Video clip from Other Peoples' Money either today or Wednesday.

Congratulations on surviving Chapters 1-7.

Key points of Chapter 8:

Key concepts

* economic profit or "super profits"--over and above normal profit

* adding average cost into the picture of supply and demand for individual firm, making it possible to graphically depict total profits

* why perfect competition should drive economic profits to zero in every industry due to new firms entering (or leaving) the industry (graphical analysis)

* stocks and bonds and how they work

Accounting profit is defined as total revenue minus explicit costs.

Economic profit is defined as total revenue minus explicit and implicit costs.

Explicit costs are costs that must explicitly be paid--as opposed to implicit costs, such as opportunity costs.

The biggest opportunity cost is the cost of an owner-entrepreneur's time and talents--and so the distinction that Frank and Bernanke makes a lot of sense for a small firm, like the fellow in the text, in Exercise 8.1, named Pudge.

Pudge is a corn farmer--his explicit costs cover land, equipment, and other supplies (he doesn't employ anyone). His explicit costs come to $10,000. His revenue from sales is $22,000 per year.

So his accounting profit is $12,000.

But what about the value of his time and energy? What's his opportunity cost? If he wasn't farming, he would be managing a retail store for $10,000 a year. So what's his economic profit (what he gets over and above both his explicit and implicit costs)? Only about $1,000 a year.

Another example of implicit costs would be rent. For instance, what if Pudge inherits the land that he had previously been renting from his uncle. He no longer has to pay rent--so his explicit costs are reduced. But he should consider what he could be earning in rent if he stopped farming and rented land to someone else--this is the opportunity cost of farming the land himself....

Note that the definition of normal profit in the margin of the text on p. 197 is incorrect. Normal profit plus economic profit equals accounting profit.

Normal profits are basically equal to implicit costs... They are normal in the sense that they are going to pay for something that had an actual opportunity cost. But the economic profits represent a "surplus"--an extra--the gravy--the whipped cream and cherries...profits over and above all costs.

When we say that competition tends to drive profits to zero, we are talking about economic profits....this is the delectable stuff that attracts other producers to the industry....

A related concept is economic rent--payment for a factor of production that exceeds the owner's reservation price

Note: your text describes accounting profits as though they are obvious, transparent, uninteresting. But what the scandals of the last year have shown is that accounting profits are not so easily pinned down--they can be affected by a number of rules, conventions, misrepresentations. The books can be cooked in a variety of ways....

So far, we have looked at profit maximization for the individual firm ONLY to emphasize that the demand curve is perfectly horizontal, the firm is a "price-taker" and the firm can only choose (in the short run) what level of production to operate at:

It chooses the point where marginal cost equals marginal revenue or price.

But we haven't specified how much profit the firm actually makes at the profit-maximizing level.

To specify this, we need to know what AVERAGE costs are at the profit maximizing point.

Let's do a brief review of the difference between different types of costs

Widget Costs and Price

What is the profit maximizing level of production? 9 units.

What is average cost at that level? 6 dollars.

What are total costs at that level? 54.

What are total revenues at that level? 108. 
(multiply price times number of units sold, or 9 times 12)

What are total accounting profits at that level? 54
(subtract costs from revenues) 

What is average profit at that level? 6
(subtract average cost from average revenue)

Notice that fixed costs don't change.

Price doesn't change.

Marginal costs increase (principle of diminishing returns or increasing costs)

Total costs increase.

Average costs, however, go down, then up. They are U-shaped.

The following graph offers a simplified illustration. At the profit maximizing level of production, which is 6, average costs are 6. The rectangle between the lower horizontal line and the price line represents economic profits.

What happens when other firms see how much this firm is making in the way of superprofits? They enter the industry. What happens then? They shift they industry supply curve to the right, which lowers price.

On the other hand, if a firm is making a loss, or negative profits, it will exit the industry, as will other firms. This will shift industry supply curve to left, raising price.

In long-run, economic profits in all industries will be zero.

The magical process by which competition supposedly prevents excess profits only works if new firms can enter the industry...if there are barriers to entry that prevent this from taking place, the process doesn't work....

Some examples of barriers to entry:

licenses (e.g. taxicabs in New York)

high start up costs (e.g. airlines)

technological advantage (e.g. Microsoft's stranglehold on operating systems)

conformity to social/cultural norms (e.g. CEOs who weren't willing to endorse the new pay systems and principles of market fundamentalism couldn't find jobs!)