Chapter 9 The quest for profit and the invisible hand

Answers to review questions

1

If the owner of a business supplies valuable resources to the firm, he may earn an
extremely large accounting profit yet still earn zero economic profit. In this case, $1
million per year would be a normal profit, implying that the firms revenues are just
sufficient to cover all implicit and explicit costs, including a return on any capital that
the owner has invested that is equal to the return it would earn in its best alternative
use.

True. Earning a normal profit shows that a firm could do no better by redeploying the
resources supplied by the owners of the firm from their current use to their next best
alternative use.

Economic profit attracts entry to an industry, increasing supply, driving down the price
and eliminating economic profit. Economic rent, however, is a return on inputs that can
not be easily duplicated. No similar process affects the return to factors of production
that are not easily duplicated.

Entry to and exit from a market shift the supply curve and cause price changes that
eliminate both economic profits and losses.

Technological change has reduced the cost of producing radios and, as the diagram on
the left shows, increased the number of radios bought. In the market for radio repairs,
however, technology has reduced the demand for repairs and thus reduced the number
of radio repair shops. This is shown in the diagram on the right.

The law of unintended consequences alerts us to the possibility that policy changes
which affect the incentives that people face in making economic decisions may have
consequences other than those that were intended by the architects of these policies. For
example, a policy that reduces the demand for addictive illicit drugs will reduce both
the equilibrium price and quantity of the drug. The lower price may unintentionally
lead to more young people becoming drug users in the first place.

An earlier payment is worth more than a later one because it could earn interest while
you are waiting for the later payment. For example, with an interest rate of 10 per cent,
$10 000 received now could be invested and be worth $10 000 (0.1) (0.1) = $11 100
after two years.

An interesting actuarial study was undertaken by an academic at Macquarie University

in which it was shown that the helmet laws may have actually cost almost half a billion
dollars annually.
Some examples of the factors that can come into play in such situations include:
Some people who may have been considering taking up cycling may have been
deterred by the financial and time costs associated with buying a helmet (knowing that
they faced fines if they did not wear one), thus reducing the possible health benefits to
be gained from the physical exercise.
Helmets may have created a false sense of security, with a couple of possible effects:
Without the correct information about how to select and properly fit a helmet, people
may have worn helmets that were less protective than they assumed, meaning that the
benefit predicted by the government was not fully recognised;
Wearing a helmet may also have encouraged riders to take more or greater risks on the
road, feeling more confident that they would not be injured.

Answers to problems
1

False. The maxim tells us that there are no unexploited economic opportunities
when the market is in long-run equilibrium.

False. Firms in long-run equilibrium have to make an accounting profit in order to

cover the opportunity cost of resources supplied by their owners. In long-run
equilibrium they make a zero economic profit.

True. These firms can earn economic profits until other firms adopt their
innovations, as their costs will be lower than those of competitors yet their
product will command the same price.

False. As the innovations spread, the industry supply curve will shift down,
causing the market price of the good to fall and eroding the short-term economic
profit. Innovating firms will earn a zero economic profit in the long-run.

The reason these firms shares are valuable is that once their products have established
a market niche, the firms will cease to give them away. The anticipated future profits of
such companies lead investors to bid for their shares now.

Johns accounting profit is his revenue ($50 000) minus his explicit costs
($42 050), or $7950 per year.

Yes, John should stay in business. The opportunity cost of his labour to run the
cafe is $10 000 $2750, or $7250 per year. Adding this implicit cost to the
explicit costs implies that the cafe is making an economic profit of $700 per year.
Since $700>0, John should stay in the business.

Johns opportunity cost rises by $1000, to $8250 per year. The cafe is now
making an economic loss of $300 per year.

The accounting profit would now be $17 950 per year. The answer to part b would
not change. If John had $100 000 of his own to invest in the cafe, he would
forego $10 000 per year in interest by not putting the money in a savings account.
That amount is an opportunity cost that must be included when calculating
economic profit.

To earn a normal profit, the cafe would have to cover all its implicit and explicit
costs. The opportunity cost of Johns time is now $10 000 year, whereas the cafes
accounting profit is only $7 950 year. Thus, the cafe would have to earn
additional revenues of $2050 year to make a normal profit.

Sue will earn $600 000 per year. This is the normal salary for a designer
($100 000) plus the economic rent ($500 000) that she collects for her special
talent. Five-sixths of her salary is economic rent.

If Sues employer withholds some of the additional revenue it takes in as a result

of hiring her, some other advertising company will offer her a higher salary and
still manage to earn an economic profit. Bidding for Sue will continue until all
firms are indifferent between paying him $600 000 and hiring any other designer
for $100 000.

Assuming that all orchards initially earn zero economic profit, the innovation will cause
one orchardists costs to fall. The firm that owns the machine will make an economic
profit in the short run, because the market price of apples will not change. As other
firms adopt the innovation, they too will make an economic profit. This economic profit
will attract new firms into the industry, and so the supply curve for apples will begin to
shift to the right, causing the market price of apples to fall. The decline in price will
continue as more firms enter, until there is no more economic profit to be made.

If the import licences were free and could not be transferred, owners of each licence
would make an economic profit of $20 000 per year. When the annual interest rate is 10
per cent, the most a buyer will be willing to pay for a stream of economic profits of $20
000 per year is the amount of money she would have to put into a savings account to
earn that much interest each year. This sum of money is $200 000. If the import
licences are auctioned, they will sell for this price, and the government will earn an
economic rent of $200 000 per licence. The buyers of the licences will make no
economic profit.

The question you should ask is: How much money would your friend need to put in the
bank at 20 per cent interest to generate annual earnings of $30 000? To find out, simply
let X denote that amount in the equation X(.2) = $30 000 and solve: X = $30 000/.2 =
$150 000.

If you pay $X for the orchard, the opportunity cost of your investment is (0.10)
($X)/year. The opportunity cost of your time is $100 000 per year. The highest value of
X for which you would be willing to own and manage the orchard is the value that
yields zero economic profit. To find that value, solve:

$250 000 $100 000 (.10)($X) = 0

X = $1 500 000
9

a The most Louisa would be willing to pay in experimental costs is $500 000.
She could charge all 100 000 patrons $5 more, but only for one night. After the
first night, other producers would figure out the recipe and compete the price
back down to $5 per plate.
b

With a patent that lasts one year, Louisa would be willing to pay up to $182.5
million dollars ($500,000/day)(365 days/year). She could charge an additional $5
per meal each night of the year before the other producers could copy her recipe.