ECON1101: Microeconomics 1

Chapter 9: The invisible hand

Types of costs
Explicit costs are the opportunity costs of resources that the firm uses that are
supplied from output the firm. They are calculated as the actual payments the
firm makes to its factors of production and other suppliers.
Implicit costs are the opportunity costs of resources that the firm uses that are
supplied by the firms owners.

Types of profit
1. Economic profit is the difference between a firms total revenue and the
sum of its explicit and implicit costs. Economic loss is an economic profit
that is less than zero.

Economic profit=RevenueExplicit costsImplicit costs

2. Accounting profit is the difference between a firms total revenue and its
explicit costs.

Accounting profit=RevenueExplicit costs

3. Normal profit is the level of accounting profit that a firm earns when
economic profit is zero. It is equal to the opportunity cost of the resources
supplied to a business by its owners.

Normal profit =Implicit costs

The invisible hand theory

Adam Smiths invisible hand theory states that the actions of self-interested
buyers and sellers, all acting independently, will often result in the socially
optimal allocation of resources.

The functions of price

1. The rationing function of price distributes scarce goods to those
consumers who value them most highly.
2. The allocative function of price directs resources away from
overcrowded markets and towards underserved markets.
a. If firms earn an economic profit, firms will enter, the supply curve
will shift rightwards, and the market price will fall until the economic
profit is zero.

b. If firms experience an economic loss, firms will leave, the supply

curve will shift leftwards, and the market price will rise until the
economic loss is zero.

Free entry and exit

The invisible hand only occurs if firms can freely enter and leave markets.

No cash at the table

The allocative function of price does not mean that there can never be any
unexploited opportunities. Instead, it means that unexploited opportunities
only last for a short time.

Examples of the invisible hand

Everyday life: The invisible hand results in supermarket checkout queues

tending to be roughly the same length.

Cost-saving innovations: The invisible hand encourages firms to develop

cost-saving innovations and earn short-term economic profit until it is
copied by other firms.

Government regulation: The invisible hand causes the prices of licences to

skyrocket because they include economic rent.

Stock market: The invisible hand results in the efficient market hypothesis,
which suggests that share prices reflect all relevant information about its
current and future earnings prospects.

Smart for one, dumb for the group

The invisible hand may not result in social optimality if a markets demand
and supply curves do not reflect all the costs and benefits.

Long-run supply in a competitive market

Long-run supply in a competitive market is perfectly elastic because all factors of
production are variable. It is perfectly elastic at the lowest point on the ATC
because economic profit is zero at that point:

P=MC=minimum value of ATC

1. It is efficient because

P=MC .

2. Goods are produced at the lowest possible cost given the existing
technology at the time because

MC=minimum value of ATC .

3. Buyers may no more than the costs incurred by suppliers because

P=minimum value of ATC .

Economic rent
Economic rent is that part of the payment for a factor of production that
exceeds the owners reservation price. Unlike economic profit, economic rent can
persist in the long-run if the factors have special characteristics that cannot be
easily produced.