6.0 Representing the Power of the Invisible Hand

6.1.1

Many nations of the world have switched to markets

They are convinced that markets will help nations realize greater wealth by making production more efficient

6.1.2

Marginal cost – how much it costs to make the next unit

Average cost – generic measure of cost, total cost of production divided by total units produced

Unit of Output

MC ACCalculating

AC

1st 100 100 100/1

2nd 90 95 190/2

3rd 80 90 270/3

4th 70 85 340/4

5th 80 84 420/5

6th 90 85 510/6

7th 100 87 610/7

8th 110 90 720/8

9th 120 93 8409

10th 130 97 970/10

6.1.3

Average 27 goals a season

This year you score (at the margin) 35

What happens to average?

It goes up

Margin pulls average along

If margin is higher than average, it pulls it up, and vice versa

6.1.4

$

Figure 6.1.1- Marginal Cost cuts Average Cost at the Minimum Point along AC curve

Units of Output

MC

AC

MC always intersects AC at the bottom or minimum of the AC curve

Marginal always pulls average in its direction

This relationship between MC and AC will be an important part of efficiency

6.1.5

For a firm in the product market,

A profit is when total revenue exceeds total costs

A loss is when total costs exceed total revenue

Breaking even is when total costs and total revenue are the same

Total revenue-

Money it takes in from sale of a product

TR = p X Q

5 cars at $20,000 each = $100,000 total revenue

Total cost-

Amount of money a firm spends on the process of producing

TC = AC X Q

Produces 5 cars at an average of $17,000 each = $85,000 total cost

- Stands for profit

TCTR

In this example,

The firm is making $15,000 profit

$100,000 - $85,000 = $15,000

6.1.6FIRM MARKET

Figure 6.1.2 - The Firm and the Market - Identifying Profit

$

AC1

Q

p

D

Q

MC, Supply Curve

p1

Q1

D1

p1

S1

AC

PROFIT

Market price is p1

Firm will produce Q1 because that is where MC (supply) is

The average cost at Q1 is AC1

Total revenue = p X Q

Total cost = AC X Q

Think of each of these as rectangles

TR > TC

Profit = TR -TC

6.1.7

Profit is revenue above costs

Costs include normal returns

Profit is gravy, it’s nice,

but not necessary to stay in business

Profits mean

that market is a good place to be

Under perfect competition,

firms have no power and all have equal access to information

Profits attract competitors

Market supply shifts out, price falls

profits are driven to zero

Only costs are covered

FIRM MARKET

Figure 6.1.3 - Competition, Market Entry, and the Squeezing of Profits

$

p1

Q

p

D

Q

p1

Q1

MC

AC2, p2

Q2

D2p2

S2

S1Shift in S

Fall inMarketPrice

AC

AC1

D1

6.1.8

Profit is a powerful yet ephemeral signal

It is a magnet that attracts competitors, yet the irony is that

the competition drives profits away

Firms only get normal returns under perfect competition

6.1.9

when profits have been driven to zero by competition

p = MC = ACat the bottom of the average curve lineMaximum productivity, minimal average

costThis is the most efficient point of

production

The self-interested behavior of seeking profits leads to the

most efficient outcome

6.1.10

Perfect competition forces firms to adopt the

most efficient, lowest cost technique

If they don’t, they get left in the dust, as customers move elsewhere,

given our nice assumption of equal access to markets and info

6.2.1

Not only do markets encourage efficiency,

they also encourage creativity and inventiveness

6.2.2

If perfect competition has a firm producing at the bottom of its average cost curve,

it can go on just making normal returns

How can you do better?

You must innovate and become more efficient than your competitors

Such innovation

will lower your cost structure

you could make a profit while others are breaking even

6.2.3

Another way to beat the market is to create a new market niche

First firm in with a new product can make big profits if the market likes it

“Build a better mousetrap”

6.2.4

Competitors will mimic you

Market price will fall, profits will disappear

Markets are always driving people to think of new products,

or better versions of old products,

or more efficient ways of producing

Markets are engines for material progress, which can benefit all

The magic of markets

under perfect competition, firms will be amazingly efficient and innovative

A nation can get the most from its resources

This is the power of the invisible hand

6.2.5

a just distribution

Markets are amoral

They just coordinate choices giventhe distribution of social endowment among

people

individual preferences

the state of technology

However, efficiency doesn’t necessarily mean