Chapter 7 - Efficiency, exchange & the Invisible hand in action

Central role of economic profit

• Accounting profit = Total revenue - Explicit costs

  • Explicit costs: actual payments a firm makes to its factors of production and other suppliers.

  • Accounting profit: difference between a firm's total revenue and its explicit costs.

• Economic profit = Total revenue - Explicit costs - Implicit costs

  • Implicit costs: opportunity costs of the resources supplied by the firm's owners.

  • Economic profit = excess profit: difference between a firm's total revenue and the sum of its explicit and implicit costs.

  • Normal profit: opportunity cost of the resources supplied by a firm's owners, equal to accounting profit minus economic profit.

The Invisible hand theory

• Rationing function of price: changes in prices distribute scarce goods to those consumers who value them most highly.

• Allocative function of price: changes in prices direct resources away from overcrowded markets and toward markets that are underserved.

• Invisible hand theory: Adam Smith's theory that the actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources.

• Barrier to entry: any force that prevents firms from entering a new market.

Economic rent vs economic profit

• Economic rent: that part of the payment for a factor of production that exceeds the owner's reservation price, the price below which the owner would not supply the factor.

  • 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.

Distinction between an equilibrium and a social optimum

• 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 a 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 be cause, when economic surplus is maximized, it is possible to pursue every goal more fully.