1 Chapter 1 Appendix

2 Indifference Curve Analysis Market Baskets are combinations of various goods. Indifference Curves are curves connecting various market basket combinations of goods that make an individual equally happy.

3 Assumptions about Preferences Persons can rank market baskets. Rankings are transitive. More is preferred to less. The marginal rate of substitution is diminishing.

4 Indifference Curves and Indifference Maps

5 Figure 1A.1 Indifference Curves B1B1 50 B2B2 U1U1 U2U2 U3U3 Expenditure on Other Goods per Month (Dollars) 0 Gasoline per Month (Gallons) QxQx

6 The amount of expenditure on other goods that a person will give up in order to get an additional unit of one good is called the marginal rate of substitution. The Marginal Rate of Substitution

7 The Budget Constraint The budget constraint is the combination of goods that a person can afford.

8 The Budget Constraint in Algebraic Terms I = P x Q x +  P i Q i Where: I is income P i is the price of good i Q i is the amount of good i purchased

9 Figure 1A.2 The Budget Constraint Expenditure on Gasoline per Month Expenditure on All Other Goods Except Gasoline per Month C F D 100 A B Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) 0 QxQx

10 Figure 1A.3 Consumer Equilibrium U1U1 U3U3 U2U2 E Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) 0QxQx A B

11 Equilibrium Condition P X = MB X

12 Figure 1A.4 Changes in Income A B Expenditure on Other Goods per Month (Dollars) Q x per Month 0 A' B'

13 Figure 1A.5 Changes in the Price of Good X A B '' B ' B Expenditure on Other Goods per Month (Dollars) 0 Q x per Month

14 Income and Substitution Effects The income effect is the change in the monthly (or other period) consumption of a good due to changing purchasing power of fixed income caused by the good’s price change. The substitution effect is the change in the monthly (or other period) consumption of the good due to the change in its price relative to other goods.

15 Figure 1A.6 Income and Substitution Effects QxQx 100 The Substitution Effect Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) The Income Effect U2U2 U1U1 E' 45 E1E E2E2

16 The Law of Demand The demand curve slopes downward. As the price rises, the quantity demanded falls.

17 Figure 1A.7 The Law of Demand D = MB Price Q x per Month0

18 Price Elasticity of Demand % Change in Quantity Demanded % Change in Price E D = QD/QDQD/QD P/PP/P =

19 Consumer Surplus Net benefit that consumers obtain from a good Total benefit to consumers from obtaining a good, less the money they give up to get the good.

20 Figure 1A.8 Consumer Surplus Consumer Surplus A D = MB Price Gasoline per Month 0 1 Q P B Market Price

21 Figure 1A.9 The Work Leisure Choice U3U3 U2U2 U1U1 E A B 24 Leisure Hours per Day Income per Day 0

22 Budget line for time allocation I = w(24 – L) Where: I is income W is wage L is the amount of time devoted to leisure

23 Analysis of Production and Cost The Production Function is the expression of the maximum output obtainable from any combination of inputs. The Short Run is the period of time in which some inputs cannot be changed. The Long Run is the period of time in which all inputs can be changed.

24 Marginal Product The increase in output associated with a one unit increase in an input is called the Marginal Product.

25 Isoquants Isoquants are curves that show alternative combinations of variable inputs that can be used to produce a given amount of output. The Marginal Technical Rate of Substitution is the amount of one input that can be given up with one additional unit of another input while keeping output constant. It is the slope of the isoquant.

26 Isocost Lines Lines that show combinations of variable inputs that cost the same are called Isocost Lines. C = P L L + P K K Where: C is the total cost P L is the price of labor (typically the wage). L is the units of labor employed. P K is the price of capital (typically a rental price or an interest rate to reflect the opportunity cost of that capital). K is the units of capital employed.

27 Figure 1A.10 Isoquant Analysis Labor Hours per Month Machine Hours per Month 0 Monthly Output = Q 1 L* E K* Isocost Lines

28 Cost Minimization Costs are minimized for every level of output where: MRTS KL = P K /P L

29 Cost Functions Total Cost Variable Cost Average Cost Average Variable Cost Average Fixed Cost Marginal Cost

30 Returns to Scale Constant Returns to Scale AC = MC AC and MC are constant. Increasing Returns to Scale AC < MC AC is diminishing. Decreasing Returns to Scale AC > MC AC is increasing.

31 Profit Maximization Assumption: All firms seek to maximize profits. Operationally, that means that firms will set production where Marginal Revenue equals Marginal Cost; MC = MR.

32 Perfect Competition The situation where: There are many buyers and sellers so that no one buyer or seller has market power. The product being sold is homogenous. There are no legal or economic barriers to entry. Information is freely available. In such a case, the market price is the Marginal Revenue to the firm and that firm will maximize profits where P = MC.

33 Figure 1A.11 Short-Run Cost Curves and Profit Maximization under Perfect Competition Price and Cost Output per Month 0 D = MR P AVC min = F MC AC E Q* Producer Surplus

34 Short-Run Supply Under perfect competition, Supply is the Marginal Cost curve emanating from the minimum of average variable cost curve.

35 Producer Surplus Producer Surplus is the difference between the market price and the minimum price for which the firm would sell the product. It is the area under the price line and above the marginal cost curve. It also represents the profit (less fixed costs) to the firm.

36 Normal and Economic Profit Normal Profit is the opportunity cost of resources of owner-supplied inputs. The value of the firm owners’ time (typically measured by their next job opportunity) plus any other inputs provided by the owner(s). Economic Profit is any profit to the firm that is above normal profit.

37 Long Run Supply In the long run, economic profit is driven to zero under competition. P = LRMC = LRAC min

38 Figure 1A.12 Long-Run Competitive Equilibrium LRAC min = P D = MR Price Output per Month 0 LRMC LRAC Q*

39 Figure 1A.13 Long-Run Supply: The Case of A Constant-Costs Competitive Industry LRACmin = P Long-Run Supply Price Output per Year0

40 Figure 1A.14 A Perfectly Inelastic Supply Curve Supply Price Output per Year 0 Q1Q1

41 Price Elasticity of Supply % Change in Quantity Supplied % Change in Price E S = = QS/QSQS/QS P/PP/P