantity do not equal their equilibrium values, a transaction can be found that will make at least some people better off without harming others. (LO4)
· When market supply and demand curves reflect the underlying costs and benefits to society of the production of a good or service, the quest for economic profit ensures not only that existing supplies are allocated efficiently among individual buyers, but also that resources are allocated across markets in the most efficient way possible. In any allocation other than the one generated by the market, resources could be rearranged to benefit some people without harming others. (LO4)
· The No-Cash-on-the-Table Principle implies that if someone owns a valuable resource, the market price of that resource will fully reflect its economic value. The implication of this principle is not that lucrative opportunities never exist, but rather that such opportunities cannot exist when markets are in equilibrium. (LO4)
· Total economic surplus is a measure of the amount by which participants in a market benefit by participating in it. It is the sum of total consumer surplus and total producer surplus in the market. One of the attractive properties of market equilibrium is that it maximizes the value of total economic surplus. (LO5)
· Efficiency should not be equated with social justice. If we believe that the distribution of income among people is unjust, we won’t like the results produced by the intersection of the supply and demand curves based on that income distribution, even though those results are efficient. (LO5)
· Even so, we should always strive for efficiency because it enables us to achieve all our other goals to the fullest possible extent. Whenever a market is out of equilibrium, the economic pie can be made larger. And with a larger pie, everyone can have a larger slice. (LO5)
· Regulations or policies that prevent markets from reaching equilibrium—such as price ceilings and price subsidies—are often defended on the grounds that they help the poor. But such schemes reduce economic surplus, meaning that we can find alternatives under which both rich and poor would be better off. The main difficulty of the poor is that they have too little income. Rather than trying to control the prices of the goods they buy, we could do better by enacting policies that raise the incomes of the poor and then letting prices seek their equilibrium levels. Those who complain that the poor lack the political power to obtain such income transfers must explain why the poor have the power to impose regulations that are far more costly than income transfers. (LO5)
KEY TERMS
accounting profit
allocative function of price
barrier to entry
economic loss
economic profit (or excess profit)
economic rent
efficient (or Pareto efficient)
explicit costs
implicit costs
invisible hand theory
normal profit
rationing function of price
REVIEW QUESTIONS
1. 1.How can a business owner who earns $10 million per year from his business credibly claim to earn zero economic profit? (LO1)
2. 2.Why do most cities in the United States now have more radios but fewer radio repair shops than they did in 1960? (LO2)
3. 3.Why do market forces drive economic profit but not economic rent toward zero? (LO3)
4. 4.Why do economists emphasize efficiency as an important goal of public policy? (LO4)
5. 5.You are a senator considering how to vote on a policy that would increase the economic surplus of workers by $100 million per year but reduce the economic surplus of retirees by $1 million per year. What additional measure might you combine with the policy to ensure that the overall result is a better outcome for everyone? (LO5)
PROBLEMS
1. 1.True or false: Explain why the following statements are true or false: (LO1, LO2, LO3, LO4)
a. The economic maxim “There’s no cash on the table” means that there are never any unexploited economic opportunities.
b. Firms in competitive environments make no accounting profit when the market is in long-run equilibrium.
c. Firms that can introduce cost-saving innovations can make an economic profit in the short run.
2. 2.John Jones owns and manages a café in Collegetown whose annual revenue is $5,000. Annual expenses are as follows: (LO1, LO2)
a. Calculate John’s annual accounting profit.
b. John could earn $1,000 per year as a recycler of aluminum cans. However, he prefers to run the café. In fact, he would be willing to pay up to $275 per year to run the café rather than to recycle. Is the café making an economic profit? Should John stay in the café business? Explain.
c. Suppose the café’s revenues and expenses remain the same, but recyclers’ earnings rise to $1,100 per year. Is the café still making an economic profit? Explain.
d. Suppose John had not had to get a $10,000 loan at an annual interest rate of 10 percent to buy equipment, but instead had invested $10,000 of his own money in equipment. How would your answer to parts a and b change?
e. If John can earn $1,000 a year as a recycler, and he likes recycling just as well as running the café, how much additional revenue would the café have to collect each year to earn a normal profit?
3. 3.The city of New Orleans has 200 advertising companies, 199 of which employ designers of normal ability at a salary of $100,000 a year. The companies that employ normal designers each collect $500,000 in revenue a year, which is just enough to ensure that each earns exactly a normal profit. The 200th company, however, employs Janus Jacobs, an unusually talented designer. Because of Jacobs’ talent, this company collects $1,000,000 in revenue a year. (LO3)
a. How much will Jacobs earn? What proportion of her annual salary will be economic rent?
b. Why won’t the advertising company for which Jacobs works be able to earn an economic profit?
4. 4.Unskilled workers in a poor cotton-growing region must choose between working in a factory for $6,000 a year and being a tenant cotton farmer. One farmer can work a 120-acre farm, which rents for $10,000 a year. Such farms yield $20,000 worth of cotton each year. The total nonlabor cost of producing and marketing the cotton is $4,000 a year. A local politician whose motto is “Working people come first” has promised that if he is elected, his administration will fund a fertilizer, irrigation, and marketing scheme that will triple cotton yields on tenant farms at no charge to tenant farmers. (LO3)
a. If the market price of cotton would be unaffected by this policy and no new jobs would be created in the cotton-growing industry, how would the project affect the incomes of tenant farmers in the short run? In the long run?
b. Who would reap the benefit of the scheme in the long run? How much would they gain each year?
5. 5.Suppose the weekly demand and supply curves for used DVDs in Lincoln, Nebraska, are as shown in the diagram. Calculate the following: (LO5)
a. The weekly consumer surplus.
b. The weekly producer surplus.
c. The maximum weekly amount that producers and consumers in Lincoln would be willing to pay to be able to buy and sell used DVDs in any given week (total economic surplus).
6. 6.Refer to Problem 5. Suppose a coalition of students from Lincoln High School succeeds in persuading the local government to impose a price ceiling of $7.50 on used DVDs, on the grounds that local suppliers are taking advantage of teenagers by charging exorbitant prices. (LO5)
a. Calculate the weekly shortage of used DVDs that will result from this policy.
b. Calculate the total economic surplus lost every week as a result of the price ceiling.
7. 7.*The government of Islandia, a small island nation, imports heating oil at a price of $2 per gallon and makes it available to citizens at a price of $1 per gallon. If Islandians’ demand curve for heating oil is given by P = 6 − Q, where P is the price per gallon in dollars and Q is the quantity in millions of gallons per year, how much economic surplus is lost as a result of the government’s policy? (LO5)
8. 8.*Refer to Problem 7. Suppose each of the 1 million Islandian households has the same demand curve for heating oil. (LO5)
a. What is the household demand curve?
b. How much consumer surplus would each household lose if it had to pay $2 per gallon instead of $1 per gallon for heating oil, assuming there were no other changes in the household budget?
c. With the money saved by not subsidizing oil, by how much could the Islandian government afford to cut each family’s annual taxes?
d. If the government abandoned its oil subsidy and implemented the tax cut, by how much would each family be better off?
ANSWERS TO CONCEPT CHECKS
1. 7.1As shown in the table below, Pudge’s accounting profit is now $10,000, the difference between his $20,000 annual revenue and his $10,000-per-year payment for land, equipment, and supplies. His economic profit is that amount minus the opportunity cost of his labor—again, the $11,000 per year he could have earned as a store manager. So Pudge is now earning a negative economic profit, −$1,000 per year. As before, his normal profit is the $11,000-per-year opportunity cost of his labor. Although an accountant would say Pudge is making an annual profit of $10,000, that amount is less than a normal profit for his activity. An economist would therefore say that he is making an economic loss of $1,000 per year. Since Pudge likes the two jobs equally well, he will be better off by $1,000 per year if he leaves farming to become a manager. (LO1)
2. 7.2If each lane did not move at about the same pace, any driver in a slower lane could reduce his travel time by simply switching to a faster one. People will exploit these opportunities until each lane moves at about the same pace. (LO3)
3. 7.3At a price of 50 cents per gallon, there is excess demand of 4,000 gallons per day. Suppose a seller produces an extra gallon of milk (marginal cost = 50 cents) and sells it to the buyer who values it most (reservation price = $2.50) for $1.50. Both buyer and seller will gain additional economic surplus of $1, and no other buyers or sellers will be hurt by the transaction. (LO4)
4. 7.4As shown in the accompanying diagram, the new loss in total economic surplus is $200 per day. (LO5)
5. 7.5With a $0.50-per-loaf subsidy, the new domestic price becomes $1.50 per loaf. The new lost surplus is the area of the small shaded triangle in the diagram: (1/2)($0.50/loaf)(1,000,000 loaves/month) = $250,000 per month. (LO5)
1Smith, Adam, The Wealth of Nations. New York, NY: Everyman’s Library, Book 1, 1910.
2For simplicity, this discussion ignores any costs associated with depreciation of the firm’s capital equipment. Because the buildings and machines owned by a firm tend to wear out over time, the government allows the firm to consider a fraction of their value each year as a current cost of doing business. For example, a firm that employs a $1,000 machine with a 10-year life span might be allowed to record $100 as a current cost of doing business each year.
3This qualification refers to the firm’s shutdown condition, discussed in Chapter 6, Perfectly Competitive Supply.
4Smith, Adam, The Wealth of Nations. New York, NY: Everyman’s Library, Book 1, 1910.
*Denotes more difficult problem.