Chapter 6

Markets in Action

Supply Reduction: 1

• Suppose a twister destroyed half the homes in Ames. How would the market respond?
  • The demand for housing may fall if people leave Ames to live elsewhere.
  • The supply of housing falls initially but then begins to increase as:
    • new construction takes place
    • people rent rooms in response to higher market prices.

• How long would it take the market to adjust ?

Supply Reduction: 2

• The supply curve for housing would initially shift to the left and then begin to move back to the right.

Supply Reduction: 3

Suppose the Government feels that the higher price, P1, of housing in Ames is too high and places a ceiling on rents. How will this affect the market adjustments?

Black Markets

• Black markets refers to illegal trading activity in which buyers and sellers try to avoid price ceilings or rationing.
  • Sugar and gasoline in WWII.
  • Cigarettes in countries with high cigarette excise taxes.

Black markets are very difficult to control or avoid when government prices levels are substantially different from market price levels.

Persistent Shortages

• Ceiling price = the maximum price sellers are allowed to charge.
  • Suppose the Govt. of Indonesia sets the ceiling price of rice below the equilibrium price.
    • There will be a persistent shortage of rice.

Rice Shortages

• How will people respond to persistent shortages of rice in Indonesia?
  • Lone lines waiting for rice.
  • Govt. employees demand priority.
  • Firms pay employees in rice.
  • Quality of rice falls.
  • Govt. takes over other marketing operations.
  • Farmers produce less rice.
  • Rice imports increase.

By setting ceiling prices below the equilibrium price, the Govt. sets the stage for further intervention in the production and marketing of rice.

Persistent_ Surpluses

• Floor price = a legalized minimum price a product can be sold at.
  • Suppose the USDA sets the price of corn at $5.00 a bushel when the equilibrium price is $3.00.
    • There will be a persistent surplus of corn.

Corn Surpluses

• Suppose the USDA becomes a corn buyer. It spends Pf(Qs - Qd) on the surplus corn it buys.
• What does it do with the corn?
  • Store it?
  • Give it away?
  • Subsidize feeding programs?
  • Destroy it?
  • Sell it at a loss?

Price Controls

• When the Government controls prices, they no longer serve as accurate signals to guide production and exchange.
• It is costly for markets to respond to the restrictions of price controls.
• People pay for price controls
  • higher prices on other products
  • market inefficiencies
  • additional government expenditures results in higher taxes.

Minimum Wages

• Minimum wages create unemployment if they are above the market equilibrium wage rates.

Equilibrium Changes

• Suppose the cost of making tires fell. What would happen to :
  • Supply of tires?
  • Demand for tires?
  • Equilibrium price of tires?
  • Demand for automobiles?

Sales Tax: 1

• The impact of a sales tax depends on the characteristics of supply and demand.

Sales Tax: 2

• If supply is highly elastic the consumer pays most of the sales tax.

Illegal Drugs: 1

• Suppose we try to discourage drug sales by placing high penalties on drug dealers.

Illegal Drugs: 2

• What if we placed high penalties on drug buyers?

Role of Inventories

• Inventories help stabilize market prices.

Inventories

• When the Government builds_ inventories to stabilize prices
  • taxpayers pay the cost
  • efficient producers receive the benefits
  • consumers may benefit
• Stabilizing farm prices does not necessarily stabilize farm revenue.

Chapter 7

Utility and Demand

Market Demand

• Market Demand is the sum of individual demands.

Budget Constraint: 1

• We assume that an individual has a fixed income and is a price taker. This gives us a budget constraint of:

Y = PAQA + PBQB

Budget Constraint: 2

• Suppose that :

Y = 1000 PA = 5 PB = 10

then

1000 = 5QA + 10QB

Preferences

• Utility is the benefit a person gets from consuming a good or service.
• Total Utility is the total benefit a person gets from the consumption of goods and services.
• Marginal Utility is the ² in total utility resulting from a one unit change in the consumption of a good or service.

Utility Declines

• Diminishing Marginal Utility -- MU is positive but diminishes as the consumption of a good increases.

Total Utility

• The total utility received from consuming a product increases but at a diminishing rate.

Consumer Equilibrium

• The consumer maximizes utility when the marginal utility per dollar spent is the same for all goods.

Utility Predictions

• The higher the price of a good:
  • the less of the good purchased
  • the greater the purchases of substitutes for the good
• The higher the consumer's income, the greater the quantity demanded of normal goods.

Consumer Surplus: 1

• The value of a good is the maximum price the consumer is willing to pay for it.
• The amount actually paid for a unit of a good is its price.
• Consumers Surplus is the difference between value and price.

Consumer Surplus: 2

• With Diminishing Marginal Utility, the consumer places higher value on the first units consumed than on the last units.
• The price is based on the last units consumed.
• Thus the consumer always has some consumers surplus.

Consumer Surplus: 3

• Consumers surplus is measured by the area of the triangle ABC.

Paradox of Value

• Why do we pay so little for water which is essential for life and so much for diamonds?

The MU of an additional unit is low for water and high for diamonds -- BUT the MU per dollar spent on diamonds and water is the same.

Chapter 8

Preferences & Choices

Consumption Choices

• Consumption choices are limited by both income and prices. We assume that

Expenditures = Income

Y0 = PAQA + PBQB

Price Changes

• As the price of Good A falls, the budget line rotates to the right.

Income Changes

• As income increases the budget line moves outward -- to the right.

Utility Function

• A Utility Function shows the relationship between the utility and the consumption levels of goods and services.

U = f(QA, QB)

Indifference Curve

An Indifference Curve shows all of the combinations of goods A and B that provide the consumer with the same level of satisfaction.

MRS

The Marginal Rate of Substitution is the rate at which a person will give up Good A to get more of Good B and at the same time remain indifferent.

• MRS is measured by the slope of the indifference curve.
• It is the ratio of the marginal utilities of Goods A & B.

Perfect Substitutes

• If Goods A & B are perfect substitutes, their MRS is the same along any indifference curve.

Perfect Complements

• If Goods A & B are perfect complements there is only one combination that will be consumed at each indifference level.

Maximizing Utility: 1

• The consumer tries to maximize utility subject to the amount of income available.

Maximizing Utility: 2

• Graphically, utility is maximized at Point A.

Maximizing Utility: 3

• As income increases, the consumer will purchase more of normal goods.

Maximizing Utility: 4

• If the price of Good A declines, the consumer will consume more of Good A and less of Good B.

Demand Curve

• Points A & B represent points on a demand curve for Good A.

at PA0 QA0 = Y0/PA0

at PA1 QA1 = Y0/PA1

Price Effect

• The Price Effect is the sum of the income and substitution effects.

Substitution Effect

• The Substitution Effect is the increase in demand due to the change in relative prices with real income held constant.

Income Effect: 1

• The Income Effect is the increase in demand at the new prices due to an increase in real income.

Income Effect: 2

• For a Normal Good the
  • substitution effect is positive
  • income effect is positive
• For an Inferior Good the
  • substitution effect is positive
  • income effect is negative

Labor Supply: 1

• We can use utility theory to analyze how people allocate their time.

Labor Supply: 2

• Now let's add the work/leisure indifference curves to our diagram.

Labor Supply: 3

• To obtain the labor supply curve, we plot hours worked against the wage rate.

Labor Supply: 4

• The higher wage rate has both a substitution_ and income effect.

As the wage rate increases, the opportunity cost of an hour of leisure increases. This substitution_ effect encourages more work.

• As the wage rate increases, real income increases. This income effect encourages the consumption of more leisure.

At some point, the income effect is likely to outweigh the substitution effect. At this point, further increases in wages will result in reductions in the hours worked.

Key Concepts

• Indifference Map
• Budget Line
• MRS
• Price Effect
• Income Effect
• Substitution Effect
• Relative Prices
• Marginal Utility

Chapter 9

Organizing Production

Firms' Problems

• They lack information
  • about the past
  • about the present
  • about the future.
• Principal-Agent Problem
  • How to get employees (agents) to act in the best interest of the employer (principal).

Principal-Agent Problem

• Ways to reduce the extent of the principal-agent problem include:
  • Ownership
    • Provide employees with part ownership of the firm.
  • Incentives
    • Bonuses
    • Profit Sharing
    • Long-term contracts
• Economists have not found a perfect solution to the principal-agent problem.
  • It exists in a wide variety of economic situations
    • Insurance
    • Bank Loans

Forms of Businesses

• Proprietorship
  • Single owner
  • Unlimited liability
• Partnership
  • Two or more owners
  • Unlimited liability
• Corporation
  • One or more owner
  • Limited liability

Business Finance

• Loans (Short-term Debt)
  • Are by far the most important source of money for firms
• Bonds (Long-term Debt)
  • Were used widely during the 1980's to replace stock financing of firms.
• Stock (Equity)
  • This is a relatively unimportant source of financing for firms.
  • The large amount of trade in old stock does not result in new revenue for the firms whose stock is traded.

Future Value

• The Future Value (FV) of an investment a year from now is:

FV = Present Value + r(Present Value)

= (1 + r)(Present Value)

• where r is the rate of return on the present value of the investment.
• The rate of return can be either positive or negative.

Present Value: 1

If we know the future value (FV) a year from now and the rate of return (r) on the present value, we can calculate the present value of the investment.

PV = FV/ (1+r)

The conversion of a future value to a present value is called discounting.

Present Value: 2

• When the discount rate is r, the present value of FV2 two years from now is:

PV2 = FV2 / (1+r)2

• This can be generalized to n years from now using the formula:

PVn = FVn / (1+r)n

Present Value: 3

• The present value of a stream of returns is equal to:

PV = ( FVt / (1+r)t )

• where the sum is over the time period t = 0, ..., n
• In other words, the present value of a stream or returns over n years is the sum of the annual present values.

Economic Cost

• Economic Cost = full opportunity cost of producing a good.
• Explicit Costs = accounting costs of inputs.
• Implicit Costs = opportunity costs not included in explicit costs.

For example, you start a company but you don't pay yourself any wage. Your labor input has an opportunity cost which is an implicit cost of production.

Cost of Capital

• There are two costs associated with capital investments:
  • Economic Depreciation = the change in market price of capital over time.
    • This is different from the accountant's definition of depreciation which is based on IRS rules.
  • Interest Cost
    • Borrowed money has an explicit interest cost.
    • If the firm's funds are used to make the investment, there is an opportunity cost associated with the investment funds.

Economic Profit

• Economic Profit = Total Revenue minus Total Economic Cost.
  • If Economic Profit is zero, there is no incentive for a firm to change anything.
• Accounting Profit = Total Revenue minus Total Explicit Costs.
  • A firm may have a positive accounting profit and a negative economic profit.

"True Costs"

Many firms ignore their economic costs. They may show a profit for the IRS to tax, but they would be better off using their resources in other ways.

Why Firms?

• Firms exist if and when they can do things more efficiently than markets.
  • By internalizing transactions, firms may have lower transaction costs than markets.
  • The technology of production may result in economies of scale in production.
  • There may be economies of bringing together "production teams."

Chapter 10

Output and Costs

Profit Maximization

• We assume that firms want to maximize profits. In doing so, they face two types of constraints.
  • Market Constraints
    • These affect input and output prices.
  • Technology Constraints
    • There is a maximum output that can be produced from any given combination of inputs.

Time Frames

• Short-run = a period of time in which at least one input is fixed.
• Long-run = is a period of time in which all inputs can be varied.

In theory, we can firm maximize profits in either the short-run or long-run. The short-run fixed costs do not affect output or price decisions.

Cost Minimization

• For production efficiency, the firm tries to maximize output for a given expenditure on inputs.

Maximize

Isocost Line

• The isocost line shows all of the input combinations that generate the same level of cost.

Isocost Map

• There is an isocost line for every cost level.

Isoquant

• An isoquant shows all the combinations of inputs that give the same level of output.

Isoquant Map

• There is an isoquant for every level of output.

Least Cost: 1

• For a given TC0 and input prices, the firm minimizes the cost of production by equating

MPL / MPK = PL / PK

Least Cost: 2

• Another way to state the least cost condition is:

MPL / PL = MPK / PK

i.e. The extra output per dollar spent on labor must be equal to the extra output per dollar spent on capital.

Total Product

• The total product (TP) of Input X is the maximum output attainable as the quantity of X increases with other inputs fixed.

Marginal Product

• The Marginal Product of Input X is the ² in TP resulting from a ² in Input X, with other inputs held constant.

MPx = ²Q / ²X

• The Average Product of Input X is the TP divided by the quantity of X.

APX = TP / X

APX & MPX

• Both the APX and MPX increase at first and then decline.
• MPX equals APX when APX is at its maximum.

Diminishing Returns

• The Law of Diminishing Returns states that:

As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.

Total Cost

• Total Cost (TC) is the sum of the costs of all inputs used in production by a firm.

TC = TFC + TVC

• Total Fixed Cost (TFC) is the cost of the fixed inputs.
• Total Variable Cost (TVC) is the cost of the variable inputs.

Average Cost

• Average Cost (AC) is equal to total cost divided by the level of output, Q.

AC = TC / Q

= TFC / Q + TVC / Q

= AFC + AVC

• Marginal Cost (MC) is the ² in total cost resulting from a ² in Input X.

MC = ²TC / ²X

Total Cost Curves

• In the short-run we have three "total" cost curves.

TC TFC TVC

Average Cost Curves

• In the short-run we have three "average" cost curves.

AC AFC AVC

Cost Curve Shifts

• The cost curves will shift if:
  • technology changes alter the production function
  • or there are changes in the input prices.
• Cost & Production are related.
  • As MPX increases MC falls.
  • As MPX falls MC increases.
  • As APX increases AVC falls.
  • As APX falls AVC increases.

Production Function

• A Production Function is the relationship between the maximum output attainable and the quantities_ of all inputs used.

Returns to Scale

• Returns to Scale are the increases in output that result from increasing all inputs by the same %.
  • Constant Returns to Scale --- the % increase in Q is equal to the % increase in inputs.
  • Increasing Returns to Scale -- the % increase in Q exceeds the % increase in inputs.
  • Decreasing Returns to Scale -- the % increase in Q is less than the % increase in inputs.

Long-Run AC

The Long-run Average Cost curve (LRAC) traces the relationship between the lowest attainable ATC and output when all inputs are varied.

Economies of Scale

• A firm may experience economies (or diseconomies) of scale due to:
  • Changes in factor prices as output changes.
  • Returns to Scale

Long-Run Costs

• All costs are variable in the long-run.
• The level of output at which LRAC is a minimum is an important determinate of market structure.

If the minimum LRAC output is small relative to total market output, the industry is more likely to have more firms and a higher degree of competition.