Types of profit The invisible hand

1
Types of profitThe invisible hand

• Today Some fundamental ideas that are important
  to every economist

2
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

3
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

4
Assumptions for todays lecture

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

5
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
6
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

7
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

8
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

9
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 firms owners (F/B, p.
  175)

10
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

11
Emmas 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

12
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

13
Emmas 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

14
Next Long-run equilibrium

• Remember that a firms 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

15
For this discussion

• Assume that costs include implicit costs
• Thus, we are calculating economic profit
• Equilibrium occurs when economic profit is zero

16
Example Start at supply S

• Market supply Firm supply

17
Profits are positive here, since P gt ATC

• Market supply Firm supply

18
What happens when economic profits are positive?

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

19
What else happens?
20
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

21
Prediction Supply continues to shift until
economic profits are 0
22
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

23
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
24
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

25
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

26
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

27
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

28
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 ?
29
Example Caesars Palace

• Billion dollar expansion announced July 2007
• Shopping and entertainment options
• The Forum Shops
• Bette Midler
• Elton John
• Jerry Seinfeld

30
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

31
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

32
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

33
Example What Echelon Place is supposed to look
like when done
34
This is what it looks like in a recent picture
35
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

36
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