Introduction to Economics
Introduction to Economics ECON 101
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Firms Objective The economic goal of the firm is to maximize economic profits Profit Total revenue Total cost As a measure of cost economists use opportunity cost opportunity cost Explicit costs Implicit costs 0 Explicit costs require a direct outlay of money by the firm a Implicit costs do not require an outlay of money by the firm economic profit Total Revenue Opportunity Cost accounting profit Total Revenue Explicit Costs Probem Suppose the farmer had to invest 1 million to open his farm which otherwise he could have deposited in a bank to earn 50000 a year interest In addition he had to give up another job that would have paid him 30000 a year H May 30 2007 111 Production Function Boring Inc makes brooms and then sells them doorto door Here is the relationship between the number of workers and output in a given day Workers Output Marginal Product NomwaHo gt x M O 155 marginal product the increase in output that arises form an additional unit of input diminishing marginal product the property whereby the marginal product of an input declines as the quantity of the input increases I H May 30 2007 211 Various Measures of Cost Workers Q FC VC TC AFC AVC ATC MC 0 O NomwaH gt x M O 155 fixed costs costs that do not vary with the qnty of output produced variable costs costs that do vary with the qnty of output produced average fixed costs fixed costs divided by the qnty of output average variable costs variable costs divided by the qnty of output marginal costs the increase in total cost that arises from an extra unit of production I H May 30 2007 3 11 Various Measures of Cost Cont Production function Totalcost curve MEI m 21 mm g mu 3 o g BEIEI an 2 E 2 sun en 1 AEIEI 4n 2U 3mm 1 a 2n 12m MEI 1 n EU EU WEIEI Quantity of Output 2 3 A 5 Number ofWorkers M ay 3072007 4 11 Various Measures of Cost Cont Cost Curves Various Measures of Cost Cont Things to have in mind about the cost curves 0 MC eventually rises with the quantity of output 0 ATC curve is U shaped 0 MC curve crosses the ATC at the minimum of average total cost When MC is less than the ATC ATC is falling When MC is greater than ATC average total cost is rising Short run vs Long run in the long run all the costs are variable I May 30 2007 611 Competitive Market Perfectly competitive market 0 There are many buyers and sellers in the market a The goods offered by the various sellers are largely the same 0 Firms can freely enter or exit the market Note buyers and sellers are price takers I May 30 2007 1 11 Revenue of a Competitive Firm Quantity Price TR AR MR 8 155 average revenue total revenue divided by the quantity sold marginal revenue the change in total revenue from an additional unit sold For a competitive firm average revenue and marginal revenue equal the price of the good I May 30 2007 8 11 Profit Maximization Quantity TR TC Profits MR MC Change in Profit 0 0 200 20 160 300 8 500 300 50 400 400 8 333 467 90 720 500 8 250 555 120 960 600 8 333 467 140 1120 700 8 500 300 150 1200 800 8 1000 200 155 1240 900 8 2000 1200 Profit maximization occurs equals marginal cost 0 When MR gt MC increase Q a When MR lt MC decrease Q 0 When MR MC profit is maximized at the quantity where marginal revenue Be careful of the units of measurement I May 30 2007 9 11 Short Run vs Long Run Short Run In the short run the firm can choose to shutdown not produce anything during a specific period of time because of market conditions 0 Shut down ifTR lt VC 0 Shut down ifTRQ lt VCQ 0 Shut down if P lt AVC Long Run In the long run the firm can choose to exit the market ie leave the market 0 Exit ifTR lt TC 9 Exit ifTRQ lt TCQ 9 Exit if P lt ATC The short run supply curve is the MC curve above the AVC The long run supply curve is the MC curve above the ATC I m H May 30 2007 10 11 Outline of the rest Market Supply Note the firms are identical a Short run market supply curve with a fixed number of firms b Long run market supply with entry and exit c Dynamics in the market a shift in demand in the short run and long run May 30 2007 3911 1 11 Marginal Utility Theory of Household Behavior When the theory of consumer behavior was rst developed an approach different from the indif ference curve analysis was utilized Economists measured the satisfaction that a person received from a unit of a commodity as the quotutilityquot or amount of psychological pleasure that commodity provided the consumer Say you consume 10 units of a commodity per month the total utility you receive is simply the sum of the utilities the total psychic pleasure received for each unit Say however that you39ve been consuming 10 units of something and you decide to consume one unit more the addition to total utility brought about by consuming one more unit is the marginal utility of the commodity DO NOT CONFUSE TOTAL AND MARGINAL UTILITY ltlt If you had to choose between giving up totally one of the following which would you choose water or the movies gtgt The movies naturally since your total utility from water is in nitely higher than that from movies ltlt However what if you had the choice of taking one extra bath per month or attending one extra movie per month which would you choose gtgt Probably the movie since the addition to total utility would likely be larger in the case of an extra movie even though the total utility of water is very high HERE WE RE COMPARING MARGINAL UTILITIES TAiMarginal Utility Lecturele Lecture on the Marginal Utility Theory of Demand Page 1 Basic hypothesis of utility theory the utility that any household derives from successive units of a particular commodity will diminish as its total consumption of the commodity increases the consumption of all other commodities being held constant ltlt How might we picture this gtgt Quantity on one axis total utility on the other ltltThe total utility curve is upward sloping is it straight or does it bendgtgt Bends downward E 5 72 2 MU0 slope of Total Utility Curve at Qo 0 Q Q0 5 5 E E U MU slope a oftotal utility b 2 cm we Additional consumption beyond Q0 reduces total utility Q Q0 ltltHow might we nd marginal utility of an extra unitgtgt Pick a point on the graph and determine how much of an increase in total utility there is if we increase consumption by one Can plot another graph with quantity and marginal utility on the axis Note that when the total utility curve becomes at the marginal utility curve hits zero TAiMarginal Utility Lecturelwp Lecture on the Marginal Utility Theory of Demand Page 2 Each point on the marginal utility curve represents the slope of a corresponding point on the total utility curve ltltWould you expect that if the hypothesis of diminishing marginal utility holds that the consumer will pay less for each additional unit consumedgtgt Yes Now we assume that the household wants to maximize utility total utility how might they go about this 1 Consumption of any free good will be pushed to the point at which its marginal utility is zero 2 For goods which are not free the household maximizing its utility will so allocate its expenditure between commodities that the utility of the last dollar spent on each is equal In our two commodity world this implies MUL Pf PC Or the household consumes enough of each commodity so that the marginal utility per dollar of the last unit consumed is equal for all goods consumed ltltWhat would happen if the two ratios were not equalgtgt The household could increase its welfare by reallocating consumption away from the low ratio to the high ratio Now by cross multiplying we can rewrite our equality conditions as PL ML PCMUC TAiMarginal Utility Lecturelwp Lecture on the Marginal Utility Theory of Demand Page 3 ltltDoes this look familiargtgt Yes looks like our equilibrium condition in indifference curve analysis So indifference curve theory and marginal utility theory propose exactly the same condi tions for utility maximization Digression Baumol and Blinder don t like the concept of measuring the consumer s pleasure in terms of utils or some other measure of psychic bliss so they convert marginal utility units to money terms by asking the following question Suppose Joe is deciding whether or not to buy a piece of pizza what is the maximum price he s willing to pay for that rst piece Let s say that he s willing to pay 600 The value to Joe of this marginal piece ofpizza is 600 Now suppose that he s only willing to pay 5 for the second piece and 4 for the third piece and he s not willing to pay anything for the 11th piece Then we could draw Joe s marginal utility curve in dollar terms as Marginal Utility in Q11 Then Joe s total utility in dollar terms would simply be the area under his marginal utility curve With this way of looking at things Joe will consume pizza until his marginal utility in dollars equals zero That is equivalent to saying as we have done above that he consumes pizza until MUFIZZH MUotherood Ppizza Potherood 39 TAiMarginal Utility Lecturelwp Lecture on the Marginal Utility Theory of Demand Page 4 11 Derivation of the Consumer39s Demand Curve Assume that F is an index of all other goods and we want to determine what the demand curve for clothing will look like if the price of clothing changes Assume that the consumer is in equilibrium and that PC falls The equilib rium condition no longer holds gt f ltltHow can we bring the consumer back into equilibriumgtgt To restore equilib rium the consumer must buy more clothing so that because of diminishing MU MUc falls If the price of clothing is cut in half consumption of clothing must rise and possibly consumption of other commodities must fall until the ratio of marginal utilities is again equated to the price ratio this leads to the basic prediction of demand theory THE LA W 0F DEMAND A rise in the price ofone commodity with income and the prices of all other commodities constant will lead to a decrease in the quantity of the commodity demanded by each household ltltDoes the slope of the demand curve depend upon total utilitygtgt No it depends upon the marginal utility over the relevant range of consumption this we would expect from our indifference curve analysis where total utilities are never mentioned 12 DiamondWater Paradox ltltWhy should water the total utility of which is so high have a lower price than diamonds which have practically no quotuse valuequotgtgt Because the exchange value of TAiMarginal Utility Lecturelwp Lecture on the Marginal Utility Theory of Demand Page 5 something is determined by the intersection of supply and demand curves water is relatively plentiful so that although total utility from consumption is high the marginal utility of the last unit is low If supply of water is tight enough price might get very high I remember a science ction story about the man who had the air concession on Mars ltltHow do diamond producers keep the price up gtgt ltltAre diamonds a good investmentgtgt P Price of water in gt quotquotquotquotquot quot the desert Dem and Curve for Water Observed price of Demand Curve diamonds forDiarnondS Observed price of water Price of diamonds when plentiful Q TAiMarginal Utility Lecturele Lecture on the Marginal Utility Theory of Demand Page 6