Microeconomics (Chapter 7)

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.

efficient

a situation is efficient if no charge is possible that will help some people without harming others.

Fact 1

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.

economic loss

an economic profit that is less than zero

barrier to entry

any force that prevents firms from entering a new market.

allocative function of price

changes in prices direct resources away from overcrowded markets and toward markets that are undeserved. Resources leave markets in which price cannot cover the cost of production and enter those in which price exceeds the cost of production.

rationing function of price

changes in prices distribute scarce goods to those consumers who value them most highly. 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.

Fact 3

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 $100,000 per year is paid $15 million, he earns an economic rent of $14,900,000 pet 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 Derek Jeter is impossible. Talented individuals who are responsible for the superior performance of a business will tend to capture the resulting financial gains an economic rents.

Fact 9

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.

Fact 10

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.

rationing function of price, allocative function of price

in the free enterprise system, market prices serve two important and distinct functions. What are the two?

Fact 11

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.

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.

explicit costs

the actual payments a firm makes to its factors of production and other suppliers.

Fact 4

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.

accounting profit

the difference between a firm's total revenue and its explicit costs

economic profit

the difference between a firm's total revenue and the sum of its explicit and implicit costs.

Fact 7

the no-cash-on-the-table principal 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 suck opportunities cannot exist when the markets are in equilibrium.

normal profit

the opportunity cost of the resources supplied by the firm's owners, equal to accounting profit minus economic profit; ____________= accounting profit - economic profit.

implicit costs

the opportunity costs of the resources supplied by the firm's owners

Fact 2

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 firm 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.

Fact 8

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.

Fact 6

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.

Fact 5

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.