Summary Principles of Microeconomics written in 2013-2014.

Chapter A: Principles of Economists

This chapter is an introduction to microeconomics. The basic principles of economist will be explained in this chapter, and you will learn to think as an economist. Economics is not a collection of settled facts but is different from many other fields of study.

An economic approach is based on confronting a hypothesis with evidence before accepting it.

Economics: the study of how people make choices taking into account scarcity and the results of those choices for society.

Economic analysis of human behaviour begins with the assumption that people are rational.

Rational person: someone with well-defined goals and will fulfil those goals as best as he can.

People normally face trade-offs when they want to achieve their goals, this is a result of scarcity.

Scarcity means that we must choose and sometimes make hard choices between things we want to do. (This is because there is not enough time or money to do everything we want to do)

This is also called the ‘No-Free-Lunch Principle: meaning that, although we have boundless needs and wants, resources available to us are limited, so having more of on good thing usually means having less of another.

Economists revolve trade-offs by using cost-benefit analysis: an action should only be taken if its benefits exceed its costs. This is also called the cost-benefit principle.

Economic surplus: the benefit of taking an action - the cost of taking that action

Opportunity cost (of an activity): the value of the next best alternative that must be forgone in order to undertake that activity. E.g. Watching movies for hours, while you could also work for 5 euro an hour.

Sunk costs: costs that are beyond recovery at the moment a decision must be made. E.g. watch a boring movie till the end instead of leaving, because you paid for the ticket.

The role of economic models:

Economists use the cost-benefit principle as an abstract model of how an idealised national individual would choose among competing alternatives. The model is a simplified representation of reality

4 important decision pitfalls:

• Pitfall 1: measuring costs and benefits as proportions rather than absolute money amount. E.g. Walk 3km to save €10 on a €1000 computer?
• Pitfall 2: ignoring opportunity costs. When performing a cost-benefit analysis of an action, it is important to account for all relevant opportunity cost, defined as the values of the most highly valued alternatives that must be forgone in order to carry out the action.
• Pitfall 3: failure to ignore sunk costs. E.g. Even though a ticket to a concert may have cost you €100, if you have already bought it and cannot sell it to anyone else, the €100 is a sunk cost and should not influence your decision about whether to go to the concert.
• Pitfall 4: failure to understand the average-marginal distinction. The focus should always be on the benefits and costs of an additional unit activity. Thus, the level of an activity should be increased if, and only if, its marginal benefit exceeds its marginal cost.

Additional unit activity = marginal costs: the increase in total costs that result from carrying out one additional unit of activity.

Marginal benefit: an increase in the total benefit that result from carrying out one additional unit of activity.

Average cost: the total cost of undertaking ‘n’ units of an activity divided by ‘n’

Average benefit: the total benefit of undertaking ‘n’ units divided by ‘n’

Microeconomics: the study of individual choice under scarcity and its implications for the behaviour of the prices and quantities in individual markets.

Macroeconomics: study of performance of national economics and the policies that governments use to try improve that performance.

Statements may be positive or normative.

Positive economics consists in the conclusion of economics that are independent of the ethical value system of the economist.  (If A happens then B happens)

The answer to a question may be positive economics

Normative economics consist in statements in economics that reflect or are based on the ethical value system of the economist, implicitly, explicitly, or omission. (If A happens then B should happen)

à choosing the question is normative economics

Sociology: rational optimisation behaviour of individuals is hardly relevant, what matters is social group behaviour.           

Chapter B: Learn about markets, specialisation and economic efficiency

This chapter explains the differences between absolute and comparative advantages. Furthermore, it is about the production possibility curve and frontier.

Economies of scale/indivisibilities: accumulated volume in production, resulting in lower cost prices per unit. E.g. producing 1000 cars is cheaper than producing 1 car.

Absolute advantage: 1 person has an absolute advantage if an hour spent in performing a task earns more than the other person in performing the same task.

Comparative advantage: 1 person has this when his opportunity cost of performing a task is lower than the other person’s opportunity cost in performing the same task.

The principle of comparative advantage: this means that everyone does best when each person concentrates on the activities for which his or her opportunity cost is lowest.

If a person produces nuts and also coffee, the opportunity costs of nuts can be calculated this way: OC nuts: Loss in coffee / Gain in nuts

Or vice versa: OC coffee: Loss in nuts / Gain in coffee

PPC (production possibility curve): a graph that shows the relationship between the quantity of one good that can be produced for every possible level of production of another good.

• Points that lie either along or within the PPC are attainable points:

Attainable point: any combination of goods that can be produced using current available resources.

• Points that lie outside the PPC are unattainable:

Unattainable point: any combination of goods that cannot be produced using currently available resources.

• Points that lie along the PCC are efficient:

Efficient point: any combination of goods for which currently available resources do not allow an increase in the production of one good without reduction of the other.

• Points that lie within the PCC are inefficient:

            Inefficient point: any combination of goods for which currently available resources enable an increase in the production of one good without reduction of production of the other.

(P. 43, figure 2.2 for clarification)

PPF (production possibility frontier):  With specialisation, the quantities people can produce together are greater than if they specialize the other way. (P.46, figure 2.6)

This is because they use their comparative advantage!

A PPF for a many-person economy:

The Production possibility frontier or production possibility curve for a multi-person and million-person economy can be found on page 47, figure 2.7. For a many-person economy the PPF is bow-shaped.

The PPF is bow-shaped because some resources are relatively well suited to picking nuts while others are relatively well suited to picking coffee e.g..

A bow shape PPF means that the opportunity cost of producing nuts increases when the economy produces more of them. This pattern of increasing opportunity costs persists over the entire length of the PPF.

Not that, this applies also to coffee.

The principle of increasing opportunity cost (also called: Low-hanging-fruit principle): When resources have different opportunity costs, we should always exploit the resource with the lowest opportunity cost first,  and afterwards use the resources with higher opportunity cost (picking the most accessible fruit first).

Example: A new CEO has been hired to reform an inefficient company. Because of the limited             time and attention the CEO has, he first focuses on the problems that are relatively easy to correct and whose elimination will provide the biggest improvements in performance These are the  low hanging fruit.

After, the CEO can look to the smaller improvements needed to make the company excellent instead of very good.

The importance of the message is: be sure to first take an advantage of the most favourable opportunities!

Factors that shift the economy’s PPF:

An economic growth results in an outward shift in the economy’s PPF.

Economic growth: the ability of the economy to produce increasing quantities of goods and services.

Economic growth is causes by different factors, e.g. increases in productive resources and improvements in knowledge and technology (those are the 2 main factors)

 (P. 49, figure 2.8 Economic growth: outward shift in the economy’s PPF)

1. The quantity of productive resources grow in an economy because of investments in new factories and equipment.

The differences in investments/resources are an important factor behind the living standards between rich and poor countries. There are differences in capital per worker.

Those have not occurred all at once but are a consequence of decades of differences in rates of savings and investment.

Even small differences in rates of investment can translate into extremely large differences in the amount of capital equipment available to each worker.

Differences of this sort:

Self-reinforcing: higher rates of savings and investment do not only cause the incomes to grow, but the resulting higher incomes make it easier to devote additional resources to savings and investment.

2.  Population growth also cause an economy’s PPF to shift outwards (and is often listed as one of the sources of economic growth). Because when the population increases, people also need more food, the growth itself cannot raise a country’s standard of living. It may even cause a decline in the standard of living if the existing population densities have already begun to put pressure on available land, water and other resources.

3. The most important factor for economic growth is improvements in knowledge and technology. Such improvements lead to higher output through increased specialisation.

Factors that may limit specialisation:

• low population density
• isolation
• laws and customs that limit people’s freedom to transact freely with one another
• size of the market
• once you are behind, you stay behind
• Developing countries do not want to have comparative advantage in raw materials and agriculture forever.
• Developing strategies aimed at changing the comparative advantage

Specialisation boost productivity but this does not mean that more specialisation is always better than less, for specialisation also entails costs. E.g. people enjoy variety in the work they do, yet variety tends to be the first thing being destroyed by specialisation.

Though, failure to specialise entails costs as well, those who do not specialise must accept low wages or work extremely long hours.

Nations can also benefit from exchange based on comparative advantage, even though one may be generally more productive than another in absolute terms.

Chapter C: Supply, demand and elasticity of markets

This chapter focuses on the supply and de demand side of the market. It explains the market and its most important concepts.

All economic systems must address:
- What should be produced?

- How should it be produced?

- For whom will it be produced?

Allocation of resources is by the forces of supply and demand is of great importance

Market: the market for any good or service consists of all buyers and sellers of that good or service

The demand curve: a schedule or graph showing the quantity of a good that buyers wish to buy at each price The demand curve is downward-sloping with respect to price.
- As price of a good or service goes down, the quantity that consumers wish to buy will increase.
- As the price of a good or service increases, the quantity consumers wish to buy will decrease.

Buyers purchase a greater quantity at lower prices and vice-versa, because:

• the substitution effect
•  income effect
• buyer’s reservation price

The substitution effect: The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. The price of the good changes relative to other prices

Income effect: The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power.

All prices change in the same way.

Buyer´s reservation price:  the largest amount of money the buyer would be willing to pay for a unit of a good.

If the reservation price (benefit) exceeds the market price (cost), the consumer will purchase the good . The benefit will exceed the cost for fewer buyers at higher prices than at lower prices.

The supply curve: a curve or schedule that tells us the quantity of a good that sellers wish to sell at each price.

The supply curve is upward-sloping with respect to the price.

à The seller charges a higher price for additional units in order to cover the higher opportunity costs of each additional unit.

Seller’s reservation price: the smallest amount for which a seller would be willing to sell an additional unit (generally equal to marginal cost)

Market equilibrium: all buyers and sellers are satisfied with their respective quantities at the prevailing market price at the intersection of demand and supply in the market equilibrium price and equilibrium quantity.

This means that the quantity people want to purchase is equal to the quantity firms produce.

Equilibrium price: the price at which a good will sell

Equilibrium quantity: the quantity supplied and demanded are equal. (There is no tendency for the system to change.)

Excess supply: the amount by which quantity supplied exceeds quantity demanded when the price of a good exceed the equilibrium price

Excess demand: the amount by which quantity demanded exceeds quantity supplied when the price of a good lies below the equilibrium price.

Price ceiling: a maximum allowable price, specified by law

Price floor: a minimum allowable price, specified by law

Change in quantity demanded: a movement along the demand curve that occurs in response to a price change

Change in demand: a shift of the entire demand curve: a demand change at the same price

Shift in demand due to complements:

- 2 goods are complements in consumption if an increase or decrease in the price of one causes a leftward or rightward shift in the demand curve for the other

E.g. tennis racquets and balls, gin and tonic, printers and paper etc.

Shift in demand due to substitutes:

- 2 goods are substitutes in consumption if an increase or decrease in the price of one causes a rightward or leftward shift in the demand curve for the other

E.g. beer and wine, coffee and tea etc.

Shift in demand due to income change:

- normal good: demand curve shifts rightwards when the income of buyers increase and leftwards when the incomes of buyers decrease

- inferior good: demand curve shift leftwards when the income of buyers increase and rightwards when the income of buyers decrease

• An increase in demand will lead to an increase in both, the equilibrium price and quantity.
• A decrease  in demand will lead to a decrease in both, the equilibrium price and quantity.

Change in quantity supplied: a movement along the supply curve that occurs in response to a price change

Change in supply: a shift of the entire supply change at the same price.

Shifts in supply:

• prices of inputs and their substitutes
•  technological change, which means that there can be produced more with the same input prices.
•  number of firms in the market
• expected future prices
• weather (farming)

• An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity.
• A decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity.

Buyer’s surplus: the difference between the buyer’s reservation price and the price he actually paid.

Seller’s surplus: the difference between the price received by the seller and his reservation price.

Total surplus: the difference between the buyer’s reservation price and the seller’s reservation price.

Economic efficiency: when the economic surplus is maximised.

Inefficient market equilibrium:  when some costs of production fall on people other than those who sell the good or service.

Price elasticity of demand: A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good

The percentage change in the quantity demanded that results from a 1 percent change in its price

= (Percentage change in quantity demanded / percentage change in price)

When price elasticity of demand is:

> 1 à elastic

< 1 à inelastic

= 1 unit elastic

Point elasticity of demand: Mid-point approach is an approximation to the value of elasticity at all points between the upper and lower point on the demand curve

- demand curve could be curved rather than straight

- this makes the mid-point approach less accurate in looking at effects of a small price change

(P/Q)x(1/slope)

Elasticity is different at each point on the demand curve!

Slope: vertical intercept/ horizontal intercept

(Most made error: elasticity = slope à it is definitely not)

• Elasticity decreases as we move down a straight-line demand curve because P/Q declines while the slope remains constant

Perfect elastic demand: even the slightest increase in price leads consumer to switch to substitutes

Perfect inelastic demand: consumers cannot switch to substitutes or stop buying when the price increases

Determinants of price elasticity:

• substitution possibilities (+)
• budget share(+)
•  time (+)

Total expenditure: P x Q

Total expenditure = total revenue

General rule: A price increase will increase total revenue when the % change in price is bigger than the percentage change in quantity.

For a straight-line demand curve total expenditure is maximised at the price corresponding to the midpoint of the demand curve.

- If demand is elastic, a price increase will reduce the total expenditure. A price reduction will increase total expenditure.

- If inelastic, a price increase will increase total expenditure. A price reduction will reduce total expenditure.

Cross-price elasticity of demand: the percentage change in quantity demanded of one good in response to a 1 percent change in the price of another good.

- Substitute goods: cross-price elasticity of demand is positive. (red/green apples?)

- complement goods: cross-price elasticity of demand is negative (pizza dough/ pizza sauce)

Income elasticity of demand: is the percentage change in quantity demanded in response to a 1 percent change in income

- normal goods: income elasticity of demand is positive

- inferior goods: income elasticity of demand is negative

Supply elasticity of supply: the percentage change in the quantity supplied that occurs in response to a 1 percent change in price.

Price elasticity of supply : (p/q)(1/slope)

The price elasticity of supply is equal to 1 at any point at a straight-line supply curve that passes through the origin.

Perfect inelastic supply: supply is perfectly inelastic with respect to price if elasticity is zero (land?)

Perfect elastic supply: supply is perfectly elastic with respect to price if elasticity is infinite (French fries?)

Determinants of supply elasticity:

- Flexibility of inputs(+)

- mobility of inputs(+)

- input substitutes (+)

- time (+)

Chapter D: The Demand side of the market

In this chapter the focus will be on the demand side of the market, the law of demand will be explained. The focus is on the consumer and the preferences of the consumer.

The law of demand:

• People do less of what they want to do as the cost of doing it rises.
• The benefit of an activity equal the highest price consumers would be willing to pay to pursue the activity (e.g. the reservation price)
•  ‘’willingness to pay’’ sometimes used to measure the value of environment goods that are not on the priced market (e.g. clean air? Less noise from a motorway?)
• As the cost of an activity rises and exceeds the reservation price, less of the activity will be pursued.

How should we allocate our incomes among the various goods and services that are available?

Utility (or benefit): the satisfaction people derive from their consumption activities

Assumption: people allocate their income to maximise their satisfaction or total utility.

Marginal utility: the additional utility gained from consuming an additional unit of good

Marginal utility: change in utility / change in consumption

= change in utility/ change in consumption

The law diminishing marginal utility: The tendency for the additional unit gained from consuming an extra unit of a good to diminish as consumption increase at some point (Herman Heinrich Gossen)

Utility maximisation can also be done between 2 goods (search for the optimal combination: the affordable combination that yields the highest total utility)

The rational spending rule: Spending  should be allocated across goods so that the marginal utility per euro is the same for each good.

(MU product 1 / price good 2) = (MU product 2/ price product 2)

This is optimal because you cannot gain anymore from any exchange between the two products.

Individual’s preferences: what do you like more?

Preference ordering: gives a scheme / mechanism that identifies the individual’s preferences over various possible bundles of goods that might be consumed

There are 6 assumptions about preferences

Assumption 1: ‘’ preferences are complete’’

Completeness: implies that an individual can compare any two bundles of goods and say which bundle is preferred.

Assumption 2: ‘’preferences are ordinal’’

Assumption 2: ‘’preferences are ordinal’’

Ordinal numbers: 1^st, 2^nd, 3^rd....

Thus, ‘’I like this more than that’ or ‘I am happier today than I was yesterday’’.

They imply ranking just by stating, it is a less restrictive assumption.

Cardinal numbers: 1, 2, 3..

Thus, ‘’ I like this 20 % more than that’’

They imply ranking by a standard value.

Assumption 3: ‘’preferences are transitive’’

Transitivity: implies consistency in preferences

If activity A is preferred to activity B (A>B)

And B is preferred to activity C (B>C), then A also has to be preferred over C (A>C)

E.g. I prefer chocolate ice over vanilla ice.

I prefer strawberry ice over chocolate ice.

This means: I prefer strawberry ice over vanilla ice (=transitivity)

Assumption 4: The satisfaction level, thus the individual’s utility, is increasing in any good. This means ‘more is better’.

It may be ever less but it remains more.

Assumption 5:  ‘’preferences are continuous’’

Continuity: implies that individuals can compare and evaluate utility of bundles that differ only slightly in size or composition.

The assumptions 1-5 make the consumer’s preferences to be written in the form of a utility function for a bundle of goods A, B, C.. etc.

= Ui = Ui (A, B, C….)

The basic feature of this function is that it permits the consumer to be willing to trade some of good X,  so that he gets more of good Y while maintaining his utility level.

Assumption 6:  ‘’preferences display a diminishing marginal rate of substitution’’

A diminishing marginal rate of substitution: an assumption about the utility function:

- When drinking 100 cups of tea and 100 cups of coffee, you may wish to trade one-to-one

- But when drinking  190 cups of tea and only  10 cups of coffee, you may wish to trade 1 cup of coffee for 20 cups of tea.

Indifference curve: a smoothly convex curve that gives the combinations of 2 goods for which the individual is indifferent (the same utility)

• the further out an indifference curve, the higher the consumer’s utility from the bundles of A and B on the curve.
•  indifference curves never touch each other, bundles that are further out on curves give higher utility.
• more of both, good A and B, is better. 
• The rational consumer will choose the feasible bundle that is on the highest attainable indifference curve.

The marginal rate of substitution (MRS) between 2 goods gives the slope of the indifference curve.

MRS implies that the less you have of good A, the more of good B you will have to give up to make  up for a further reduction in the quantity of good A while keeping utility constant.

Consumer rationality: the consumer will allocate spending so that MRS equals relative price

- What would you gain by exchanging on unit of A for B (benefit) is the same as what you would have to pay for B relative to A (cost) so you do not do it.

- Same as utils/€

Rational response to a change in price: Suppose the price of good B falls, thus the budget line shifts.

The consumer’s utility maximising point shifts to a higher indifference curve.

This means that the consumer is better off, has a higher utility level. As a result the consumption of good B rises.

Rational response to change in income: As the consumer’s income rises and prices are unchanged, the consumption of both goods rises. Thus, not only good B as in the example above.

Rational response to change in income if B is an inferior good: As income rises, prices unchanged, consumption of B falls.

Individual demand curves are identical.

The market demand curve is derived by multiplying each quantity on the individual demand curve by the number of consumers in the market.

Consumer surplus: the difference between a consumer’s reservation price for a product ant the market price actually paid.

Calculating consumer surplus: Reservation price – market price

Total consumer’s surpluses together: add all the individual surpluses.

In a graph:

1. search for equilibrium price

2. find height of the triangle (highest price – equilibrium price)

3. find the base of the triangle

4. (1/2)x height x base = consumer surplus

Chapter E: The competitive market based on the supply side of the market

The increasing opportunity cost (low-hanging-fruit principle): first take the easy options, then go for the more difficult or costly alternatives. (Applicable to the individual producer an across producers)

à explains the upward-sloping of curves. Costs tend to rise when producers expand production (individually and market).

Concepts of production:

Factor of production: an input used in the production for a good or service

Short run: a period of time sufficiently short that at least some of the firm’s factors of production are fixed

It often means that output gains from each additional work begin to diminish after a certain amount of workers, thus therefore,  machines will also be used.  (Like a bottle factory)

Law of diminishing returns:

• A property of the relationship between the amount of a good or service produced and the amount of a variable factor required to produce it
• Increased production of the good eventually requires ever-larger increases in the variable factor when some factors of production are fixed.

Long run: a period of time of sufficient length that all the firm’s factors of production are variable.

Fixed factor of production: an input whose quantity cannot be altered in the short run (a bottle-making machine)

Variable factor of production: an input whose quantity can be altered in the short run.

Fixed cost: the sum of all payments made to the firm’s fixed factors of production. These are the payments that have to be made for the service of an input regardless of whether and how much production actually takes place.

Variable cost: the sum of all payments made to the variable factors of production

Total cost: the sum of all payments made to the firm’s fixed and variable factors of production

Marginal cost: the change in total cost divided by the corresponding change in output as output changes from one level to another (by definition it consists of the variable costs)

MC = change in total costs / change in output

Average total cost (ATC): total costs / total output

Average variable costs (AVC): variable costs/ total output

MC always goes through the minimum of ATC where MC=ATC.

Because:

• as long as the marginal costs of the next unit is below the average costs per unit, the average costs per unit goes down. (when a younger-than-average student walks in the room, the average goes down).
• as long as the marginal costs of the next unit is above the average costs per unit the average cost per unit goes up. (when an older-than-average student walks in the room, the average goes up)

Determinants of supply:

• Technology
• Input prices
• Number of suppliers
• Expectations
• Changes in prices of other products

Profit: the total revenue a firm receives from the sale of its products minus all costs of production.

(explicit and implicit costs!)

Profit-maximising firm: a firm whose primary goal is to maximise the difference between its total revenues and total costs.

The perfectly competitive market: a market in which no individual supplier has significant influence on the market price of the product.

Price taker: a firm that has no influence over the price at which it sells its product

Imperfectly competitive firm: a firm that has at least some influence over the price at which it sells its product.

The characteristics of perfect competition:

• All firms sell the same standardises product
• The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged
• Productive resources are mobile
• Buyers and sellers are well informed

The individual firm’s demand curve is often horizontal at the market price. This is because there are many identical firms, so if a firm raises its price even a little, it will lose all its customers.

A profitable firm: a firm whose total revenue exceeds its total cost

Profits= TR-TC = (P x Q) – (ATC x Q)

To be profitable: P has to be bigger than ATC

If P > MC à the firm can increase its profit by expanding production

If P < MC à the firm can increase its profit by producing and selling less output

The firm’s profit-maximising supply rule in perfect competition: price (marginal revenue) = marginal costs

Profit: ( P-ATC) x Q

A negative profit (loss) is when P < ATC

Producer surplus:  the difference between the seller’s reservation price and the market price

Surplus: ½ x base x height

Shutdown conditions of a firm

A firm must cover its variable cost to minimise losses when producing at a loss.

à Short-run shutdown conditions is where P x Q < VC for all levels of Q or where P < minimum value of AVC.

You make a loss when you cover the VC and only a part of the fixed cost but when you shut down your loss is larger (=all FC).

Chapter F: Market efficiency

Efficiency: a situation where no further transaction is possible that will help some without harming people.

- the market will be in equilibrium à called ‘Pareto efficiency’

When there is no efficiency, there is a market disequilibrium. Or buyers or sellers want more quantity.

Observation on efficiency: when the price is above or below the equilibrium price, the quantity exchanged will be lower than the market equilibrium quantity.

à Thus, only the equilibrium price will maximise economic surplus.

Markets will be (Pareto) efficient when:

•  Buyers and sellers are well informed
• Markets are perfectly competitive
• The demand and supply curves satisfy certain other restrictions (external effects)
• Transaction costs are low/absent

A price ceiling can affect the economic surplus.

Deadweight loss: the reduction in total economic surplus that results from the adoption of a policy

Chapter G: The Invisible Hand theory, profits and losses

This chapter will explain the Invisible Hand Theory and its observation. Moreover, the emphasis is on the profits and losses a company can gain and what affect this will have on the exit or entry of other producers into the market.

The 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.

According to Adam Smith:

• People are motivated by self-interest
• The goal of profit maximisation will serve society’s collective interest

Explicit costs: the actual payments a firm makes to its factors of production and other suppliers, such as wages and material.

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

e.g. :

• Forgone interest on your own money invested in the firm
• The well-paid job that you gave up.

Accounting profit: total revenue minus – explicit costs

Economic profit: total revenue - explicit minus implicit costs

To calculate this, you have to calculate the opportunity costs of the resources supplied by the firm.

Normal profit: accounting profit – economic profit

The central role of economic profit:

When a firm’s accounting profit is equal to the opportunity costs of the resources supplied by the firm’s owners, the firm’s economic profit is zero.

• Accounting profit = normal profit, when economic profit = 0

For a firm to remain in business in the long run, it must earn an economic profit greater than or equal to zero.

According to the invisible hand theory:

Profits and losses would ensure that:

• Supplies within a market would be distributed efficiently (rationing function)
• Resources would be allocated across markets to produce the most efficient possible mix of goods and services (allocation function)

Responses to profits and losses would ensure that:

• Markets with firms earning economic profits will attract firms/resources
• Markets where firms are experiencing economic losses tend to lose firms/resources

Short-run economic profit:

Entry effects: economic profits attract firms to enter the market à the supply curve shifts outwards.

This results in reducing prices and economic profits.

• The entry of firms continues until all firms earn an economic profit of zero
• Prices below minimum ATC result in economic losses

The exit of firms: when firm exits the industry, the supply curve shifts inwards by which the market price increases.

Observations of the Invisible Hand Theory:

• In a competitive market, all firms will tend to earn zero economic profits in the long run

This is the consequence of the price movements caused by entry and exit of firms trying to maximise economic profits.

P = MC = MR (zero economic profits in the long run)

• The equilibrium price predicts it, when people confront an opportunity for gain, they are going to exploit it
• High profits for the first producer who came up with the idea, think about ‘Facebook’. This producer will exploit maximum profits before other producers jump in and profits go down.
• Firms are price takers

In the long-run equilibrium, firms enter and exit until price is at the minimum of the remaining firms’ ATC. Supply is at output price equal to the minimum ATC. Thus, producers earn zero economic profit.

The long-run supply curve in a perfectly competitive market:

• An increase in demand temporarily increases the price and allows firms to earn economic profits.

 In addition, it attracts new firms to enter the industry, increasing supply, driving down the price and eliminating economic profits

• A decrease in demand temporarily decreases the price and causes firms to suffer economic losses.

In addition, it leads to some firms exiting the industry, decreasing supply, driving up the price and eliminating economic losses

Key features of the Invisible Hand theory:

Efficiency: the market outcome is efficient in the long run

• P = MC
• If outcome is increased: MC > MB(benefit)
• If output is decreased: MC < MB

Fairness: the market is fair

• The price the buyers pay is not higher than the cost incurred by the sellers
• The cost includes a normal profit

The importance of free entry and exit: Free entry and exit must exist for the allocative function of price to operate.

Entry barrier: any force that prevents firms from entering a new market. They can be caused by legal constraints and unique market characteristics.

Exit barriers: are frequently caused by political responses to declining demand or rising costs.

Exit barriers can make newcomers hesitate, so they indirectly induce entry barriers.

E.g. Keeping bus services open in less busy regions or late hours.

The invisible hand in action:

Key idea: opportunities for private gain seldom remain unexploited for very long

- the equilibrium principle

Cost-saving innovations:

In the short run:

• no impact on the price
• economic profit will increase

In the long run:

• other companies will do the same innovation
• market supply increases as the price falls
• after all the firms have done the innovation, the economic profit will be zero again.
• any firm without the innovation, would have an economic loss equal to the economic profit of other firms gained through the innovation (in the first place)

Present value of future costs and benefits: Earnings received in the future are less valuable than earnings received today

Time value of money: money deposited today will grow in value over time.

Present value: the amount that must be deposited today at a given interest rate (r) to generate a given balance (M) at a specific time (t) in the future.

PV deposited today at r will generate:

• M= PV(1+r) à after 1 year
• M= PV(1+r)2 à after 2 years
• M= PV(1+r)n à after n years

To calculate PV= M / (1+r)^t

The distinction between equilibrium and a social optimum:

• The equilibrium principle means that there are no unexploited opportunities available to individuals in markets that are equilibrium
• The market equilibrium does not imply that the resulting allocation is necessarily best from the point of view of the society as a whole.
• Equilibrium will not be socially optimal when the cost and benefit for individuals differ from society as a whole.