Introductory Microeconomics

1
Introductory Microeconomics
The Quest for Profit and the Invisible Hand
2
Example 8.1.
For the supply and demand curves shown, suppose a
tax of 6/lb is levied on sellers. What share of
the burden of this tax be borne by buyers? By
sellers?
3
Example 8.1.
The equilibrium price, including the tax, will
rise from 6/lb to 10/lb.
Buyers pay 10/lb (including the tax), 4 higher
than before. So the buyers share of the tax is
(10-6)/6 2/3.
(as seen by the buyers)
Sellers receive 4/lb (net of the tax), 2 less
than before. So the sellers share of the tax is
(6-4)/6 1/3.
4
Example 8.2.

• How would your answers to Example 8.1 have been
  different if the tax had been collected from
  buyers instead of sellers?

5
Example 8.2.
At a quantity of 8 million lb/month, the buyer is
willing to pay 10/lb. With a tax of 6/lb, the
most he would be willing to pay the seller, net
of the tax, is only 4/lb. So the demand curve
as seen by the sellers is the original demand
curve shifted down by 6/lb.
6
Example 8.2.
So, as before, the buyer pays 10/lb and the
seller receives 4/lb in equilibrium. As before
the buyers share of the tax is 2/3 and the
sellers share is 1/3.
7
Example 8.3.
If the supply curve is completely elastic, what
share of a tax of 1/lb is borne by buyers? By
sellers?

• To get an answer for this question, do we need to
  consider the two possibilities?
• Tax collected from the buyers
• Tax collected from the sellers

8
Example 8.3.
For this empirically most relevant case, the tax
is borne entirely by buyers.
When supply is perfectly elastic, taxing sellers
because they can afford the tax more easily than
buyers makes no economic sense at all. The
burden of a tax falls where it can, not where it
is placed.
9
Different Types of Profit

• Profit Total revenue - Total cost
• Accounting profit Total revenue - Explicit
  costs
• Economic profit Total revenue - All costs
  (implicit and explicit)
• Normal profit the opportunity cost of the
  resources owned by the firm

10
Different Types of Profit
Normal profit
Opportunity cost of resources supplied by owners
of firm
Accounting profit
Economic profit
Total Revenue
Explicit costs
Explicit costs
11
Example 8.4.
Cullen Buffet runs a miniature golf course in
Odessa, Texas.
12
Example 8.4.

• He rents the course and equipment from a large
  recreational supply company, for which he pays a
  monthly fee of 1000.
• He supplies his own labor, and considers the job
  of running the golf course just as attractive as
  his only other employment opportunity, working in
  a grocery store at a salary of 800/mo.
• Monthly revenue from ticket sales is 2000/mo.
• What at is Cullen's accounting profit? His
  economic profit?

13
Example 8.4.

• He rents the course and equipment from a large
  recreational supply company, for which he pays a
  monthly fee of 1000.
• He supplies his own labor, and considers the job
  of running the golf course just as attractive as
  his only other employment opportunity, working in
  a grocery store at a salary of 800/mo.
• Monthly revenue from ticket sales is 2000/mo.
• What at is Cullen's accounting profit? His
  economic profit?

Accounting profit 2000 - 1000
1000/mo. Economic profit 2000 - 1000 - 800
200/mo.
14
Example 8.5.
Now suppose Cullen learns that his Uncle Warren
has died and left him this parcel of land in New
York City.
15
Example 8.5.

• The land has been cleared, and Cullen discovers
  that a construction company is willing to install
  and maintain a miniature golf course on it for a
  payment of 4000/month.
• A market survey reveals that he would collect
  16,000/month in revenue by operating a miniature
  golf course there.
• The cost of living in New York is the same as in
  Odessa.
• If Cullen opens a golf course on the Manhattan
  site, what will be his accounting profit?

Accounting profit 16,000 - 4000 12,000/mo
16
Example 8.6.

• Suppose Cullen's land would sell for 100,000,000
  in today's real estate market, and suppose that
  the interest rate is 1/month.
• What is Cullens economic profit from running the
  Manhattan golf course?
• Should he relocate to Manhattan?

17
Example 8.6.

• 1. The opportunity cost of devoting the land to a
  miniature golf course is the interest that Cullen
  could have earned from the money he could have
  gotten from selling the land
• (0.01)x(100,000,000) 1,000,000/mo.
• 2. The opportunity cost of his time is 200/mo
  (economic profit he could have earned).
• So his monthly economic profit in Manhattan is
• 16,000 - 4000 - 200 - 1,000,000 -978,200
  lt 0.
• So Cullen should stay in Odessa.

18
Example 8.6.

• 1. The opportunity cost of devoting the land to a
  miniature golf course is the interest that Cullen
  could have earned from the money he could have
  gotten from selling the land
• (0.01)x(100,000,000) 1,000,000/mo.
• 2. The opportunity cost of his time is 800/mo
  (the amount he could have earned at the grocery).
• So his monthly economic profit in Manhattan is
• 16,000 - 4000 - 800 - 1,000,000 -978,800
  lt 0.
• So Cullen should stay in Odessa.

19
Example 8.6.

• 1. The opportunity cost of devoting the land to a
  miniature golf course is the interest that Cullen
  could have earned from the money he could have
  gotten from selling the land
• (0.01)x(100,000,000) 1,000,000/mo.
• 2. The opportunity cost of his time is 800/mo
  (the amount he could have earned at the grocery)
  200/mo (economic profit he could have earned).
• So his monthly economic profit in Manhattan is
• 16,000 - 4000 - 800 - 200 - 1,000,000
  -979,000 lt 0.
• So Cullen should stay in Odessa.

20
Competition tends to drive economic profit down
to zero

• When a firm is making positive economic profit,
  it is earning more than the cost of all the
  resources required to produce the goods it sells.
  
• This means that another firm could produce the
  same goods and in the process increase its
  owners' wealth.
• Entry by new firms will cause price to fall until
  economic profit is driven down to zero.

21
Competition tends to drive economic profit down
to zero

• Likewise, an industry in which firms are earning
  negative economic profit is one in which firms
  are failing to cover all the costs of the
  resources they use.
• If this situation is expected to persist, some
  firms will go out of business.
• Exit will continue until price rises to cover all
  resource costs.
• So in long-run equilibrium in a competitive
  industry, firms will earn zero economic profit.

22
Example 8.7. (Rent)

• Normal agricultural land yields 50 bushels of
  corn per acre each year.
• Corn sells for 1/bushel, and a farmer can farm
  500 acres with an equivalent amount of physical
  and psychological effort as is demanded by a
  factory job, which pays 10,000/yr and is the
  only other job available.
• If labor and land are the only farm costs, how
  much will normal agricultural land rent for?

23
Example 8.7. (Rent)

• Normal agricultural land yields 50 bushels of
  corn per acre each year.
• Corn sells for 1/bushel, and a farmer can farm
  500 acres with an equivalent amount of physical
  and psychological effort as is demanded by a
  factory job, which pays 10,000/yr and is the
  only other job available.
• If labor and land are the only farm costs, how
  much will normal agricultural land rent for?

Total revenue from farming 25,000/yr Total
costs 10,000 500x(land rent per
acre) Economic profit 0 implies rent for 500
acres 15,000/yr implies rent 30 per
acre.
24
Example 8.8. (Rent)
Suppose there is one 500 acre plot that yields
twice as much corn as the normal farmland that
rents for 30 per acre.
How much will this plot rent for?
25
Example 8.8. (Rent)

• How much will this plot rent for?
• Total revenue 100(500) 50,000/yr
• Total cost 10,000 land rent
• Economic profit TR TC
• 50,000/yr - 10,000/yr land rent

Farmers will bid for the fertile patch until it
is no longer possible to earn positive economic
profit from farming it. Economic Profit 0
implies land rent 40,000, or 80 per acre
26
Example 8.9.
Imagine yourself a member of the California state
legislature. You have been asked by the governor
to vote for a bill whose purpose is to alleviate
poverty among farm workers in a rural county.
27
Example 8.9.

• Farm workers in that county rent their farmland
  from landowners and are allowed to keep the
  proceeds from the sale of the crops they grow.
• Because of limited rainfall, their crops are
  usually meager, resulting in very low incomes for
  the average worker.
• The bill under consideration would authorize
  public funds to construct an irrigation system
  that would double the crop yields on the land in
  the county.
• Will this bill achieve its desired purpose of
• raising farmers' incomes?

28
Example 8.9.
The bill under consideration would authorize
public funds to construct an irrigation system
that would double the crop yields on the land in
the county.
Limited rainfall
Irrigation system
29
Example 8.9.

• Will this bill achieve its desired purpose of
• raising farmers' incomes?
• With the introduction of the irrigation project
  grain yields are now twice as high as before, so
  total revenues will double.
• If the land rent remained at its original level,
  a farm worker would then earn more than he could
  by working in a factory.

30
Example 8.9.

• Will this bill achieve its desired purpose of
• raising farmers' incomes?
• What the supporters of the bill have failed to
  recognize is that land rents will not remain the
  same.
• Both factory workers and farmers would bid
  vigorously for farm parcels, and the rental price
  of farmland will continue to rise until it
  reaches a level that equalizes the incomes of
  farmers and factory workers.
• The beneficiaries of the state supported
  irrigation project would be not the impoverished
  farm workers but the owners of the land.

31
Example 8.9.

• Will this bill achieve its desired purpose of
• raising farmers' incomes?
• The beneficiaries of the state supported
  irrigation project would be not the impoverished
  farm workers but the owners of the land.
• These owners already have high incomes.
• Why should tax dollars be spent to
• increase their incomes further?

32
Example 8.10.

• Suppose one firm is like all others except that
  it employs an extraordinarily efficient manager.
• This manager is so efficient that the firm earns
  500,000 of economic profit each year.
• The firm operates in an industry in which the
  economic profit of other firms hovers very close
  to zero.

If this manager received the same salary as all
other managers, the firm that employed her would
have much lower costs than all other firms in the
industry. Is this a stable outcome?
33
Example 8.10.
Is this a stable outcome?

• There would be a strong incentive for some other
  firm to bid this manager away by offering her a
  higher salary.
• Suppose a new firm offered her 300,000 more than
  her current annual salary and she accepted.
• That new firm would then earn an economic profit
  of 200,000/year.
• That's not as good as an economic profit of
  500,000/year. But it's 200,000/year better
  than the normal profit her original employer will
  earn without her.

34
Example 8.10.
Is this a stable outcome?

• Still other firms would have an incentive to
  offer even more for this manager.
• Theory tells us that the bidding should continue
  until the cost savings for which she is
  responsible are entirely incorporated into her
  salary.
• If her salary is 500,000/year higher than the
  salary of an ordinary manager, her employer will
  earn zero economic profit.
• Once her salary is bid up to that level, the firm
  that hires her will no longer enjoy a cost
  advantage over the other firms in the industry.

35
Example 8.11.

• The owner of the team that wins the NBA
  Championship receives additional television
  revenues of 40 million.

36
Example 8.11.

• Whichever team hires Shaquille ONeal wins the
  Championship.

37
Example 8.11.

• There is free agency and teams can bid openly for
  any player's services.
• By how much will ONeal's salary exceed
• the salaries of other players?

• Suppose ONeal received only a 39 million salary
  premium from his current team.
• Some other team could increase its wealth by
  bidding ONeal away with a higher salary.
• Only when ONeal's salary premium is 40 million
  will there be no further tendency for bidding.

38
Example 8.12.

• Ford has sued GM for 1 billion for infringement
  on Ford's patent on a revolutionary new engine
  technology.
• GM has a reasonable claim that it developed an
  equivalent technology independently.

versus
39
Example 8.12.

• The legal issues are complex, and experts regard
  the case as too close to call.
• Whichever side hires the better lawyer is sure to
  win.

40
Example 8.12.

• Smith and Jones are the best two patent lawyers
  in the world.
• Both are outstanding but Jones is ever so
  slightly better.

Smith
Jones
What are the equilibrium fees for Smith and Jones
in this case?
41
Example 8.12.
What are the equilibrium fees for Smith and Jones
in this case?

• Fees aside, whichever side hires Jones will be
  1 billion better off than if it hadn't hired
  Jones.
• So in equilibrium Jones's fee will be 1 billion,
  Smith's zero.

42
Although competition drives economic profit to
zero, economic rent can persist indefinitely.
43
The function of price

1. The rationing function of price to distribute
   scarce goods to those consumers who value them
   most highly.
2. The allocative function of price to direct
   resources away from overcrowded markets and
   toward markets that are underserved.

44
Price -- Adam Smiths Invisible Hand
45
Carrot and stick

• The carrot of economic profit and the stick of
  economic loss are the only forces necessary to
  assure not only that
• existing supplies in any market will be allocated
  efficiently,but also that
• resources will be allocated across markets to
  produce the most efficient possible mix of goods
  and services.

46
Zero economic profit in long run
Consider an industry in which the current market
price enables firms to earn a positive economic
profit.
47
Economic profit in short and long run
Price falls, making each firms economic profit
smaller than before.
The existence of positive economic profits
attracts new firms, shifting supply outward
48
Economic profit in short and long run
As long as price remains above the minimum value
of ATC, profits lure new entrants. Supply
continues to shift out until . .
49
Economic profit in short and long run
Supply continues to shift out until price falls
to min ATC. At that point economic profit is zero
and there is no further incentive to enter.
50
Economic profit in short and long run
What if the firms are originally earning economic
losses?
51
Economic profit in short and long run
Supply continues to shift inward until price
rises to min ATC.
52
Example 8.13. Present Value and the Time Value
of Money

• Suppose the annual interest rate on bank deposits
  is 10 percent. If you deposit 100 on January 1
  of this year, how much will it be worth by
  January 1 of next year?
• 100 (1.10) 110.

53
Present value

• For any given interest rate, the present value of
  a sum of money that you will receive at a
  specific time in the future is the amount of
  money you would have to put in the bank today at
  that interest rate in order to have exactly the
  required sum on the future date.

54
Example 8.14.

• If the annual interest rate is 10 percent, what
  is the present value of 110 to be received one
  year from now?
• As we saw in the previous example, 100 deposited
  today at 10 percent interest will be worth 110 a
  year from now.
• So the present value of 110 a year from now is
  100.

55
Example 8.15.

• If the annual interest rate is 5 percent, what is
  the present value of 52.50 a year from now?
• Let PV the present value of 52.50 to be
  received in 1 year.
• PV (1.05) 52.50.
• So PV 52.50/ 1.05 50.

If you put 50 in the bank today at 5 percent
interest, in a year's time you will have 52.50.
56
Present value

• More generally, when the interest rate (expressed
  as a proportion) is r, the present value of M
  one year from now is given by
• PV M/(1r).

57
Example 8.16.

• When the annual interest rate is 10 percent, what
  is the present value of a payment of 121 to be
  received 2 years from now?
• Put 100 in the bank today at 10 percent
  interest.
• After one year 100(1.1) 110
• After two years 110 (1.10) 100 (1.1)2
  121
• That is, PV 121/(1.1)2 100

58
Present value

• More generally, if annual interest rate is r,
  present value of M dollars delivered T years from
  now
• PV M/(1 r)T

59
Time value of money

• The time value of money exists because money can
  be used to purchase real assets that generate
  increased output over time.
• For example, a 12 foot tree 6 years from now is
  equivalent to a 5 foot tree right now.

60
(No Transcript)
61
Compound interest

• Present value in reverse the miracle of compound
  interest
• 1000 deposited at 7 percent interest by Ben
  Franklin in late 1700s 3 trillion today
• 1000 deposited at 7 percent interest in 1945
  64,000 today

62
The miracle of compound interest
Assume annual income of 100000.
63
Example 8.17.

• Jones can enter a business whose revenues and
  costs occur through time as follows

Revenue Costs
Now 0 300
1 year hence 0 0
2 year hence 363 0
3 year more 0 0
Present value of economic profit present value
of revenue - present value of costs 363/(1.1)2
- 300 300 - 300 0.
64
Example 8.18.

• Should Jones enter this business if the interest
  rate is 12 percent?

Revenue Costs
Now 0 300
1 year hence 0 0
2 year hence 363 0
3 year more 0 0
Enter only if PV of economic profit gt 0. At 12
percent, PV of revenue 363/(1.12)2 289.38 PV
of economic profit 289.38 - 300 -10.62 lt 0,
so don't enter.
65
Example 8.19.

• Should Jones enter this business if the interest
  rate is 8 percent?

Revenue Costs
Now 0 300
1 year hence 0 0
2 year hence 363 0
3 year more 0 0
PV of revenue 363/(1.08)2 311.21 PV of
economic profit 311.21 - 300 11.21gt 0, so
Jones should enter.
66
Interest rate and investment

• Almost all investment projects require that costs
  be incurred in the short run in order that
  benefits accrue in the long run.
• The higher the interest rate, the lower is the
  present value of benefits received in the future.
  
• So as a general rule, an investment project is
  less likely to be worthwhile when interest rates
  are high than when interest rates are low.

67
Interest rate and investment
Why does the Fed lower interest rates during a
recession?
Alan Greenspan, Chairman of the Board of
Governors of the Federal Reserve of the United
States from 1987 to 2006
Ben Bernanke, Chairman of the Board of Governors
of the Federal Reserve of the United States since
February 1, 2006
68
Stocks

• A stock is an ownership claim to the present
  value of the accounting profits in a company.
• If you own 100 of a company's 1000 shares
  outstanding, you own one-tenth of the present
  value of the company's earnings.

69
Buying a stock involves risk
April 15, 1912
70
Example 8.20.

• A company's accounting profits are 100,000 per
  year.
• If the annual interest rate is 10 percent, what
  is the present value of this firm's accounting
  profit?
• PV 100,000/(1.1) 100,000/(1.1)2
  100,000/(1.1)3 ....
• 100,000/(1.1) 1 1/1.1 1/(1.1)2 1/(1.1)3
  ....
• 100,000/(1.1) 1/(1-1/1.1) 100,000/(1.1)
  1.1/0.1
• 1,000,000
• (If you put 1,000,000 in the bank at 10 percent,
  you would generate a flow of earnings of
  100,000/yr)

Note on infinite geometric sum 1 x x2 x3
. 1/(1-x)
71
Example 8.21.

• If this company has 1000 shares of stock
  outstanding, how much will each one sell for?
• 1,000,000/1000 1,000/share

72
Example 8.22.

• Suppose accounting profit from the firm in the
  preceding example were to double. How would the
  value of its stock price change?
• PV of profit 2,000,000
• Price per share 2,000,000/1000 2000/share

73
The Efficient Markets Hypothesis

• At any moment, the market price of a firms stock
  reflects all relevant available information about
  the present value of the firms current and
  future accounting profits.

74
The Efficient Markets Hypothesis

• Suppose the efficient markets hypothesis were
  false.
• For example, suppose Genentechs current share
  price is 100 when it comes up with a cancer cure
  that will double its accounting profit from now
  on.
• What would happen if the firms stock price
  failed to adjust right away to 200?
• Someone with no talent, no luck, and no
  willingness to work hard could get rich just by
  buying shares of Genentech.

75
Example 8.23.

• The Ace Investment Advisory Group has put
  together a special stock fund that includes only
  shares of monopolies that earn profits at least
  50 percent higher than the overall industrial
  average.
• If you invest in this fund, do you expect to do
  better than if you had invested in non-monopolies?

If investing in monopolies yielded a higher
payoff, the prices in their stocks would be bid
up until the return was brought into balance with
the return on stock in other companies.
76
Is investing in Microsoft a good bet?
77
Is investing in Microsoft a good bet?
78
Example 8.24.

• Consider a perpetual bond that pays 120/yr to
  its owner (a perpetual bond entitles the bearer
  to the same annual payment forever).
• By how much would the price of this bond rise if
  the interest rate fell from 10 percent to 5
  percent?

The price at 10 percent is 120/0.101200. At
5 percent the price will be 120/0.052400. So
the rise in price is 1200.
79
Example 8.25. Price Supports as a Device for
Saving Family Farms

• Family farms tend to have higher costs than large
  corporate farms.
• As more and more family farms give way to
  corporate farms, lower costs lead to lower
  prices, which result in economic losses for
  family farms.
• To ease the plight of the family farmer, Congress
  has passed legislation that pegs prices of farm
  products higher than market-clearing levels.
• Will this policy help tenant farmers in the long
  run?

80
Example 8.25. Price Supports as a Device for
Saving Family Farms

• When the price of farm products rises, farms that
  were earning zero economic profit will now earn
  positive economic profit.
• The lure of positive profit causes others to bid
  for agricultural land, which causes land prices
  to rise.
• The long-run effect of agricultural price
  supports was thus to drive up the rent for
  farmland, which does nothing to assure the
  survival of tenant farmers.

81
Example 8.25. Price Supports as a Device for
Saving Family Farms
We are not sure how we can benefit from the price
support.

• A much more direct and efficient way to aid
  family farmers would be to reduce their income
  taxes.
• In the case of more extreme need, farmers could
  be given outright cash grants.

82
Example 8.26.

• A trucker gets 5000 for driving a trailer full
  of cargo from New York to San Francisco, a trip
  that takes him one week.
• The rent for his rig is 3000/wk and he spends
  1000 on gas.
• Meals and other expenses come to another 500/wk.
• His alternative employment is to work as a local
  deliveryman at a salary of 500/wk, a task he
  finds equally attractive as trucking.
• What is this trucker's economic profit?

83
Example 8.26.

• A trucker gets 5000 for driving a trailer full
  of cargo from New York to San Francisco, a trip
  that takes him one week.
• The rent for his rig is 3000/wk and he spends
  1000 on gas.
• Meals and other expenses come to another 500/wk.
• His alternative employment is to work as a local
  deliveryman at a salary of 500/wk, a task he
  finds equally attractive as trucking.
• What is this trucker's economic profit?

Total revenue 5000 Total cost 3000
1000 500 500 5000 Economic profit
5000 - 5000 0
84
Example 8.27.

• Now suppose the trucker from the previous example
  installs an airfoil on the roof of the cab of his
  rig, resulting in a fuel savings of 25 percent.
• If the airfoil rents for 50/wk,
• what is the trucker's new economic profit?

85
Example 8.27.

• If the airfoil rents for 50/wk,
• what is the trucker's new economic profit?
• Total revenue 5000/wk, the same as before.
• Total cost 5000 - 250 50 4800
• So economic profit 5000 - 4800 200.

86
Example 8.28.

• Suppose all truckers but one have installed the
  airfoil described in the preceding example.
• What will be the economic profit of the lone
  holdout?

• As more and more truckers install the airfoils,
  costs go down and this places downward pressure
  on trucking prices.
• By the time all truckers have installed the
  airfoils, trucking rates will have fallen by the
  full 200 in net cost savings made possible by
  the airfoil.
• Thus the lone trucker without an airfoil will
  suffer an economic loss of 200/wk.

87
Example 8.28.
Moral Early adopters of cost-saving innovations
tend to earn positive economic profits. Late
adopters tend to earn negative economic profits.
88
Example 8.29.

• On April 24, 2003, the Commissioner for Transport
  (HKSAR), Mr Robert Footman, announced a scheme to
  relax general stopping restrictions for taxis to
  provide immediate relief to the trade under the
  difficult operating environment with the outbreak
  of atypical pneumonia.
• To whom does the scheme benefit? Drivers or
  owners of taxi operating licenses?

89
Example 8.29.

• In Hong Kong it is easy to become a taxi driver.
  Thus, in a recession, the supply of drivers is
  essentially perfectly elastic, possibly with the
  best alternative of unemployment benefits as the
  reservation wage.
• The relaxation of road restrictions for taxis is
  supposed to increase the demand for taxis and
  hence revenue.
• When the revenue is higher, more people will try
  to enter the trade of taxi drivers, bidding up
  the rental rate of taxis.
• Higher rental rate leads to higher taxi operating
  license premium.
• Thus, the relaxation benefits the taxi operating
  license owner (who are relatively rich) but not
  the taxi drivers (who are relatively poor).

90
End