Concepts – Chapter 7

3 types of profit

Accounting profit = Firm’s total revenue – Explicit costs

Economic profit/excess profit = Total revenue – implicit costs – explicit costs. Guides decisions. Earning ->
Attract resources

Normal profit: The opportunity cost of the resources supplied by the firm’s owners, equal to accounting profit –
Economic profit. The profit that could have been earned instead e.g by saving the invested 1 million for
equipment we could have saved money with interest rate of 10% -> $100 000. This is our opportunity cost.

Economic loss: Economic profit less than 0. – lose resources.

Explicit costs: Actual payments a firm makes to its factors of production (inputs needed for production) and
other supplier e.g. Salary, capital costs and local costs.

Implicit costs/opportunity costs/normal profit: Opportunity costs of the resources supplied by the firm’s
owner. The value of the best option, the value we give up by using resources the way we do.

2 functions of price:

Allocative function of price: Changes in prices direct resources away from overcrowded markets and toward
markets that are underserved. = Resources leaves markets where cost of production is higher than price and enter
markets where price exceeds cost of production instead.

Rationing function of the price: Changes in prices distribute scarce goods to customers who values them the
most = When the supply of a good is limited, the price increases to help reduce the demand and allocate the
available quantity to those who are willing and able to pay the higher price. E.g. Oil if it runs out, price
increases, lower demand and the oil will be more conserved.

Market equilibrium: Firms earn economic profits lead to increased supply and reduced prices which leads to
profits to disappear. Firms face economic losses, some exit market, reduce supply and raise prices. In perfectly
competitive markets the resources allocate efficiently, no opportunity for profit because the profit attracts new
firms which adjust supply abd demand to the equilibrium.

- It is efficient however real world factors like externalities, market entry barriers, and international
trade policies complicate the achievement of true efficiency.

Invisible hand theory: Adam Smith’s theory – Actions, allocation of independent, self interested buyers and
sellers will often result in the most efficient allocation of resources. – with the help of economic profit and loss.

- Not just refer to opportunities to Earn economic profits

- Other opportunities to earn desirable outcome. E.g queues

Barrier to entry: Any force that prevents firms from entering a new market. Free entry and exit is important for
a competitive market. If free entry, firms can easily enter where other firms are making profit which lowers the
price to cost of production. However forces such as laws or product compatibility allow some firms to have
higher profit. If they can’t leave unprofitable they will be hesitant to enter new ones.

Economic rent: Part of payments for an input that is above the supplier’s reservation price for that input. Excess
payment made to or for a factor of production over and above the amount expected by its owner. E.g willing to
lease for 100/year but farmer pays 1000/ year = Economic rent of 900/year. Can be positive but 0 in perfect
competition.
 - That part of the payment for a factor of production that exceeds owner’s reservation price, the pruce
below which the owner would not supply the factor.
- Extra money someone earns because they have something special or unique that others cant easily
replicate or replace such as the talented chef that earned 150 000 extra when her payment was actually
just 30 000. The owner bid up the salary till they would make no profit – equilibrium.

The equilibrium/no cash on the table principle: When market reaches its equilibrium, no further opportunities
for gain are available to individuals. Exploiting opportunities moves market towards the equilibrium. 3 ways to
gain big payoff: Work hard, have unusual skill and talent pr simply lucky.

Economic Efficieny or pareto efficient: A situation is efficient if no change is possible that will help some
people without harming others.

- Efficient: equilibrium price and quantity

- Not efficient: Prices above or below equilibrium

Total economic surplus: Sum of consumer surplus and producer surplus.

Economic surplus: Refers to the state where there are more goods and services available in an economy than
consumers purchase or use. Combined benefit both consumers and producers get from market transactions.

Consumer surplus: Difference between people’s highest willingness to pay (area under demand curve) - what
they have to pay (total cost). Big as possible

Producer surplus: Total revenue (price received for a product) – marginal cost to produce it (measured as the
area under S). The supply curve shows marginal production costs, so the area below shows the cost of producing.

Surplus:

• Measuring benefits for consumers and producers: consumer and producer surpluses
• See what happens if we go in and try to influence the outcome in a market with regulations or taxes

Deadweight loss = A cost to society created by market inefficiency which occurs when supply and demand are
out of equilibrium. Causes losses for both buyers and sellers in a market e.g. from taxes. Occurs as a result of a
policy or an occurrence within a market.

Regulations or policies that prevents market form reaching equilibrium:

E.g Farmer

- Explicit costs: Land and equipment rental $10.000/year

- Payment for own salary $11.000 – Implicit costs, normal profit, the opportunity cost of the only
resource he supplies, his lanor.
- Total Revenue $22.000
- Accounting costs = 22000-10000 = 10 000 yearly payment
- Economic costs = 22000-11000-10000 = 1000/year
- Economic profit = Better of by 1000 if he remains in farming.
- Economic loss (revenue now 20000) = 20000-11000-10000 = (-1000)/year -> shutdown farming and
continue working at the retail store.

Examples:

- If a farmer has the option to switch from farming to working in retail, the economic profit helps
determine whether he should continue farming or switch.
 - An example was provided where a farmer initially earns a profit farming, but if his revenue drops due to
bad weather, he may be better off quitting farming, especially if he can earn more elsewhere or rent out
his land. This leads to a deeper understanding of economic decision-making, where firms and
individuals allocate resources to maximize their profits and minimize opportunity costs.

Cost of preventing price adjustments

- Price ceilings, caps: (e.g., rent controls) can cause excess demand, where more people want the good
(e.g., apartments) than are available at the capped price.

o Leads to queues or black markets where people pay above-market prices.

o May create inefficiency and welfare loss as the market cannot allocate goods efficiently.
o However, these policies may be used for social reasons (e.g., affordable housing) despite the
economic drawbacks.

- Price subsidies
- Reason: Make housing and other basic goods more affordable for low income customers however
prevent markets from reaching equilibrium and reduces total economic surplus.

Response to losses and profits

 Markets in which firms are earning economic profit will attract resources
 Markets in which firms are suffering economic losses will lose resources

Tax Incidence (Who bears the tax burden):

 The elasticity of demand and supply determine who bears the burden of a tax.
 If demand is inelastic (e.g., gasoline), consumers bear most of the tax.
 If demand is elastic (e.g., restaurant meals), producers bear more of the tax burden.

Notes

- Market equilibrium is the price where supply and demand have balance with no additional benefits
which means that they have maximized total economic surplus making it the most efficient way to
allocate resources in a perfectly competitive market.
- Lower or above equilibrium means missed opportunities for beneficial trades – not efficient
- However efficient market isnt always good because they see income and preferences as fixed.
- Efficient means that it help achieve goals, better direct resources where its needed.

Why price ceilings cause more harm:

- Misallocation of Resources: (the good should go. to the

consumer who values it the nost, the one that is willing to pay
the highest price, highest consumer surplus, since more
consumer surplus increase the total. surplus. This maximizes
the total surplus in market)
- Inefficient Actions: Loss of total surplus because more
resources are used, do additional costs to secure the good that
isnt helping: Wastes time and resoucres, no increase in supply,
inequitable distribution.
- without making situation better.
 - Better Alternatives to Help the Poor: Price ceilings help low
income families, however income transfer better directly to
them.
- Pie analogy – price control pie smaller for everyone, without the pie bigger and everyone get a large
slice of pie. By transferring income to the poor rather than using price controls, everyone can benefit
from a larger economic surplus
- Price subsidies – help low income consumer by subsidizing essential goods like bread, however work
like price ceilings
o Lead to waste since encourage buying more is good than efficient, additional not values
enough by consumers – loss in surplus
o Better solution – efficient give income transfer – less costly and more effective

Today’s lecture focused on how supply and demand interact at the market level to determine the market price
and quantity. Market prices play two roles: a rational function, distributing scarce resources to those willing to
pay for them, and an allocative function, where profits attract more suppliers and resources shift from
overcrowded markets to underserved ones. This aligns with Adam Smith’s idea of the invisible hand, where self-
interested individuals unknowingly create the most efficient allocation of resources.

We also discussed economic profit, which differs from accounting profit by including both explicit costs (actual
payments) and implicit costs (opportunity costs, like the value of the next best alternative). Opportunity cost is
the value of what you give up when choosing one option over another. For example, if a farmer has the option to
switch from farming to working in retail, the economic profit helps determine whether he should continue
farming or switch.

An example was provided where a farmer initially earns a profit farming, but if his revenue drops due to bad
weather, he may be better off quitting farming, especially if he can earn more elsewhere or rent out his land. This
leads to a deeper understanding of economic decision-making, where firms and individuals allocate resources to
maximize their profits and minimize opportunity costs.

The lecture then covered market equilibrium, where firms earning economic profits attract more firms,
increasing supply and lowering prices until profits disappear. Conversely, if firms face economic losses, some
exit the market, reducing supply and raising prices. Ultimately, in a perfectly competitive market, resources are
allocated efficiently, and there are no more opportunities for profit because any profit potential attracts new
firms, adjusting supply and demand to the equilibrium.

Lastly, the efficiency of markets was highlighted, with an analogy to how people behave in supermarkets.
Consumers look for the fastest, most efficient way to get what they want—similar to how markets work to
allocate resources in the most effective way possible.

The teacher discussed how market behavior, supply, and demand interact to create economic equilibrium, where
the price and quantity of goods align with both consumer and producer interests. When markets are at
equilibrium, they are considered efficient, as there are no further incentives for buyers or sellers to change their
behavior. However, achieving equilibrium in reality is complicated, as it assumes perfect conditions like no
barrier to market entry and exit, and no externalities (unaccounted costs or benefits).

The example with the milk industry illustrated this concept. If the price of milk is too low (e.g., $1 per gallon),
there’s excess demand, where consumers want more milk than is being supplied, creating a pressure for prices to
rise. At a higher price, like $2 per gallon, there’s excess supply because suppliers are willing to produce more
than consumers are willing to buy. This situation also creates an incentive for suppliers to lower prices slightly to
sell more milk, leading to better deals for both consumers and producers. Ultimately, these adjustments move the
market toward equilibrium, where supply equals demand.

However, the theory assumes that firms can easily enter and exit markets, which isn’t always the case in the real
world due to barriers like capital costs, regulations, or market power. This is why economic efficiency, while
ideal, is difficult to achieve in practice.

Another key point was the issue of externalities—costs or benefits that are not reflected in market transactions.
For example, when consumers buy a car, the environmental costs of manufacturing and driving the car (like CO2
emissions) aren’t factored into the price of the car. This lack of accounting for externalities leads to market
inefficiencies, as it doesn’t reflect the true societal costs. The teacher mentioned that understanding economics is
crucial for addressing problems like climate change, as it requires pricing externalities correctly to ensure
efficient resource allocation.

The teacher also brought up the European Union’s carbon pricing policies. Currently, emissions from products
produced within the EU are priced through an emission trading scheme, but emissions from imports are not. To
address this, the EU has introduced border carbon adjustments—tariffs on imports based on their carbon
emissions. This policy aims to level the playing field between EU producers (who pay for their emissions) and
foreign producers (who may not), encouraging global competition to account for environmental costs. However,
this is a complex issue, with debates about how to set the right price for emissions and how to handle
international trade.

In conclusion, while market equilibrium is theoretically efficient, real-world factors like externalities, market
entry barriers, and international trade policies complicate the achievement of true efficiency. Understanding
these dynamics is key to addressing broader economic and environmental challenges, such as those posed by
climate change.

Here’s a more concise bullet point summary based on your text:

Market Efficiency & Resource Allocation:

 Efficiency means goods and services go to those willing to pay the most, and resources (like labor)
move to profitable markets.
 However, market efficiency doesn’t account for basic needs (e.g., low-income families) or fairness—
it only focuses on maximizing surplus.
 Social policies are needed to address issues like unequal access to basic goods, which the market
alone can’t resolve.
Consumer and Producer Surplus:

 Consumer Surplus: The difference between what consumers are willing to pay for a good and what they
actually pay.
 Example: Willing to pay $160 for a cinema ticket but only pay $80. The $80 difference is the surplus.
 Producer Surplus: The difference between the price producers receive for a good and the cost of
producing it.
 Example: Selling apples for $3.50 when the cost is $1.50. The $2 difference is the surplus.
Graphing Surpluses:

 Consumer Surplus: The area below the demand curve and above the price line.
 Producer Surplus: The area above the supply curve and below the price line.
 Total surplus is the sum of both consumer and producer surplus.
Effects of Taxes on Surplus:

 A tax shifts the supply curve (for producers) upward, increasing the price consumers pay while reducing
the price producers receive.
  New Equilibrium: Tax causes a higher market price and lower quantity, reducing both consumer and
producer surplus.
 Tax is intended to correct market failures or account for externalities (e.g., environmental harm), but it
reduces total welfare.
Tax Impact on Welfare:

 After a tax is applied, the total surplus (consumer + producer) is reduced due to the price increase and
the reduction in market quantity.
 The tax shifts the supply curve, affecting producer incentives and altering the overall market outcome.
Key Point:

 Markets are efficient in maximizing surplus but do not address fairness or unmet needs. Taxes and policies
are necessary to correct market failures and account for externalities like environmental damage.

Here’s a more concise summary of the key points from your text:

Tax Impact on Surplus:

 When a tax is introduced, it causes a shift in the supply curve, increasing the price consumers pay and
reducing the price producers receive.
 Tax revenue: The government collects tax revenue, which is the area between the new and old supply
curves, multiplied by the quantity sold.
 Deadweight loss: Taxes create inefficiencies, reducing the total surplus (consumer + producer) and
causing a deadweight loss. This loss represents the market inefficiency due to the tax.
Calculation of Surplus with Tax:

 Consumer Surplus and Producer Surplus are reduced after a tax is applied, and the government’s tax
revenue is an additional area in the model.
 The total surplus after the tax is less than before due to deadweight loss, which measures the lost
efficiency in the market.
Tax Incidence (Who bears the tax burden):

 The elasticity of demand and supply determine who bears the burden of a tax.
 If demand is inelastic (e.g., gasoline), consumers bear most of the tax.
 If demand is elastic (e.g., restaurant meals), producers bear more of the tax burden.
Price Controls & Market Distortions:

 Price caps (e.g., rent controls) can cause excess demand, where more people want the good (e.g.,
apartments) than are available at the capped price.
Consequences of price caps:

 Leads to queues or black markets where people pay above-market prices.

 May create inefficiency and welfare loss as the market cannot allocate goods efficiently.
 However, these policies may be used for social reasons (e.g., affordable housing) despite the economic
drawbacks.
Key Takeaway:

 Taxes and price controls are intended to address externalities or social goals but often lead to market
inefficiencies (deadweight loss). Understanding these trade-offs is essential when designing economic
policies.