MICROFOUNDATIONS OF SUPPLY & DEMAND Chap 8,9, and 11.

PREFERENCES & BUDGET CONSTRAINTS Chap 8,9

FRUIT SALAD Bananas cost $5 and Apples cost $10. What is the best fruit salad you can make with $60.

BUDGET CONSTRAINT Income creates limits on how much of each good can be purchased. Deciding to purchase an amount of one, one is a decision not to purchase the other. AppleBanana

UTILITY AND CHOICE Many possible choices which is best. We hypothesize another, more theoretical measure of overall happiness, called utility, which consumers are attempting to maximize. Given their income, consumers choose a shopping basket of goods to get the most utility.

MARGINAL UTILITY: DIMINISHING RETURNS The marginal utility of a good is the amount of extra utility that a consumer can get from consuming a bit more of the good (or the amount of utility they would lose by consuming a bit less of the good). Marginal utility is not constant for any good. Utility is diminishing, meaning that the more of a good you consume, the less extra utility that you get from consuming a bit more of it.

Δ Utility Δ apple AppleUtility Δapple ΔUtility

UTILITY CURVE: FRUIT SALAD ApplesBananas

MARGINAL UTILITY AS A GUIDE LINE FOR MAXIMIZATION. As consumers choose goods to maximize utility, they must ask how much goods add to their utility relative to how much they cost. Choose to buy those goods for which you get the most bang for the buck (i.e. the most extra utility per $ cost). If put more of good A into your market basket and take good B out of your market basket. If put more of good B into your market basket and take good A out of your market basket.

EQUILIBRIUM As you choose more goods with high bang-for-buck, their bang will diminish (diminishing marginal utility). As you put low bang-for-buck goods back, their marginal utility will increase. Eventually, will come to chose a market basket such that

MU B MU B /P B Utility Total Utility Banana Apple MU A MU A /P A

A B PBPB PAPA Budget Constraint If B = 0 If B = P A PAPA PBPB For every extra P A of Bananas that you eat you must give up P B Apples. If A = 0 Slope:

A B PBPB PAPA Budget Constraint For every extra P A of Bananas that you eat you must give up P B Apples. Slope:

INDIFFERENCE CURVES Indifference Curves are a tool for describing trade-offs  Often used to study trade-offs of risk and return. Compare all possible combinations of goods and rank them according to the utility generated by a particular combo.  In particular, find those combos which produce an identical level of welfare.

A B I1I1 I2I2 I3I3 Shape of Indifference Curves Indicate Properties of Consumer Demand More is better – Higher indifference curves generate more utility.  Indifference curves don’t cross Goods are substitutes- To make you just as happy to give up one good you need to get more of the other.  Indifference curves have negative slope. Each good has diminishing marginal utility. To make you just as happy to give up increasing amounts of one good, you need to get an increasing amount of the other good.  Indifference curves are steep toward the left and flatter toward the right. (Negative) Slope of the Indifference Curve is the amount of A you need to compensate you for giving up a unit of B. (Negative) Slope is called the marginal rate of substitution.

Income Good Time I2I2 Income Bad Time Risk Aversion

Return I2I2 Risk I1I1 I2I2 Risk Return Tradeoff

A B I1I1 I2I2 I3I3 Can Do Better Unobtainable F CD E COMPARE INDIFFERENCE CURVES Indifference Curve 3 does not cross the budget constraint. No point is affordable. Indifference Curve 1 crosses the budget constraint, points C and E are affordable. However, by definition, these points are no better than point D and other points directly below the budget constraint which are worse (in utility terms) than points on the budget constraint directly above them. Only an indifference curve that touches but does not cross the budget curve can contain the optimum combo at the tangency point, F. F maximizes Utility

OPTIMAL CHOICE The consumer can maximize utility by being on the highest indifference curve that is in the budget curve set. Best choice is to choose the point on an indifference curve that is tangent to the budget line. At a point of tangency, two lines have the same slope.

PRICE CHANGES AND DEMAND Assume we are at the optimal market basket, Now, assume that the price of bananas goes down, then either the marginal utility of apples must fall or the marginal utility of banana’s must fall. Either banana purchases must rise or apple purchases must fall or both.  Substitution Effect Consumers buy two goods and have a limited amount of income Y. Price of apples goes up and this will reduce the spending power of Y. Either the consumer must drop demand for Apples or Bananas or both.  Income Effect

PRICE OF B GOES DOWN If Good B becomes cheaper, the amount of good A you can buy if you buy B = 0 is unchanged, but each extra unit of B costs more in relative terms. The budget curve flattens and rotates around the vertical axis. The new tangent point implies an optimum with more B. (Consumption of Good A may go up or down depending on complementarity).

A B I1I1 I2I2 F G Equilibrium at point G Price of B drops. Becomes larger Becomes flatter Budget Curve Rotates New Optimum with Higher B

MU B Utility Banana Utility Banana Apple MU A MU B /P B MU A /P A Price of Bananas Goes to 4 Optimal Banana’s Rise, Optimal Apple’s Fall

Apples Bananas I1I1 I2I2 H G Decompose into two parts 1. Move to a combination with a lower MRS Pure Substitution Effect F 2. Move to a higher indifference curve Pure Income Effect

A D I1I1 I2I2 I3I3 PBPB P1P1 P2P2 P3P3 P4P4 I4I4 B B Foundation of Demand Curve

A B I1I1 I2I2 F D Income Declines & Fall Both Apples and Bananas fall Consumer moves to lower indifference curve

Utility Banana Apple Utility Total MU B MU A MU B /P B MU A /P A

Banana Apple Utility Utility Total MU A MU B MU A /P A MU B /P B Apple Banana Income falls to 20

COSTS OF PRODUCTION Chapters 11

Costs: Explicit vs. Implicit Explicit Costs of Production: Direct payments for resources not owned by a firm (raw materials, wages, energy payments, interest payments). Opportunity Cost: Lost payment for best alternative use of input. Implicit Costs: Opportunity Costs of assets owned by firms Ex. Owner of barbershop could earn $100 per hour working as a barber. Implicit cost of the owners time is $100 per hour. Opportunity cost of equity capital is return that could have been earned elsewhere.

Accounting vs. Economic Profits Profits are revenues less costs. Economic profits are revenues less explicit and implicit costs. Economic profits attract competition so they typically don’t last. Accountants do not fully incorporate all implicit costs including cost of equity capital or owner’s contribution of time or expertise. Accountants do incorporate some implicit costs (such as depreciation) into their profit& loss statements.

Short-Run vs. Long Run Firms typically have several types of inputs that they can adjust to adjust production. Long-run - When firms are able to adjust all of their inputs including physical plant. Short-run – When firms are able to adjust only some of their inputs (usually energy, labor, and raw material costs).

Productivity Average Productivity of Labor is output per work unit. Marginal Productivity of Labor is the extra production that is obtained from an extra unit of labor.

Short Run Production Function ΔLabor ΔTP ΔLabor ΔTP Total Product TP

Production in the Short-Run Given a set of fixed inputs (like plant and capital equipment), a firm can vary other inputs (typically labor) in order to vary production. Typically, as you add workers, you get more output. Up to a point, each additional worker adds synergy and adding more workers leads to more and more extra pay-off and marginal product may rise. But at some point, capacity constraints bind, diminishing returns sets in, and the addition of extra workers will generate less and less extra production.

Small Scale Schedule: Bakery

Large Scale Schedule

Productivity Labor productivity depends on the number of workers First, increasing, then, decreasing Average product of labor begins decreasing when marginal product of labor drops below average. Note: Marginal Product crosses through average product at the peak of average product. As long as the next worker adds more product than the average worker, they will increase the average. Once diminishing returns set in, additional workers may add less to output than the average worker, reducing the overall average.

MPL, APL L MPL APL

Fixed Costs vs. Variable Costs In short-run, we distinguish between the costs that are adjustable as production level is adjusted (variable costs) and costs that are unchanged regardless of scale of production (fixed costs). Variable costs (Wages of production workers, supply and raw materials costs) Fixed costs (Depreciation costs, Financial costs, wages of non- production workers).

Types of Costs Total Fixed Costs – Invariant to the number of goods produced (in the short-run) Average Fixed Costs – Decreasing in the number of goods produced. Total Variable Costs- Increasing in the number of goods produced (once synergy point is passed). Total Costs: Fixed Costs + Variable Costs

Bakery: Wages $10 per Worker, $5 Wheat per Loaf

Total Variable Costs are increasing at an accelerating rate. Reason: Diminishing returns to variable inputs.

Costs: Average vs. Marginal Total Costs are the sum of all relevant costs for a firm. Average Costs: Costs per unit of output. Marginal Cost: Extra Cost per Extra Unit of Output.

Cost Schedules

Average and Marginal Costs Average Fixed Costs decreases as production increases AVC, ATC, MC all increase as diminishing returns kick in MC equals AVC and ATC when each of the latter are at their minimum level.

Long Run Costs In the short-run, the size of a firms physical plant is a fixed factor. Over-time, the plant size can adjust. In the bakery example, extra ovens can be added.

Average Total Cost Schedules at Different Scales of Production

Minimizing Costs in the Long Run Consider average total cost schedules at different numbers of ovens. Each oven will have a production level that generates the minimum average total cost. To minimize average costs in the long-run, choose the number of ovens which will have the lowest, minimum average total cost.

Average Total Cost Schedules at Different Scales of Production Minimum of the different cost Schedules Connect the Dots Long Run Average Total Costs

If we adjust capital scale continuously, the collection of minimum points is the Long Run Average Total cost curve LR ATC Short-run ATC Output Cost MC

Economies of Scale When firms are able to adjust all of their inputs, they can choose a size that will minimize costs. If a firm is able to achieve some economies of scale, increasing size will reduce the average total cost. Sources of Economies of Scale Production requires major expenditure on items needed to produce even zero products Ex. Software, pharmaceuticals Production requires many specific steps which can be most efficiently done through specialization Ex. Airplanes, automobiles

Long Run ATC increasing returns to scale. Output Costs LR ATC Economies of Scale

Returns to Scale Scale Economies is not always likely to characterize production. If each production unit can act autonomously with identical costs then we may experience constant returns to scale. Firms at some point experience diseconomies of scale or increasing long run average total costs. Sources of diseconomies of scale Limits of managerial attention. Limits of some other fixed resource.

Long Run ATC decreasing returns to scale. Output Costs LR ATC Constant Returns Scale Diseconomies

Overall Cost Function LR ATC Minimum Efficient Scale Costs Output MES is smallest production level at which the firm can reach the lowest ATC

MES and Market Structure If MES is relatively large in comparison with the market demand: $ Q D LRAC The market is most efficiently served by a single firm---natural monopoly!

MES and Market Structure If MES is relatively small in comparison with market demand: $ Q Many “small” firms in the market.

Learning Outcomes Students should be able to: Examine an indifference curve and budget curve and explain which point maximizes utility and why. Define and calculate various types of economic costs. Fixed, variable, total, average, marginal. Describe the shape of various relevant cost curves Average Total (in LR and SR), Average Fixed, Marginal Costs Describe the relationship between production, productivity (marginal and average) and the law of diminishing returns.