FIRST MEETING PJJ ECN3101: MICROECONOMICS 11 FEBRUARY 2012 (8.30 -10.20AM) SEMESTER 2, 2011/2012
164
FIRST MEETING PJJ ECN3101: MICROECONOMICS 11 FEBRUARY 2012 (8.30 -10.20AM) SEMESTER 2, 2011/2012
description
FIRST MEETING PJJ ECN3101: MICROECONOMICS 11 FEBRUARY 2012 (8.30 -10.20AM) SEMESTER 2, 2011/2012. Chapter 2. The Basics of Supply and Demand. Lecture Outline. Supply and demand Market mechanism Effects of changes in market equilibrium Elasticities of supply and demand - PowerPoint PPT Presentation
Transcript of FIRST MEETING PJJ ECN3101: MICROECONOMICS 11 FEBRUARY 2012 (8.30 -10.20AM) SEMESTER 2, 2011/2012
FIRST MEETING PJJ ECN3101: MICROECONOMICS
11 FEBRUARY 2012 (8.30 -10.20AM)
SEMESTER 2, 2011/2012
Chapter 2
The Basics of Supply and Demand
Lecture OutlineSupply and demandMarket mechanismEffects of changes in market equilibriumElasticities of supply and demandEffects of government intervention- price
controls
Supply and Demand
Supply and demand analysis can:1. Help to understand and predict how world
economic conditions affect market price and production.
2. Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy.
3. Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers
The supply curve
Law of supplyShows the relationship
between the quantity of a good that producers are willing to sell and the price of the good.
Supply curve slopes upward demonstrating a positive relationship between price and output at higher prices firms will
increase output and vice versa
Price
Quantity
P2
P1
Q2Q1
S
Movement and shifting of supply curve
Changes in the quantity supplied
- movement along the curve caused by a change in price
Change in supply
- shift of the curve caused by a change in something other than price such as change in costs of production due to
changes in input prices, technology improvement and increase in number of producers
Other variables affecting supply
• Example: Costs of Production• When cost of inputs (such as
labor, capital and raw materials) used in production changes.
• Lower costs of production allow a firm to produce more at each price.
• Suppose the cost of raw materials falls. Supply curve shifts right to S’.
• Higher costs of production reduces production. Suppose the cost of raw materials increase
• Supply curve shifts left to S”
Price
Quantity
P1
P2
Q1Qo
S
S’
Q2
S”
The Demand Curve Law of Demand Shows the relationship between
the quantity of a good that consumers are willing to buy and the price of the good
o Demand curve slopes downward demonstrating a negative relationship between quantity demanded and price.o consumers are willing to buy
more at a lower price as the product becomes relatively cheaper
Price
Quantity
P2
P1
Q2Q1
D
Movement and shifting of demand curve
Changes in the quantity demand- movements along the demand curve caused by a change in price
Change in demand- a shift of the entire demand curve caused by a change in something other than price (such as income, taste and preferences, number of consumer, etc)
Other variables affecting demandIncome increases in income allow consumers to purchase more at all prices
For normal goods – the relationship between income and demand is positive (income - demand for normal .
For inferior good - the relationship between income and demand is negative.
Price of related goods For substitutes goods (coffee and tea) the relationship – positive Price of coffee – quantity coffee demanded – demand for tea For complements goods (car and petrol) – negative relationship Price of petrol – quantity petrol demanded – demand for car Consumer tastesNumber of consumer
Change in Demand
Income increases Initially purchased Qo at
P2 and Q1 at P1 Now purchased Q1 at P2
and Q2 at P1 Increase in income
↑DD demand curve shifts right.
Income decreases Decrease in income
DD demand curve shifts left.
Price
Quantity
P2
P1
Q1Qo
DD’
Q2
D”
The market mechanism
Is the tendency in a free market for price to change until the market clears.
Markets clear when quantity demanded equals quantity supplied at the prevailing price.
Market clearing price – price at which markets clear or at equilibrium.
The market mechanism
At market equilibriumThere is no shortage
or excess demandThere is no surplus or
excess supplyQuantity supplied
equals quantity demanded (Qd = Qs)
Price
Quantity
Po
Qo
D
S
Market equilibrium
Market surplusIf the market price is
above equilibrium there is excess supply/ surplus (Qs > Qd)
There will be a downward pressure on price.
Qd ↑ and Qs ↓Market adjust until
new equilibrium is reached (E).
Price
Quantity
Po
Qo
D
S
E
surplus
P1
Qd Qs
Market shortage
The market price is below equilibrium there is excess demand or shortage (Qd > Qs)
Upward pressure on prices
Qd ↓ and Qs ↑Market adjust until
new equilibrium is reached (E).
Price
Quantity
Po
Qo
D
S
E
shortageP1
Qs Qd
The Market Mechanism
Supply and demand interact to determine the market clearing price
When not in equilibrium, the market will adjust to eliminate shortage or surplus and return to equilibrium.
Market must be competitive for the mechanism to be efficient.
Changes in market equilibrium (Supply change)
Initial equilibrium at A.Suppose raw material
prices fall – cost of production decrease.
Supply curve shifts to right from S to S’
There is surplus at Po between Q1 and Q2
Price will adjust downward to reach equilibrium at P3 & Q3
Price
Quantity
Po
Q3
D
S
A
P3
Q1 Q2
S’
B
surplus
Changes in market equilibrium (Demand change)
Suppose income increases
Demand curve shifts to right from D to D’
There will be shortage at Po between Q1 and Q2
Price adjust upward to reach equilibrium at P3 and Q3
Price
Quantity
Po
Q3
D’S
AP3
Q1 Q2
B
shortage
D
Changes in market equilibrium (DD and SS change)
Initially market in equilibrium at A (P1, Q1)
Suppose income ↑ & raw material prices ↓.
Both DD and SS curve shifts rightward to D’ and S’.
New equilibrium at B (P2, Q2)
Price and quantity increases
Price
Quantity
P1
D’S
AP2
Q1 Q2
B
D
S’
Shifts in supply and demand
When supply and demand change simultaneously, the impact on the equilibrium price & quantity is determined by:
1. The relative size and direction of the change.
2. The shape of the supply and demand curve.
An Application: Market for a College Education
The supply curve for a college education shifted up as the costs of equipment, maintenance and wages rose - increased costs of production (S1970 shifts to S2002).
DD curve shifted to the right as a growing number of high school graduates desired a college education (D1970 shifts to D2002).
Both price and enrollments rose sharply.
Price (annual cost)
Quantity(millions enrolled)
$2,530
8.6
S1970
A
$3,917
13.2
B
D1970
s2002
D20
02
Elasticities of Supply and Demand
Measures the sensitivity of quantity demanded to price or income changes.
It measures the percentage change in the quantity demanded of a good that results from a one percent change in price or incomes
Price elasticity of demand
Can be written as:Ed = % Δ Qd % Δ P
Ed = Δ Q/ Q X 100 Δ P/ P
Ed = P Δ Q Q Δ P
Price elasticity of demand
Usually a negative number because the relationship between price and quantity demanded is inverse according to law of demand:
1. As price , quantity 2. As price , quantity
When Ed > 1, the good is price elastic (%ΔQ > %ΔP)
When Ed < 1, the good is price inelastic (%ΔQ < %ΔP)
Linear demand curve and elasticity Given a linear DD curve:
Top portion of DD curve is elastic – P is high and Q small.
The bottom portion of demand curve is inelastic – P is low & Q high.
The steeper the DD curve , the more inelastic the good.
The flatter the demand curve , the more elastic the good.
Two extreme cases of demand curve:
Completely inelastic demand – vertical curve
Infinitely elastic demand – horizontal curve
2
4 8
P
Q
Ed = -
Unit elastic
Ed = 0
Elastic (Ed >1)
Inelastic(Ed < 1)
Extreme cases of demand curves
Price
Quantity
Price
Quantity
Ed = -
Ed = 0
Completely inelastic demand Completely elastic demand
Other demand elasticitiesIncome elasticity of demand
Measures how much quantity demanded changes with a change in come.
EI = Δ Q/ Q X 100
Δ I/ I
EI = I Δ Q
Q Δ I
Normal good (positive)
Inferior good (negative)
Other demand elasticities
Cross-price elasticity of demand Measures the percentage change in the
quantity demanded of one good that results from a one percentage change in the price of another good.
EQbPm = Δ Qb / Qb X 100
Δ Pm / Pm EQbPm = Pm ΔQb
Qb ΔPm
Complements : Gasoline and Cars : (negative)(Pgasoline ↑, Qcar ↓)
Substitutes: Butter and margarine (positive)(Pbutter ↑, Qmargarine ↑)
Price elasticity of supply
Measures the sensitivity of quantity supplied given a change in price.
measures the percentage change in the quantity supplied resulting from a one percent change in price
Can be written as:Es = % Δ Qs % Δ PEs = Δ Q/ Q X 100 Δ P/ P
Es = P Δ Qs Qs Δ P
Short-run vs long-run elasticity
To examine how much demand or supply changes in response to a change in price – must consider how much time is allowed for the quantity demanded or supplied to respond to the price change.
Short-run demand and supply curves look very different from the long-run.
Influenced by Demand & durabilityIncome elasticitiesSupply & durability
Short-run vs long-run elasticity
i. Demand and durabilityFor many goods – DD is more price elastic in long-
run than short-run because it takes time for consumer to change their consumption habits.
E.g. if P of coffee rises , the Qd will fall only gradually
If P of gasoline rises, Qd decrease in the short-run but it has greatest impact on demand by inducing consumers to buy smaller & more fuel-efficient cars.
DLR
DSR
Gasoline: Short-run and Long-run Demand Curves
P
Q
1. In the short-run, an increase in price has only a small effect on the quantity of gasoline demanded.
2. Motorists may drive less, but they will not change the kinds of cars they are driving overnight.
3. In the long-run – there is tendency for drivers to shift to smaller and more fuel-efficient cars, so the effect of the price increase will be larger
4. Thus demand is more elastic in the long run than in the short run.
ii. Income elasticities
o Also varies with the amount time consumers have to an income change.
o For most goods & services – food, beverages, fuel, etc. – income elasticity of demand is larger in the long run than in the short run
o This is because the change in consumption takes time, and demand initially increases only by a small amount.
o The long-run elasticity will be larger than the short-run elasticity.
Elasticity of supplyiii. Supply and durabilityo Elasticity of supply also differ from the long run to the short run. o For most products (agricultural products), long run supply is much
more price elastic than short run supply.o Firms face capacity constraints in the short run and need time to
expand capacity by building new production and hiring workers.o The output can be expanded more in the long run than in the short
run.o For some goods & services, short-run supply is completely
inelastic. E.g. rental housing.o In short run, there is only fixed number of rental units. An increase
in demand will only pushes rents up. Only in the long run the quantity supplied increases.
Effects of Price controls
Markets are rarely free of government interventionImposed taxes, grant subsidies and implement
price controlsPrice controls [price ceilings (max) and price floors
(min)] usually hold the price above or below the equilibrium price.
When price is below equilibrium price – there is excess demand (shortage)
When price is above equilibrium price – there is excess supply (surplus)
Effects of Price controlsPrice is regulated to
be no higher than Pmax
Qs falls and Qd increases
A shortage created in the market
Price
Quantity
Po
P max
Qs Qo Qd
shortage
E
S
D
Chapter 3
Consumer Behavior
Consumer Behavior
Consumer preferences- Assumptions- Indifference curves and Indifference maps- The shape of Indifference curves- Marginal rate of substitution (MRS)- Perfect substitutes and perfect complements
Budget Constraints- Budget line- The effects of changes in income and prices
Corner SolutionsMarginal utility and consumer choice
IntroductionHow are consumer preferences used to
determine demand?How do consumers allocate income to the
purchase of different goods?How do consumers with limited income
decide what to buy?How can we determine the nature of
consumer preferences for observations of consumer behavior?
The explanation of how consumers allocate income to the purchase of different goods and services
There are 3 steps involved in the study of consumer behavior
1. Consumer Preferences To describe how and why people prefer one good to
another
2. Budget Constraints Consumer have limited incomes which restrict the
quantities of goods they can buy
3. Consumer choice What combination of goods will consumers buy to
maximize their satisfaction – given their preferences and limited incomes?
Theory of consumer behavior
Consumer Preferences – Basic Assumptions
1. Preferences are complete. Consumers can compare and rank market baskets (for
any market basket A and B – consumer will prefer A to B, will prefer B to A or indifferent (or equally satisfied)
2. Preferences are transitive. If prefer A to B, and B to C, then the consumer must
prefer A to C. Transitivity is normally regarded as necessary for consumer consistency.
3. Consumers always prefer more of any good to less.
More is better – however some goods may be undesirable such air-pollution.
Consumer Preferences
Consumer preferences can be represented graphically using indifference curves
An Indifference curve represent all combinations of market baskets that provide a consumer with the same level of satisfaction. A person will be equally satisfied with either
choice
Indifference Curves: An Example
Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
•Because more of each good is preferred to less:•Basket A preferred to G•E is preferred to A•Indifferent between B, A, & D• A preferred to H – lies below U1
Indifference Curves: An Example
Food
10
20
30
40
10 20 30 40
Clothing
50
U1
G
D
A
EH
B
Indifference Curves
Any market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curve.
Points on the curve are preferred to points southwest of the curve
Indifference curves slope downward to the right.If it sloped upward it would violate the assumption
that more is preferred to less (compare point A and E).
Indifference Maps
To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map
Each indifference curve in the map shows the market baskets among which the person is indifferent.
U2
U3
Indifference Map
Food
Clothing
U1
ABD
Market basket A (U3) is preferred to B (U2).Market basket B (U2) is preferred to D (U1).* U3 generates the highest level of satisfaction followed by U2 and U1
Indifference curves cannot intersect because it violates the assumption that more is better
Food
Clothing
•A and B at U1 so consumer are indifferent between A and B•A and D at U2, so consumer are indifferent between A and D•So this means that consumer are indifferent between B and D – this can’t be true •Because B must be preferred to D because it contains more of both Food and Clothing
U2
U2
U1
U1
A
B
D
A
B
D
EG
-1
-6
1
1
-4
-21
1
The shapes of indifference curves describes how a consumer is willing to substitute one good for another (consumer face trade-offs)
A to B, give up 6 clothing to get 1 foodD to E, give up 2 clothing to get 1 foodThe more clothing and less food a person consumes – the more clothing he will give up in order to obtain more food.
Food
Clothing
2 3 4 51
2
4
6
8
10
12
14
16
The Shape of Indifference Curves
Marginal Rate of Substitution
The slope of the indifference curve is called marginal rate of substitution (MRS)
It quantifies the maximum amount of a good a consumer is willing to give up in order to obtain one additional unit of another good.
Marginal Rate of Substitution
Food2 3 4 51
Clothing
2
4
6
8
10
12
14
16 A
B
D
EG
-6
1
1
11
-4
-2-1
MRS = 6
MRS = 2
The MRS of food F for clothing C is the maximum amount of C that a person is willing to give up to obtain 1 additional unit of F
MRS = - C / F
Diminishing Marginal Rate of Substitution
The MRS decreases as we move down the indifference curveThe MRS went from 6 to 4 to 1
This is because the indifference curves are convex As more of one good is consumed, a consumer would
prefer to give up fewer units of a second good to get additional units of the first one.
Another way of describing this principle is to say that consumers generally prefer a balanced market basket
Perfect Substitutes and Perfect Complements
The shape of an indifference curve describes the willingness of a consumer to substitute one good to another
Indifference curves with different shapes imply a different willingness to substitute
Two extreme cases arePerfect substitutesPerfect complements
Perfect Substitutes
Orange Juice(glasses)
Apple Juice(glasses)
2 3 41
1
2
3
4
0
2 goods are perfect substitutes when the MRS of one good for the other is constant.
Example 1:
A person might consider apple juice and orange juice perfect substitutesThey would always trade 1 glass of OJ for 1 glass of AJ
Example 2:
• Amy likes M&M, plain and peanut. For Amy the MRS between plain and peanut M&M’s does not vary with the quantities she consumes.
Right Shoes
LeftShoes
2 3 41
1
2
3
4
0
PerfectComplements
Two goods are perfect complements when the IC for the goods are shaped as right angles.
Example 1:
1 left shoe and 1 right shoe- both must be used at the same time.
Example 2:
Peter is very choosy about his buttered popcorn. He tops every quart of popped corn with exactly one quarter cup of melted butter.
Measuring Consumer PreferencesThe theory of consumer behavior does not
required assigning a numerical value to the level of satisfaction
Although ranking of market baskets are good (where we use indifference curve to describe graphically consumer preferences), sometimes numerical value are useful
The concept is known as UtilityA numerical score representing the satisfaction
that a consumer gets from a given market basket.
UtilityUtility function
Formula that assigns a level of utility to individual market baskets
If the utility function is
U(F,C) = F + 2CIt tells the level of satisfaction obtained from
consuming F units of food and C units of clothing
o A market basket with 8 units of food and 3 units of clothing gives a utility of
14 = 8 + 2(3)
Utility - Example
Market Basket
Food Clothing Utility
A 8 3 8 + 2(3) = 14
B 6 4 6 + 2(4) = 14
C 4 4 4 + 2(4) = 12
Consumer is indifferent between A & B because the utility is same (14) and prefers both to C because utility is smaller (12)
Utility - Example
Food10 155
5
10
15
0
Clothing
U1 = 25
U2 = 50
U3 = 100A
B
C
If the utility function, U = FCBasket C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5)
If the utility function, U (F, C) = 4FC C 100 = 4 (2.5)(10) A 100 = 4 (5) (5) B 100 = 4 (10) (2.5)
UtilityThere are two types of ranking
Ordinal rankingPlaces market baskets in the order of most preferred to
least preferred, but it does not indicate how much one market basket is preferred to another.
Cardinal rankingUtility function describing the extent to which one market basket is preferred to another
• Because our objective is to understand consumer behaviour it is sufficient to know how consumers rank different baskets with ordinal utility functions.
Budget ConstraintsBudget constraints limit an individual’s
ability to consume in light of the prices they must pay for various goods and services.
The Budget LineIndicates all combinations of two commodities
for which total money spent equals total income.We assume only 2 goods are consumed, so we
do not consider savings (all income are spent)
The Budget Line
Let F equal the amount of food purchased, and C is the amount of clothing.
Price of food = PF and price of clothing = PC
Then PF F is the amount of money spent on food, and PC C is the amount of money spent on clothing. Budget line then can be written:
ICPFP CF
Example: Assume income of $80/week, PF = $1 and PC = $2
Market Basket
Food
PF = $1
Clothing
PC = $2
IncomeI = PFF + PCC
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
C
F
P
P
F
C Slope -
2
1-
The Budget Line
10
20
A
B
D
E
G
(I/PC) = 40
Food40 60 80 = (I/PF)20
10
20
30
0
Clothing
•To see how much of C must be given up to consume more of F. Divide both side with Pc and solve for C.
PF F + Pc C = I
(PF /Pc) F + (Pc/Pc) C = I / Pc
C = I/Pc - (PF /Pc) F
The Budget Line
As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other.
The slope of the line measures the relative cost of food and clothing.
The slope is the negative of the ratio of the prices of the two goods.
The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
The Budget Line - ChangesThe Effects of Changes in Income
An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).
Can buy more of both goods with more incomeA decrease in income causes the budget line to
shift inward, parallel to the original line (holding prices constant).
Can buy less of both goods with less income
In both cases there will be changes in the vertical intercept of the budget line but does not change the slope
The Budget Line - Changes
A increase inincome shiftsthe budget lineoutward
Food(units per week)
Clothing(units
per week)
80 120 16040
20
40
60
80
0
(I = $160)L2
(I = $80)
L1
L3
(I =$40)
A decrease inincome shiftsthe budget lineinward
The Budget Line - Changes
The Effects of Changes in PricesIf the price of one good increases, the budget line
rotates inward, pivoting from the other good’s intercept.
If price of food increases and you buy only food (x-intercept), then can’t buy as much food. The point shifts in.
If buy only clothing (y-intercept), can buy the same amount. No change
The Budget Line - Changes
The Effects of Changes in PricesIf the price of one good decreases, the
budget line rotates outward, pivoting from the other good’s intercept.
If price of food decreases and you buy only food (x-intercept), then can buy more food. The point shifts out.
If buy only clothing (y-intercept), can buy the same amount. No change
The Budget Line - Changes
(PF = 1)
L1
An increase in theprice of food to$2.00 changesthe slope of thebudget line androtates it inward.
L3
(PF = 2)(PF = 0.50)
L2
A decrease in theprice of food to$.50 changesthe slope of thebudget line androtates it outward.
40Food(units per week)
Clothing(units
per week)
80 120 160
40
The Budget Line - ChangesThe Effects of Changes in Prices
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
However, the budget line will shift inward to a point parallel to the original budget line
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
However, the budget line will shift outward to a point parallel to the original budget line
Consumer ChoiceGiven preferences and budget constraints, how do
consumers choose what to buy?Consumers choose a combination of goods that will
maximize their satisfaction, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.They spend all their income – more is better
2. It must give the consumer the most preferred combination of goods and services.
Consumer Choice Consumer will choose highest indifference curve on budget line
where the indifference curve is just tangent to the budget line. Slope of the budget line = the slope of the indifference curve. Recall, the slope of an indifference curve is:
F
CMRS
C
F
P
PSlope
Further, the slope of the budget line is:
Consumer’s optimal consumption point,
C
F
P
PMRS
B
A
D
Clothing
Food
30
20
20 40
Point C – maximum consumer satisfaction MRS = Pf/Pc.
Point B MRS > Pf/Pc satisfaction is not maximized need to F and C
Point D cannot be obtained with the given level of income
Point C MRS < Pf/Pc so satisfaction is not maximized need to F and C
Consumer Optimum Choice
●c
∆10
∆10
Corner SolutionA corner solution exists if a consumer buys in
extremes, and buys all of one category of good and none of another. MRS is not necessarily equal to slope of budget
line
For a corner solution, utility is maximized at a point on one axis where the budget constraint intersects the highest attainable indifference curve at zero consumption for one good with all income used for the other good.
YogurtFrozen
IceCream
P
PMRS
A Corner Solution
Ice Cream (cup/month)
FrozenYogurt
(cupsmonthly)
B
A
U2 U3U1
A corner solutionexists at point B.
Chapter 4
Individual and Market Demand
Chapter 4 78
Topics to be Discussed
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Chapter 4 79
Individual DemandDemand curve can be derived from consumption
choices made by consumer who is faced with budget constraint
Price Changes The impact of a change in the price can be illustrated using
indifference curves. For each price change, we can determine how much of the
good the individual would purchase given their budget lines and indifference curves
When there is a decrease in price, the budget line will rotate outward (Q↑), while when the price increase the budget line will rotate inward (↓Q).
Chapter 4 80
Change in price (price effect and the demand curve)1. Assume Y= $20, Pc = $2 and Pf = $2, $1
and 0.50.
2. Initial equilibrium = A, consume 6C and 4F
3. Suppose there is a fall in the price of food from $2 to $1 (Pc unchanged)
4. Lower Pf rotates the budget line outward new equilibrium at B (consume 4C & 12F)
5. Suppose Pf reduce to $0.50, budget line rotates outward further new equilibrium at C (consume 3C & 20F)
6. The equilibrium points A, B and C used to derive demand curve for food.
7. At every point on DD curve – consumer is maximizing utility by satisfying MRS = Pf/Pc
I1
I2 I3
Q food
Q food
●A
●B●C
Price-consumption curve
6
43
4 12 20P food
Q cloth
4 12 20
DD
$2
$1
.50
●A’
●B’
●C’
Chapter 4 81
Individual Demand Curves – Important Properties
The level of utility changes as we move along the curve (the lower the price of product, the higher the consumer’s purchasing power and the higher its level of utility).
At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS = Pf / Pc .
If the price consumption curve is downward-sloping, the two goods are considered substitutes.
If the price consumption curve is upward-sloping, the two goods are considered complements.
Chapter 4 82
Effect of a Price Change
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50Demand Curve
•E: Pf/Pc = 2/2 = 1 = MRS•G: Pf/Pc = 1/2 = .5 = MRS•H:Pf/Pc = .5/2 = .25 = MRS
When the price falls: Pf/Pc & MRS also fall
Chapter 4 83
Individual Demand Income Changes
Changing income, with prices fixed, causes consumer to change their market baskets.
An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.
Simultaneously, the increase in income shifts the demand curve to the right.
The income-consumption curve traces out the utility-maximizing combinations of food and clothing associated with every income level.
Chapter 4 84
Income changes (income effect & change in demand)1. Assume Pc = $1 and Pf = $2, $1 and Y=
$10, $20 and $30
2. Initial equilibrium = A, consume 3C and 4F
3. Suppose there is a in the income from $10 to $20 there will be a parallel shift outward of budget line new equilibrium at B (consume 5C & 10F)
4. Suppose Y to $30 budget line shifts outward again new equilibrium at C (consume 7C & 16F)
5. Higher income implies consumer will increase their consumption of both goods
6. The effect of income changes are shown with a shift of demand curve to right.
I1
I2
I3
Q food
Q food
●A●B
●C
income-consumption curve
75
3
4 10 16P food
Q cloth
4 10 16D1
$2 ●A’●B’●C’
D2 D3
Chapter 4 85
Normal versus InferiorIncome Changes
When the income-consumption curve has a positive slope:
The quantity demanded increases with income.The income elasticity of demand is positive.The good is a normal good.
When the income-consumption curve has a negative slope:
The quantity demanded decreases with income.The income elasticity of demand is negative.The good is an inferior good.
Chapter 4 86
Effects of Income Changes on inferior goods
Steak
An increase in income, with the prices fixed,causes consumers to alter their choice ofmarket basket.Hamburger is a normal good between point A and B. But becomes an inferior good when the income consumption curve bends backward between B and C.
3
4
A U1
5
10
B
U2
● C
U3
Hamburger
Chapter 4 87
Engel Curves
Income-consumption curves can be used to construct Engel curves
Engel Curves Engel curves relate the quantity of good
consumed to income. If the good is a normal good, the Engel curve
is upward sloping. If the good is an inferior good, the Engel
curve is downward sloping.
Chapter 4 88
Engel Curves
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Engel curves slopeupward for
normal goods.
Chapter 4 89
Engel Curves
Hamburger
30
10
Income($ per
month)
20
4 8 12 16
●A
●B
●C
Inferior
Normal
Chapter 4 90
Income and Substitution Effects
A change in the price of a good has two effects: i. Substitution EffectRelative price of a good changes when price changesConsumers will tend to buy more of the good that has
become relatively cheaper, and less of the good that is relatively more expensive.
ii. Income EffectConsumers experience an increase in real purchasing
power when the price of one good falls.
Chapter 4 91
Income and Substitution Effects
Substitution EffectThe substitution effect is the change in an
item’s consumption associated with a change in the price of the item, with the level of utility held constant.
When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good.
Chapter 4 92
Income and Substitution Effects
Income EffectThe income effect is the change in an item’s
consumption brought about by the increase in purchasing power, with the price of the item held constant.
When a person’s income increases, the quantity demanded for the product may increase or decrease.
Chapter 4 93
Income and Substitution Effects: Normal Good
Food (units per month)O
Clothing(units per
month) R
F1
C1 A
U1
ETotal Effect
SubstitutionEffect
D
The substitution effect,F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.
●B
U2
TF2
C2
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.
The income effect, EF2, ( from D to B) keeps relativeprices constant but increases purchasing power.
Chapter 6
Firm Theory: Production
Chapter 6 95
Topics to be Discussed
The Technology of Production
Production with One Variable Input (Labor)
Isoquants
Production with Two Variable Inputs
Returns to Scale
Chapter 6 96
Production Decisions of a Firm1. Production Technology
Describe how inputs can be transformed into outputs
Inputs: land, labor, capital & raw materials Outputs: cars, desks, books, etc.
Firms can produce different amounts of outputs using different combinations of inputs
2. Cost Constraints Firms must consider prices of labor, capital and
other inputs Firms want to minimize total production costs partly
determined by input prices
Chapter 6 97
3. Input Choices Given input prices and production technology, the
firm must choose how much of each input to use in producing output
Given prices of different inputs, the firm may choose different combinations of inputs to minimize costs If labor is cheap, may choose to produce with more
labor and less capital Firm’s production technology can be represented by
production function
Chapter 6 98
The Technology of ProductionThe production function for two inputs:
q = F(K,L)Shows what is technically feasible when the firm
operates efficiently.Function shows the highest output that a firm can
produce for every specified combinations of inputsOutput (q) is a function of capital (K) and Labor (L)The production function is true for a given
technology If technology increases, more output can be produced for
a given level of inputs
Chapter 6 99
Short Run versus Long RunIt takes time for a firm to adjust production from one set
of inputs to anotherFirms must consider not only what inputs can be varied
but over what period of time that can occur
Short RunPeriod of time in which quantities of one or more
production factors cannot be changedThese inputs are called fixed inputs (capital is fixed and
labour is variable).
Long-runAmount of time needed to make all production inputs
variable.
Chapter 6 100
Production: One Variable InputObservations:
1. When labor is zero, output is zero as well.
2. With additional workers, output (q) increases up to 8 units of labor.
3. Beyond this point, output declines.
4. Increasing labor can make better use of existing capital initially
5. After a point, more labor is not useful and can be counterproductive.
Chapter 6 101
Production: One Variable Input
Average product of Labor - Output per unit of a particular product
Measures the productivity of a firm’s labor in terms of how much, on average, each worker can produce
L
q
Input Labor
Output AP
Chapter 6 102
Production: One Variable Input
Marginal Product of Labor – additional output produced when labor increases by one unit
Change in output divided by the change in labor
L
q
Input Labor
Output MPL
Chapter 6 103
How output varies with changes in labor. Output is maximized at 112 units.
Chapter 6 104
At point D, output is maximized.
Labor per Month
Output per Month
0 2 3 4 5 6 7 8 9 101
Total Product
60
112
A
B
C
D
Chapter 6 105
Average Product
10
20
Output per worker
30
80 2 3 4 5 6 7 9 101 Labor per Month
E
Marginal Product
•Left of E: MP > AP & AP is increasing•Right of E: MP < AP & AP is decreasing•At E: MP = AP & AP is at its maximum•At 8 units, MP is zero and output is at max
Marginal product is positive as long as total output is increasingMarginal Product crosses Average Product at its maximum
Chapter 6 106
Law of Diminishing Marginal Returns
As the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease.
When the labor input is small and capital is fixed, output increases considerably since workers can begin to specialize and MP of labor increases
When the labor input is large, some workers become less efficient and MP of labor decreases
Usually used for short run when one variable input is fixed
Chapter 6 107
Law of Diminishing Marginal ReturnsAssumptions made:Assumes the quality of the variable input is
constantAssumes a constant technology
Changes in technology will cause shifts in the total product curve
More output can be produced with same inputsLabor productivity can increase if there are
improvements in technology, even though any given production process exhibits diminishing returns to labor.
Chapter 6 108
The Effect of Technological Improvement
Output
50
100
Labor pertime period0 2 3 4 5 6 7 8 9 101
A
O1
C
O3
O2
B
As move from A to B to C labor productivity is increasing over time
Chapter 6 109
Long run: Production with Two Variable Inputs
Firm can produce output by combining different amounts of labor and capital
In the long-run, capital and labor are both variable.
Chapter 6 110
1. Each entry in table is the maximum (technically efficient) output that can be produced with each combination of labor and capital
2. E.g. a) 4L and 2C yield 85 units of output
b) various combinations of L and C can produce 75 unit of outputs
3. This information in table can also be presented graphically using isoquants
Chapter 6 111
Labor1 2 3 4 5
q1 = 55
q2 = 75
q3 = 90
1
2
3
4
5
D
E
A B C
Capital
1. Isoquant - curves showing all possible combinations of inputs that yield the same output
2. Output increases as we move from q1=55 to q2=75 and to q3=90
3. A » 3C : 1L and D »1C: 3L = 55
4. B » 3C : 2L = 75
5. C » 3C : 3L = 90
Chapter 6 112
1. Diminishing Returns to Labor with IsoquantsHolding capital at 3 and increasing labor from 0 to 1 to 2 to 3.
Output increases at a decreasing rate (0, 55, 20, 15) illustrating diminishing marginal returns from labor in the short-run and long-run.
2. Diminishing Returns to Capital with IsoquantsHolding labor constant at 3 increasing capital from 0 to 1 to 2
to 3.Output increases at a decreasing rate (0, 55, 20, 15) due to
diminishing returns from capital in short-run and long-run.
Chapter 6 113
Diminishing Returns
Labor per year1 2 3 4 5
Increasing labor holding capital
constant (A, B, C) OR
Increasing capital holding labor
constant (E, D, C
q1 = 55
q2 = 75
q3 = 90
1
2
3
4
5Capitalper year
D
E
A B C
Chapter 6 114
Slope of Isoquant : Substituting Among InputsFirms must decide what combination of inputs to use to
produce a certain quantity of output There is a trade-off between inputs allowing them to
use more of one input and less of another for the same level of output.
Slope of the isoquant shows how one input can be substituted for the other and keep the level of output the same.
Slope of isoquant is the marginal rate of technical substitution (MRTS)
Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant.
Chapter 6 115
The marginal rate of technical substitution equals:
) of level fixed a(for qLK MRTS
input LaborinChange
inputCapitalinChange MRTS
As increase labor to replace capital, Labor becomes relatively less productive, Capital becomes relatively more productive - need less capital to keep output constant, isoquant becomes flatter.
Chapter 6 116
Marginal Rate of Technical Substitution
Labor per month
1
2
3
4
1 2 3 4 5
5Capital per year
Slope measures MRTSMRTS decreases as move down
the isoquants
1
1
1
1
2
1
2/3
1/3
Q1 =55
Q2 =75
Q3 =90
Chapter 6 117
MRTS and Isoquants
Assuming there is diminishing MRTSIncreasing labor in one unit increments from 1
to 5 results in a decreasing MRTS from 1 to 1/2.Productivity of any one input is limited
Diminishing MRTS occurs because of diminishing returns and implies isoquants are convex.
There is a relationship between MRTS and marginal products of inputs.
Chapter 6 118
Rearranging equation, we can see the relationship between MRTS and MPs
MRTSL
K
MP
(MP
K))((MP- L(MP
0 K))((MP L))((MP
K
L
KL
KL
)(
)
))(
Chapter 6 119
Isoquants: Special Cases
Two extreme cases show the possible range of input substitution in production
1. Perfect substitutes MRTS is constant at all points on isoquant Same output can be produced with a lot of
capital or a lot of labor or a balanced mix.
Chapter 6 120
Perfect Substitutes
Laborper month
Capitalper
month
Q1 Q2 Q3
A
B
C
Same output can be reached with mostly capital or mostly labor (A or C) or with equal amount of both (B)
Chapter 6 121
Perfect Complements Fixed proportions production function There is no substitution available between inputs The output can be made with only a specific
proportion of capital and labor Cannot increase output unless increase both
capital and labor in that specific proportion
Chapter 6 122
Fixed-Proportions Production Function
Labor per month
Capitalper
month
L1
K1Q1
A
Q2
Q3
B
C
Same output can only be produced with one set of inputs.
Chapter 6 123
Returns to Scale
Besides tradeoff between inputs to keep production the same, we are also concern on how does a firm decide on the best way to increase output in the long run
One of the way is to change the scale of production by increasing all inputs in proportion (If double inputs, output will most likely increase but by how much?)
There are 3 types of returns to scale (rate at which output increases as inputs are increased proportionately)Increasing returns to scaleConstant returns to scaleDecreasing returns to scale
Chapter 6 124
Increasing returns to scale: Output more than doubles when all inputs are
doubled (input increase 10%, output increases more than 10%)
Larger output associated with lower cost.Arise because the larger scale of operation allows
managers and workers to specialize their tasks and use of more sophisticated equipments and factories
Chapter 6 125
Constant returns to scale: Output doubles when all inputs are doubled (input
increase 10%, output increases 10%)
Size of firm’s operation does not affect productivity.
Decreasing returns to scale: output less than doubles when all inputs are
doubled.
Decreasing efficiency with large size.
Chapter 6 126
Examplea. Electronics & Equipment: Constant Returns to Scale
c. Primary Metal: Increasing Returns to Scale
K
L
K
L
K
L
b. Food: Decreasing Returns to Scale
•
•100
200
100 200
Q=200
Q=100
200
100 •
•Q=142
Q=100
Q=200Q=236
Q=100
200
100
200100
200100
•
•
Chapter 7
The Cost of Production
Chapter 7 128
Topics to be DiscussedMeasuring Cost
Cost in the Short Run
Cost in the Long Run
Long-Run Versus Short-Run Cost Curves
Chapter 7 129
IntroductionProduction technology, together with prices of factor
inputs, determine the firm’s cost of productionThe optimal, cost minimizing, level of inputs can be
determined.A firm’s costs depend on the rate of output and will
change over time.The characteristics of the firm’s production
technology can affect costs in the long run and short run.
Chapter 7 130
Measuring Cost: Which Costs Matter? Economic Cost vs Accounting Cost
Accountants tend to take a retrospective view of firms costs, where as economists tend to take a forward-looking view
Accounting CostActual expenses plus depreciation charges
for capital equipmentEconomic Cost
Cost to a firm of utilizing economic resources in production, including opportunity cost
Accountants and economists often treat depreciation differently as well
Chapter 7 131
Economic costs distinguish between costs the firm can control and those it cannotConcept of opportunity cost plays an important role
Opportunity costCost associated with opportunities that are foregone
when a firm’s resources are not put to their highest-value use.
An ExampleA firm owns its own building and pays no rent for
office space. The building could have been rented instead.
Foregone rent is the opportunity cost of using the building for production and should be included in economic costs of doing business
Economic Costs
Chapter 7 132
Sunk CostAlthough opportunity costs are hidden and should be
taken into account, sunk costs should notSunk Cost
Expenditure that has been made and cannot be recoveredShould not influence a firm’s future economic decisions.
Firm buys a piece of equipment that cannot be converted to another use
Expenditure on the equipment is a sunk costHas no alternative use so cost cannot be recovered –
opportunity cost is zero
Chapter 7 133
Fixed Costs and Variable Costs
Some costs vary with output, while some remain the same no matter amount of output
Total cost can be divided into:
1. Fixed Cost Does not vary with the level of output
2. Variable Cost Cost that varies as output varies
Chapter 7 134
Fixed and Variable Costs
Total output is a function of variable inputs and fixed inputs.
Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs), or…
VC FC TC
Chapter 7 135
Short run versus long run
Which costs are variable and which are fixed depends on the time horizon
Short time horizon – most costs are fixedLong time horizon – many costs become
variable
Chapter 7 136
Fixed Cost Versus Sunk Cost
Fixed cost and sunk cost are often confused
Fixed CostCost paid by a firm that is in business
regardless of the level of output
Sunk Cost Cost that have been incurred and cannot be
recovered
Chapter 7 137
Measuring Costs
Marginal Cost (MC):The cost of expanding output by one unit.Fixed cost have no impact on marginal cost,
so it can be written as:
Δq
ΔTC
Δq
ΔVC MC
Chapter 7 138
Measuring Costs
Average Total Cost (ATC)Cost per unit of outputAlso equals average fixed cost (AFC) plus
average variable cost (AVC).
q
TVC
q
TFC
q
TC ATC
AVCAFC q
TC ATC
Chapter 7 139
A Firm’s Short Run Costs
Chapter 7 140
Determinants of Short-run CostsThe rate at which these costs increase depends
on the nature of the production processThe extent to which production involves diminishing
returns to variable factors
Diminishing returns to laborWhen marginal product of labor is decreasing
If marginal product of labor decreases significantly as more labor is hiredCosts of production increase rapidlyGreater and greater expenditures must be made to
produce more output
Chapter 7 141
Cost Curves for a Firm
Output
Cost($ peryear)
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
VC
Variable costincreases with production and
the rate varies withincreasing &
decreasing returns.
TC
Total costis the vertical
sum of FC and VC.
FC50
Fixed cost does notvary with output
Chapter 7 142
Cost Curves
0
20
40
60
80
100
120
0 2 4 6 8 10 12
Output (units/yr)
Co
st (
$/u
nit
) MC
ATC
AVC
AFC
Chapter 7 143
Cost Curves
When MC is below AVC, AVC is fallingWhen MC is above AVC, AVC is risingWhen MC is below ATC, ATC is fallingWhen MC is above ATC, ATC is risingTherefore, MC crosses AVC and ATC at
the minimumsThe Average – Marginal relationship
Chapter 7 144
Cost Curves for a FirmThe line drawn from
the origin to the variable cost curve: Its slope equals AVCThe slope of a point
on VC or TC equals MC
Therefore, MC = AVC at 7 units of output (point A)
1 2 3 4 5 6 7 8 9 10 11 12 13
Output
P
100
200
300
400
FC
VC
TC
A
Chapter 7 145
Cost in the Long Run
In the long run a firm can change all of its inputs
In making cost minimizing choices, must look at the cost of using capital and labor in production decisions
Chapter 7 146
Cost in the Long RunThe Isocost Line
A line showing all combinations of L & K that can be purchased for the same cost
Total cost of production is sum of firm’s labor cost, wL and its capital cost rK
C = wL + rKFor each different level of cost, the equation
shows another isocost line
Rewriting C as an equation for a straight line:K = C/r - (w/r)L
Chapter 7 147
Cost in the Long Run
Slope of the isocost: -w/r = is the ratio of the wage rate to rental cost
of capital.This shows the rate at which capital can be
substituted for labor with no change in cost.
rwLK
Chapter 7 148
Optimal Combination of inputs
Determined by combining isocosts with isoquants
Firm choose the output to produce and then determine how to do that at minimum costIsoquant is the quantity firm wish to produceIsocost is the combination of K and L that
gives a set cost
Chapter 7 149
Producing a Given Output at Minimum Cost
Labor per year
Capitalper
year
Isocost C2 shows quantity Q1 can be produced withcombination K2L2 or K3L3.However, both of these
are higher cost combinationsthan K1L1.
Q1
Q1 is an isoquant for output Q1.
There are three isocost lines, of which 2 are possible choices in
which to produce Q1
C0 C1 C2
AK1
L1
K3
L3
K2
L2
Chapter 7 150
Input Substitution When an Input Price Change
If the price of labor changes, then the slope of the isocost line change, w/r
It now takes a new quantity of labor and capital to produce the output
If price of labor increases relative to price of capital - capital is substituted for labor as capital are relatively cheaper
Chapter 7 151
Input Substitution When an Input Price Change
C2
The new combination of K and L is used to produce Q1.
Combination B is used in place of combination A.K2
L2
B
C1
K1
L1
A
Q1
If the price of laborrises, the isocost curve
becomes steeper due to the change in the slope -(w/L).
Labor per year
Capitalper
year
Chapter 7 152
Cost in the Long Run How does the isocost line relate to the firm’s production
process?
KL
MPMP- MRTS
LK
rw
LK
lineisocost of Slope
costminimizesfirmwhenrw
MPMP
K
L
rwKL MPMP
Chapter 7 153
Cost in the Long Run
Cost minimization with Varying Output LevelsFor each level of output, there is an isocost
curve showing minimum cost for that output level
A firm’s expansion path shows the minimum cost combinations of labor and capital at each level of output.
Slope equals K/L
Chapter 7 154
A Firm’s Expansion Path
Expansion Path
The expansion path illustratesthe least-cost combinations oflabor and capital that can be used to produce each level of
output in the long-run.
Capitalper
year
25
50
75
100
150
50Labor per year
100 150 300200
A
$2000
200 Units
B
$3000
300 Units
C
Chapter 7 155
Long-Run Versus Short-Run Cost Curves
In the short run some costs are fixedIn the long run firm can change anything
including plant sizeCan produce at a lower average cost in long
run than in short runCapital and labor are both flexible
We can show this by holding capital fixed in the short run and flexible in long run
Chapter 7 156
Capital is fixed at K1To produce q1, min cost at K1,L1If increase output to Q2, min cost
is K1 and L3 in short run
The Inflexibility of Short-Run Production
Long-RunExpansion Path
Labor per year
Capitalper
year
L2
Q2
K2
D
C
F
E
Q1
A
BL1
K1
L3
PShort-RunExpansion Path
In LR, can change capital and min costs falls to K2 and L2
Chapter 7 157
Long-Run Versus Short-Run Cost Curves
In the long-run:Firms experience increasing and decreasing
returns to scale and therefore long-run average cost is “U” shaped.
U-shaped LAC shows economies of scale for relatively low output levels and diseconomies of scale for higher levels Long-run marginal cost curve measures the change in long-run total costs as output is increased by 1 unit.
Chapter 7 158
Long-Run Average and Marginal Cost
Output
Cost($ per unitof output
LAC
LMC
A
Long-run marginal cost leads long-run average cost:
1. If LMC < LAC, LAC will fall
2. If LMC > LAC, LAC will rise3. Therefore, LMC = LAC at the minimum of LAC
4. In special case where LAC if constant, LAC and LMC are equal
Chapter 7 159
Economies and Diseconomies of Scale
Economies of scale (firm able to double output for less then twice the cost)
As output increases, firm’s AC of producing is likely to decline to a point
1. On a larger scale, workers can better specialize2. Scale can provide flexibility to vary the combination
of inputs used – managers can organize production more effectively
3. Firm may be able to get inputs at lower cost if can get quantity discounts. Lower prices might lead to different input mix
Chapter 7 160
Diseconomies of scale (doubling output requires more than twice the cost)
At some point, AC will begin to increase1. Factory space and machinery may make it more
difficult for workers to do their job efficiently
2. Managing a larger firm may become more complex and inefficient as the number of tasks increase
3. Bulk discounts can no longer be utilized. Limited availability of inputs may cause price to rise
Chapter 7 161
The Relationship between Long-Run and Short-Run Cost Curves
We will use short and long-run cost to determine the optimal plant size
We can show the short run average costs for 3 different plant sizes (SAC1, SAC2 and SAC3)
This decision is important because once built, the firm may not be able to change plant size for a while
Chapter 7 162
Long-Run Cost with Economiesand Diseconomies of Scale
Chapter 7 163
The optimal plant size will depend on the anticipated outputIf expect to produce q0, then should build
smallest plant: AC = $8If produce more, like q1, AC rises
If expect to produce q2, middle plant is least cost
If expect to produce q3, largest plant is best
Long-Run Cost with Economiesand Diseconomies of Scale
End
