ECON201 Week 5 notes ONLINE w/ Professor Stephen Haynes
ECON201 Week 5 notes ONLINE w/ Professor Stephen Haynes ECON201 Online, Stephen Haynes
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This 12 page Class Notes was uploaded by Kathryn Sternberger on Thursday February 5, 2015. The Class Notes belongs to ECON201 Online, Stephen Haynes at University of Oregon taught by Stephen Haynes in Winter2015. Since its upload, it has received 149 views.
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ECON201 Week 5 Chapter 7 Consumer Choice 6 questions on Exam Two Introduction The theory of consumer choice based on the idea that consumers will maximize their level of satisfaction or utility given the constraints dictated by their income and the prices of consumer goods Every point on a demand curve represents the best affordable choice for a consumer at a particular price Traditional utility theory which is the assertion that every action generates a benefit and a cost It is probably apparent that when evaluating consumer choice marginal costbenef1ts will also be important Utilitarian logic will be used to explain the law of demand and the negatively sloped demand curve Recent findings in neuroscience that contribute to understanding consumer choice Neuroscientists findings support utilitarian thought 71 Traditional Consumer Choice Utility Theory 9 A consumer on a fixed budget wants to find the best combination of movies and books he she can purchase to maximize utility satisfaction Consumer Constraints the budget line 0 A consumer s ability to purchase is limited by income in this example we assume that the consumer in question has an income of 27 pmonth With the price of movies being 3 and books being 1 see figure 71 pg 154 o All the points within the shaded triangle are possible given income and price but do NOT exhaust the while all the points on the budget line exhaust the budget meaning she would be using all 27 9 the budget line is included in the budget set set of affordable combinations of two goods 0 The budget line illustrates the combinations of two goods a consumer CAN buy while the demand curve illustrates the amount of ONE good a consumer is WILLING and able to buy KNOW THE DIFFERENCE Total Marginal Utility 0 Consumer objective maximize utility satisfaction 0 Total Utility vs Marginal utility see figure 72 pg 156 I Total utility shows the relationship between the number of movies watched or any good service and total utility satisfaction I Total satisfaction increases but at a decreasing rate with the number of movies watched I Marginal Utility shows that the marginal utility from each movie decreases as the number of movies increases focuses on the satisfaction gained by each individual movie not satisfaction as a whole I The shape of utility curves illustrate the law of diminishing marginal utility don t get confused remember what we learned about the law of diminishing returns involve that concept to what we are looking out now I The law of diminishing marginal utility which means the rst unit of a product will generate the most satisfaction satisfaction will decrease with each additional unit acquired so satisfaction increases at a decreasing rate gt This law of diminishing marginal utility is responsible for the negative slope of the marginal utility line see pg 156 gure 73 The marginal Principle and the Equimarginal Rule 0 Employing the marginal principle a consumer picks the quantity of a product at which the marginal bene t of the product equals its marginal cost gt Consumers pick the combination of two activities where the marginal utility bene t per dollar for the rst activity equals the marginal utility bene t per dollar for the second activity This satisfies the equimarginal rule taken directly from Professor Haynes checklist The equimarginal rule states pick the combination of two activities where the marginal bene t per dollar for the rst activity equals the marginal bene t per dollar fro the second activity 9 The math of all this stuff 0 0 To compute the marginal cost of a movie we use the principle of opportunity cost the opportunity cost is what you sacri ce to get it Law of diminishing returns tells us that the marginal bene t decreases as the number of movies increases continuing with the prior example So for a consumer who purchases books and movies the number of books sacrificed per movie equals the price of movies divided by the price of books Books per movie Pm price of movies Pb price of books So if pm3 and pbl then movies are three times more expensive than books the consumer sacri ces three books per movie seen in utility terms the marginal cost a movie equals the number of books sacrificed times the marginal utility of books lost per book Mathematically it looks like this MCmoviePm X MUb MCmarginal cost Pb MUmarginal utility Conditions for Utility Maximization 0 Utility is maximized when the chosen bundle of goods satis es the following two conditions 1 Equimarginal rule 2 Affordability the money spent on the two goods adds up to the xed budget for the two goods meaning it is on the budget line 0 See page 158 gure 74 for a graphic illustration of maximization o What happens when the logic of the equimarginal rule is violated I The consumer could increase utility by shifting the budget in favor of the good with a higher marginal utility 71 The Law of Demand and the Individual Demand Curve Effect of a Decrease in Price 0 Decrease in price increases marginal utility o The curve shifts upward gure 75 pg 161 o The decrease in price of one good means that the original utility maximization point now violates the equimarginal rule 0 The logical consumer would relocate the budget in favor of the other good Income and Substitution Effects of a Decrease in Price 0 Substitution Effect From the books example a decrease in the price of movies decreases the price of movies relative to the price of books causing the consumer to substitute movies for books I The original utility maximization point will change the consumer will shift to purchase more movies because the utility of movies has increased now that the price has decreased 0 Income Effect A decrease in the price of movies increases the consumer s real income purchasing power and the consumer will buy more of all normal goods including movies I The consumer moves downward along the movie curve until the additional amount of income is spent in the books example 6 9 It really helps to see the graph on these things gure 76 pg 162 The individual Demand Curve 9 Application A revenue neutral gasoline tax 0 Fed gov t imposes a tax of 3 per gallon of gas 0 Combined with a cut in income taxes so total tax revenue does not change 0 How will the tax effect gas consumption I Assuming that the change in tax will have no effect on gas consumption is faulty I The previous logic would be ignoring the substitution effect of a price change I Though a taxpayer could still afford the amount of gas they had purchased before with the tax the marginal utility p gallon of gas will decrease and so the original bundle of goods is no longer the best combination I Revenue neutral gas tax would decrease gas consumption Chapter 8 Production Technology and Cost 9 Learn the relationship between quantity of output and the cost of production 9 Production cost is determined by production technology 9 Distinguish between short run and long run 9 How firms use short term and long run cost curves to make decisions 81 Economic Cost and Economic Profit A firms objective is to maximize economic profit Economic profit total revenue economic cost Total revenue price punit X quantity sold if a firm charges each consumer the same price Remember the principle of opportunity cost the opportunity cost of something is what you sacrifice to get it Economic cost opportunity cost There are two kinds of costs 0 Explicit costs a monetary payment I Examples labor cost capital material ect o Implicit costs the opportunity cost that does not involve monetary payment I Examples entrepreneur s time entrepreneur s funds Application l A study of Canadian workers showed that the lower the wage of a worker the more likely they were to become an entrepreneur This is completely logical because the lower the wage made in paid employment the lower the opportunity cost of starting your own business You don t have as much to loose Economic cost explicit cost implicit cost Accounting cost is much simpler O 0 They ignore implicit costs so Accounting cost explicit cost Accounting pro t then Accounting pro t total revenue accounting cost Accounting pro t is always higher than economic pro t Accounting cost is always lower than economic cost For the purposes of this book and this class I presume when cost and pro t are mentioned it is referring to economic cost and economic profit 82 A rm with a xed production facility shortrun costs The book uses the example of a small business producing plastic paddles for rafts using molds Production and marginal product take a look at g 81 pg 188 0000 O A single worker yields 1 paddle pday Two workers yield 5 paddles pday The marginal product of labor between 1 and 2 workers 4 paddles Marginal product of labor the change in output from one additional unit of labor Total product curve the relationship between quantity of output and quantity of labor I Shows effects of labor specialization AND diminishing returns I In gure 81 diminishing returns occurs for 3 or more workers Why does productivity increase when rm increases workforce I Less time between tasks I Increase pro ciency at tasks Why does diminishing returns occur here I Workers increase but production facility are held constant I Each worker gets a smaller share of the production facility and therefore at a certain point end up spending time waiting Short run total cost 9 Let s look at the relationship between output and production cost 0 Fixed cost FC cost that doesn t vary with the quantity produced I Examples the facility building the molds for the paddles 0 Variable cost VC cost that varies with the quantity produced I Examples the workers perhaps the plastic o Shortrun total cost TC the total cost of production when at least one input is xed equal to xed cost plus variable cost TC FC VC 9 Let s try this ourselves Opportunity cost of your time is 50 pday Hire workers at rate of 50 pday Purchase workshop amp building for 365000 Your interest rate you could have earned on that money was 10 pyear the opportunity cost taking that money out of savings and using it is 36500 pyear or 100 pday VVVV Have your book open to page 189 Table 82 If TC FC VC For one worker TC 100 50 TC 150 9 If you look at the table you can nd the input numbers you need for the formula Fixed cost is column 3 and total cost is column 5 average total cost is already computed for us in the table as well which helps to check your answer if you need to when you try these out in column 8 Looking to gure 82 on page 190 o Shortrun cost show the relationship between the quantity of output and production costs Shortrun total cost equals xed cost plus variable cost The horizontal line on the graph xed cost The lower curve represented by the grey color VC The upper curve represented by the blue color TC The vertical distance between TC and VC the rms xed cost notice that this distance remains the same at each level of output OOOOO Short Run Average Cost 0 Average fixed cost AFC xed cost divided by quantity produced AFC E Q For one worker m so AFC 100 1 For two workers m so AFC 50 2 0 Average Variable Cost AVC variable cost divided by quantity produced AFC E Q For two workers so AVC 20 5 9 NOTICE gt For small quantities of output the AVC decreases as the quantity produced increases negatively sloped curve 339 Because of specialization gt For large quantities of output the AVC increases and as output increases positively sloped curve 339 Because of diminishing returns 0 Short Run average total cost ATC cost divide by the quantity produced equal to AFC plus AVC ATC EEVCAFCAVC Q Q Q 9 It s a good idea to look at gure 83 on pg 191 0 Why are they Ushaped I Tug of war between spread of xed costs and diminishing returns 0 Shortrun ATC and AVC are Ushaped curves 0 As quantity produced increases xed costs are spread over more and more units pushing down the AVC 0 As quantity increases diminishing returns pulls up average total cost 0 ATC is negatively sloped at 10 paddles why I Spreading of xed costs I Labor specialization Shortrun marginal cost 0 Change in short run total cost resulting from a one unit increase in output 0 000000 MC Change in TC Change in Q One worker produces 1 paddle per day at a cost of 50 Two workers produce 5 paddles per day at a marginal cost of 50 The marginal increase in product is 4 paddles 50 so MC 1250 4 Marginal cost decreases as output increases why I Labor specialization I Productivity Specialization decreases marginal cost Figure 84 pg 192 MC has a negative slope for small quantities specialization MC has a positive slope for large quantities diminishing returns MC intersects the ATC curve at the minimum point of average cost When MC is less than ATC then ATC is decreasing When MC is greater than ATC then ATC is increasing When MC is equal to ATC then ATC is neither rising nor falling this is where the ATC and MC curve intersect 9 Look at the GPA example on p6 193 if you are confused about this concept you may nd it helpful I didn t nd it particularly helpful in increasing my understanding of the above material but perhaps you will Application 2 OOOOOOO Think of a firm with 10 shovels One shovel p worker Wage is 12 hour Takes 2 hours to dig one hole MC of 1St hole dug is 24 First 10 holes MC will remain constant After 10 holes we will see the principle of diminishing returns 83 Productions and Cost in the Long Run Long run period of time over which a firm is perfectly exible in its choice of inputs 0 The key difference is that with longrun we don t see diminishing returns because there is capability of expansion Longrun total cost LTC total cost of production when a firm is perfectly exible in choosing inputs Replication O 0000 0 Still utilizing the paddle example Say we decide we want to double our output We can build another facility identical to the original Identical facility output and workforce Doubling output with replication doesn t change longrun AVC because cost increases proportionately with output Constant returns scale a situation in which the longrun total cost increases with output so average cost is constant gt Longrun AC LAC is sloped downward for up to 10 paddles and then is held constant In general replication means longrun total cost will increase proportionately with quantity produced so AVC remains constant Expansion 0 Build one single larger workshop that is capable of producing twice the output as the original at a much lower cost than the original 9 Longrun marginal cost LMC O 0 Change in longrun cost resulting from a oneunit increase in output Increase in cost when a firm can change production facility as well as workforce Reducing output with indiVisible outputs O O 0 Say we want to decrease output from 10 paddles to 5 We might guess that TC would be cut in half this isn t the case We still need the same space we used for 10 paddles still need the same mold we used for 10 paddles capital cost doesn t get cut in half so TC doesn t get cut in half either AC of producing 5 paddles pday will actually exceed the AC of producing 10 pday IndiVisible outputs an input that cannot be scaled down to produce a smaller quantity of output Examples of indiVisible outputs pg 196 I Railroad tracks I Large ships for shipping company I Blast furnace for steel company I Xray CAT scan machines Scaling down and labor specialization 0 Another reason for an increase in LAC for a smaller operation is l A decrease in specialization 2 A decrease in continuity and proficiency 3 An increase in time between tasks Economies of Scale o A situation in which LAC of production decreases as output increases 0 Minimum efficient scale the output at which scale economies are exhausted 0 Once minimum ef ciency scale average cost no longer decreases as output increases Diseconomies of Scale 0 De ned as A situation in which the longrun average cost of production increases as output increases A positively sloped longrun average cost LAC indicates the presence of diseconomies of scale This occurs for two reasons 1 Coordination problems gt A large organization requires more meetings reports administrative work activities ect If an increase in the rm s output requires additional layers of management the longrun averagecost curve My be positively sloped 2 Increasing input costs gt When a form increases his output it will demand more of its inputs and My be forced to pay higher prices from some of these inputs 339 Example expanding construction rm may be forced to pay higher wages to attract more workers An increase in wages or a decrease in productivity could cause a positively sloped LAC curve 0 Firms recognize possibility of diseconomies of scale and adopt strategies to avoid them Example 3M a global tech company They make a conscience effort to keep production units as small as possible to keep the exible When a production unit gets too large the company breaks it apart Actual Longrun Average Cost Curves 0 Why is the typical longrun averagecost curve Lshaped Longrun average cost curves are negatively sloped for small quantities of output because economies of scale are resulting from indivisible inputs and labor specialization As output increases the average cost curve eventually becomes horizontal and remains that way for a long range of output Over the horizontal portion of the curve increases in inputs lead to proportionate increase in output so the average cost does not change LAC is constant Shortrun versus longrun average cost 0 So why is the shortrun average cost curve Ushaped while the typical longrun averagecost curve is Lshaped I For small inputs the shortrun curve is positively sloped because of diminishing returns decrease in productivity and increase in marginal cost I If a rm increases output while holding at least one input xed average cost will be pulled down I The difference between short and long run is a rms exibility in choosing inputs Application 3 0 Cost of producing the rst berglass whale is 16000 0 Every whale after that would be 5000 0 The marginal cost decreases as the number of whales increases 84 Examples of Production Cost 9 Actual production costs for several products Scale Economies in Wind Power 0 Energy turbines I Large turbines are initially more expensive than the small ones but the higher cost is offset by its generating capacity I Scale economies the good kind occur because the cost of installing and maintaining wind turbines increases less than proportionately with the turbines generating capacity I Large turbine has 4 times the generation capacity of the mall ones see table 85 on page 200 Average Cost of a Music Video 0 Music video is an information good large rst copy price and then a very low marginal cost after that 0 First cost of typical music video is 223000 Marginal cost of reproduction is tiny to zero 0 See gure 87 pg 201 the AverageCost Curve for an Information good I Averagecost curve is negatively sloped I Gets closer and closer to the horizontal axis as the quantity distributed increases I Gap decreases as the xed production cost is spread over a large number of copies 0 Solar vs Nuclear The Crossover o In 1998 the cost of solar power was almost triple the cost of nuclear energy 0 Recent innovations for solar energy has pushed the cost p kwh down While an increase in the capitol cost of nuclear reactors have increased 0 The cost gap has eliminated the cost of solar power and is roughly the same as the unit cost of nuclear power 0 Table 86 on page 202 is helpful for de nitions and equations