Principles of Microeconomics

Principles of Microeconomics
Welcome to Day 12 Principles of Microeconomics

What do we want the economy to do
What do we want the economy to do? 1) Produce a lot of stuff 2)Produce the stuff we want the most 3)Distribute various things to people who value those things highly

An economy that does these things is operating efficiently
An economy that does these things is operating efficiently. Efficient The allocation of resources when the net benefits of all economic activities are maximized.

An economy that is operating efficiently has both: 1) Efficient production 2) Efficient allocation of goods.

Will a market economy do these things. How does a business make money
Will a market economy do these things? How does a business make money? Producing a lot of what people want the most and selling it.

The better a business correctly estimates what its customers value, and makes a lot of those things, the higher its profit. And of course, we want the economy to be able to adjust to changing circumstances. Will a market economy do that?

Rainy Winter Increases Demand
Q1 Q2

Can a command economy do this
Can a command economy do this? The incentive problem and the information problem.

The Incentive Problem What does an umbrella businessman get if he gets umbrellas quickly out to a rainy area? What does the 2nd undersecretary of umbrellas in Washington get if he gets umbrellas quickly out to a rainy area?

The Information Problem How does the 2nd Undersecretary of Umbrellas know we need more umbrellas in Bakersfield? How do private business owners of umbrella companies know?

Every time you go shopping, it is a transfer of information fest!!!

You are letting sellers know what you want
You are letting sellers know what you want. Sellers are letting you know what they can make at what cost.

The Invisible Hand Adam Smith – 1776 The Wealth of Nations Because trades are voluntary, in helping yourself, when you are helping yourself, you help others also.

The way for the businessman to make money is to most effectively serve his customers. In doing what is best for him, he is being lead, as if by an “invisible hand” to help society.

So what can go wrong? Market Failure - The failure of private decisions in the marketplace to achieve an efficient allocation of scarce resources.

In other words, we are making too much or too little of something because of a failure to properly take account of its benefits and costs. What markets does the government heavily regulate in the U.S. economy?

Externalities – an action taken by a person or firm that imposes benefits or costs outside of any market exchange.

We’ve seen these pictures earlier this semester, but we didn’t have a name for what they were yet. Now we do.

Quiz today? Magic 8 ball says ….

So what to do? We have seen one solution, which is government regulation of the industry. There is another, which is to charge, or tax, people for the harm they are doing to others. This will “internalize the externality.

Here is our factory causing $100,000 worth of harm to the people around the factory. It could cut the pollution in half by spending $25,000 on scrubbers. Will the owner do it? What if he had to pay $1 in taxes for each $1 harm done by his pollution?

Some people have proposed a “carbon tax” as part of the solution to global warming.

Besides externalities, there is another type of marked failure is known as public goods.

Public Goods A good for which the cost of exclusion is prohibitive and for which the marginal cost of an additional user is zero.

For example, a streetlight placed on a block.

Examples of Public Goods 1) Streetlights 2) Roads 3) National Defense 4) Light Houses 5) Free Television

The Free Rider Problem Free Riders – People or firms that consume a public good without paying for it.

The government gets around the problem by not asking you to pay, but telling you to pay.

In theory, the government can handle this problem
In theory, the government can handle this problem. In practice, we still have our old problems of: 1) information. 2) incentive.

Tragedy of the Commons - What happens when property rights are not assigned?

Once property rights are assigned, problem solved
Once property rights are assigned, problem solved. This is why the cow population is thriving and whales are hunted almost to extinction.

The air is a commons. Unless the government enforces regulation or taxes.

Of course, we have talked about air pollution before, under externalities. The tragedy of the commons isn’t really a new thing, it is a subset of externalities. Who owns the air?

The Analysis of Consumer Choice
Chapter 7 The Analysis of Consumer Choice

1. THE CONCEPT OF UTILITY Learning Objectives
Define what economists mean by utility. Distinguish between the concepts of total utility and marginal utility. State the law of diminishing marginal utility and illustrate it graphically. State, explain, and illustrate algebraically the utility-maximizing condition.

1.1 Total Utility Total utility is the number of units of utility that a consumer gains from consuming a given quantity of a good, service, or activity during a particular time period.

Total Utility and Marginal Utility Curves

1.2 Marginal Utility Marginal utility is the amount by which total utility rises with consumption of an additional unit of a good, service, or activity, all other things unchanged. The law of diminishing marginal utility is the tendency of marginal utility to decline beyond some level of consumption during a period.

Write your name, class day and time, and Quiz #5 at the top of the paper.

The Invisible Hand can work because price allows for the effective use of 1) ____ and 2) ____ in a market economy. Hint: both answers start with the letter “i”.

We’ve seen that when the thing is free, the best thing to do is just take it until marginal utility hits zero. But what if you have to pay a price?

Now the amount of things you can take is limited, so the question is “is getting one more of this worth giving up some of that?”

How do you decide what to buy at the store
How do you decide what to buy at the store? From an economist’s point of view, it is all about comparing how much you like the thing to its price. Buy the things you really like compared to their prices, and don’t buy what you don’t like very much compared to its price.

How much you like the thing is measured by its marginal utility
How much you like the thing is measured by its marginal utility. So the mathematical way to write out the comparison of how much you like one more unit of X compared to the price of X is MUX PX

MUX PX Can also be understood as the utils you get in return for spending $1 more on the good. Spend your dollars on whatever gets you the higher return on those dollars.

1.3 Maximizing Utility The budget constraint is a restriction that total spending cannot exceed the budget available Applying the marginal decision rule The utility gained by spending an additional dollar on good X: EQUATION 1.1 EQUATION 1.2 EQUATION 1.3

1.3 Maximizing Utility Equation 1.3 states:
Utility maximizing condition: Utility is maximized when total outlays equal the budget available and when the ratios of marginal utilities to prices are equal for all goods and services. The problem of divisibility: The marginal decision rule to utility maximization can be applied only when the goods are divisible

2. UTILITY MAXIMIZATION AND DEMAND
Learning Objectives Derive an individual demand curve from utility-maximizing adjustments to changes in price. Derive the market demand curve from the demand curves of individuals. Explain the substitution and income effects of a price change. Explain the concepts of normal and inferior goods in terms of the income effect.

2.1 Deriving an Individual’s Demand Curve
Example: Mary Andrews consumes only apples, denoted by A and oranges, denoted by O Apples cost $2 per pound Oranges cost $1 per pound Budget allows her to spend $20 per month on the two goods Equation 2.1 Equation 2.2 Equation 2.3

Utility Maximization and an Individual’s Demand Curve

Deriving a Market Demand Curve

Chapter 8 Production and Cost

1. PRODUCTION CHOICES AND COSTS: THE SHORT RUN
Learning Objectives Understand the terms associated with the short-run production function—total product, average product, and marginal product—and explain and illustrate how they are related to each other. Explain the concepts of increasing, diminishing, and negative marginal returns and explain the law of diminishing marginal returns. Understand the terms associated with costs in the short run—total variable cost, total fixed cost, total cost, average variable cost, average fixed cost, average total cost, and marginal cost—and explain and illustrate how they are related to each other. Explain and illustrate how the product and cost curves are related to each other and to determine in what ranges on these curves marginal returns are increasing, diminishing, or negative.

1. PRODUCTION CHOICES AND COSTS: THE SHORT RUN
Firms are organizations that produce goods and services. The short run refers to a planning period over which the managers of a firm must consider one or more of their factors of production as fixed in quantity. A fixed factor of production is a factor of production whose quantity cannot be changed during a particular period. A variable factor of production is a factor of production whose quantity can be changed during a particular period. The long run is the planning period over which a firm can consider all factors of production as variable.

1.1 The Short-Run Production Function
A production function captures the relationship between factors of production and the output of a firm. Total, marginal, and average products The total product curve is a graph that shows the quantities of output that can be obtained from different amounts of a variable factor of production, assuming other factors of production are fixed. Slope of the total product curve = ΔQ/ΔL The marginal product is the amount by which output rises with an additional unit of a variable factor. The marginal product of labor is the amount by which output rises with an additional unit of labor. EQUATION 1.1

The average product is the output per unit of variable factor. The average product of labor is the ratio of output to the number of units of labor (Q/L). EQUATION 1.2

Point on graph A B C D E F G H I Units of labor per day 1 2 3 4 5 6 7 8 Jackets per day 0.0 1.0 3.0 7.0 9.0 10.0 10.7 11.0 10.5

From Total Product to the Average and Marginal Product of Labor
Panel (a) Units of labor per day 1 2 3 4 5 6 7 8 Jackets per day 1.0 3.0 7.0 9.0 10.0 10.7 11.0 10.5 Marginal product 2.0 4.0 0.7 0.3 -0.5 Average product 1.5 2.33 2.25 1.78 1.57 1.31

Total Product and Marginal Product Curves
Slope = 0.7 Slope = -0.5 Total product Slope = 2 Slope = 2 Slope = 0.3 Slope = 1 Slope = 4 Slope = 1 Average product Marginal product

Answer whether the following statement is true, false, or uncertain, and explain your answer. A person at the donut shop will buy donuts until the marginal utility of the next donut is zero or negative.

Increasing, Diminishing, and Negative Marginal Returns
Firms experience increasing marginal returns when the range over which each additional unit of a variable factor adds more to total output than the previous unit. Firms experience diminishing marginal returns when the range over which each additional unit of a variable factor adds less to total output than the previous unit. Firms experience negative marginal returns when the range over which additional units of a variable factor reduce total output, given constant quantities of all other factors. The law of diminishing marginal returns state that the marginal product of any variable factor of production will eventually decline, assuming the quantities of other factors of production are unchanged.

Increasing, Diminishing, and Negative Marginal Returns
Increasing marginal returns Negative marginal returns Diminishing marginal returns

1.2 Costs in the Short Run Variable costs are the costs associated with the use of variable factors of production. Fixed costs are the costs associated with the use of fixed factors of production. Total variable cost is a cost that varies with the level of output. Total fixed cost is a cost that does not vary with output. Total cost is the sum of total variable cost and total fixed cost. EQUATION 1.3

From Total Production to Total Cost
11 jackets: variable cost=$700 10 jackets: variable cost=$500 9 jackets: variable cost=$400 9 jackets: variable cost=$400 D’ 3 jackets: variable cost=$200 1 jacket: variable cost=$100 0 jackets: variable cost=$0

From Total Production to Total Cost
Quantity/day 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 Labor/day 1.00 1.63 2.00 2.33 2.58 2.80 3.00 3.38 4.00 5.00 7.00 Total variable cost $0 $100 $163 $200 $233 $258 $280 $300 $338 $400 $500 $700 Diminishing marginal returns Increasing marginal returns

From Variable Cost to Total Cost
$200 Total cost curve Total Fixed cost = $200 $200 Total variable cost curve Diminishing marginal returns Increasing marginal returns

Marginal and Average Costs
Average total cost is total cost divided by quantity; it is the firms total cost per unit of output. EQUATION 1.4 Average variable cost is total variable cost dIvided by quantity; it is the firm’s total variable cost per unit of output. EQUATION 1.5 Average fixed cost is total fixed cost divided by quantity. EQUATION 1.6 EQUATION 1.7 EQUATION 1.8

Total Cost and Marginal Cost
Slope=$200 Slope=$100 Slope=$38 Slope=$62 Slope=$22 Slope=$20 Slope=$33 Slope=$25 Slope=$37 Slope=$63 Slope=$100 Marginal cost curve

Marginal Cost, Average Fixed Cost, Average Variable Cost, and Average Total Cost in the Short Run

2. PRODUCTION CHOICES AND COSTS: THE LONG RUN
Learning Objectives Apply the marginal decision rule to explain how a firm chooses its mix of factors of production in the long run. Define the long-run average cost curve and explain how it relates to economies and diseconomies or scale.

2.2 Costs in the Long Run The Long run average cost curve is a graph showing the firms lowest cost per unit at each level of output, assuming that all factors of production are variable. ATC20 ATC30 ATC50 ATC40 Long-run average cost (LRAC)

Economies and Diseconomies of Scale
Economies of scale refers to a situation in which the long run average cost declines as the firm expands its output. Diseconomies of scale refers to a situation in which the long run average cost increases as the firm expands its output. Constant returns to scale refers to a situation in which the long run average cost stays the same over an output range. Economies and diseconomies of scale affect the sizes of firms operating in a market. Economies of scale Constant returns to scale Diseconomies of scale

Reasons for Economies of Scale 1) Mass Production Assembly Line Machines. 2) Specialization of Labor. Reasons for Diseconomies of Scale 1) Command and Control Problems. 2) Law of Increasing Opportunity Cost (the additional workers are getting worse).

1) This is a reason that marginal product of labor rises in the short run. 2) This is a reason that marginal cost rises in the short run. A) Diminishing marginal returns. B) Law of increasing opportunity costs C) Command and control problems. D) Specialization of labor.

Competitive Markets for Goods and Services
Chapter 9 Competitive Markets for Goods and Services

1. PERFECT COMPETITION: A MODEL
Learning Objectives Explain what economists mean by perfect competition. Identify the basic assumptions of the model of perfect competition and explain why they imply price-taking behavior.

1. PERFECT COMPETITION: A MODEL
Perfect competition is a model of the market based on the assumption that a large number of firms produce identical goods consumed by a large number of buyers.

1.1 Assumptions of the Model
Price takers are individuals or firms who must take the market price as given. Identical goods A large number of buyers and sellers Ease of entry and exit

2. OUTPUT DETERMINATION IN THE SHORT RUN
Learning Objectives Show graphically how an individual firm in a perfectly competitive market can use total revenue and total cost curves or marginal revenue and marginal cost curves to determine the level of output that will maximize its economic profit. Explain when a firm will shut down in the short run and when it will operate even if it is incurring economic losses. Derive the firm’s supply curve from the firm’s marginal cost curve and the industry supply curve from the supply curves of individual firms.

The Market for Radishes

Total Revenue Total revenue is a firm’s output multiplied by the price at which it sells that output. EQUATION 2.1

Total Revenue, Marginal Revenue, and Average Revenue

Price, Marginal Revenue, and Average Revenue
Marginal revenue is the increase in total revenue when the quantity supplied is raised by one unit. For a perfectly competitive firm, the marginal revenue is equal to the price per unit of the good being sold. In a perfectly competitive market, marginal revenue curve is the demand curve that a firm faces.

Price, Marginal Revenue, and Demand

Total Revenue, Total Cost, and Economic Profit

2.3 Applying the Marginal Decision Rule
The slope of the total revenue curve is marginal revenue The slope of the total cost curve is marginal cost When marginal revenue equals marginal cost Economic profit, the difference between total revenue and total cost, is maximized Economic profit per unit is the difference between price and average total cost.

Applying the Marginal Decision Rule

Suffering Economic Losses in the Short Run

Write down one of the two reasons given in class for average total costs to rise in the long run. This question is worth 1 point.

Economic Profit = Total Revenue minus Total Cost
Economic Profit = Total Revenue minus Total Cost. Total cost includes all the implicit costs of production also, such as the value of your time and the rental/sales value of resources you own.

TR goes below TVC P goes below AVC Shutdown Point

Marginal Cost and Supply

In the long-run, if there are economic profits, there will be entry
In the long-run, if there are economic profits, there will be entry. If there are economic losses, there will exit.

3.1 Economic Profit and Economic Loss in the Long Run
The long run and zero economic profits - Economic profits in a system of perfectly competitive markets will, in the long run, be driven to zero in all industries

Eliminating Economic Profits in the Long Run

Eliminating Economic Losses in the Long Run

3.1 Economic Profit and Economic Loss
Entry, exit, and production costs Constant-cost industry is when expansion of the industry does not affect the prices of factors of production Increasing-cost industry is an industry in which the entry of new firms bids up the prices of factors of production and thus increases production costs Decreasing-cost industry is an industry in which production costs fall as firms enter in the long run Long-run industry supply curve is a curve that relates the price of a good or service to the quantity produced after all long-run adjustments to a price change have been completed.

Long-Run Supply Curves in Perfect Competition

3.2 Changes in Demand Changes in demand occur due to a change in:
Preferences Incomes The price of a related good Population Consumer expectations A change in demand causes a change in the market price Thus shifting the marginal revenue curves of firms in the industry

Short-Run and Long-Run Adjustments to an Increase in Demand

Principles of Microeconomics

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