Transcript price elasticity of demand

Introduction to Agricultural
Economics
SAB – 101
T-R: 9.30 am – 10.45 am
Fall 2016
Instructor: Sankalp Sharma
Email: [email protected]
Who am I?
A word on my teaching philosophy
About this class
- In class expectation
- Out of class expectation
- Book
- Homework
- Grading
In-class Expectation
- Key to learning: interaction
- Review previous class’ notes before class (same file will be updated)
- Attend all classes (cannot emphasize enough)
Ask questions…
But don’t be a troll!
No cellphones or laptops during the class !!
Out-of-class Expectation
- No gains without practice.
- Reading not enough, you must practice problems.
- Form groups to practice.
- Understand concept, memorization won’t help you.
Book
Introduction to Agricultural Economics 4th edition
(Penson et al.)
Buy used copy from Amazon for $11
Homework
- Frequently assigned.
- Usually only one question.
- A random student will be asked to solve the HW on the
board.
Grading
- Exams will be long and difficult.
- Everything taught in class is fair game.
- But grading will be easy.
- 40% midterm, 40% final, 20% HW, (bonus: 20% class interaction)
Questions?
What is Economics?
Problem
Resources
Required
Solution
What is Economics?
- Solutions often compromised due to several moving parts.
- One solution might be agreeable to a certain group, but not to a
different one.
- Eg: Difficult to make policymaking decisions.
- Best possible solutions rarely achievable.
Economics: How the world works
Consumer
preferences
Producer
wants profit
Creates
Demand
Create Supply
Equilibrium:
create price for
a quantity
Does the previous chart hold true always?
Consumer
preferences
Producer
wants profit
- No, not always
- Producers often influence our preferences.
- Eg: Let’s say a new product Apple Inc. comes out with.
Why is Economics Useful in Agriculture
- Several problems both on the consumer side and producer side.
- Cost-benefit analysis.
- Think of farm/crop insurance subsidies and the need for them.
So let’s begin…
Theory of Consumer Behavior
In the book: chapter 3, part 2: Understanding Consumer
behavior.
What is utility?
What is utility?
 It is a set of preferences.
What does a typical utility function (U) look like?
U(.)
Food, wealth,
health, etc.
What does “my” utility function look like?
U(.)
Food, travel, health,
swimming, relationship
with significant other,
Game of Thrones
Goods
Each item in the box is defined as a “Good”
Utility: The higher the better
What do we require to make our
utility higher?
Answer: Resources
What kind of resources?
What do I mean by a resource?
Provide some examples of resources needed for the following “goods”:
- Food.
- Travel.
- Running.
- Swimming.
Resource for our purposes: Money
- We only focus on money in this class.
- Most things besides “time” can be bought through money.
Utility: In-depth
- In real life difficult to measure someone’s level of utility
- Think of water (measured in gallons)
- But how does one measure somebody’s satisfaction level.
- For eg: you eat two cups of ice-cream, can you tell me how
“happy you are” vs. when you have three cups?
Utils
- Is the scale used to measure utility. (For eg: a scale of 1 to
10)
- It is an arbitrary scale
- No real-life meaning.
- Still useful to get a sense of someone’s level of utility.
Utils: No real life interpretation without
context
- For eg: Let’s say Papa Johns comes up with a new Pizza.
- Most likely, you will tell your friend how many slices you ate
and whether you liked it or not.
- … and not whether you received 7 utils or 10 utils from it.
Utility: Mathematical Representation
- Suppose there are two types of pizzas:
Papa Johns and Dominoes.
Utility value = (quantity of papa johns pizzas) × (quantity of Dominoes pizzas)
A different utility value:
*Utility value = √(quantity of papa johns pizzas) × (quantity of Dominoes pizzas)
*Above equation known as a: utility function as well.
Question: Utility value/utils
Ronald (Ron) Weasley is a student at Hogwarts, he likes two types of drinks:
Butterbeer and Pumpkin juice
His utility function is:
Utility = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑡𝑡𝑒𝑟𝑏𝑒𝑒𝑟 2 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑝𝑢𝑚𝑝𝑘𝑖𝑛 𝑗𝑢𝑖𝑐𝑒
2
He is able to acquire 2 glasses of butterbeer and 3 glasses of pumpkin juice. What is his
utility value?
Solution
Solution
• Ron’s utility = 22 × 32 = 4 × 9 = 36
Another Example:
- Ron’s friend Dean Thomas also goes to Hogwarts and has the following
utility function:
Dean’s Utility = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑡𝑡𝑒𝑟𝑏𝑒𝑒𝑟 2 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑝𝑢𝑚𝑝𝑘𝑖𝑛 𝑗𝑢𝑖𝑐𝑒 2 +
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑡𝑡𝑒𝑟𝑏𝑒𝑒𝑟 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑝𝑢𝑚𝑝𝑘𝑖𝑛 𝑗𝑢𝑖𝑐𝑒
He is able to acquire 1 glass of butterbeer and 4 glasses of pumpkin juice
What is Dean’s utility?
Who was able to acquire a higher utility level?
Solution
Solution
Dean’s utility = 12 × 42 + 1 × 4 = 20
..and who reached a higher utility level?
Ron!
What does a utility curve look like graphically?
See book (chapter 3)
Butterbeers per units of time
Marginal utility (MU)
“Marginal”  English definition: adj. “very narrow /
slight/minor importance.
“Marginal”  Economics definition: “change”
Marginal utility: Change in utility as more of a “good” is
consumed.
Marginal utility
How to find MU?
Formula  MU =
∆ Utility
∆ Butterbeer
"∆" represents an “increase”.
Typically "∆" in the denominator represents an “increase” by 1.
Can you think of a good that decreases
utility?
Marginal Utility
Two components in the formula: change in numerator (∆ utility) and
change in denominator (∆ butterbeer)
∆ utility = Old utility − New utility
∆ butterbeer = 1
Question: Marginal Utility
- Let’s return to our previous examples of Ron and Dean’s
utility:
Suppose now Ron is able to consume 3 glasses of butterbeer
instead of 2. (His consumption of pumpkin juice remains the
same).
What is his marginal utility?
Solution
∗ MUbutterbeer =
∆ Utility
∆ Butterbeer
What is Ron’s change in utility from drinking one more glass of butterbeer?
∆ Utility = Ron′ s new utility − Ron′ s old utility
We have already calculated Ron’s utility at 2 butterbeers, which was:
36
*MUbutterbeer  means marginal utility of butterbeers
Solution
- What is Ron’s new utility?
Recall that Ron’s utility function is:
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑡𝑡𝑒𝑟𝑏𝑒𝑒𝑟
2
× 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑝𝑢𝑚𝑝𝑘𝑖𝑛 𝑗𝑢𝑖𝑐𝑒
2
Previously Ron was drinking 2 glasses of butterbeer, therefore his utility was:
𝟐2 × 32 = 36
Now, he drinks 3 glasses, therefore his new utility is:
𝟑2 × 32 = 81
Solution
-Therefore Ron’s change in utility is:
∆ Utility = Ron′ s old utility − Ron′ s new utility
= 81 – 36 = 45
Question: Dean Thomas’s MU
- Lets suppose dean also gets an extra glass of butterbeer. Recall that he was
originally consuming:
1 glass of butterbeer and 4 glasses of pumpkin juice.
… and his utility function is given by:
Dean’s Utility = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑡𝑡𝑒𝑟𝑏𝑒𝑒𝑟 2 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑝𝑢𝑚𝑝𝑘𝑖𝑛 𝑗𝑢𝑖𝑐𝑒
𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑏𝑢𝑡𝑡𝑒𝑟𝑏𝑒𝑒𝑟 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑝𝑢𝑚𝑝𝑘𝑖𝑛 𝑗𝑢𝑖𝑐𝑒
Find Dean’s marginal utility of butterbeer?
2
+
Homework 1: Marginal utility of pumpkin
juice
- In the previous two examples, suppose instead of Butterbeer, both
Ron and Dean receive an additional glass of pumpkin juice. Find both
Ron and Dean’s marginal utility of pumpkin juice.
Law of Diminishing Marginal Utility
- Draco Malfoy is also Ron’s friend. His utility function is given by:
Utility value =
1 1
x2y2
Let’s say he is initially able to consume, 1 glass of butterbeer and 1 glass of pumpkin juice.
Subsequently, he consumes:
1)
2)
2 glasses of butterbeer, while his pumpkin juice consumption remains the same.
3 glasses of butterbeer, while his pumpkin juice consumption remains the same.
Find his utility level at each of the three levels, tell me his MU of buttebeer after each increase of
butterbeer consumption.
Hint:
1
2
- 2 = 1.44
1
2
- 3 = 1.73
Solution?
Indifference Curves
- Again, let’s return to our butterbeer and pumpkin juice example.
- In our initial eg: Ron was consuming 2 glasses of butterbeer and 3
glasses of pumpkin juice.
- (2,3) is referred to as a consumption bundle.
- That “consumption bundle” got him to a utility level of 36.
Indifference Curves
- Can you think of a different consumption bundle, which gives Ron the
same utility?
- You need to find a different combination of butterbeer and pumpkin
juice consumption which gives Ron the same utility amount?
- Can you find two such combinations?
Indifference curves: Graphical representation
Butterbeer
A and B are two
consumption bundles,
which give the same utility
level.
A
2
B
1
3
6
Utility level = 36
Pumpkin juice
Solution?
(?,?)
(?,?)
Solution
(3,2)
(1,6)
Marginal Rate of Substitution
- Ron “substitutes” pumpkin juice for butterbeer to maintain the same
level of utility.
- MRS (of pumpkin juice for butterbeer) =
∆ butterbeer
∆ pumpkin juice
- Interpretation of the above formula: MRS represents the number of
glasses of butterbeer Ron is willing to give up to consume an
additional glass of pumpkin juice.
What does this imply?
- Butterbeer more valuable for his utility.
- Ron wants 3 glasses of pumpkin juice in exchange for giving up only a
single glass of butterbeer.
Budget Constraint
- Thus far we have been assuming that Ron, Dean and Draco have just
been able to acquire the drinks that increase their utility.
- We know for a fact that nothing in the real world comes without a
price.
- The budget constraint is given by:
price of butterbeer × qty of butterbeer
+ price of pumpkin juice × qty of pumpkin juice = I
Let’s return to Ron’s example
Let price of a single glass of butterbeer be $5 and a single glass of
pumpkin juice be $4.
Given that Ron consumes 2 glasses of butterbeer and 3 glasses of
pumpkin juice. How much Income does he need to satisfy his utility?
Solution?
Solution
- price of butterbeer × qty of butterbeer + price of pumpkin juice ×
qty of pumpkin juice = I
Therefore, Income needed:
5 × 2 + 4 × 3 = $22
Budget constraint: Graphical explanation
- So we just found how much money it would take to buy 2 glasses of
butterbeer and 3 glasses of pumpkin juice = $22.
Suppose we now have 100 bucks and the prices of butterbeer and
pumpkin juice remain the same. How would you graph the curve?
Budget constraint: Graphical explanation
• Equation to graph?
- 5*y+4*x=100
Y  butterbeer
x  pumpkin juice
y
20
25
x
What happens when price of butterbeer
changes?
What happens when price of pumpkin juice
changes?
What happens when price of both changes?
What happens when income increases?
What happens when income decreases?
Midterm
October 31st 2016
- Material Covered up to that date will be in the exam.
Consumer Equilibrium and Market Demand
- Chapter 4, in Introduction to Agricultutal Economics,
Penson et al.
Consumer Equilibrium
- So now we know what an individual’s utility is.
- And we know their budget.
- Can we then find the “consumption bundle” that maximizes their
utility.
- “Equilibrium” definition: A state of balance. Or a steady state.
- “Equilibrium” economics definition: When the no-one has any
incentive to deviate from the current consumption, all things being
constant.
Things you need to find the “best”
consumption bundle:
Price of goods
Utility function
Find Marginal Rate
of Substitution:
Find consumer
equilibrium
Budget
What does consumer equilibrium mean?
It is simply:
- “consumer equilibrium”  is the “demand” for a particular good.
- At equilibrium the consumer identifies the “quantity” of a good,
which he wants to buy at a given price.
What is demand?
A demand curve is a schedule that shows, holding all other factors
constant, the inverse or opposite relationship between the price of a
good and the amount/quantity of good consumed.
Price
Demand curve
3
2
1
2
4
6
Quantity of a
good
The relationship that matters
𝑀𝑅𝑆𝑝,𝑏
𝑃𝑝
=
𝑃𝑏
𝑝  pumpkin juice
𝑏  butterbeer
Goal  Find the point on the line that maximizes utility.
Graphical representation
Butterbeer
A and B are two
consumption bundles,
which give the same utility
level.
For the blue budget
constraint, utility is
maximized at A
A
2
B
1
Utility level = 36
For the orange budget
constraint, utility is
maximized at B.
3
6
Pumpkin juice
Changes in Equilibrium
As stated previously:
-Changes in income or price of goods, would lead to a change in
consumer demand for goods and services.
-This assumes that every other factor remains constant.
Example: Changes in Equilibrium
Albus Dumbledore likes Cauldron Cakes and Treacle tarts at Hogsmeade
village.
Price of cauldron cake: $2
Price of treacle tart: $3
His equilibrium consumption is at: 3 cauldron cakes and 2 treacle tarts.
Graph his indifference curve, point of
consumption and budget constraint.
Now assume that price of cauldron cake
decreases by 1
Two things happen:
 Since Cauldron cake is cheaper, Albus wants to “substitute” cauldron
cakes for treacle tart. This is called the substitution effect
But his effective income also went up because one of the goods
(cauldron cake) is cheaper. So he could consumer more of both goods.
This is called the “income effect”.
Graphical representation: Equilibrium change
𝑡𝑜𝑟𝑔 is the original treacle tart
consumption.
Treacle
tart
𝑐𝑐𝑜𝑟𝑔 is the “original” cauldron
cake consumption.
t 𝑛𝑒𝑤
A  original consumer equilibrium
C
A
t 𝑜𝑟𝑔
B  “substitution” move
B
C  final equilibrium
Substitution
effect
𝑡𝑜𝑟𝑔 is the new treacle tart
consumption.
Income effect
cc𝑜𝑟𝑔
cc𝑛𝑒𝑤
Cauldron cake
𝑐𝑐𝑜𝑟𝑔 is the new cauldron cake
consumption.
Drawing graphs for substitution and income
effects: Steps
- Draw original budget constraint. Mark point of “consumer equilibrium”
- Once price changes, draw new budget constraint. Identify new “consumer
equilibrium”.
- Identify substitution effect. It is the movement on the original indifference
curve
- Draw parallel hyphenated budget constraint to the new budget constraint,
on the original indifference curve. (shown in graph)
- Identify income effect. It is the distance between the hyphenated
constraint and the new budget constraint.
- ** Strongly recommend reading the book!!
Question: draw graph for new equilibrium
when, price of cauldron cake increases by 1.
What would happen if income increased to
50?
- How do the substitution and income effects work then?
Homework 3: Draw graph for when the price
of treacle tart decreases by 1?
Solution?
Market Demand
- The horizontal sum of individual demands is called the “market
demand”.
Albus
Market
Cornelius
Price
=
+
Qty
Qty
Aggregated quantity
Consumer Surplus
Is the difference between the maximum price consumers are willing to
pay and the actual price they actually pay.
Price
10
2
CS
5
Qty
Important disclaimer:
-
Price
10
2
This here is a demand curve,
not a budget constraint!
Remember budget constraint
comes into play when both axis
have two goods.
The demand curve explains the
relationship between price and
quantity of an individual good.
CS
5
How do we find the “consumer surplus”?
Basically find the area of the triangle.
…and what’s the formula?
1
2
Area of triangle = × 𝑏𝑎𝑠𝑒 × ℎ𝑒𝑖𝑔ℎ𝑡
Question: Find the CS for the following
problem
Price
20
4
CS
7
Question: Find the CS for the following
problem
Price
20
4
CS
7
Solution?
Measurement and Interpretations of Elasticities
In the book: Chapter 5 (please review book carefully)
The story so far:
- We have learned about utility.
- From there we get the demand for a good we desire.
- When a group of people have separate demand curves, aggregating
them gives us the market demand.
- What is left is the degree of responsiveness to change in prices and
incomes.
This degree of responsiveness is known as an
elasticity.
Very Elastic
Less Elastic
Price
Price
Quantity
Quantity
Definitions:
1) Own price elasticity of demand or just the price elasticity of
demand is the measure of responsiveness of quantity demanded of
good X to a change in the price of good X.
2) Income elasticity of demand is the measure of responsiveness of
quantity demanded of good X to a change in the income.
3) Cross price elasticity of demand is the measure of responsiveness
of quantity demanded of good Y to a change in the price of good X.
Own Price Elasticity of Demand
How do you find it?
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋
𝑒=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋
Own Price Elasticity of Demand
How do you find it?
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋
𝑒=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋
%∆𝑄
𝑒=
%∆𝑃
Response in quantity
Change in price
response
change
Own price elasticity: Specifics
%∆𝑄
𝑒=
%∆𝑃
Numerator: %∆𝑄 =
Qnew −Qold
Qold
Denominator: %∆𝑄 =
Pnew −Pold
Pold
Own Price Elasticity: Example
Anakin Skywalker is a Pizza enthusiast. His price and quantity
movements are described in the table below.
Find his own price elasticity of demand?
$ per unit
Price
Quantity
4
$3
3 slices
3
$2
5 slices
Pizza demand curve
2
1
1
2 3 4 5 6
Slices per
day
Solution
Q new − Q old 5 − 3 2
%∆𝑄 =
=
=
Q old
3
3
Pnew − Pold 2 − 3 −1
%∆𝑄 =
=
=
Pold
3
3
Put in the formula:
2
%∆𝑄
= 3 = −2
−1
%∆𝑃
3
Own Price Elasticity: Another Question
Luke Skywalker is a Burger enthusiast. His price and quantity
movements are described in the table below.
Find his own price elasticity of demand?
$ per unit
Pizza demand curve
4
3
2
1
1
2 3 4 5 6
Slices per
day
Price
Quantity
$3
3 slices
$2
4 slices
Solution?
Income elasticity of Demand
-Same idea as before. Now we find, measure of responsiveness of
quantity demanded of good X to a change in the income.
$ per unit
Price
new demand
Original demand
𝑋1
𝑋2
Units of X
Income elasticity of Demand
How do you find it?
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑋
𝑒=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
%∆𝑄
𝑒=
%∆𝐼
Response in quantity
Change in income
response
change
Question: Income Elasticity of Demand
Darth Sidious likes owning lightsabers. When his income is $100 his
demand for lightsabers is 20. His income rises by 100% a year later. He
now demands 40 lightsabers. Find his elasticity of demand?
Cross Price Elasticity of Demand
- Cross price elasticity of demand is the measure of responsiveness of
quantity demanded of good Y to a change in the price of good X.
How do you find it?
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑌
𝑒=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋
%∆𝑄𝑌
𝑒=
%∆𝑃𝑋
Cross-Price Elasticities
If the elasticity is:
- Positive: The goods are substitutes
- Negative: The goods are complements
- Zero: The goods are independent.
Homework 3: Cross Price Elasticity of Demand
- Nathan Drake likes to eat two types of cookies: Choco-chip and
Peanut Butter cookies. He was consuming 4 choco-chip cookies and 5
peanut butter cookies. The price of choco-chip cookies went up by
20%, which resulted in him decreasing his choco-chip cookie
consumption by 25% and increasing peanut butter cookie
consumption by 20%.
Find Nathan’s own-price elasticity of demand and cross-price of
elasticity of demand.
Are choco-chip cookies: complements? Substitutes or independent?
Solution?
Introduction to Production and Resource Use
- Thus far we have talked about:
- Consumers and their utility.
- The demand that emerges from that utility.
- We now transition into how that demand gets translated into an
actual product through resource use.
Inputs, Production and Costs
-
Classification of inputs and how they are used in production.
The production function.
Total costs, average costs and marginal costs.
Marginal and Average Revenue.
But first we start with Perfect Competition
What is perfect competition?
“the situation prevailing in a market in which buyers and sellers are so
numerous and well informed that all elements of monopoly are absent
and the market price of a commodity is beyond the control of
individual buyers and sellers.”
**The farm sector comes closer than any other sector of the economy
to satisfying the conditions of perfect equilibrium.
Conditions for Perfect Equilibrium
- The products sold in the market are homogenous. Buyers in the
market choose from a number of sellers.
- Any business can enter the market, without barriers.
- No single seller has a disproportionate influence on price. (That is
imperfect competition, which we will get to later.
**Everything we talk about from here on out assumes the conditions
for perfect equilibrium. Keep that in the back of your mind.
Inputs
- You are a supplier of wheat. You have to make wheat? What do you
require?
Inputs
- You are a supplier of wheat. You have to make wheat? What do you
require?
-
Land
Labor
Capital
Management
The Production Function
A production function characterizes the relationship between the use
of inputs and the level of output.
𝑜𝑢𝑡𝑝𝑢𝑡 = 𝑓(𝑖𝑛𝑝𝑢𝑡 1, 𝑖𝑛𝑝𝑢𝑡 2, … , 𝑖𝑛𝑝𝑢𝑡 𝑛)
Say 𝑛 = 10, there could be more.
𝑜𝑢𝑝𝑢𝑡 is measured in physical quantity. For example: Bushels of wheat
and Gallons of milk.
Total Physical Product Curve
“Shows the relationship between output and one input, while holding
other inputs fixed.
output
TPP curve
Daily labor use
Marginal Physical Product
“Explains how output changes as an input is changed
(increase/decrease).
Formula
𝑀𝑃𝑃 =
∆ 𝑜𝑢𝑡𝑝𝑢𝑡
∆ 𝑖𝑛𝑝𝑢𝑡
1) The MPP measures the rate of change in output in response to a
change in use of labor.
2) When TPP is decreasing MPP is negative.
Average Physical Product
Is defined exactly as the words say. APP is capturing average output per
input use, holding all other inputs constant.
For example: output per hour of labor spent.
APP =
𝑜𝑢𝑡𝑝𝑢𝑡
𝑖𝑛𝑝𝑢𝑡 𝑢𝑠𝑒
Let’s start with an example
-
1
2
3
4
Daily labor use
Daily output
level
MPP
APP
10
1
16
2
20
4.8
22
6.5
26
8.1
32
9.6
40
10.8
50
11.6
62
12.0
72
11.7
MPP =
∆𝑜𝑢𝑡𝑝𝑢𝑡
∆𝑖𝑛𝑝𝑢𝑡
Let’s start with an example
-
1
2
3
4
Daily labor use
Daily output
level
MPP
10
1
16
3
0.33
0.19
20
4.8
0.45
0.24
22
6.5
0.85
0.30
26
8.1
0.40
0.3
32
9.6
0.25
0.30
40
10.8
0.15
0.27
50
11.6
0.08
0.23
62
12.0
0.02
0.19
72
11.7
-0.02
0.15
∆ 2
∆ 1
APP: (2) / (1)
0.1
Relation between MPP and APP
- If MPP is above the APP, the APP must be rising.
- If MPP is below the APP, the APP must be falling.
- The MPP cuts the APP from above, at the point where APP is at its
maximum.
MPP/APP
MPP
APP
Labor Use
Homework 4:
Calculate the MPP and APP for the following table:
Graph the MPP/APP curves?
1
2
3
4
Daily
labor
use
Daily
output
level
MPP
APP
1
10
2
15
?
?
3
45
?
?
4
60
?
?
5
55
?
?
?
Summary of production strategy
- If MPP is rising, it makes sense to increase input use.
- If MPP is falling, irrational to increase input use, since both Average
output and marginal output are declining.
- In some cases average output might flat line, in that case maintaining
inputs is ideal.
Costs
We talked about this: as resources in the very first lecture.
Broadly categorized into two categories:
- Short-run: there are both fixed and variable costs.
- Long-run: there are no fixed costs.
For example: once you bought equipment, it would be considered a fixed
cost for at least a season (short-run). Since you have no choice but to use it.
Short-Run Costs
Short-run Costs:
-Total Variable cost (TVC). (Egs of variables costs?)
-Total Fixed cost (TFC).
TC = TFC + TVC
Graphically understanding: TFC & TVC
- Fixed cost (TFC) creates a flat line along the x-axis.
- Variable cost (TVC), rises with input use.
- Therefore, TFC is also rises along with the TVC
Dollars
500
Total Cost
400
Total variable Cost
300
200
Total fixed Cost
100
1
3
4.8
6.5 8.1 9.6
10.8
11.6
Output
Average Total Cost
- Average total cost (ATC): is the cost per unit of output.
Formula: ATC =
𝑇𝐶
𝑜𝑢𝑡𝑝𝑢𝑡
This formula can be split into two parts, just like the cost function
𝑇𝐹𝐶
Formula: AFC =
𝑜𝑢𝑡𝑝𝑢𝑡
𝑇𝑉𝐶
Formula AVC =
𝑜𝑢𝑡𝑝𝑢𝑡
Understanding the nature of costs
Terms to keep in mind
- ATC
- AFC
- AVC
- AFC declines with production, because cost is fixed cost never changes.
- AVC decline upto a certain point in the output, but rise when output
expands further.
Average Variable cost & the APP curve
- Both curves are basically mirror images.
- The maximum APP in the example shown is at 0.31 and is attained
when daily labor is 26 hours.
- The AVC is at it’s lowest point then. (Graph: next slide)
- When output per unit of labor rises, AVC must necessarily decline.
Short-Run Cost Schedule
Total
ouput
TFC
AFC
TVC
1
100
?
50
3
100
?
80
4.8
100
?
100
6.5
100
?
110
8.1
100
?
130
9.6
100
?
160
10.8
100
?
200
11.6
100
?
250
12.0
100
?
310
11.7
100
?
380
AVC
TC
MC
ATC
AFC = TFC/output
Short-Run Cost Schedule
Total
ouput
TFC
AFC
(2)/(1)
TVC
AVC
(4)/(1)
TC
(2)+(4)
MC
ATC
(3)+(5)
1
100
100
50
50.00
150
150
3
100
33.3
80
26.67
180
60
4.8
100
20.83
100
20.83
200
41
6.5
100
15.38
110
16.92
210
32.31
8.1
100
12.35
130
16.05
230
28.40
9.6
100
10.42
160
16.67
260
27.08
10.8
100
9.26
200
18.52
300
27.78
11.6
100
8.62
250
21.55
350
30.17
12.0
100
8.33
310
25.83
410
34.17
11.7
100
8.55
380
32.48
480
41.03
Marginal Cost (MC)
Defined as: the change in firm’s total costs as output changes.
- The most important cost.
- Both in terms of money and time.
Formula  MC=
∆𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
∆𝑜𝑢𝑡𝑝𝑢𝑡
Also think in terms of time: For instance the marginal cost of money.
You spent tens of hours trying to learn a skill and were able/unable to.
For example: An Olympic swimmer, who trains for years (thinktime as a cost/resource) and
is unable to win a medal.
Returning to our Short-run Cost Schedule
MC is:
Total
ouput
TFC
AFC
(2)/(1)
TVC
AVC
(4)/(1)
TC
(2)+(4)
MC
ATC
(3)+(5)
1
100
100
50
50.00
150
3
100
33.3
80
26.67
180
?
60
4.8
100
20.83
100
20.83
200
?
41
6.5
100
15.38
110
16.92
210
?
32.31
8.1
100
12.35
130
16.05
230
?
28.40
9.6
100
10.42
160
16.67
260
?
27.08
10.8
100
9.26
200
18.52
300
?
27.78
11.6
100
8.62
250
21.55
350
?
30.17
12.0
100
8.33
310
25.83
410
?
34.17
11.7
100
8.55
380
32.48
480
?
41.03
150
Returning to our Short-run Cost Schedule
What is the MC here?:
Total
ouput
TFC
AFC
(2)/(1)
TVC
AVC
(4)/(1)
TC
(2)+(4)
MC
ATC
(3)+(5)
1
100
100
50
50.00
150
3
100
33.3
80
26.67
180
15.00
60
4.8
100
20.83
100
20.83
200
11.11
41
6.5
100
15.38
110
16.92
210
5.88
32.31
8.1
100
12.35
130
16.05
230
12.50
28.40
9.6
100
10.42
160
16.67
260
20.00
27.08
10.8
100
9.26
200
18.52
300
33.33
27.78
11.6
100
8.62
250
21.55
350
62.50
30.17
12.0
100
8.33
310
25.83
410
150.0
34.17
11.7
100
8.55
380
32.48
480
N/A
41.03
150
Understanding the MC curve?
- Why is there an N/A in the table?
- Well you will notice that output in fact declines in the last cell.
- Can’t have a negative MC.
Graph: Marginal & Average Cost
60
MC
50
Dollars
40
ATC
30
AVC
20
AFC
10
3
4.8
6.5 8.1 9.6
10.8
11.6
Output
Graph: Observations
- ATC starts out so high.
- But AVC pulls it down, before ATC starts to rise again through rising
AVC.
- As an example: Think initial farm investment.
Question: Calculate Marginal Cost
Output
Total Cost
MC
1
21
3
51
?
5
71
?
8
81
?
13
101
?
21
131
?
23
171
?
19
211
?
Understanding Revenue: Short-Run Decisionmaking
- Total Revenue = Output price × Output
Marginal Revenue: Is the change in revenue by producing more
output.
Formula  marginal revenue =
∆𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
∆𝑜𝑢𝑡𝑝𝑢𝑡
How much should a firm/company produce?
- Easily one of the most important decisions for the firm.
- Produce too much, while incurring a higher cost. Only to see
consumers not buying your product.
- A business should never increase the use of an input if marginal cost
exceeds marginal revenue.
How much should a firm produce?
- Produce at the point, where:
𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡
- Intuition: The equation above is the point at which the marginal
revenue from the sale of another unit of output equals the marginal
cost of producing that output.
- Economic Profit from production is maximized when the firm
operates where marginal cost is equal to marginal revenue.
In Perfect Competition…
In perfect equilibrium: marginal revenue is the output price.
Consider the following table:
Total ouput
Output
Price
Total
Revenue
TC
Economic
Profit
TC
(2)+(4)
MC
Marginal
Revenue
1
45
?
150
?
150
3
45
?
180
?
180
?
?
4.8
45
?
200
?
200
?
?
6.5
45
?
210
?
210
?
?
8.1
45
?
230
?
230
?
?
9.6
45
?
260
?
260
?
?
10.8
45
?
300
?
300
?
?
11.6
45
?
350
?
350
?
?
12.0
45
?
410
?
410
?
?
11.7
45
?
480
?
480
?
?
In Perfect Competition…
In perfect equilibrium: marginal revenue is the output price.
Consider the following table:
Total output
Output
Price
Total
Revenue
TC
Economic
Profit
TC
(2)+(4)
MC
Marginal
Revenue
1
45
45
150
-105
150
3
45
135
180
-45.00
180
15
45
4.8
45
216
200
16.00
200
11.11
45
6.5
45
292
210
82.50
210
5.88
45
8.1
45
364
230
134.50
230
12.5
45
9.6
45
432
260
172.00
260
20.00
45
10.8
45
486
300
186.00
300
33.33
45
11.6
45
522
350
172.00
350
62.50
45
12.0
45
540
410
130.00
410
150.00
45
11.7
45
526
480
46.50
480
N/A
N/A
A few observations
- The marginal revenue curve is flat, notice again that marginal revenue
curve is the output price.
- The flatness suggests that the firm/business is a price taker.
- The business is small enough to not have a perceptible impact on the
market price.
Bottomline: Average Revenue = Marginal Revenue = Output price.
The profit maximizing level of output is found at the point, where the
marginal revenue curve intersects with the marginal cost curve.
Graphical Analysis:
Breakeven point: Average
Revenue = Average Total
Cost
70
MC
60
50
Dollars
MR
40
Economic Profit
ATC
30
AVC
20
10
0,0
Produce at this output
level
Shut down
point
1
3
4.8
6.5 8.1 9.6 10.8
11.6
Output
Summary of Analysis
- If marginal revenue (same as average revenue/output price) falls to
where the ATC is then: the firm’s average total costs will be the same
as the average revenue. Can still produce, by “breaking even”.
- If MR/AR/Price were to fall further, where it is just tangent to the AVC,
then production must shutdown. Firm can no longer afford to remain
in production.
- Shaded area is the economic profit.
Level of Resource Use
- We have just determined what the profit-maximizing level of output
should be.
So how to find the optimal input use level?
- Compare profit-maximizing output level to actual input use.
Let’s return to the very first table
1
2
3
4
Daily labor use
Daily output
level
MPP
10
1
16
3
0.33
0.19
20
4.8
0.45
0.24
22
6.5
0.85
0.30
26
8.1
0.40
0.3
32
9.6
0.25
0.30
40
10.8
0.15
0.27
50
11.6
0.08
0.23
62
12.0
0.02
0.19
72
11.7
-0.02
0.15
∆ 2
∆ 1
APP: (2) / (1)
0.1
But there is another way
Profit-maximizing input demand:
Marginal Benefit from input use =
Product (MVP).
∆𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
∆𝑖𝑛𝑝𝑢𝑡
= Marginal Value
We were using Labor initially so,
Marginal Value product for Labor = 𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟 × 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑝𝑟𝑖𝑐𝑒
MPP vs MB
Profit-maximizing level of input
- Occurs when,
𝑀𝑉𝑃𝑙𝑎𝑏𝑜𝑟 = 𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒
Here, if additional labor were applied the marginal cost would exceed
the marginal benefit of labor use.
Which would no longer be the profit-maximizing point.
Marginal Value Product Example
Use of
Labor
MPP
MVP
($45 price)
Wage
Marginal
Net Benefit
Cumulative
Net Benefit
16
0.33
?
5.00
?
?
20
0.45
?
5.00
?
?
22
0.85
?
5.00
?
?
26
0.40
?
5.00
?
?
32
0.25
?
5.00
?
?
40
0.15
?
5.00
?
?
50
0.08
?
5.00
?
?
62
0.03
?
5.00
?
?
76
-0.02
?
-
-
-
10
Marginal Value Product Example
Use of
Labor
MPP
MVP
Wage
Marginal
Net Benefit
(3) / (4)
Cumulative
Net Benefit
16
0.33
14.85
5.00
9.85
9.85
20
0.45
20.25
5.00
15.25
25.10
22
0.85
38.25
5.00
33.25
58.35
26
0.40
18.00
5.00
13.00
71.35
32
0.25
11.25
5.00
6.25
77.60
40
0.15
6.75
5.00
1.75
79.35
50
0.08
3.60
5.00
-1.40
77.95
62
0.03
1.35
5.00
-3.65
74.30
76
-0.02
-0.90
-
-
-
10
Conclusion
Because the MVP is nothing but the MPP multiplied by a fixed price.
The slope of the MVP mirrors that of the MPP.
If you fix output price as 1, then we can also say:
𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟 = 𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒
Homework 5:
1
2
3
4
5
6
Daily
labor
use
Daily
output
level
MPP
MVP
($5
price)
Wage rate
Marginal Cumulative
Net
Net Benefit
Benefit
1
10
2
15
?
?
3
?
?
3
30
?
?
3
?
?
4
47
?
?
3
?
?
5
60
?
?
?
?
?
6
65
?
?
?
?
?
7
55
?
?
-
3
Draw a graph/s for all the curves.
7
?
?
Midterm Reminder
- As previously discussed. Midterm is on the 31st of October
- Questions from material in Chapters 3 through 7 will be asked in the
exam.
- Mix of multiple choice and fill in the blanks questions.
- Won’t be required to draw graphs.
- Some questions will have a special answer choice: “Unsure,
explanation below”. Good way to get extra credit.
- All the questions will come from material covered in the notes.
- You don’t have to worry about anything not in the notes.
General Advice About the Midterm
Economics of Input and Product Substitution
Chapter 7: In the book.
Understanding interaction of inputs
- In the previous chapter, we focused on varying use of one input.
- The purpose was to understand:
- Important production concepts.
- Their relationship to the cost of production.
- And the profit-maximizing level of output.
We now expand this discussion to include two inputs and input
substitution.
The purpose of this chapter is to explain the economics of input
substitution in the short-run and long-run.
Isoquant
A curve that reflects the combination of two inputs that result in a
particular level of output is called an isoquant.
- Along the isoquant, an infinite number of combinations of two inputs
(say labor and capital) give the same level of output.
- As the quantity of labor increases less capital is necessary to produce
a given level of output.
Graphical comparison of Isoquants and
Isoutility.
- Notice the similarities.
butterbeer
capital
isoquant
isoutility
𝑈1
𝑌1 =20
𝑈0
𝑌0 =10
Pumpkin
juice
labor
Isoquants Continued
- A higher level of isoquant implies a higher output.
Question: Would a producer always want to increase his/her output?
Isoquants Continued
- A higher level of isoquant implies a higher output.
Question: Would a producer always want to increase his/her output?
Answer: No. Recall that the goal of the producer is profit-maximize,
excess production only increases his marginal cost.
And as mentioned in the previous chapter if marginal cost > marginal
revenue, then the producer should not use any more inputs.
Marginal Rate of Technical Substitution
(MRTS)
- Recall earlier, when we were talking about utility, we talked about
marginal rate of substitution.
- That was defined as the rate at which a consumer would give up
consumption of one good for the other, such that his utility remains
the same.
-RTS is the exact same idea: how much would a producer substitute
one input for the other to maintain the same level of output.
Mathematical representation
Formula,
𝑀𝑅𝑇𝑆𝑐𝑎𝑝𝑖𝑡𝑎𝑙,𝑙𝑎𝑏𝑜𝑟 =
∆𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟
=
∆𝑙𝑎𝑏𝑜𝑟
𝑀𝑃𝑃𝑐𝑎𝑝𝑖𝑡𝑎𝑙
- Therefore, the MRTS (capital for labor) is nothing but the ratio of
The above equation indicates the change in labor must be
compensated by changes in capital to keep the output at the same
level.
MRTS: Further explained
- When labor is substituted for capital along an isoquant, the MRTS of
capital for labor falls.
- Just like MRS (in utility theory), a declining MRTS is the consequence of the
law of diminishing marginal returns.
- Recall that after some point as you increase labor the MPP falls.
Also keep in mind that while having any combination of inputs on an
isoquant is going to keep the output at the same level, there is only a certain
region of input choices, which maximize profit.
Eg: Think of a producer trying to decide between two types of fertilizers.
MRTS: Extreme Cases
Substitute inputs at the extreme can be either perfect substitutes or
perfect complements.
The isoquants we have seen in the graph, can be called imperfect
substitutes.
Understanding Min and Max functions:
For a perfect complement:
𝑜𝑢𝑡𝑝𝑢𝑡 = min(𝑖𝑛𝑝𝑢𝑡1, 𝑖𝑛𝑝𝑢𝑡2)
“Min” here stands for minimum function
 “Max” stands for maximum function
“Min” function continued
For example. Suppose an engine requires 1 part of two different inputs.
You have 10 parts of the first input and 12 parts of the second.
How many engines can you make?
𝑜𝑢𝑡𝑝𝑢𝑡 = min(10,12)
= 10
Having two additional parts of the second input is a waste because you
can’t use them.
You can think of other examples in agriculture.
The Iso-Cost line
- Again, the same idea as before: just like a consumer’s budget
constraint: An Iso-cost line is nothing but a producer’s budget
constraint.
For example:
$10 × 𝑢𝑠𝑒 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟 + $100 × 𝑢𝑠𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = $1000
𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒
𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑙𝑖𝑛𝑒 = −
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
Slope of the given budget line is?
Always remember, to find the slope of any equation convert it to the
form:
𝑦 = 𝑎 + 𝑏𝑥
Y value to put on the vertical axis.
X value to put on the horizontal axis.
b slope of the line.
A the intercept.
Graph of Iso-Cost line
capital
20
15
10
5
50
100
150
200
labor
If the budget doubles then?
capital
20
15
10
5
50
100
150
200
labor
If budget doubles then?
capital
20
15
10
5
50
100
150
200
labor
If the budget halves then?
capital
20
15
10
5
50
100
150
200
labor
Draw graphs for when wage rate decreases to
$5
Homework 6: Isoquant & Isocost
Question: Suppose there is a pumpkin juice producer, the wage rate for
employed labor is $10 an hour and the cost of capital is $100. Based on this
information, answer the following questions.
1) Let’s say the hourly budget is: $1000. Draw iso-cost line.
2) What is the least cost level of capital and labor this business should
utilize when packaging 1000 cases of pumpkin juice? How did you arrive
at this answer?
3) How much does it cost his business to package 1000 cases of pumpkin
juice?
4) If the firm can sell the juice for $50 per case, what is the profit?
Least-cost use of inputs for a given output
Two input decisions, a business faces in the short-run that pertain to
input use:
- First is the least cost combination of inputs to produce a given level of
output.
- Second is the least cost combination of inputs to produce a given a
level of budget.
Short-run Least Cost Input Use
The business wants to produce a given level of output and wants to
do so at the lowest possible cost.
- Graphically: this is the point where the iso-cost line is just tangent ot
the isoquant curve.
- Notice again the analogous nature of this setup and the one in
consumer theory.
Graphical comparison
Producer
Consumer
butterbeer
producer’s iso-cost
Consumer’s budget
constraint
Capital
isoquant
isoutility
H
𝑈1
𝑌1 =20
G
𝑈0
𝑌0 =10
Pumpkin
juice
Labor
Relation between MRTS and input price ratio
- The slopes at the point where the Iso-cost line touches the isoquant
are the same. (Point G or H) in the previous slide.
- At this point the MRTS of capital for labor (𝑀𝑅𝑇𝑆𝑐𝑎𝑝𝑖𝑡𝑎𝑙,𝑙𝑎𝑏𝑜𝑟 ) is
equal to the input price ratio.
Mathematically,
⇒ 𝑀𝑅𝑇𝑆𝑐𝑎𝑝𝑖𝑡𝑎𝑙,𝑙𝑎𝑏𝑜𝑟
𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟
𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒
=
=
𝑀𝑃𝑃𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑛𝑡𝑎𝑙 𝑟𝑎𝑡𝑒
Notice again the parallel with consumer
theory
Consumer theory
MRS =
𝑀𝑈𝑔𝑜𝑜𝑑1
𝑀𝑈𝑔𝑜𝑜𝑑2
=
𝑝𝑟𝑖𝑐𝑒𝑔𝑜𝑜𝑑1
𝑝𝑟𝑖𝑐𝑒𝑔𝑜𝑜𝑑2
Producer theory
𝑀𝑅𝑇𝑆𝑐𝑎𝑝𝑖𝑡𝑎𝑙,𝑙𝑎𝑏𝑜𝑟
𝑀𝑃𝑃𝑙𝑎𝑏𝑜𝑟
𝑤𝑎𝑔𝑒 𝑟𝑎𝑡𝑒
=
=
𝑀𝑃𝑃𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑛𝑡𝑎𝑙 𝑟𝑎𝑡𝑒
Long-Run Expansion of Input use
- Thus far we have talked about short-run input use decisions.
- Some costs are fixed, others are variable in the short-tun
- In the long-run, all costs are variable.
Long-Run Average Costs (LAC)
Recall that: 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝑂𝑢𝑡𝑝𝑢𝑡
However, we were talking about that ATC in the “short-run”. Think
perhaps of costs of a farmer for 1 season.
Cost per unit
A typical short-run average cost curve can be graphically expressed as:
SAC
output
- The presence of the fixed cost gives the SAC its u-shape.
- Consider the following SAC curves:
𝑆𝐴𝐶𝐶
Cost per unit
𝑆𝐴𝐶𝐴 𝑆𝐴𝐶𝐵
O
-
A
B
C
output
The average costs represents the sizes of three business: A, B and C.
A is the smallest with costs represented by: 𝑆𝐴𝐶𝐴
B is larger, with average cost curve as: 𝑆𝐴𝐶𝐵
C is largest, with curve being: 𝑆𝐴𝐶𝐶
The values OA, OB and OC on the horizontal axis depict the least cost
output level.
- If the business decides it wants to get bigger from A to C, it can
produce at OC instead of OA.
- The point of the previous slide is to show, how the “long-run” average
cost evolves as business alter their sizes.
- The long-run average cost curve, illustrates to the business how
varying its size will effect the business’s economic efficiency.
LAC: Definition & Graph
Cost per unit
Is comprised of points on a series of short-run average cost curves.
- The idea is to determine the profitability of different sizes of
operations.
- Since the business eventually desires to expand.
Graph:
LAC
output
Returns to Size
- Constant returns to size (CRS): An increase in output caused by an
exactly proportional increase in inputs. For example: doubling inputs
causes output to double.
- Increasing returns to size (CRS): An increase in output more than
proportional increase in inputs. For example: doubling inputs causes
output to triple.
- Decreasing returns to size (CRS): An increase in output more than
proportional increase in inputs. For example: doubling inputs causes
output to triple.
Production Possibilities Frontier
- Thus far we have examined issues associated with the combination of
inputs used by a business.
- We focused on the degree to which one input could be substituted
for another to producer a given level of output.
It is also important to understand the substitution among the
different products the business can produce.
Production Possibilities Frontier
- Chapter 6 introduced the concept of technical efficiency by indicating
the minimal of hours required to produce given levels of output.
Technical Efficiency: “maximum output possible from the given level of
inputs”.
Production Possibilities Frontier: Illustrates the maximum output for
different combinations of two products a firm can produce.
An Example:
- A company has an option of canning either all fruit, all vegetables or
some combination of these two products:
- The company has a fixed canning capacity.
Marginal Rate of Transformation (MRT)
- Represents the rate at which the canning of fruit must contract
(expand) for a one-case increase (decrease).
∆ 𝑐𝑎𝑛𝑛𝑒𝑑 𝑓𝑟𝑢𝑖𝑡
𝑀𝑅𝑇 =
∆ 𝑐𝑎𝑛𝑛𝑒𝑑 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠
Marginal Rate of Transformation (MRT)
Cases of Canned Fruit
Cases of Canned Vegetables
Marginal Rate of
Transformation
135,000
0
128,000
10,000
?
119,000
20,000
?
108,000
30,000
?
95,000
40,000
?
80,000
50,000
?
63,000
60,000
?
44,000
70,000
?
23,000
80,000
?
0
90,000
?
Marginal Rate of Transformation (MRT)
Cases of Canned Fruit
Cases of Canned Vegetables
Marginal Rate of
Transformation
∆(1)/ ∆ (2)
135,000
0
128,000
10,000
-0.7
119,000
20,000
-0.9
108,000
30,000
-1.1
95,000
40,000
-1.3
80,000
50,000
-1.5
63,000
60,000
-1.7
44,000
70,000
-1.9
23,000
80,000
-2.1
0
90,000
-2.3
PPF: Graph
Canned fruit
140
- The end points indicate
specialization in either
canning fruit or canning
vegetables.
PPF curve
120
100
80
- Any point on the line would
result in the canning of
some of both commodities
with the same inputs
60
40
20
0
20
40
60
80
100
120
140
Canned vegetables
Profit-Maximizing Combination of Products
- The ISO-Revenue line is:
= 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑎𝑛𝑛𝑒𝑑 𝑓𝑟𝑢𝑖𝑡 × 𝑐𝑎𝑛𝑛𝑒𝑑 𝑓𝑟𝑢𝑖𝑡
+ 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑎𝑛𝑛𝑒𝑑 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠 × 𝑐𝑎𝑛𝑛𝑒𝑑 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠
Slope of this line is?
Profit-Maximizing Combination of Products
- The ISO-Revenue line is:
= 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑟𝑢𝑖𝑡 × 𝑓𝑟𝑢𝑖𝑡 + 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠 × 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠
Slope of this line is?
𝑝𝑟𝑖𝑐𝑒 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠
𝑠𝑙𝑜𝑝𝑒 = −
𝑝𝑟𝑖𝑐𝑒 𝑓𝑟𝑢𝑖𝑡
Another way to remember the slope
Profit-Maximizing Combination of Products
The profit maximizing business seeks to maximize the revenue for the
least cost combination of inputs.
The business wants to determine the point where the MRT equals the
relative prices of the products being sold.
𝑀𝑅𝑇 = 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝐼𝑆𝑂 − 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐿𝑖𝑛𝑒
∆ 𝑐𝑎𝑛𝑛𝑒𝑑 𝑓𝑟𝑢𝑖𝑡
𝑝𝑟𝑖𝑐𝑒 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠
⇒
=−
∆ 𝑐𝑎𝑛𝑛𝑒𝑑 𝑣𝑒𝑔𝑒𝑡𝑎𝑏𝑙𝑒𝑠
𝑝𝑟𝑖𝑐𝑒 𝑓𝑟𝑢𝑖𝑡
Let’s return to the table
Cases of Canned
Fruit
Cases of Canned
Vegetables
Revenue: price fruit: Marginal Rate of
$33.33, price
Transformation
vegetables:
∆(1)/ ∆ (2)
Slope
135,000
0
?
128,000
10,000
?
-0.7
?
119,000
20,000
?
-0.9
?
108,000
30,000
?
-1.1
?
95,000
40,000
?
-1.3
?
80,000
50,000
?
-1.5
?
63,000
60,000
?
-1.7
?
44,000
70,000
?
-1.9
?
23,000
80,000
?
-2.1
?
0
90,000
?
-2.3
?
Let’s return to the table
Cases of Canned
Fruit
Cases of Canned
Vegetables
Revenue: price fruit: Marginal Rate of
$33.33, price
Transformation
vegetables: $25
∆(1)/ ∆ (2)
Slope
135,000
0
4,449,550
128,000
10,000
4,516,240
-0.7
0.75
119,000
20,000
4,446,270
-0.9
0.75
108,000
30,000
4,349,640
-1.1
0.75
95,000
40,000
4,166,350
-1.3
0.75
80,000
50,000
3,916,400
-1.5
0.75
63,000
60,000
3,599,790
-1.7
0.75
44,000
70,000
3,216,520
-1.9
0.75
23,000
80,000
2,766,590
-2.1
0.75
0
90,000
2,250,000
-2.3
0.75
Solution?
Where is the profit maximizing point?
Understanding it Graphically
Canned fruit
140
PPF curve
120
Iso-Revenue
Line
100
80
60
40
20
0
20
40
60
80
100
120
140
Canned vegetables
What happens when price of fruit decreases
to $25?
-
Find new slope?
Canned fruit
140
Draw the profit maximizing
point on the graph?
PPF curve
120
Iso-Revenue
Line
100
80
60
40
20
0
20
40
60
80
100
120
140
Canned vegetables
Market Equilibrium in Perfect Competition
- Thus far we have discussed individual demand and market demand
- This represents only 1 half of the relationship needed to understand
changing market conditions.
- We now turn our attention to the market supply curve.
Recall that in the previous two chapters we discussed the producer’s
production strategies.
All we are doing is simply extending the discussion to several
producers.
Review of the individual Supply Curve
Derivation: Market Supply
- Recall the individual business’s supply curve, is derived at the point
where marginal cost = marginal revenue.
Market Supply curve: found by horizontally summing individual
supplies.
Graphically
Consider two growers of broccoli: A and B
Price
Broccoli
Price
Broccoli
Price
Broccoli
3.00
3.00
3.00
2.50
2.50
2.50
2.00
2.00
2.00
+
1.50
=
1.50
1.50
1.00
1.00
1.00
0.50
0.50
0.50
1
2
3
4
5
6
Quantity Broccoli
1
2
3
4
5
6
Quantity Broccoli
1
2
3
4
5
6
Quantity Broccoli
Graph: Explanation
- Grower A would be willing to supply 1 ton of fresh broccoli if the
market price of were $1.00 per pound
- And 2 tons if price was $1.50 per pound.
- Grower B on the other hand would not produce at $1.00 per
pound.
- He/she wants $1.50 per pound to produce 1 pound of broccoli.
Graph: Explanation
Now suppose that the market supply of broccoli was limited to these
two suppliers then:
Market Supply:
At $1.00 per pound, the supply is 1 pound of broccoli.
At $1.50 per pound, the supply is 3 pounds of broccoli.
How did we get that?
Market Supply generally has a positive slope.
Because quantity supplied increases as the price received increases.
Producer’s Surplus
Producer surplus is the economic return above the firm’s variable cost
of production.
- When economic profit exists, surpluses are accruing to businesses.
- A business will supply the first unit of output at the price equal to
marginal cost of producing it.
- Say, MC was $1 and product price was $4, then the producer’s surplus
is $3.
- Now suppose the MC of producing the 100th unit was $3 then the
producer surplus would be $1
Market Supply
Price
Product price
$4
PS
Output
For Practice
Consumer Surplus Vs Producer Surplus
Market Equilibrium
- Thus far we have discussed Market Demand and Market Supply.
- Before we move forward a brief refresher on Market Demand:
Market Equilibrium
- We are now ready to understand how the shifts in demand and
supply work.
- But first let’s look at a simple demand and supply graph:
Shifts in Demand
- Caused by an external factor impacting utility.
- A shift is not a movement on a demand curve.
- We can expect both prices and quantities to respond in unison.
Shifts in Supply
- Caused by external shocks to supply.
Eg: In agriculture, think weather shocks, etc.
Shifts in both Demand & Supply
Adjustments to Market Equilibrium
Market Surplus
Vs
Market Shortage
S
D
Surplus
𝑃𝑆
𝑃𝑒
𝑃𝑑
Shortage
𝑄𝑑
𝑄𝑒
𝑄𝑠
Adjustment to the Market Equilibrium
- Below the market equilibrium / clearing price: Quantity demanded is
more than quantity supplied. So we would have a shortage.
- Above the market equilibrium / clearing price: Quantity supplied is
more than quantity demanded. So we would have a shortage.
- Eventually we expect the prices and quantities to return to the
equilibrium
Homework 7
Q: Consider the beef market, where currently demand and supply is
relatively stable. However, due to production problems the supply
decreases. Also, after the supply decrease, the government restricts
the total quantity of beef in the market, which is lower than the new
equilibrium. Draw the market movements in a graph and label all prices
and quantities.
Market Equilibrium: Imperfect Competition
- Upto this point we have assumed that conditions required for perfect
equilibrium exist in the market place.
- In reality, the economy does not consist of perfectly competitive
firms.
- In this chapter we will examine several forms of imperfect
competition.
Market Equilibrium: Imperfect Competition
- We now tread into concepts such as:
1. Monopolistic Competition.
2. Monopoly.
3. Oligopoly.
Market Structure Characteristics
1.
2.
3.
4.
The number and size distribution of sellers and buyers.
The degree of product differentiation.
The extent of the barriers to entry.
The economic environment within which the industry operates.
First 3 much more important.
Number of Firms & Size Distribution
- Competitive conditions break down when the number of firms
declines.
- The prices are less likely to set by the forces of supply and demand.
- Greater market concentration as firms decline.
Product Differentiation
- Refers to the extent buyers in the market perceive of the
differentiation in the product.
- If the buyers perceive the product to be identical, then the product is
said to be homogenous.
- In a homogenous market, a seller has difficulty in setting a high price.
- Because products supplied are identical, buyers have little incentive in
paying for higher prices.
Barriers to Entry
- Forces that make it difficult for firms to enter the market.
- Some barriers are created by existing firms.
Four common barriers to entry:
1.
2.
3.
4.
Absolute unit cost – advantages.
Economies of scale.
Capital Access and cost.
Preferential government policies.
Before we move on…
Brief refresher on conditions for perfect competition:
1. All firms sell an identical (homogenous) product.
2. All firms are price-takers, they cannot control the market price of
their product.
3. All firms have a relatively small market share.
4. The industry is characterized by free entry and exit of firms
Monopolistic Competition
- Conditions of monopolistic competition basically mirror those of perfect
competition, with one key difference.
- Monopolistic competition occurs when products in the market are
differentiated.
- The differentiation in the product gives some flexibility in pricing the
product.
- A monopolistic competition becomes a price taker if it can effectively
differentiate its product in the market, when others in the market are
offering similar products.
- Classic example in agriculture: Farm input manufactures advertising to
promote branded hybrid seeds.
Monopolistic competition
- While monopolistic competition allows producers to set prices.
- The extent of it, depends on the degree of product differentiation.
- Therefore, you’ll notice that all producers are desperately trying to
differentiate their product through advertisements.
- Eg: Think attack Ads as well.
Monopolistic competition: Specifics
- Cost structure of firms monopolistic competition is same as perfect
competition.
- No new firms allowed to enter in the short-run.
- However, product differentiation allows for downward sloping
demand and marginal revenue.
- In perfect competition demand and marginal revenue were flat.
-
Price
Quantity
15
0
14
2
13
4
12
6
11
8
10
10
9
12
8
14
7
16
6
18
5
20
4
22
3
24
2
26
1
28
0
30
Total Revenue
Marginal Revenue
-
Price
Quantity
Total Revenue
Marginal Revenue
15
0
0
14
2
28
14
13
4
52
12
12
6
72
10
11
8
88
8
10
10
100
6
9
12
108
4
8
14
112
2
7
16
112
0
6
18
108
-2
5
20
100
-4
4
22
88
-6
3
24
72
-8
2
26
52
-10
1
28
28
-12
0
30
0
-14
Monopolistic Competition: Short-run
Equilibrium
- Output determined at the point where marginal cost = marginal
revenue.
- Price determined through demand curve.
- Profit: Area between price and ATC (average total cost)
Monopolistic competition: Short-run
- Graphs
Monopolistic competition: Long-run
- Entrants allowed.
- Profits lowered.
- Demand curve shifts downwards.
- Monopolistic competition inefficient than perfect competition.
Long-run: Graphs
Homework: 8
Price
Quantity
Total
Revenue
Total Cost
17
0
14
2
20
11
4
24
8
6
25
5
8
27
2
10
29
0
12
31
Marginal
Revenue
Marginal
cost
1. Find output of monopolistic firm? (For that you need marginal revenue and marginal
cost)
2. Graph everything: indicate output point, demand and marginal revenue curve, finally
indicate profit area?
Oligopoly
- Similar to monopolistic competition with one key difference.
- There are few sellers.
- Each of which is large enough to have an influence on the market volume
and price.
- Differentiating the product is still the objective of an oligopolist.
- Oligopolists have what is known as market power.
Oligopoly: continued
- If an oligopolist tries to raise its price, then there is no reason for other
oligopolies to follow.
- If an oligopolist attempts to lower its price, then the other firms will immediately
retaliate.
- Oligopolies emerge because of thin markets or barriers to entry.
- Price leadership occurs in oligopolies, where one firm leads and other set prices
accordingly.
- Classic example: airline industry.
Oligopoly: continued
- Creates opportunities for collusion amongst firms.
- But this does not necessarily occur.
- Mergers and Acquisitions another common feature of oligopolies.
(One of the reason oligopolies are formed).
- Most recent example: Merger of AT&T and Time Warner.
- Important points to remember:
1) If an oligopolist reduces prices, then other oligopolists in the market
will follow suit because they do not want to be undercut in the
market.
2) However, if 1 oligopolist increases his price, then it is not necessary
that others follow the leader, since the rest might be eyeing a
higher market share.
Monopoly
- At the opposite end of perfect competition is monopoly.
- Only 1 seller in the market.
- Number one reason for monopolies to exist: barriers to entry.
Classic example: Microsoft, only recognizable broad social network.
Monopoly: continued
- A monopoly is similar to an oligopoly, except that a monopolist does
not have to worry about retaliation.
- Monopoly prices are usually higher. Should make sense, it has no
competition.
- If input costs increase, monopolies can easily pass that cost to the
consumer.
- However, in practice monopolists don’t want keep prices too high, to
discourage entry into the market.
Goal of a monopoly  to remain a monopoly
Graphs:
Unlike monopolistic competition, monopolies realize profits even in the
long-run.
Summary table: Imperfect competition
Item
Perfect
Competition
Monopolistic
Competition
Oligopolies
Monopolies
Number of sellers
Numerous
Many
Few
One
Ease of Entry or exit
Unrestricted
Unrestricted
Partially restricted
Restricted absolute
Ability to set price
None
Some
Yes
Absolute
Long-run profits
None
None
Yes
Yes
Product differentiation
None
Yes
Yes
Product is unique
Examples:
Corn producers
Soft-drink bottlers
Airline Industry
Microsoft
Consumer and Producer Surplus in imperfect
competition
Consumer and Producer Surplus in Imperfect
Competition
Imperfect Competition in Buying
1. Monopsony
2. Oligopsony
3. Monopsonistic Competition
Imperfect Competition in Buying
- Upto this point we have considered imperfect competition in selling
activities.
- Imperfect competition can influence the market price for resources
used in production.
- Eg: Think of a single grain elevator in a region, on which several
farmers are dependent for selling their grain.
Monopsony
- Buyer’s monopoly is basically known as a monopsony.
- A monopsonist is the only buyer in the market and therefore faces
and faces an upward sloping market input supply curve.
- As a consequence, its buying decisions affect input prices.
Monopsony
- The monopsonist typically considers the marginal input cost of
purchasing an additional unit of resource.
- Marginal input cost: is defined as the change in the cost of a resource
used in production as more of this resource is employed.
Monopsony: Example
Units of variable
input
Price per unit
1
$3.00
2
3.50
3
4.00
4
4.50
5
5.00
6
5.50
7
6.00
8
6.50
9
7.00
10
7.50
Total cost of input
Marginal input
cost
Monopsony: Example
Units of variable
input
Price per unit
Total cost of input
Marginal input
cost
1
$3.00
3
2
3.50
7
4
3
4.00
12
5
4
4.50
18
6
5
5.00
25
7
6
5.50
33
8
7
6.00
42
9
8
6.50
52
10
9
7.00
63
11
10
7.50
75
12
Graphical analysis
Understanding the relationship of Marginal Revenue Product (MRP),
supply of input and marginal cost of input (MIC)
The case of sole buyer and sole seller
Eg: Consider the case of a meat packer, who is the only buyer of beef
cattle in the region and the only one supplying packaged beef to
restaurants.
What is the profit maximizing level of input?
Graphical Analysis
MIC
Supply of input
𝑃𝑃𝐶
𝑃𝑀𝑃𝐶
𝑃𝑃𝐶𝑀
𝑃𝑀𝑀
MVP
MRP
𝑃𝑀𝑃𝐶
𝑄𝑃𝐶𝑀
𝑄𝑀𝑀
𝑄𝑃𝐶
Notation for graph
-
𝑃𝑀𝑀 , 𝑄𝑀𝑀  monopsonist buyer, monopoly seller.
𝑃𝑃𝐶 , 𝑄𝑃𝐶  perfect competition buyer and seller.
𝑃𝑀𝑃𝐶 , 𝑄𝑀𝑃𝐶  perfect competition in selling and monopsonist buyer.
𝑃𝑃𝐶𝑀 , 𝑄𝑃𝐶𝑀  perfect completion in buying and monopoly seller.
Oligopsony and Monopsonistic Competition
- Oligopsony: Few buyers instead one one.
- Monopsonistic Competition: Several buyers but differentiated
services.
Monopoly: Ceiling price
- Federal regulations force lower price.
- Quantity in market increases.
- Profit of monopolist lowered
Graph: Monopoly ceiling price
Monopoly: Lump-sum Tax
- Profit of monopoly lowered again because of the tax.
- Higher ATC than before causes lower profits.
- Quantity remains the same.
Graph: Lump-sum Tax
Monopsony: Minimum Price
Graph:
Chapter 11
Product Markets & National Output
- National Economy.
- Gross Domestic Product.
- Consumption, Savings and Investment
Circular Flow of Payments
- Barter Economy: In which households and businesses exchange
goods and services as a means for paying for their purchases.
- Since there is no money to pay to serve as a medium for exchange.
- Households/businesses barter amongst themselves to obtain goods and
services.
- Problem with barter economy?
- Random question: When was money invented?
- Study of money is known as?
Circular Flow of Payments
- Barter Economy: In which households and businesses exchange
goods and services as a means for paying for their purchases.
- Since there is no money to pay to serve as a medium for exchange.
- Households/businesses barter amongst themselves to obtain goods and
services.
- How would that work?
- Problem with barter economy?
- Random question: When was money invented?
- Study of money is known as: Numismatics
Monetary Economy
- When there is “money” in the economy, households/businesses now
receive money for the services rendered/goods exchanged.
- Typically businesses receive “money” for the goods and services
provided to household
National Income
𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
= 𝒘𝒂𝒈𝒆𝒔 + 𝒓𝒆𝒏𝒕𝒔 + 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
+ 𝒑𝒓𝒐𝒇𝒊𝒕𝒔 𝒂𝒄𝒄𝒓𝒖𝒊𝒏𝒈 𝒕𝒐 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒓𝒆𝒔𝒐𝒖𝒓𝒄𝒆 𝒐𝒘𝒏𝒆𝒓𝒔
- The monetary value of the products flowing to households through
the product markets represents the national product.
This is how a domestic economy works
Quick Announcement
Syllabus for the final exam:
6,7,8,9, 12 (partial)
Not 11!
Composition & Measurement of GDP
GDP : Gross Domestic Product
Two approaches:
(1) – Expenditures approach  activity in the product market.
(2) - Income Approach  activity in the resources market.
GDP
GDP =
Total Consumption + Gross Private Domestic Investment +
Government purchases of goods and services +
Net exports of goods and services